Financial Institutions (FISI) 10-Q 2021 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

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

For the quarterly period ended              June 30, 2021            

or

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

For the transition period from ________ to ________

Commission File Number:     000-26481     

Financial Institutions, Inc.

(Exact name of registrant as specified in its charter)

New York	16-0816610
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
220 LIBERTY STREET, WARSAW, New York	14569
(Address of principal executive offices)	(Zip Code)

(585) 786-1100

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Securities Exchange Act of 1934:

Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common stock, par value $0.01 per share	FISI	Nasdaq Global Select Market

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 every Interactive Data File required to be submitted 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 such files). Yes  ☑    No  ☐    

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer	☐	Accelerated filer	☑
Non-accelerated filer	☐	Smaller reporting company	☐
		Emerging growth company	☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

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

The registrant had 15,841,929 shares of Common Stock, $0.01 par value, outstanding as of July 31, 2021.

FINANCIAL INSTITUTIONS, INC.

Form 10-Q

For the Quarterly Period Ended June 30, 2021

TABLE OF CONTENTS

		PAGE
PART I.	FINANCIAL INFORMATION
ITEM 1.	Financial Statements
	Consolidated Statements of Financial Condition (Unaudited) - at June 30, 2021 and December 31, 2020	3
	Consolidated Statements of Income (Unaudited) - Three and six months ended June 30, 2021 and 2020	4
	Consolidated Statements of Comprehensive Income (Unaudited) - Three and six months ended June 30, 2021 and 2020	5
	Consolidated Statements of Changes in Shareholders’ Equity (Unaudited) - Three and six months ended June 30, 2021 and 2020	6
	Consolidated Statements of Cash Flows (Unaudited) - Six months ended June 30, 2021 and 2020	8
	Notes to Consolidated Financial Statements (Unaudited)	9
ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	44
ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk	64
ITEM 4.	Controls and Procedures	65
PART II.	OTHER INFORMATION
ITEM 1.	Legal Proceedings	66
ITEM 6.	Exhibits	67
	Signatures	68

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PART I. FINANCIAL INFORMATION

ITEM 1.      Financial Statements

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Financial Condition (Unaudited)

(Dollars in thousands, except share and per share data)	June 30, 2021			December 31, 2020
ASSETS
Cash and due from banks	$	206,387		$	93,878
Securities available for sale, at fair value		902,845			628,059
Securities held to maturity, at amortized cost (net of allowance for credit losses of $6 and $7, respectively) (fair value of $226,044 and $282,035, respectively)		218,858			271,966
Loans held for sale		3,929			4,305
Loans (net of allowance for credit losses of $46,365 and $52,420, respectively)		3,585,803			3,542,718
Company owned life insurance		102,257			100,895
Premises and equipment, net		43,572			40,610
Goodwill and other intangible assets, net		74,262			73,789
Other assets		157,189			156,086
Total assets	$	5,295,102		$	4,912,306
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing demand	$	1,121,827		$	1,018,549
Interest-bearing demand		799,299			731,885
Savings and money market		1,796,813			1,642,340
Time deposits		941,282			885,593
Total deposits		4,659,221			4,278,367
Short-term borrowings		—			5,300
Long-term borrowings, net of issuance costs of $1,244 and $1,377, respectively		73,756			73,623
Other liabilities		74,999			86,653
Total liabilities		4,807,976			4,443,943
Shareholders’ equity:
Series A 3% preferred stock, $100 par value; 1,533 shares authorized;    1,435 shares issued		143			143
Series B-1 8.48% preferred stock, $100 par value; 200,000 shares authorized; 171,486 and  171,847 shares issued, respectively		17,149			17,185
Total preferred equity		17,292			17,328
Common stock, $0.01 par value; 50,000,000 shares authorized; 16,099,556 shares issued		161			161
Additional paid-in capital		125,253			125,118
Retained earnings		356,485			324,850
Accumulated other comprehensive (loss) income		(5,934	)		2,128
Treasury stock, at cost – 257,627 and 57,630 shares, respectively		(6,131	)		(1,222	)
Total shareholders’ equity		487,126			468,363
Total liabilities and shareholders’ equity	$	5,295,102		$	4,912,306

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Income (Unaudited)

(In thousands, except per share amounts)	Three months ended June 30,						Six months ended June 30,
	2021			2020			2021			2020
Interest income:
Interest and fees on loans	$	36,393		$	35,197		$	73,452		$	72,057
Interest and dividends on investment securities		4,498			4,538			8,685			9,120
Other interest income		61			24			88			235
Total interest income		40,952			39,759			82,225			81,412
Interest expense:
Deposits		2,165			4,677			4,400			11,696
Short-term borrowings		—			284			119			1,176
Long-term borrowings		1,055			617			2,117			1,235
Total interest expense		3,220			5,578			6,636			14,107
Net interest income		37,732			34,181			75,589			67,305
(Benefit) provision for credit losses		(4,622	)		3,746			(6,603	)		17,661
Net interest income after (benefit) provision for credit losses		42,354			30,435			82,192			49,644
Noninterest income:
Service charges on deposits		1,287			480			2,579			2,067
Insurance income		1,147			819			2,543			2,168
Card interchange income		2,194			1,776			4,152			3,378
Investment advisory		2,886			2,251			5,658			4,497
Company owned life insurance		693			462			1,350			927
Investments in limited partnerships		238			(244	)		1,093			(31	)
Loan servicing		91			50			188			57
(Loss) income from derivative instruments, net		(592	)		1,940			1,283			2,686
Net gain on sale of loans held for sale		790			612			1,868			864
Net (loss) gain on investment securities		(3	)		674			71			895
Net gain (loss) on other assets		153			(1	)		148			63
Net gain (loss) on tax credit investments		276			(40	)		191			(80	)
Other		1,030			934			2,025			2,132
Total noninterest income		10,190			9,713			23,149			19,623
Noninterest expense:
Salaries and employee benefits		14,519			15,074			28,984			30,088
Occupancy and equipment		3,286			3,388			6,668			7,144
Professional services		1,603			1,580			3,498			3,732
Computer and data processing		3,460			2,699			6,581			5,372
Supplies and postage		430			517			914			1,070
FDIC assessments		480			539			1,245			911
Advertising and promotions		436			545			760			1,100
Amortization of intangibles		266			287			537			581
Other		2,464			1,946			4,497			4,247
Total noninterest expense		26,944			26,575			53,684			54,245
Income before income taxes		25,600			13,573			51,657			15,022
Income tax expense		5,400			2,441			10,747			2,763
Net income	$	20,200		$	11,132		$	40,910		$	12,259
Preferred stock dividends		366			366			731			731
Net income available to common shareholders	$	19,834		$	10,766		$	40,179		$	11,528
Earnings per common share (Note 4):
Basic	$	1.25		$	0.67		$	2.53		$	0.72
Diluted	$	1.25		$	0.67		$	2.52		$	0.72
Cash dividends declared per common share	$	0.27		$	0.26		$	0.54		$	0.52

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Unaudited)

(Dollars in thousands)	Three months ended June 30,						Six months ended June 30,
	2021			2020			2021			2020
Net income	$	20,200		$	11,132		$	40,910		$	12,259
Other comprehensive income (loss), net of tax:
Securities available for sale and transferred securities		5,002			1,741			(9,400	)		13,847
Hedging derivative instruments		(501	)		(388	)		1,063			(297	)
Pension and post-retirement obligations		137			233			275			467
Total other comprehensive income (loss), net of tax		4,638			1,586			(8,062	)		14,017
Comprehensive income	$	24,838		$	12,718		$	32,848		$	26,276

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

Three and six months ended June 30, 2021 and 2020

(Dollars in thousands, except per share data)	Preferred Equity			Common Stock		Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Loss			Treasury Stock			Total Shareholders’ Equity
Balance at December 31, 2020	$	17,328		$	161	$	125,118		$	324,850		$	2,128		$	(1,222	)	$	468,363
Comprehensive income:
Net income		—			—		—			20,710			—			—			20,710
Other comprehensive loss, net of tax		—			—		—			—			(12,700	)		—			(12,700	)
Common stock issued		—			—		3			—			—			298			301
Purchases of common stock for treasury		—			—		—			—			—			(5,963	)		(5,963	)
Purchases of 8.48% preferred stock		(6	)		—		—			—			—			—			(6	)
Share-based compensation plans:
Share-based compensation		—			—		216			—			—			—			216
Restricted stock units released		—			—		(446	)		—			—			446			—
Cash dividends declared:
Series A 3% Preferred-$0.75 per share		—			—		—			(1	)		—			—			(1	)
Series B-1 8.48% Preferred-$2.12 per    share		—			—		—			(364	)		—			—			(364	)
Common-$0.27 per share		—			—		—			(4,272	)		—			—			(4,272	)
Balance at March 31, 2021	$	17,322		$	161	$	124,891		$	340,923		$	(10,572	)	$	(6,441	)	$	466,284
Comprehensive income:
Net income		—			—		—			20,200			—			—			20,200
Other comprehensive income, net of tax		—			—		—			—			4,638			—			4,638
Purchases of common stock for treasury		—			—		—			—			—			(1	)		(1	)
Purchases of 8.48% preferred stock		(30	)		—		(7	)		—			—			—			(37	)
Share-based compensation plans:
Share-based compensation		—			—		562			—			—			—			562
Restricted stock awards issued		—			—		(223	)		—			—			223			—
Stock awards		—			—		30			—			—			88			118
Cash dividends declared:
Series A 3% Preferred-$0.75 per share		—			—		—			(1	)		—			—			(1	)
Series B-1 8.48% Preferred-$2.12 per    share		—			—		—			(365	)		—			—			(365	)
Common-$0.27 per share		—			—		—			(4,272	)		—			—			(4,272	)
Balance at June 30, 2021	$	17,292		$	161	$	125,253		$	356,485		$	(5,934	)	$	(6,131	)	$	487,126

Continued on next page

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited) (Continued)

Three and six months ended June 30, 2021 and 2020

(Dollars in thousands, except per share data)	Preferred Equity		Common Stock		Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Loss			Treasury Stock			Total Shareholders’ Equity
Balance at December 31, 2019	$	17,328	$	161	$	124,582		$	313,364		$	(14,513	)	$	(1,975	)	$	438,947
Cumulative-effect adjustment		—		—		—			(8,719	)		—			—			(8,719	)
Balance at January 1, 2020	$	17,328	$	161	$	124,582		$	304,645		$	(14,513	)	$	(1,975	)	$	430,228
Comprehensive income:
Net income		—		—		—			1,127			—			—			1,127
Other comprehensive income, net of tax		—		—		—			—			12,431			—			12,431
Purchases of common stock for treasury		—		—		—			—			—			(196	)		(196	)
Share-based compensation plans:
Share-based compensation		—		—		332			—			—			—			332
Restricted stock units released		—		—		(469	)		—			—			469			—
Cash dividends declared:
Series A 3% Preferred-$0.75 per share		—		—		—			(1	)		—			—			(1	)
Series B-1 8.48% Preferred-$2.12 per    share		—		—		—			(364	)		—			—			(364	)
Common-$0.26 per share		—		—		—			(4,164	)		—			—			(4,164	)
Balance at March 31, 2020	$	17,328	$	161	$	124,445		$	301,243		$	(2,082	)	$	(1,702	)	$	439,393
Comprehensive income:
Net income		—		—		—			11,132			—			—			11,132
Other comprehensive income, net of tax		—		—		—			—			1,586			—			1,586
Share-based compensation plans:
Share-based compensation		—		—		369			—			—			—			369
Restricted stock awards issued		—		—		(272	)		—			—			272			—
Stock awards		—		—		(19	)		—			—			114			95
Cash dividends declared:
Series A 3% Preferred-$0.75 per share		—		—		—			(1	)		—			—			(1	)
Series B-1 8.48% Preferred-$2.12 per    share		—		—		—			(365	)		—			—			(365	)
Common-$0.26 per share		—		—		—			(4,164	)		—			—			(4,164	)
Balance at June 30, 2020	$	17,328	$	161	$	124,523		$	307,845		$	(496	)	$	(1,316	)	$	448,045

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Unaudited)

(Dollars in thousands)	Six months ended June 30,
	2021			2020
Cash flows from operating activities:
Net income	$	40,910		$	12,259
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,931			3,950
Net amortization of premiums on securities		2,452			1,378
(Benefit) provision for credit losses		(6,603	)		17,661
Share-based compensation		778			701
Deferred income tax expense (benefit)		2,333			(1,663	)
Proceeds from sale of loans held for sale		42,767			31,504
Originations of loans held for sale		(40,523	)		(33,070	)
Income on company owned life insurance		(1,350	)		(927	)
Net gain on sale of loans held for sale		(1,868	)		(864	)
Net gain on investment securities		(71	)		(895	)
Net gain on other assets		(148	)		(63	)
Noncash restructuring charges against assets		11			—
Decrease (increase) in other assets		2,950			(36,571	)
(Decrease) increase in other liabilities		(14,620	)		16,772
Net cash provided by operating activities		30,949			10,172
Cash flows from investing activities:
Purchases of available for sale securities		(411,641	)		(121,622	)
Purchases of held to maturity securities		(1,830	)		(4,761	)
Proceeds from principal payments, maturities and calls on available for sale securities		70,596			59,228
Proceeds from principal payments, maturities and calls on held to maturity securities		54,288			53,282
Proceeds from sales of securities available for sale		51,891			29,631
Net loan originations		(37,523	)		(276,409	)
Purchases of company owned life insurance, net of proceeds received		(12	)		(7	)
Proceeds from sales of other assets		2,459			482
Purchases of premises and equipment		(6,284	)		(2,375	)
Cash consideration paid for acquisition, net of cash acquired		(759	)		—
Net cash used in investing activities		(278,815	)		(262,551	)
Cash flows from financing activities:
Net increase in deposits		380,854			438,333
Net decrease in short-term borrowings		(5,300	)		(170,200	)
Repurchase of preferred stock		(43	)		—
Purchases of common stock for treasury		(5,964	)		(196	)
Cash dividends paid to common and preferred shareholders		(9,172	)		(8,895	)
Net cash provided by financing activities		360,375			259,042
Net increase in cash and cash equivalents		112,509			6,663
Cash and cash equivalents, beginning of period		93,878			112,947
Cash and cash equivalents, end of period	$	206,387		$	119,610

See accompanying notes to the consolidated financial statements.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1.) BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations

Financial Institutions, Inc. (the “Company”) is a financial holding company organized in 1931 under the laws of New York State (“New York”). The Company provides diversified financial services through its subsidiaries, Five Star Bank, SDN Insurance Agency, LLC (“SDN”), Courier Capital, LLC (“Courier Capital”) and HNP Capital, LLC (“HNP Capital”). The Company offers a broad array of deposit, lending and other financial services to individuals, municipalities and businesses in Western and Central New York through its wholly-owned New York chartered banking subsidiary, Five Star Bank (the “Bank”). The Bank also has indirect lending network relationships with franchised automobile dealers in the Capital District of New York and Northern and Central Pennsylvania. SDN provides a broad range of insurance services to personal and business clients. Courier Capital and HNP Capital provide customized investment management, investment consulting and retirement plan services to individuals, businesses, institutions, foundations and retirement plans.

Basis of Presentation

The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The accounting and reporting policies conform to U.S. generally accepted accounting principles (“GAAP”). Certain information and footnote disclosures normally included in financial statements prepared in conformity with GAAP have been condensed or omitted pursuant to such rules and regulations. However, in the opinion of management, the accompanying consolidated financial statements reflect all adjustments of a normal and recurring nature necessary for a fair presentation of the consolidated statements of financial condition, income, comprehensive income, changes in shareholders’ equity and cash flows for the periods indicated and contain adequate disclosure to make the information presented not misleading. These consolidated financial statements should be read in conjunction with the Company’s 2020 Annual Report on Form 10-K for the year ended December 31, 2020. The results of operations for any interim periods are not necessarily indicative of the results which may be expected for the entire year.

Operational, Accounting and Reporting Impacts Related to the COVID-19 Pandemic

The COVID-19 pandemic has negatively impacted the global economy, including our operating footprint of Western and Central New York. In response to this crisis, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was passed by Congress and signed into law on March 27, 2020. The CARES Act provided an estimated $2.2 trillion to fight the COVID-19 pandemic and stimulate the economy by supporting individuals and businesses through loans, grants, tax changes, and other types of relief. Some of the provisions applicable to the Company include, but are not limited to:

• Accounting for Loan Modifications - The CARES Act provided that a financial institution may elect to suspend (1) the application of GAAP for certain loan modifications related to COVID-19 that would otherwise be categorized as a troubled debt restructuring (“TDR”) and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes.

• Paycheck Protection Program - The CARES Act established the Paycheck Protection Program (“PPP”), an expansion of the Small Business Administration’s (“SBA”) 7(a) loan program and the Economic Injury Disaster Loan Program (“EIDL”), administered directly by the SBA. On December 27, 2020, the Consolidated Appropriations Act, 2021 provided approximately $284 billion for PPP loans in an additional round of funding under the program and extended the PPP through March 31, 2021. This additional round of PPP loan funding is authorized for first-time borrowers and for second draws by certain borrowers who have previously received PPP loans.  On March 30, 2021, the PPP Extension Act of 2021 was signed into law, which extended the program to May 31, 2021.

• Mortgage Forbearance - Under the CARES Act, a borrower with a federally backed mortgage loan that is experiencing financial hardship due to COVID-19 may request a forbearance through September 30, 2021.

Also, in response to the COVID-19 pandemic, the Board of Governors of the Federal Reserve System (“FRB”), the Federal Deposit Insurance Corporation (“FDIC”), the National Credit Union Administration (“NCUA”), the Office of the Comptroller of the Currency (“OCC”), and the Consumer Financial Protection Bureau (“CFPB”), in consultation with the state financial regulators (collectively, the “agencies”) issued a joint interagency statement (issued March 22, 2020; revised statement issued April 7, 2020). Some of the provisions applicable to the Company include, but are not limited to:

• Accounting for Loan Modifications - Loan modifications that do not meet the conditions of the CARES Act may still qualify as a modification that does not need to be accounted for as a TDR. The agencies confirmed with FASB staff that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or insignificant delays in payment.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1.) BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

• Past Due Reporting - With regard to loans not otherwise reportable as past due, financial institutions are not expected to designate loans with deferrals granted due to COVID-19 as past due because of the deferral. A loan’s payment date is governed by the due date stipulated in the legal agreement. If a financial institution agrees to a payment deferral, these loans would not be considered past due during the period of the deferral.

• Nonaccrual Status and Charge-offs - During short-term COVID-19 modifications, these loans generally should not be reported as nonaccrual or as classified.

Effective March 23, 2020 through July 9, 2020, for consumer customers, the Bank waived early CD penalty fees for withdrawals up to $20,000 (limited to one penalty-free withdrawal per CD account); eliminated all insufficient funds (overdrafts) and returned item fees; eliminated all Pay by Phone fees; waived all late fees; offered the opportunity for monthly mortgage, home equity loan or home equity line payment relief; offered the opportunity to defer unsecured consumer loans or lines of credit and secured consumer loans and lines of credit payments; and offered unsecured personal loans up to $5,000, up to 60 months at 2.95% APR subject to credit approval. ATM access fees were reinitiated on September 19, 2020.

As part of the first round of PPP loans we have helped more than 1,700 customers obtain more than $270 million in loans as of December 31, 2020. Of those loans, we have helped customers complete the forgiveness process for approximately $183 million of loans in the first six months of 2021. Also, during the first six months of 2021, we have helped customers obtain approximately $107 million of new PPP loans under the second round of the PPP. Additionally, as of June 30, 2021, approximately 3% of our commercial loan and mortgage customers, 1% of our residential real estate loans and lines customers and less than 1% of our indirect loans customers have active payment deferrals, in accordance with the previously noted loan modifications under the CARES Act or agencies guidelines.

Reclassifications

Certain reclassifications of previously reported amounts have been made to conform to the current year presentation. Such reclassifications did not impact net income or shareholders’ equity as previously reported.

Use of Estimates

The preparation of these financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Material estimates relate to the determination of the allowance for credit losses, the carrying value of goodwill and deferred tax assets, and assumptions used in the defined benefit pension plan accounting.

Cash Flow Reporting

Supplemental cash flow information is summarized as follows for the six months ended June 30 (in thousands):

	2021		2020
Supplemental information:
Cash paid for interest	$	8,148	$	18,545
Cash paid for income taxes		7,100		959
Noncash investing and financing activities:
Real estate and other assets acquired in settlement of loans		—		646
Accrued and declared unpaid dividends		4,638		4,259
Common stock issued for acquisition		301		—
Assets acquired and liabilities assumed in business combinations:
Fair value of assets acquired		449		—

- 10 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1.) BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Recent Accounting Pronouncements

In 2017, the United Kingdom’s Financial Conduct Authority (“FCA”), who is responsible for regulating the London Interbank Offered Rate (“LIBOR”), announced its intention that it would no longer be necessary to persuade or compel its panel banks to submit LIBOR rates after December 31, 2021. On March 5, 2021, the ICE Benchmark Administration (“IBA”), the administrator of LIBOR, released the results of its consultation on the cessation timeline for certain LIBOR tenors. In coordination with the IBA, the FCA also confirmed when certain LIBOR tenors will cease to exist. The results of the consultation indicated that certain LIBOR tenors (overnight, one-month, three-month, six-month, and twelve-month USD LIBOR) will be extended to June 30, 2023 to allow some legacy contracts that cannot be easily amended to mature on their current terms. Notwithstanding the extension of certain LIBOR tenors to 2023, banks may no longer offer new LIBOR-based contracts after December 31, 2021. Given that LIBOR is a widely used pricing index for loan and derivative contracts, a Company-wide initiative was introduced to assess all LIBOR exposures through the Company’s loan, deposit, borrowing and derivative categories, while developing a plan for the ultimate cessation of the index. In developing the transition plan, the Company has followed best practice recommendations from the Federal Reserve’s Alternative Reference Rate Committee, our third-party derivative advisor and the Internal Swaps and Derivatives Association. To date, the Company has identified the portion of loan notes that reference LIBOR, which are primarily representative of commercial relationships. Additionally, the Company has 1 designated derivative instrument that is utilized to hedge the LIBOR characteristic of a future dated borrowing (i.e. Federal Home Loan Bank Advance). In 2015, the Company issued $40 million in fixed to floating rate subordinated notes that currently bear a fixed rate of interest at 6.00% until April 2025, when the rate converts to a floating rate equal to three-month LIBOR plus 3.944%; the indenture under which the notes were issued includes language allowing an alternate index to be applied in the event that LIBOR becomes unavailable at the floating rate determination date. At this time, no other borrowing or deposit relationships have been identified that utilize LIBOR as an index.

In March 2020, the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The ASU provides temporary optional expedients and exceptions to GAAP guidance on contract modifications and hedge accounting to ease the financial reporting burdens of the expected market transition from LIBOR and other interbank offered rates to alternative rates, such as SOFR. ASU 2020-04 became effective during the first quarter of 2020 and applies to contract modifications and amendments made as of the beginning of the reporting period including the ASU’s issuance date, March 12, 2020, through December 31, 2022. The adoption of this guidance in 2020 resulted in the application of certain practical expedients, which did not have a material effect on the Company's consolidated financial statements

In January 2021, the FASB issued ASU No. 2021-01, Reference Rate Reform (Topic 848): Scope. The ASU clarifies that certain optional expedients and exceptions in ASC 848 for contract modifications and hedge accounting apply to derivatives that are affected by the discounting transition. The ASU also amends the expedients and exceptions in ASC 848 to capture the incremental consequences of the scope clarification and to tailor the existing guidance to derivative instruments affected by the discounting transition. ASU 2021-01 was effective upon issuance and applies through December 31, 2022. The Company is in the process of determining which optional expedients to elect, if any, as well as the timing and application of those elections. At this time, the Company does not expect any elections to have a significant impact on its financial statements.

(2.) BUSINESS COMBINATIONS

2021 Activity

On February 1, 2021, SDN completed the acquisition of the assets of Landmark Group (“Landmark”), an independent insurance brokerage firm. Consideration for the acquisition included common shares of Company stock and cash. As a result of the acquisition, SDN recorded goodwill of $611 thousand and other intangible assets of $399 thousand. The goodwill and other intangible assets are expected to be deductible for income tax purposes. The allocation of acquisition cost to the assets acquired and liabilities assumed and pro forma results of operations for this acquisition have not been presented because the effect of this acquisition was not material to the Company’s consolidated financial statements.

On August 2, 2021, SDN completed the acquisition of the assets of an employee benefits and consulting firm.  The consideration for the acquisition, deductibility of acquired assets for income tax purposes, allocation of acquisition cost to the assets acquired and liabilities assumed and pro forma results of operations for this acquisition have not been presented because the effect of this acquisition was not material to the Company’s consolidated financial statements.

2020 Activity – No Activity

- 11 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(3.) RESTRUCTURING CHARGES

On July 17, 2020, the Bank announced management’s decision to adapt to a full-service branch model to streamline retail branches to better align with shifting customer needs and preferences. The transformation resulted in 6 branch closures and a reduction in staffing. The announcement was the result of a nine-month comprehensive assessment of all lines of business and functional areas, conducted in partnership with a leading process improvement organization. The data-driven analysis identified, among other things, overlapping service areas, automation opportunities and streamlining of processes and operations that would enhance customer experiences and facilitate the long-term sustainability of current and future branches. The announced consolidations represented about 10 percent of the branch network and impacted approximately 6 percent of the total Company workforce. Where possible, those impacted were offered alternative roles or the opportunity to apply for open positions in other areas of the Company. Separated associates received a comprehensive severance package based on tenure.

In October 2020, the Company announced the planned closure of 1 additional branch that closed in January 2021. This location was not included in the branch consolidations announced in July, as alternative options were being considered and consolidation was not possible given its significant distance from other Bank branches.

The Company incurred total pre-tax expense related to the branch closures of approximately $1.7 million, including approximately $0.2 million in employee severance, $0.5 million in lease termination costs and $1.0 million in valuation adjustments on branch facilities. The Company recognized all of these expenses during 2020. The Company expects $0.8 million of total costs will result in future cash expenditures. The Company anticipates annual expense savings of approximately $2.7 million as a result of these branch closures.

The Company incurred 0 restructuring charges during the six months ended June 30, 2021 and 2020.

The following table represents the changes in the restructuring reserve (in thousands):

	Three months ended June 30,					Six months ended June 30,
	2021			2020		2021			2020
Balance at beginning of period	$	1,161		$	—	$	1,245		$	—
Restructuring charges		—			—		—			—
Cash payments		(68	)		—		(146	)		—
Charges against assets		(5	)		—		(11	)		—
Balance at end of period	$	1,088		$	—	$	1,088		$	—

In contemplation of the transactions noted above, certain long-lived assets have met the held for sale criteria as of June 30, 2021. The Company reclassified $1.1 million from premises and equipment, net to other assets on the consolidated statement of financial condition as of June 30, 2021. NaN long-lived assets were reclassified as held for sale as of December 31, 2020.

- 12 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(4.) EARNINGS PER COMMON SHARE (“EPS”)

The following table presents a reconciliation of the earnings and shares used in calculating basic and diluted EPS (in thousands, except per share amounts).

	Three months ended June 30,						Six months ended June 30,
	2021			2020			2021			2020
Net income available to common shareholders	$	19,834		$	10,766		$	40,179		$	11,528
Weighted average common shares outstanding:
Total shares issued		16,100			16,100			16,100			16,100
Unvested restricted stock awards		(6	)		(5	)		(6	)		(4	)
Treasury shares		(269	)		(77	)		(237	)		(84	)
Total basic weighted average common shares outstanding		15,825			16,018			15,857			16,012
Incremental shares from assumed:
Exercise of stock options		—			—			—			—
Vesting of restricted stock awards		88			29			86			46
Total diluted weighted average common shares outstanding		15,913			16,047			15,943			16,058
Basic earnings per common share	$	1.25		$	0.67		$	2.53		$	0.72
Diluted earnings per common share	$	1.25		$	0.67		$	2.52		$	0.72

For each of the periods presented, average shares subject to the following instruments were excluded from the computation of diluted EPS because the effect would be antidilutive (in thousands):

	Three months ended June 30,				Six months ended June 30,
	2021		2020		2021		2020
Stock options		—		—		—		—
Restricted stock awards		1		74		6		38
Total		1		74		6		38

- 13 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.) INVESTMENT SECURITIES

The amortized cost and fair value of investment securities are summarized below (in thousands):

	Amortized			Unrealized		Unrealized		Fair
	Cost			Gains		Losses		Value
June 30, 2021
Securities available for sale:
U.S. Government agency and government sponsored enterprises	$	6,249		$	314	$	—	$	6,563
Mortgage-backed securities:
Federal National Mortgage Association		514,661			10,821		2,400		523,082
Federal Home Loan Mortgage Corporation		301,495			1,563		3,357		299,701
Government National Mortgage Association		45,710			537		224		46,023
Collateralized mortgage obligations:
Federal National Mortgage Association		20,362			69		79		20,352
Federal Home Loan Mortgage Corporation		6,747			—		47		6,700
Privately issued		—			424		—		424
Total mortgage-backed securities		888,975			13,414		6,107		896,282
Total available for sale securities	$	895,224		$	13,728	$	6,107	$	902,845
Securities held to maturity:
State and political subdivisions	$	113,437		$	3,383	$	—	$	116,820
Mortgage-backed securities:
Federal National Mortgage Association		9,649			509		—		10,158
Federal Home Loan Mortgage Corporation		5,099			212		—		5,311
Government National Mortgage Association		31,170			971		—		32,141
Collateralized mortgage obligations:
Federal National Mortgage Association		24,099			808		—		24,907
Federal Home Loan Mortgage Corporation		28,847			1,092		—		29,939
Government National Mortgage Association		6,563			205		—		6,768
Total mortgage-backed securities		105,427			3,797		—		109,224
Total held to maturity securities		218,864		$	7,180	$	—	$	226,044
Allowance for credit losses - securities		(6	)
Total held to maturity securities, net	$	218,858
December 31, 2020
Securities available for sale:
U.S. Government agency and government sponsored enterprises	$	6,239		$	396	$	—	$	6,635
Mortgage-backed securities:
Federal National Mortgage Association		350,627			15,549		44		366,132
Federal Home Loan Mortgage Corporation		225,645			3,155		24		228,776
Government National Mortgage Association		22,107			830		—		22,937
Collateralized mortgage obligations:
Federal National Mortgage Association		3,047			97		—		3,144
Federal Home Loan Mortgage Corporation		—			—		—		—
Privately issued		—			435		—		435
Total mortgage-backed securities		601,426			20,066		68		621,424
Total available for sale securities	$	607,665		$	20,462	$	68	$	628,059

- 14 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.) INVESTMENT SECURITIES (Continued)

	Amortized			Unrealized		Unrealized		Fair
	Cost			Gains		Losses		Value
December 31, 2020 (continued)
Securities held to maturity:
State and political subdivisions	$	144,506		$	4,478	$	—	$	148,984
Mortgage-backed securities:
Federal National Mortgage Association		10,776			703		—		11,479
Federal Home Loan Mortgage Corporation		5,858			382		—		6,240
Government National Mortgage Association		37,084			1,578		—		38,662
Collateralized mortgage obligations:
Federal National Mortgage Association		29,988			1,075		—		31,063
Federal Home Loan Mortgage Corporation		35,897			1,581		—		37,478
Government National Mortgage Association		7,864			265		—		8,129
Total mortgage-backed securities		127,467			5,584		—		133,051
Total held to maturity securities		271,973		$	10,062	$	—	$	282,035
Allowance for credit losses - securities		(7	)
Total held to maturity securities, net	$	271,966

The Company elected to exclude accrued interest receivable (“AIR”) from the amortized cost basis of debt securities disclosed throughout this footnote. For available for sale (“AFS”) debt securities, AIR totaled $1.6 million and $1.2 million as of June 30, 2021 and December 31, 2020. For held to maturity (“HTM”) debt securities, AIR totaled $751 thousand and $905 thousand as of June 30, 2021 and December 31, 2020, respectively. AIR is included in other assets on the Company’s consolidated statements of financial condition.

For the three months ended June 30, 2021 and 2020, credit loss expense (credit) for HTM investment securities was $(1) thousand and $(5) thousand, respectively. For the six months ended June 30, 2021 and 2020, credit loss expense (credit) for HTM investment securities was $(1) thousand and $(6) thousand, respectively.

Investment securities with a total fair value of $715.3 million and $567.4 million at June 30, 2021 and December 31, 2020, respectively, were pledged as collateral to secure public deposits and for other purposes required or permitted by law.

Sales of securities available for sale were as follows (in thousands):

	Three months ended June 30,				Six months ended June 30,
	2021		2020		2021		2020
Proceeds from sales	$	25,216	$	26,474	$	51,891	$	29,631
Gross realized gains		162		616		251		616
Gross realized losses		165		—		180		9

The scheduled maturities of securities available for sale and securities held to maturity at June 30, 2021 are shown below (in thousands). Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.

	Amortized		Fair
	Cost		Value
Debt securities available for sale:
Due in one year or less	$	4,875	$	4,922
Due from one to five years		61,273		64,618
Due after five years through ten years		162,075		168,601
Due after ten years		667,001		664,704
Total available for sale securities	$	895,224	$	902,845
Debt securities held to maturity:
Due in one year or less	$	39,335	$	39,782
Due from one to five years		75,284		78,219
Due after five years through ten years		18,793		19,459
Due after ten years		85,452		88,584
Total held to maturity securities	$	218,864	$	226,044

- 15 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.) INVESTMENT SECURITIES (Continued)

Unrealized losses on investment securities for which an allowance for credit losses has not been recorded and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands):

	Less than 12 months				12 months or longer				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
June 30, 2021
Securities available for sale:
U.S. Government agency and government sponsored    enterprises	$	—	$	—	$	—	$	—	$	—	$	—
Mortgage-backed securities:
Federal National Mortgage Association		212,724		2,400		72		—		212,796		2,400
Federal Home Loan Mortgage Corporation		211,699		3,293		3,565		64		215,264		3,357
Government National Mortgage Association		32,744		224		—		—		32,744		224
Collateralized mortgage obligations:
Federal National Mortgage Association		8,855		79		—		—		8,855		79
Federal Home Loan Mortgage Corporation		6,700		47		—		—		6,700		47
Privately issued		—		—		—		—		—		—
Total mortgage-backed securities		472,722		6,043		3,637		64		476,359		6,107
Total available for sale securities		472,722		6,043		3,637		64		476,359		6,107
Total temporarily impaired securities	$	472,722	$	6,043	$	3,637	$	64	$	476,359	$	6,107
December 31, 2020
Securities available for sale:
U.S. Government agencies and government sponsored    enterprises	$	—	$	—	$	—	$	—	$	—	$	—
Mortgage-backed securities:
Federal National Mortgage Association		18,155		44		—		—		18,155		44
Federal Home Loan Mortgage Corporation		10,932		24		—		—		10,932		24
Government National Mortgage Association		—		—		—		—		—		—
Collateralized mortgage obligations:
Federal National Mortgage Association		—		—		8		—		8		—
Federal Home Loan Mortgage Corporation		—		—		—		—		—		—
Privately issued		—		—		—		—		—		—
Total mortgage-backed securities		29,087		68		8		—		29,095		68
Total available for sale securities		29,087		68		8		—		29,095		68
Total temporarily impaired securities	$	29,087	$	68	$	8	$	—	$	29,095	$	68

- 16 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(5.) INVESTMENT SECURITIES (Continued)

The total number of securities positions in the investment portfolio in an unrealized loss position at June 30, 2021 was 65 compared to 8 at December 31, 2020. At June 30, 2021, the Company had positions in 3 investment securities with a fair value of $3.6 million and a total unrealized loss of $64 thousand dollars that has been in a continuous unrealized loss position for more than 12 months. At June 30, 2021, there were a total of 62 securities positions in the Company’s investment portfolio with a fair value of $472.7 million and a total unrealized loss of $6.0 million that had been in a continuous unrealized loss position for less than 12 months. At December 31, 2020, the Company had a position in 1 investment security with a fair value of 8 thousand dollars and a total unrealized loss of less than 1 thousand dollars that had been in a continuous unrealized loss position for more than 12 months. At December 31, 2020, there were a total of 7 securities positions in the Company’s investment portfolio with a fair value of $29.1 million and a total unrealized loss of $68 thousand that had been in a continuous unrealized loss position for less than 12 months. The unrealized loss on investment securities was predominantly caused by changes in market interest rates subsequent to purchase. The fair value of most of the investment securities in the Company’s portfolio fluctuates as market interest rates change.

Securities Available for Sale

As of June 30, 2021 and December 31, 2020, 0 allowance for credit losses has been recognized on available for sale securities in an unrealized loss position as management does not believe any of the securities were impaired due to reasons of credit quality. This is based upon our analysis of the underlying risk characteristics, including credit ratings, and other qualitative factors related to our available for sale securities and in consideration of our historical credit loss experience and internal forecasts. The issuers of these securities continue to make timely principal and interest payments under the contractual terms of the securities. Furthermore, management does not have the intent to sell any of the securities classified as available for sale in the table above and believes that it is more likely than not that we will not have to sell any such securities before a recovery of cost. The unrealized losses are due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such investments decline.

Securities Held to Maturity

The Company’s HTM investment securities include debt securities that are issued by U.S. government agencies or U.S. government-sponsored enterprises. These securities carry the explicit and/or implicit guarantee of the U.S. government, are widely recognized as “risk free,” and have a long history of zero credit loss.  In addition, the Company’s HTM investment securities include debt securities that are issued by state and local government agencies, or municipal bonds.

The Company monitors the credit quality of our municipal bonds through the use of a credit rating agency or by ratings that are derived by an internal scoring model. The scoring methodology for the internally derived ratings is based on a series of financial ratios for the municipality being reviewed as compared to typical industry figures. This information is used to determine the financial strengths and weaknesses of the municipality, which is indicated with a numeric rating. This number is then converted into a letter rating to better match the system used by the credit rating agencies. As of June 30, 2021, $107.1 million of our municipal bonds were rated as an equivalent to Standard & Poor’s A/AA/AAA, with $6.0 million internally rated to be the equivalent of Standard & Poor’s A/AA/AAA rating. Additionally, one municipal bond was rated below investment grade, with a BB+ Standard & Poor’s equivalent rating. The below investment grade bond represented exposure of $280 thousand, or 0.25% of the municipal bond portfolio and has been closely monitored for repayment. As of December 31, 2020, $135.7 million of our municipal bonds were rated as an equivalent to Standard & Poor’s A/AA/AAA, with $8.5 million internally rated to be the equivalent of Standard & Poor’s A/AA/AAA rating. Additionally, one municipal bond was rated below investment grade, with a BB+ Standard & Poor’s equivalent rating. The below investment grade bond represented exposure of $279 thousand, or 0.19% of the municipal bond portfolio and has been closely monitored for repayment.

As of June 30, 2021 and December 31, 2020, the Company had 0 past due or nonaccrual held to maturity investment securities.

- 17 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(6.) LOANS

The Company’s loan portfolio consisted of the following as of the dates indicated (in thousands):

	Principal Amount Outstanding		Net Deferred Loan (Fees) Costs			Loans, Net
June 30, 2021
Commercial business	$	735,928	$	(4,720	)	$	731,208
Commercial mortgage		1,317,754		(2,350	)		1,315,404
Residential real estate loans		576,632		13,671			590,303
Residential real estate lines		77,773		3,008			80,781
Consumer indirect		868,430		30,588			899,018
Other consumer		15,322		132			15,454
Total	$	3,591,839	$	40,329			3,632,168
Allowance for credit losses - loans							(46,365	)
Total loans, net						$	3,585,803
December 31, 2020
Commercial business	$	798,409	$	(4,261	)	$	794,148
Commercial mortgage		1,256,525		(2,624	)		1,253,901
Residential real estate loans		586,537		13,263			599,800
Residential real estate lines		86,708		3,097			89,805
Consumer indirect		812,816		27,605			840,421
Other consumer		16,913		150			17,063
Total	$	3,557,908	$	37,230			3,595,138
Allowance for credit losses - loans							(52,420	)
Total loans, net						$	3,542,718

Loans held for sale (not included above) were comprised entirely of residential real estate mortgages and totaled $3.9 million and $4.3 million as of June 30, 2021 and December 31, 2020, respectively.

The CARES Act was passed by Congress and signed into law on March 27, 2020. The CARES Act established the PPP, an expansion of the SBA’s 7(a) loan program and the EIDL, administered directly by the SBA. The Company had $177.7 million and $253.1 million of PPP loans (included in Commercial business above) as of June 30, 2021 and December 31, 2020, respectively. In addition, the CARES Act provides that a financial institution may elect to suspend (1) the application of GAAP for certain loan modifications related to COVID-19 that would otherwise be categorized as a TDR and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes. Accordingly, the Company had $532.4 million of loans with modifications related to COVID-19 during 2020, with $69.1 million and $113.0 million still on deferral as of June 30, 2021 and December 31, 2020, respectively.

The Company elected to exclude AIR from the amortized cost basis of loans disclosed throughout this footnote. As of June 30, 2021 and December 31, 2020, AIR for loans totaled $12.9 million and $13.6 million, respectively, and is included in other assets on the Company’s consolidated statements of financial condition.

- 18 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(6.) LOANS (Continued)

Past Due Loans Aging

The Company’s recorded investment, by loan class, in current and nonaccrual loans, as well as an analysis of accruing delinquent loans is set forth as of the dates indicated (in thousands):

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Nonaccrual		Current		Total Loans		Nonaccrual with no allowance
June 30, 2021
Commercial business	$	80	$	—	$	—	$	80	$	1,555	$	734,293	$	735,928	$	899
Commercial mortgage		900		—		—		900		885		1,315,969		1,317,754		355
Residential real estate loans		612		16		—		628		2,615		573,389		576,632		2,615
Residential real estate lines		116		—		—		116		280		77,377		77,773		280
Consumer indirect		2,643		502		—		3,145		1,250		864,035		868,430		1,250
Other consumer		65		24		42		131		8		15,183		15,322		8
Total loans, gross	$	4,416	$	542	$	42	$	5,000	$	6,593	$	3,580,246	$	3,591,839	$	5,407
December 31, 2020
Commercial business	$	264	$	87	$	—	$	351	$	1,975	$	796,083	$	798,409	$	1,502
Commercial mortgage		822		26		—		848		2,906		1,252,771		1,256,525		2,709
Residential real estate loans		984		60		—		1,044		2,587		582,906		586,537		2,587
Residential real estate lines		40		15		—		55		323		86,330		86,708		323
Consumer indirect		3,966		1,348		—		5,314		1,495		806,007		812,816		1,495
Other consumer		133		18		231		382		—		16,531		16,913		—
Total loans, gross	$	6,209	$	1,554	$	231	$	7,994	$	9,286	$	3,540,628	$	3,557,908	$	8,616

There were 0 loans past due greater than 90 days and still accruing interest as of June 30, 2021 and December 31, 2020. There were $42 thousand and $231 thousand in consumer overdrafts which were past due greater than 90 days as of June 30, 2021 and December 31, 2020, respectively. Consumer overdrafts are overdrawn deposit accounts which have been reclassified as loans but by their terms do not accrue interest.

The Company recognized 0 interest income on nonaccrual loans during the six months ended June 30, 2021 and 2020.

Troubled Debt Restructurings

A modification of a loan constitutes a TDR when a borrower is experiencing financial difficulty and the modification constitutes a concession. Commercial loans modified in a TDR may involve temporary interest-only payments, term extensions, reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, collateral concessions, forgiveness of principal, forbearance agreements, or substituting or adding a new borrower or guarantor.

There were 0 loans modified as a TDR during the six months ended June 30, 2021 and 2020. There were 0 loans modified as a TDR within the previous 12 months that defaulted during the six months ended June 30, 2021 and 2020. For purposes of this disclosure, a loan modified as a TDR is considered to have defaulted when the borrower becomes 90 days past due.

- 19 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(6.) LOANS (Continued)

Collateral Dependent Loans

Management has determined that specific commercial loans on nonaccrual status, all loans that have had their terms restructured in a troubled debt restructuring and other loans deemed appropriate by management where repayment is expected to be provided substantially through the operation or sale of the collateral to be collateral dependent loans. Collateral dependent loans at June 30, 2021 and December 31, 2020 included certain criticized COVID-19 bridge loans not otherwise classified as nonaccrual. The following table presents the amortized cost basis of collateral dependent loans by collateral type as of June 30, 2021 and December 31, 2020 (in thousands):

	Collateral type
	Business assets		Real property		Total		Specific Reserve
June 30, 2021
Commercial business	$	910	$	1,148	$	2,058	$	1,409
Commercial mortgage		—		64,499		64,499		11,880
Total	$	910	$	65,647	$	66,557	$	13,289
December 31, 2020
Commercial business	$	2,379	$	—	$	2,379	$	1,383
Commercial mortgage		—		36,625		36,625		8,187
Total	$	2,379	$	36,625	$	39,004	$	9,570

Credit Quality Indicators

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors such as the fair value of collateral. The Company analyzes commercial business and commercial mortgage loans individually by classifying the loans as to credit risk. Risk ratings are updated any time the situation warrants. The Company uses the following definitions for risk ratings:

Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company’s credit position at some future date.

Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loans that do not meet the criteria above that are analyzed individually as part of the process described above are considered “uncriticized” or pass-rated loans and are included in groups of homogeneous loans with similar risk and loss characteristics.

- 20 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(6.) LOANS (Continued)

The following tables set forth the Company’s commercial loan portfolio, categorized by internally assigned asset classification, as of the dates indicated (in thousands):

	Term Loans Amortized Cost Basis by Origination Year
	2021		2020		2019		2018		2017		Prior		Revolving Loans Amortized Cost Basis		Revolving Loans Converted to Term		Total
June 30, 2021
Commercial Business
Uncriticized	$	65,107	$	175,374	$	97,307	$	60,740	$	20,000	$	21,457	$	281,613	$	0	$	721,598
Special mention		27		104		14		129		26		1,083		2,974		0		4,357
Substandard		0		65		173		945		213		133		3,724		0		5,253
Doubtful		0		0		0		0		0		0		0		0		0
Total	$	65,134	$	175,543	$	97,494	$	61,814	$	20,239	$	22,673	$	288,311	$	0	$	731,208
Commercial Mortgage
Uncriticized	$	137,070	$	340,304	$	196,386	$	145,712	$	145,919	$	181,455	$	165	$	0	$	1,147,011
Special mention		496		16,636		50,195		9,635		25,426		39,954		0		0		142,342
Substandard		0		327		2,938		11,733		1,276		9,777		0		0		26,051
Doubtful		0		0		0		0		0		0		0		0		0
Total	$	137,566	$	357,267	$	249,519	$	167,080	$	172,621	$	231,186	$	165	$	0	$	1,315,404

	Term Loans Amortized Cost Basis by Origination Year
	2020		2019		2018		2017		2016		Prior		Revolving Loans Amortized Cost Basis		Revolving Loans Converted to Term		Total
December 31, 2020
Commercial Business
Uncriticized	$	350,992	$	112,469	$	82,029	$	31,990	$	8,195	$	16,600	$	179,770	$	0	$	782,045
Special mention		0		360		21		709		41		1,025		2,995		0		5,151
Substandard		193		211		1,183		464		202		309		4,390		0		6,952
Doubtful		0		0		0		0		0		0		0		0		0
Total	$	351,185	$	113,040	$	83,233	$	33,163	$	8,438	$	17,934	$	187,155	$	0	$	794,148
Commercial Mortgage
Uncriticized	$	310,364	$	227,406	$	163,839	$	161,771	$	74,915	$	154,399	$	731	$	0	$	1,093,425
Special mention		14,299		42,305		19,505		27,530		12,256		28,744		43		0		144,682
Substandard		189		2,521		1,890		1,648		3		9,344		199		0		15,794
Doubtful		0		0		0		0		0		0		0		0		0
Total	$	324,852	$	272,232	$	185,234	$	190,949	$	87,174	$	192,487	$	973	$	0	$	1,253,901

- 21 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(6.) LOANS (Continued)

The Company utilizes payment status as a means of identifying and reporting problem and potential problem retail loans. The Company considers nonaccrual loans and loans past due greater than 90 days and still accruing interest to be non-performing. The following tables set forth the Company’s retail loan portfolio, categorized by performance status, as of the dates indicated (in thousands):

	Term Loans Amortized Cost Basis by Origination Year
	2021		2020		2019		2018		2017		Prior		Revolving Loans Amortized Cost Basis		Revolving Loans Converted to Term		Total
June 30, 2021
Residential Real Estate Loans
Performing	$	51,557	$	134,889	$	92,197	$	76,496	$	58,061	$	174,488	$	0	$	0	$	587,688
Nonperforming		0		198		245		602		751		819		0		0		2,615
Total	$	51,557	$	135,087	$	92,442	$	77,098	$	58,812	$	175,307	$	0	$	0	$	590,303
Residential Real Estate Lines
Performing	$	0	$	0	$	0	$	0	$	0	$	0	$	71,762	$	8,739	$	80,501
Nonperforming		0		0		0		0		0		0		64		216		280
Total	$	0	$	0	$	0	$	0	$	0	$	0	$	71,826	$	8,955	$	80,781
Consumer Indirect
Performing	$	242,845	$	254,491	$	160,077	$	125,332	$	77,625	$	37,398	$	0	$	0	$	897,768
Nonperforming		86		224		419		261		187		73		0		0		1,250
Total	$	242,931	$	254,715	$	160,496	$	125,593	$	77,812	$	37,471	$	0	$	0	$	899,018
Other Consumer
Performing	$	3,067	$	4,805	$	2,338	$	1,191	$	513	$	728	$	2,804	$	0	$	15,446
Nonperforming		0		0		8		0		0		0		0		0		8
Total	$	3,067	$	4,805	$	2,346	$	1,191	$	513	$	728	$	2,804	$	0	$	15,454

	Term Loans Amortized Cost Basis by Origination Year
	2020		2019		2018		2017		2016		Prior		Revolving Loans Amortized Cost Basis		Revolving Loans Converted to Term		Total
December 31, 2020
Residential Real Estate Loans
Performing	$	137,926	$	103,923	$	87,153	$	66,446	$	67,473	$	134,292	$	0	$	0	$	597,213
Nonperforming		0		199		765		665		233		725		0		0		2,587
Total	$	137,926	$	104,122	$	87,918	$	67,111	$	67,706	$	135,017	$	0	$	0	$	599,800
Residential Real Estate Lines
Performing	$	0	$	0	$	0	$	0	$	0	$	0	$	79,257	$	10,225	$	89,482
Nonperforming		0		0		0		0		0		0		65		258		323
Total	$	0	$	0	$	0	$	0	$	0	$	0	$	79,322	$	10,483	$	89,805
Consumer Indirect
Performing	$	295,216	$	202,187	$	166,773	$	111,008	$	47,793	$	15,949	$	0	$	0	$	838,926
Nonperforming		70		652		319		287		132		35		0		0		1,495
Total	$	295,286	$	202,839	$	167,092	$	111,295	$	47,925	$	15,984	$	0	$	0	$	840,421
Other Consumer
Performing	$	6,774	$	3,177	$	1,765	$	907	$	369	$	508	$	3,563	$	0	$	17,063
Nonperforming		0		0		0		0		0		0		0		0		0
Total	$	6,774	$	3,177	$	1,765	$	907	$	369	$	508	$	3,563	$	0	$	17,063

- 22 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(6.)LOANS (Continued)

Allowance for Credit Losses - Loans

On January 1, 2020, the Company adopted Accounting Standards Update (“ASU”) No. 2016-13, Financial Instruments – Credit Losses (Topic 326) – Measurement of Credit Losses on Financial Instruments. ASU 2016-13 amends guidance on reporting credit losses for financial assets held at amortized cost basis and available for sale debt securities. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial assets to present the net amount expected to be collected. The Company adopted ASU 2016-13 using the modified retrospective approach. Results for the periods beginning after January 1, 2020 are presented under Accounting Standards Codification (“ASC”) 326 while prior period amounts continue to be reported in accordance with previously applicable GAAP. The Company recorded a net reduction of retained earnings of $8.7 million upon adoption. The transition adjustment includes an increase in credit-related reserves of $9.6 million, $14 thousand, and $2.1 million for loans, held to maturity investment securities and unfunded commitments, respectively, net of the corresponding increase in deferred tax assets of $3.0 million.

The following table sets forth the changes in the allowance for credit losses - loans for the three- and six-month periods ended as of the dates indicated (in thousands):

	Commercial Business			Commercial Mortgage			Residential Real Estate Loans			Residential Real Estate Lines			Consumer Indirect			Other Consumer			Total
Three months ended June 30, 2021
Beginning balance	$	12,670		$	22,672		$	3,109		$	482		$	10,557		$	338		$	49,828
Charge-offs		(92	)		0			(56	)		0			(1,157	)		(424	)		(1,729	)
Recoveries		379			7			59			0			1,583			95			2,123
Provision (credit)		(1,952	)		(1,017	)		(813	)		(87	)		(235	)		247			(3,857	)
Ending balance	$	11,005		$	21,662		$	2,299		$	395		$	10,748		$	256		$	46,365
Six months ended June 30, 2021
Beginning balance	$	13,580		$	21,763		$	3,924		$	674		$	12,165		$	314		$	52,420
Charge-offs		(178	)		(203	)		(67	)		(70	)		(3,570	)		(505	)		(4,593	)
Recoveries		617			7			64			0			3,253			159			4,100
Provision (credit)		(3,014	)		95			(1,622	)		(209	)		(1,100	)		288			(5,562	)
Ending balance	$	11,005		$	21,662		$	2,299		$	395		$	10,748		$	256		$	46,365

	Commercial Business			Commercial Mortgage			Residential Real Estate Loans			Residential Real Estate Lines		Consumer Indirect			Other Consumer			Total
Three months ended June 30, 2020
Beginning balance	$	10,223		$	15,154		$	6,170		$	899	$	10,645		$	265		$	43,356
Charge-offs		(25	)		(1,072	)		(2	)		0		(2,554	)		(70	)		(3,723	)
Recoveries		1,483			0			8			0		1,379			67			2,937
Provision (credit)		718			1,584			(407	)		40		1,752			59			3,746
Ending balance	$	12,399		$	15,666		$	5,769		$	939	$	11,222		$	321		$	46,316
Six months ended June 30, 2020
Beginning balance, prior to adoption of ASC 326	$	11,358		$	5,681		$	1,059		$	118	$	11,852		$	414		$	30,482
Impact of adopting ASC 326		(246	)		7,310			3,290			607		(1,234	)		(133	)		9,594
Beginning balance, after adoption of ASC 326		11,112			12,991			4,349			725		10,618			281			40,076
Charge-offs		(8,266	)		(1,072	)		(100	)		0		(5,978	)		(339	)		(15,755	)
Recoveries		1,541			0			18			3		3,047			217			4,826
Provision		8,012			3,747			1,502			211		3,535			162			17,169
Ending balance	$	12,399		$	15,666		$	5,769		$	939	$	11,222		$	321		$	46,316

- 23 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(6.) LOANS (Continued)

Risk Characteristics

Commercial business loans primarily consist of loans to small to mid-sized businesses in our market area in a diverse range of industries. These loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. Further, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value. The credit risk related to commercial loans is largely influenced by general economic conditions, including the impact of the COVID-19 pandemic on small to mid-sized business in our market area, and the resulting impact on a borrower’s operations or on the value of underlying collateral, if any.

Commercial mortgage loans generally have larger balances and involve a greater degree of risk than residential mortgage loans, potentially resulting in higher potential losses on an individual customer basis. Loan repayment is often dependent on the successful operation and management of the properties, as well as on the collateral securing the loan. Economic events, including the impact of the COVID-19 pandemic on the ability of the tenants to pay rent at these properties, or conditions in the real estate market could have an adverse impact on the cash flows generated by properties securing the Company’s commercial real estate loans and on the value of such properties.

Residential real estate loans (comprised of conventional mortgages and home equity loans) and residential real estate lines (comprised of home equity lines) are generally made based on the borrower’s ability to make repayment from his or her employment and other income but are secured by real property whose value tends to be more easily ascertainable. Credit risk for these types of loans is generally influenced by general economic conditions, including the impact of the COVID-19 pandemic on the employment income of these borrowers, the characteristics of individual borrowers, and the nature of the loan collateral.

Consumer indirect and other consumer loans may entail greater credit risk than residential mortgage loans and home equities, particularly in the case of other consumer loans which are unsecured or, in the case of indirect consumer loans, secured by depreciable assets, such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances such as job loss, illness or personal bankruptcy, including the heightened risk that such circumstances may arise as a result of the COVID-19 pandemic. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

- 24 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(7.) LEASES

ASC 842, Leases (“ASC 842”), establishes a right of use model that requires a lessee to record a right of use asset and a lease liability for all leases with terms longer than 12 months. The Company is obligated under a number of non-cancellable operating lease agreements for land, buildings and equipment with terms, including renewal options reasonably certain to be exercised, extending through 2061. NaN building lease was subleased for terms extending through June 30, 2021.

The following table represents the consolidated statements of financial condition classification of the Company’s right of use assets and lease liabilities:

		June 30,			December 31,
	Balance Sheet Location	2021			2020
Operating Lease Right of Use Assets:
Gross carrying amount	Other assets	$	27,772		$	23,697
Accumulated amortization	Other assets		(4,686	)		(3,741	)
Net book value		$	23,086		$	19,956
Operating Lease Liabilities:
Right of use lease obligations	Other liabilities	$	24,803		$	21,507

The weighted average remaining lease term for operating leases was 23.8 years at June 30, 2021 and the weighted-average discount rate used in the measurement of operating lease liabilities was 3.69%. The Company utilizes its incremental borrowing rate at lease inception, on a collateralized basis, over a similar term for the discount rate.

The following table represents lease costs and other lease information:

	Three months ended June 30,						Six months ended June 30,
	2021			2020			2021			2020
Lease costs:
Operating lease costs	$	795		$	678		$	1,475		$	1,355
Variable lease costs (1)		90			101			188			202
Sublease income		(12	)		(12	)		(23	)		(23	)
Net lease costs	$	873		$	767		$	1,640		$	1,534
Other information:
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows from operating leases							$	1,349		$	1,296
Right of use assets obtained in exchange for new operating    lease liabilities							$	4,178		$	405

⁽¹⁾ Variable lease costs primarily represent variable payments such as common area maintenance, insurance, taxes and utilities.

Future minimum payments under non-cancellable operating leases with initial or remaining terms of one year or more, are as follows at June 30, 2021 (in thousands):

Twelve months ended June 30,
2022	$	2,334
2023		2,045
2024		1,507
2025		1,417
2026		1,338
Thereafter		30,217
Total future minimum operating lease payments		38,858
Amounts representing interest		(14,055	)
Present value of net future minimum operating lease payments	$	24,803

- 25 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(8.) GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill

The carrying amount of goodwill totaled $66.7 million and $66.1 million as of both June 30, 2021 and December 31, 2020. The Company performs a goodwill impairment test on an annual basis as of October 1st or more frequently if events and circumstances warrant.

	Banking		All Other (1)		Total
Balance, December 31, 2020	$	48,536	$	17,526	$	66,062
Acquisition		—		611		611
Balance, June 30, 2021	$	48,536	$	18,137	$	66,673

⁽¹⁾ All Other includes the SDN, Courier Capital and HNP Capital reporting units

Goodwill and other intangible assets added during the period relates to the acquisition of assets of Landmark Group, which was completed on February 1, 2021. See Note 2 – Business Combinations for additional information.

Other Intangible Assets

The Company has other intangible assets that are amortized, consisting of core deposit intangibles and other intangibles (primarily related to customer relationships). Gross carrying amount, accumulated amortization and net book value, were as follows (in thousands):

	June 30,			December 31,
	2021			2020
Other intangibles assets:
Gross carrying amount	$	16,324		$	15,925
Accumulated amortization		(8,735	)		(8,198	)
Net book value	$	7,589		$	7,727

Amortization expense for total other intangible assets was $266 thousand and $537 thousand for the three and six months ended June 30, 2021, respectively, and $287 thousand and $581 thousand for the three and six months ended June 30, 2020, respectively. As of June 30, 2021, the estimated amortization expense of other intangible assets for the remainder of 2021 and each of the next five years is as follows (in thousands):

2021 (remainder of year)	$	513
2022		960
2023		887
2024		816
2025		745
2026		675

(9.) OTHER ASSETS

A summary of other assets as of the dates indicated are as follows (in thousands):

	June 30,		December 31,
	2021		2020
Operating lease right of use assets	$	23,086	$	19,956
Tax credit investments		44,662		34,370
Derivative instruments		16,443		20,120
Collateral on derivative instruments		8,780		19,630
Other		64,218		62,010
Total other assets	$	157,189	$	156,086

- 26 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(10.) DERIVATIVE INSTRUMENT AND HEDGING ACTIVITIES

Risk Management Objective of Using Derivatives

The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities, and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments.

Cash Flow Hedges of Interest Rate Risk

The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company uses interest rate caps and interest rate swaps as part of its interest rate risk management strategy. Interest rate caps designated as cash flow hedges involve the receipt of variable amounts from a counterparty if interest rates rise above the strike rate on the contract in exchange for an up-front premium. During the first six months of 2021 and in 2020, such derivatives were used to hedge the variable cash flows associated with short-term borrowings. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. The Company is hedging its exposure to the variability in future cash flows for forecasted transactions over a period of approximately 60 months. As of June 30, 2021, the Company had 1 outstanding forward starting interest rate derivative with a notional value of $50.0 million that was designated as a cash flow hedge of interest rate risk. The derivative becomes effective in April 2022.

For derivatives designated and that qualify as cash flow hedges of interest rate risk, the gain or loss on the derivative is recorded in accumulated other comprehensive income (loss) and subsequently reclassified into interest expense in the same period(s) during which the hedged transaction affects earnings. Amounts reported in accumulated other comprehensive income (loss) related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s borrowings. During the next twelve months, the Company estimates that $64 thousand will be reclassified into interest expense.

Interest Rate Swaps

The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. These interest rate swaps are simultaneously hedged by offsetting interest rate swaps that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate swaps associated with this program do not meet hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings.

Credit-risk-related Contingent Features

The Company has agreements with certain of its derivative counterparties that contain one or more of the following provisions: (a) if the Company defaults on any of its indebtedness, including a default where repayment of the indebtedness has not been accelerated by the lender, the Company could also be declared in default on its derivative obligations, and (b) if the Company fails to maintain its status as a well-capitalized institution, the counterparty could terminate the derivative positions and the Company would be required to settle its obligations under the agreements.

- 27 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(10.) DERIVATIVE INSTRUMENT AND HEDGING ACTIVITIES (Continued)

Mortgage Banking Derivatives

The Company extends rate lock agreements to borrowers related to the origination of residential mortgage loans. To mitigate the interest rate risk inherent in these rate lock agreements when the Company intends to sell the related loan, once originated, as well as closed residential mortgage loans held for sale, the Company enters into forward commitments to sell individual residential mortgages. Rate lock agreements and forward commitments are considered derivatives and are recorded at fair value.

Fair Values of Derivative Instruments on the Balance Sheet

The table below presents the notional amounts, respective fair values of the Company’s derivative financial instruments, as well as their classification on the balance sheet as of June 30, 2021 and December 31, 2020 (in thousands):

					Asset derivatives					Liability derivatives
	Gross notional amount				Balance	Fair value				Balance	Fair value
	June 30, 2021		Dec. 31, 2020		sheet line item	June 30, 2021		Dec. 31, 2020		sheet line item	June 30, 2021		Dec. 31, 2020
Derivatives designated as hedging instruments
Cash flow hedges	$	50,000	$	50,000	Other assets	$	1,004	$	—	Other liabilities	$	—	$	311
Total derivatives	$	50,000	$	50,000		$	1,004	$	—		$	—	$	311
Derivatives not designated as hedging instruments
Cash flow hedges	$	—	$	100,000	Other assets	$	—	$	—	Other liabilities	$	—	$	—
Interest rate swaps (1)		716,115		631,907	Other assets		15,108		19,626	Other liabilities		14,972		19,837
Credit contracts		115,833		113,434	Other assets		14		23	Other liabilities		53		86
Mortgage banking		27,730		28,225	Other assets		317		471	Other liabilities		39		1
Total derivatives	$	859,678	$	873,566		$	15,439	$	20,120		$	15,064	$	19,924

⁽¹⁾ The Company secured its obligations under these contracts with $8.7 million and $19.6 million in cash at June 30, 2021 and December 31, 2020, respectively.

Effect of Derivative Instruments on the Income Statement

The table below presents the effect of the Company’s derivative financial instruments on the income statement for the three and six months ended June 30, 2021 and 2020 (in thousands):

		Gain (loss) recognized in income					Gain (loss) recognized in income
	Line item of gain (loss)	Three months ended June 30,					Six months ended June 30,
Undesignated derivatives	recognized in income	2021			2020		2021			2020
Cash flow hedges	Income from derivative instruments, net	$	—		$	—	$	—		$	—
Interest rate swaps	Income from derivative instruments, net		(333	)		1,681		1,439			2,405
Credit contracts	Income from derivative instruments, net		(12	)		128		36			123
Mortgage banking	Income from derivative instruments, net		(247	)		131		(192	)		158
Total undesignated		$	(592	)	$	1,940	$	1,283		$	2,686

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(11.) SHAREHOLDERS’ EQUITY

Common Stock

The changes in shares of common stock were as follows for the three and six months ended June 30, 2021 and 2020:

	Outstanding			Treasury			Issued
2021
Shares at December 31, 2020		16,041,926			57,630			16,099,556
Shares issued for Landmark Group acquisition		12,831			(12,831	)		—
Restricted stock units released		18,819			(18,819	)		—
Treasury stock purchases		(244,677	)		244,677			—
Shares at March 31, 2021		15,828,899			270,657			16,099,556
Restricted stock awards issued		9,350			(9,350	)		—
Stock awards		3,680			(3,680	)		—
Shares at June 30, 2021		15,841,929			257,627			16,099,556
2020
Shares at December 31, 2019		16,002,899			96,657			16,099,556
Restricted stock units released		22,921			(22,921	)		—
Treasury stock purchases		(6,436	)		6,436			—
Shares at March 31, 2020		16,019,384			80,172			16,099,556
Restricted stock awards issued		12,798			(12,798	)		—
Stock awards		5,403			(5,403	)		—
Shares at June 30, 2020		16,037,585			61,971			16,099,556

Share Repurchase Program

In November 2020, the Company’s Board of Directors authorized a share repurchase program for up to 801,879 shares of common stock. Repurchased shares are recorded in treasury stock, at cost, which includes any applicable transaction costs. 238,439 shares were repurchased at an average price of $24.30 during the six months ended June 30, 2021. NaN shares were repurchased under this program during the three months ended June 30, 2021 and during the year ended December 31, 2020. As of June 30, 2021, the remaining number of shares authorized for repurchase under the repurchase program was 563,440.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(12.) ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following tables present the components of other comprehensive income (loss) for the three and six months ended June 30, 2021 and 2020 (in thousands):

	Pre-tax Amount			Tax Effect			Net-of-tax Amount
Three months ended June 30, 2021
Securities available for sale and transferred securities:
Change in unrealized gain/loss during the period	$	6,661		$	1,707		$	4,954
Reclassification adjustment for net gains included in net income (1)		64			16			48
Total securities available for sale and transferred securities		6,725			1,723			5,002
Hedging derivative instruments:
Change in unrealized gain/loss during the period		(674	)		(173	)		(501	)
Pension and post-retirement obligations:
Amortization of prior service credit included in income		—			—			—
Amortization of net actuarial loss included in income		185			48			137
Total pension and post-retirement obligations		185			48			137
Other comprehensive income	$	6,236		$	1,598		$	4,638
Six months ended June 30, 2021
Securities available for sale and transferred securities:
Change in unrealized gain/loss during the period	$	(12,701	)	$	(3,254	)	$	(9,447	)
Reclassification adjustment for net gains included in net income (1)		63			16			47
Total securities available for sale and transferred securities		(12,638	)		(3,238	)		(9,400	)
Hedging derivative instruments:
Change in unrealized gain/loss during the period		1,429			366			1,063
Pension and post-retirement obligations:
Amortization of prior service credit included in income		(1	)		—			(1	)
Amortization of net actuarial loss included in income		371			95			276
Total pension and post-retirement obligations		370			95			275
Other comprehensive loss	$	(10,839	)	$	(2,777	)	$	(8,062	)

⁽¹⁾ Includes amounts related to the amortization/accretion of unrealized net gains and losses related to the Company’s reclassification of available for sale investment securities to the held to maturity category. The unrealized net gains/losses will be amortized/accreted over the remaining life of the investment securities as an adjustment of yield.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(12.) ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

	Pre-tax Amount			Tax Effect			Net-of-tax Amount
Three months ended June 30, 2020
Securities available for sale and transferred securities:
Change in unrealized gain/loss during the period	$	2,912		$	746		$	2,166
Reclassification adjustment for net gains included in net income (1)		(571	)		(146	)		(425	)
Total securities available for sale and transferred securities		2,341			600			1,741
Hedging derivative instruments:
Change in unrealized gain/loss during the period		(522	)		(134	)		(388	)
Pension and post-retirement obligations:
Amortization of prior service credit included in income		(9	)		(3	)		(6	)
Amortization of net actuarial loss included in income		323			84			239
Total pension and post-retirement obligations		314			81			233
Other comprehensive income	$	2,133		$	547		$	1,586
Six months ended June 30, 2020
Securities available for sale and transferred securities:
Change in unrealized gain/loss during the period	$	19,363		$	4,961		$	14,402
Reclassification adjustment for net gains included in net income (1)		(746	)		(191	)		(555	)
Total securities available for sale and transferred securities		18,617			4,770			13,847
Hedging derivative instruments:
Change in unrealized gain/loss during the period		(399	)		(102	)		(297	)
Pension and post-retirement obligations:
Amortization of prior service credit included in income		(18	)		(5	)		(13	)
Amortization of net actuarial loss included in income		646			166			480
Total pension and post-retirement obligations		628			161			467
Other comprehensive income	$	18,846		$	4,829		$	14,017

⁽¹⁾ Includes amounts related to the amortization/accretion of unrealized net gains and losses related to the Company’s reclassification of available for sale investment securities to the held to maturity category. The unrealized net gains/losses will be amortized/accreted over the remaining life of the investment securities as an adjustment of yield.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(12.) ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) (Continued)

Activity in accumulated other comprehensive income (loss), net of tax, for the three and six months ended June 30, 2021 and 2020 was as follows (in thousands):

	Hedging Derivative Instruments			Securities Available for Sale and Transferred Securities			Pension and Post- retirement Obligations			Accumulated Other Comprehensive Income (Loss)
Three months ended June 30, 2021
Balance at beginning of period	$	1,248		$	341		$	(12,161	)	$	(10,572	)
Other comprehensive income (loss) before reclassifications		(501	)		4,954			—			4,453
Amounts reclassified from accumulated other comprehensive    income (loss)		—			48			137			185
Net current period other comprehensive income (loss)		(501	)		5,002			137			4,638
Balance at end of period	$	747		$	5,343		$	(12,024	)	$	(5,934	)
Six months ended June 30, 2021
Balance at beginning of period	$	(316	)	$	14,743		$	(12,299	)	$	2,128
Other comprehensive income (loss) before reclassifications		1,063			(9,447	)		—			(8,384	)
Amounts reclassified from accumulated other comprehensive    income (loss)		—			47			275			322
Net current period other comprehensive income (loss)		1,063			(9,400	)		275			(8,062	)
Balance at end of period	$	747		$	5,343		$	(12,024	)	$	(5,934	)
Three months ended June 30, 2020
Balance at beginning of period	$	(427	)	$	12,979		$	(14,634	)	$	(2,082	)
Other comprehensive income (loss) before reclassifications		(388	)		2,166			—			1,778
Amounts reclassified from accumulated other comprehensive    income (loss)		—			(425	)		233			(192	)
Net current period other comprehensive income (loss)		(388	)		1,741			233			1,586
Balance at end of period	$	(815	)	$	14,720		$	(14,401	)	$	(496	)
Six months ended June 30, 2020
Balance at beginning of period	$	(518	)	$	873		$	(14,868	)		(14,513	)
Other comprehensive income (loss) before reclassifications		(297	)		14,402			—			14,105
Amounts reclassified from accumulated other comprehensive    income (loss)		—			(555	)		467			(88	)
Net current period other comprehensive income (loss)		(297	)		13,847			467			14,017
Balance at end of period	$	(815	)	$	14,720		$	(14,401	)	$	(496	)

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(12.) ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) (Continued)

The following table presents the amounts reclassified out of each component of accumulated other comprehensive income (loss) for the three and six months ended June 30, 2021 and 2020 (in thousands):

Details About Accumulated Other Comprehensive Income (Loss) Components	Amount Reclassified from Accumulated Other Comprehensive Income (Loss)						Affected Line Item in the Consolidated Statement of Income
	Three months ended
	June 30,
	2021			2020
Realized gain (loss) on sale of investment securities	$	(3	)	$	674		Net gain (loss) on investment securities
Amortization of unrealized holding losses    on investment securities transferred from    available for sale to held to maturity		(61	)		(103	)	Interest income
		(64	)		571		Total before tax
		16			(146	)	Income tax expense
		(48	)		425		Net of tax
Amortization of pension and post-retirement items:
Prior service credit (1)		—			9		Salaries and employee benefits
Net actuarial losses (1)		(185	)		(323	)	Salaries and employee benefits
		(185	)		(314	)	Total before tax
		48			81		Income tax benefit
		(137	)		(233	)	Net of tax
Total reclassified for the period	$	(185	)	$	192
	Six months ended
	June 30,
	2021			2020
Realized gain on sale of investment securities	$	71		$	895		Net gain (loss) on investment securities
Amortization of unrealized holding losses    on investment securities transferred from    available for sale to held to maturity		(134	)		(149	)	Interest income
		(63	)		746		Total before tax
		16			(191	)	Income tax (expense) benefit
		(47	)		555		Net of tax
Amortization of pension and post-retirement items:
Prior service credit (1)		1			18		Salaries and employee benefits
Net actuarial losses (1)		(371	)		(646	)	Salaries and employee benefits
		(370	)		(628	)	Total before tax
		95			161		Income tax benefit
		(275	)		(467	)	Net of tax
Total reclassified for the period	$	(322	)	$	88

⁽¹⁾ These items are included in the computation of net periodic pension expense. See Note 14 – Employee Benefit Plans for additional information.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(13.) SHARE-BASED COMPENSATION PLANS

The Company maintains certain share-based compensation plans, approved by the Company’s shareholders, that are administered by the Management Development and Compensation Committee (the “MD&C Committee”) of the Board. The share-based compensation plans were established to allow for the grant of compensation awards to attract, motivate and retain employees, executive officers and non-employee directors who contribute to the long-term growth and profitability of the Company and to give such persons a proprietary interest in the Company, thereby enhancing their personal interest in the Company’s success.

The MD&C Committee approved the grant of restricted stock units (“RSUs”) and performance share units (“PSUs”) shown in the table below to certain members of management during the six months ended June 30, 2021.

	Number of Underlying Shares		Weighted Average Per Share Grant Date Fair Value
RSUs		59,998	$	27.50
PSUs		22,178		27.58

The grant-date fair value for the RSUs granted during the six months ended June 30, 2021 is equal to the closing market price of our common stock on the date of grant reduced by the present value of the dividends expected to be paid on the underlying shares.

NaN percent of the PSUs that ultimately vest is contingent on achieving specified return on average equity (“ROAE”) targets relative to the SNL Small Cap Bank & Thrift Index, a market index the MD&C Committee has selected as a peer group for this purpose. These shares will be earned based on the Company’s achievement of a relative ROAE performance requirement, on a percentile basis, compared to the SNL Small Cap Bank & Thrift Index over a three-year performance period ended December 31, 2023. The shares earned based on the achievement of the ROAE performance requirement, if any, will vest on the third anniversary of the grant date assuming the recipient’s continuous service to the Company.  The remaining 50 percent of the PSUs that ultimately vest is contingent upon achievement of an average return on average assets (“ROAA”) performance requirement over a three-year performance period ended December 31, 2023. The shares earned based on the achievement of the ROAA performance requirement, if any, will vest on the third anniversary of the grant date assuming the recipient’s continuous service to the Company.  

The grant-date fair values for both the ROAE and the ROAA portions of PSUs granted during the six months ended June 30, 2021 are equal to the closing market price of our common stock on the date of grant reduced by the present value of the dividends expected to be paid on the underlying shares.

During the six months ended June 30, 2021, the Company issued a total of 3,680 shares of common stock in lieu of cash for the annual retainer of 6 non-employee directors and granted a total of 9,350 restricted shares of common stock to non-employee directors, of which 4,670 shares vested immediately and 4,680 shares will vest after completion of a one-year service requirement. The market value of the stock and restricted stock at the close of the Nasdaq Global Select Market on the date of grant was $32.06.

The following is a summary of restricted stock awards and restricted stock units activity for the six months ended June 30, 2021:

	Number of Shares			Weighted Average Market Price at Grant Date
Outstanding at beginning of year		168,513		$	25.65
Granted		91,526			27.99
Vested		(29,888	)		26.64
Forfeited		(25,977	)		26.68
Outstanding at end of period		204,174		$	26.42

At June 30, 2021, there was $3.4 million of unrecognized compensation expense related to unvested restricted stock awards and restricted stock units that is expected to be recognized over a weighted average period of 2.15 years.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(13.) SHARE-BASED COMPENSATION PLANS (Continued)

The Company amortizes the expense related to share-based compensation awards over the vesting period. Share-based compensation expense is recorded as a component of salaries and employee benefits in the consolidated statements of income for awards granted to management and as a component of other noninterest expense for awards granted to directors. The share-based compensation expense included in the consolidated statements of income, is as follows (in thousands):

	Three months ended June 30,				Six months ended June 30,
	2021		2020		2021		2020
Salaries and employee benefits	$	383	$	228	$	571	$	532
Other noninterest expense		179		141		207		169
Total share-based compensation expense	$	562	$	369	$	778	$	701

(14.) EMPLOYEE BENEFIT PLANS

The components of the Company’s net periodic benefit expense for its pension and post-retirement obligations were as follows (in thousands):

	Three months ended June 30,						Six months ended June 30,
	2021			2020			2021			2020
Service cost	$	1,049		$	923		$	2,098		$	1,846
Interest cost on projected benefit obligation		551			635			1,102			1,270
Expected return on plan assets		(1,307	)		(1,284	)		(2,613	)		(2,568	)
Amortization of unrecognized prior service credit		(1	)		(9	)		(1	)		(18	)
Amortization of unrecognized net actuarial loss		186			323			371			646
Net periodic benefit expense	$	478		$	588		$	957		$	1,176

The net periodic benefit expense is recorded as a component of salaries and employee benefits in the consolidated statements of income. The Company’s funding policy is to contribute, at a minimum, an actuarially determined amount that will satisfy the minimum funding requirements determined under the appropriate sections of the Internal Revenue Code. The Company has 0 minimum required contribution for the 2021 fiscal year.

(15.) COMMITMENTS AND CONTINGENCIES

Financial Instruments with Off-Balance Sheet Risk

The Company has financial instruments with off-balance sheet risk established in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk extending beyond amounts recognized in the financial statements.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is essentially the same as that involved with extending loans to customers. The Company uses the same credit underwriting policies in making commitments and conditional obligations as for on-balance sheet instruments.

Off-balance sheet commitments consist of the following (in thousands):

	June 30, 2021		December 31, 2020
Commitments to extend credit	$	936,937	$	1,012,810
Standby letters of credit		24,526		22,393

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(15.) COMMITMENTS AND CONTINGENCIES (Continued)

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the agreement. Commitments generally have fixed expiration dates or other termination clauses which may require payment of a fee. Commitments may expire without being drawn upon; therefore, the total commitment amounts do not necessarily represent future cash requirements. Each customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if any, is based on management’s credit evaluation of the borrower. Standby letters of credit are conditional lending commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support private borrowing arrangements. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers.

Unfunded Commitments

At June 30, 2021 and December 31, 2020, the allowance for credit losses for unfunded commitments totaled $2.1 million and $3.1 million, respectively, and was included in other liabilities on the Company's consolidated statements of financial condition. For the three months ended June 30, 2021 and 2020, credit loss (benefit) expense for unfunded commitments was $(764) thousand and $5 thousand, respectively. For the six months ended June 30, 2021 and 2020, credit loss (benefit) expense for unfunded commitments was $(1.0) million and $498 thousand, respectively.

Contingent Liabilities and Litigation

In the ordinary course of business, there are various threatened and pending legal proceedings against the Company. Management believes that the aggregate liability, if any, arising from such litigation, except for the matter described below, would not have a material adverse effect on the Company’s consolidated financial statements.

As previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020 as filed with the SEC on March 15, 2021 and as disclosed in Part II, Item 1 of this Quarterly Report on Form 10-Q, we are party to an action filed against us on May 16, 2017 by Matthew L. Chipego, Charlene Mowry, Constance C. Churchill and Joseph W. Ewing in the Court of Common Pleas in Philadelphia, Pennsylvania.  Plaintiffs seek class certification to represent classes of consumers in New York and Pennsylvania along with statutory damages, interest and declaratory relief. The plaintiffs seek to represent a putative class of consumers who are alleged to have obtained direct or indirect financing from us for the purchase of vehicles that we later repossessed. The plaintiffs specifically claim that the notices the Bank sent to defaulting consumers after their vehicles were repossessed did not comply with the relevant portions of the Uniform Commercial Code in New York and Pennsylvania. We dispute and believe we have meritorious defenses against these claims and plan to vigorously defend ourselves.

In February 2020, we agreed to engage in mediation with the plaintiffs and the mediation commenced in May 2021.  On October 19, 2020, the Court granted plaintiffs’ motion for judgment on the pleadings dismissing our affirmative defense against one named New York plaintiff that his claim was time-barred under New York law, applying a six-year statute of limitations rather than the three years limitation period we had argued. The plaintiff’s motion for class certification was argued on June 16, 2021 and the motion remains pending.

If we settle these claims or the action is not resolved in our favor, we may suffer reputational damage and incur legal costs, settlements or judgments that exceed the amounts covered by our existing insurance policies. We can provide no assurances that our insurer will insure the legal costs, settlements or judgments we incur in excess of our deductible. If we are unsuccessful in defending ourselves from these claims or if our insurer does not insure us against legal costs we incur in excess of our deductible, the result may materially adversely affect our business, results of operations and financial condition.

- 36 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(16.) FAIR VALUE MEASUREMENTS

Determination of Fair Value – Assets Measured at Fair Value on a Recurring and Nonrecurring Basis

Valuation Hierarchy

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. ASC Topic 820, “Fair Value Measurements and Disclosures,” establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. There have been no changes in the valuation techniques used during the current period. The fair value hierarchy is as follows:

• Level 1 - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

• Level 2 - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.

• Level 3 - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

Transfers between levels of the fair value hierarchy are recorded as of the end of the reporting period.

- 37 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(16.) FAIR VALUE MEASUREMENTS (Continued)

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the Company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein. A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

Securities available for sale: Securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

Derivative instruments: The fair value of derivative instruments is determined using quoted secondary market prices for similar financial instruments and are classified as Level 2 in the fair value hierarchy.

Loans held for sale: The fair value of loans held for sale is determined using quoted secondary market prices and investor commitments. Loans held for sale are classified as Level 2 in the fair value hierarchy.

Collateral dependent loans: Fair value of collateral dependent loans with specific allocations of the allowance for credit losses – loans is measured based on the value of the collateral securing these loans and is classified as Level 3 in the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory and/or accounts receivable and collateral value is determined based on appraisals performed by qualified licensed appraisers hired by the Company. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and the client’s business. Such discounts are typically significant and result in a Level 3 classification of the inputs for determining fair value. Collateral dependent loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above.

Long-lived assets held for sale: The fair value of the long-lived assets held for sale was based on estimated market prices from independently prepared current appraisals and are classified as Level 2 in the fair value hierarchy.

Loan servicing rights: Loan servicing rights do not trade in an active market with readily observable market data. As a result, the Company estimates the fair value of loan servicing rights by using a discounted cash flow model to calculate the present value of estimated future net servicing income. The assumptions used in the discounted cash flow model are those that we believe market participants would use in estimating future net servicing income, including estimates of loan prepayment rates, servicing costs, ancillary income, impound account balances, and discount rates. The significant unobservable inputs used in the fair value measurement of the Company’s loan servicing rights are the constant prepayment rates and weighted average discount rate. Significant increases (decreases) in any of those inputs in isolation could result in a significantly lower (higher) fair value measurement. Although the constant prepayment rate and the discount rate are not directly interrelated, they will generally move in opposite directions. Loan servicing rights are classified as Level 3 measurements due to the use of significant unobservable inputs, as well as significant management judgment and estimation.

Other real estate owned (foreclosed assets): Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. The appraisals are sometimes further discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business. Such discounts are typically significant and result in a Level 3 classification of the inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

Commitments to extend credit and letters of credit: Commitments to extend credit and fund letters of credit are principally at current interest rates, and, therefore, the carrying amount approximates fair value. The fair value of commitments is not material.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(16.) FAIR VALUE MEASUREMENTS (Continued)

Assets Measured at Fair Value

The following tables present for each of the fair-value hierarchy levels the Company’s assets that are measured at fair value on a recurring and nonrecurring basis as of the dates indicated (in thousands).

	Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Total
June 30, 2021
Measured on a recurring basis:
Securities available for sale:
U.S. Government agency and government sponsored enterprises	$	—	$	6,563		$	—	$	6,563
Mortgage-backed securities		—		896,282			—		896,282
Other assets:
Hedging derivative instruments		—		1,004			—		1,004
Fair value adjusted through comprehensive income	$	—	$	903,849		$	—	$	903,849
Other assets:
Derivative instruments - interest rate swaps		—		15,108			—		15,108
Derivative instruments - credit contracts		—		14			—		14
Derivative instruments - mortgage banking		—		317			—		317
Other liabilities:
Derivative instruments - interest rate swaps		—		(14,972	)		—		(14,972	)
Derivative instruments - credit contracts		—		(53	)		—		(53	)
Derivative instruments - mortgage banking		—		(39	)		—		(39	)
Fair value adjusted through net income	$	—	$	375		$	—	$	375
Measured on a nonrecurring basis:
Loans:
Loans held for sale	$	—	$	3,929		$	—	$	3,929
Collateral dependent loans		—		—			53,268		53,268
Other assets:
Long-lived assets held for sale		—		1,118			—		1,118
Loan servicing rights		—		—			1,433		1,433
Other real estate owned		—		—			646		646
Total	$	—	$	5,047		$	55,347	$	60,394

There were 0 transfers between Levels 1 and 2 during the six months ended June 30, 2021. There were 0 liabilities measured at fair value on a nonrecurring basis during the six months ended June 30, 2021.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(16.) FAIR VALUE MEASUREMENTS (Continued)

	Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Total
December 31, 2020
Measured on a recurring basis:
Securities available for sale:
U.S. Government agency and government sponsored enterprises	$	—	$	6,635		$	—	$	6,635
Mortgage-backed securities		—		621,424			—		621,424
Other liabilities:
Hedging derivative instruments		—		(311	)		—		(311	)
Fair value adjusted through comprehensive income	$	—	$	627,748		$	—	$	627,748
Other assets:
Derivative instruments - cash flow hedges	$	—	$	—		$	—	$	-
Derivative instruments - interest rate swaps		—		19,626			—		19,626
Derivative instruments - credit contracts		—		23			—		23
Derivative instruments - mortgage banking		—		471			—		471
Other liabilities:
Derivative instruments - interest rate swaps		—		(19,837	)		—		(19,837	)
Derivative instruments - credit contracts		—		(86	)		—		(86	)
Derivative instruments - mortgage banking		—		(1	)		—		(1	)
Fair value adjusted through net income	$	—	$	196		$	—	$	196
Measured on a nonrecurring basis:
Loans:
Loans held for sale	$	—	$	4,305		$	—	$	4,305
Collateral dependent loans		—		—			29,434		29,434
Other assets:
Loan servicing rights		—		—			1,320		1,320
Other real estate owned		—		—			2,966		2,966
Total	$	—	$	4,305		$	33,720	$	38,025

There were 0 transfers between Levels 1 and 2 during the six months ended June 30, 2020. There were 0 liabilities measured at fair value on a nonrecurring basis during the six months ended June 30, 2020.

The following table presents additional quantitative information about assets measured at fair value on a recurring and nonrecurring basis for which the Company has utilized Level 3 inputs to determine fair value as of June 30, 2021 (dollars in thousands).

Asset	Fair Value		Valuation Technique	Unobservable Input	Unobservable Input Value or Range
Collateral dependent loans	$	53,268	Appraisal of collateral (1)	Appraisal adjustments (2)	22.4% (3) / 0 - 35%
Loan servicing rights		1,433	Discounted cash flow	Discount rate	10.3% (3)
				Constant prepayment rate	14.2% (3)
Other real estate owned		646	Appraisal of collateral (1)	Appraisal adjustments (2)	46.2% (3)

⁽¹⁾ Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various Level 3 inputs which are not identifiable.

⁽²⁾ Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.

⁽³⁾ Weighted averages.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(16.) FAIR VALUE MEASUREMENTS (Continued)

Changes in Level 3 Fair Value Measurements

There were 0 assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of or during the six months ended June 30, 2021 and 2020.

Disclosures about Fair Value of Financial Instruments

The assumptions used below are expected to approximate those that market participants would use in valuing these financial instruments.

Fair value estimates are made at a specific point in time, based on available market information and judgments about the financial instrument, including estimates of timing, amount of expected future cash flows and the credit standing of the issuer. Such estimates do not consider the tax impact of the realization of unrealized gains or losses. In some cases, the fair value estimates cannot be substantiated by comparison to independent markets. In addition, the disclosed fair value may not be realized in the immediate settlement of the financial instrument. Care should be exercised in deriving conclusions about our business, its value or financial position based on the fair value information of financial instruments presented below.

The estimated fair value approximates carrying value for cash and cash equivalents, Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”) stock, accrued interest receivable, non-maturity deposits, short-term borrowings and accrued interest payable.

The following presents (in thousands) the carrying amount, estimated fair value, and placement in the fair value measurement hierarchy of the Company’s financial instruments as of the dates indicated.

	Level in	June 30, 2021				December 31, 2020
	Fair Value			Estimated				Estimated
	Measurement	Carrying		Fair		Carrying		Fair
	Hierarchy	Amount		Value		Amount		Value
Financial assets:
Cash and cash equivalents	Level 1	$	206,387	$	206,387	$	93,878	$	93,878
Securities available for sale	Level 2		902,845		902,845		628,059		628,059
Securities held to maturity, net	Level 2		218,858		226,044		271,973		282,035
Loans held for sale	Level 2		3,929		3,929		4,305		4,305
Loans	Level 2		3,532,535		3,564,623		3,513,284		3,549,770
Loans (1)	Level 3		53,268		53,268		29,434		29,434
Long-lived assets held for sale	Level 2		1,118		1,118		—		—
Accrued interest receivable	Level 1		15,431		15,431		15,635		15,635
Derivative instruments – cash flow hedges	Level 2		1,004		1,004		—		—
Derivative instruments – interest rate products	Level 2		15,108		15,108		19,626		19,626
Derivative instruments – credit contracts	Level 2		14		14		23		23
Derivative instruments – mortgage banking	Level 2		317		317		471		471
FHLB and FRB stock	Level 2		9,154		9,154		8,619		8,619
Financial liabilities:
Non-maturity deposits	Level 1		3,717,939		3,717,939		3,392,774		3,392,774
Time deposits	Level 2		941,282		941,649		885,593		887,113
Short-term borrowings	Level 1		—		—		5,300		5,300
Long-term borrowings	Level 2		73,756		78,286		73,623		83,953
Accrued interest payable	Level 1		2,868		2,868		4,381		4,381
Derivative instruments – cash flow hedges	Level 2		—		—		311		311
Derivative instruments – interest rate products	Level 2		14,972		14,972		19,837		19,837
Derivative instruments – credit contracts	Level 2		53		53		86		86
Derivative instruments – mortgage banking	Level 2		39		39		1		1

⁽¹⁾ Comprised of collateral dependent loans.

- 41 -

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(17.) SEGMENT REPORTING

The Company has 1 reportable segment, Banking, which includes all of the company’s retail and commercial banking operations. This reportable segment has been identified and organized based on the nature of the underlying products and services applicable to the segment, the type of customers to whom those products and services are offered and the distribution channel through which those products and services are made available.

All other segments that do not meet the quantitative threshold for separate reporting have been grouped as “All Other.” This “All Other” grouping includes the activities of SDN, a full-service insurance agency that provides a broad range of insurance services to both personal and business clients, and Courier Capital and HNP Capital, our investment advisor and wealth management firms that provide customized investment management, investment consulting and retirement plan services to individuals, businesses, institutions, foundations and retirement plans, and Holding Company amounts, which are the primary differences between segment amounts and consolidated totals, along with amounts to eliminate balances and transactions between segments.

The following tables present information regarding our business segments as of and for the periods indicated (in thousands).

	Banking		All Other		Consolidated Totals
June 30, 2021
Goodwill	$	48,536	$	18,137	$	66,673
Other intangible assets, net		10		7,579		7,589
Total assets		5,257,795		37,307		5,295,102
December 31, 2020
Goodwill	$	48,536	$	17,526	$	66,062
Other intangible assets, net		28		7,699		7,727
Total assets		4,875,673		36,633		4,912,306

	Banking			All Other (1)			Consolidated Totals
Three months ended June 30, 2021
Net interest income (expense)	$	38,788		$	(1,056	)	$	37,732
Benefit (provision) for credit losses		4,622			—			4,622
Noninterest income		6,603			3,587			10,190
Noninterest expense		(23,199	)		(3,745	)		(26,944	)
Income (loss) before income taxes		26,814			(1,214	)		25,600
Income tax (expense) benefit		(5,780	)		380			(5,400	)
Net income (loss)	$	21,034		$	(834	)	$	20,200
Six months ended June 30, 2021
Net interest income (expense)	$	77,706		$	(2,117	)	$	75,589
Benefit (provision) for credit losses		6,603			—			6,603
Noninterest income		15,878			7,271			23,149
Noninterest expense		(45,832	)		(7,852	)		(53,684	)
Income (loss) before income taxes		54,355			(2,698	)		51,657
Income tax (expense) benefit		(11,815	)		1,068			(10,747	)
Net income (loss)	$	42,540		$	(1,630	)	$	40,910

⁽¹⁾ Reflects activity from the acquisition of assets of Landmark Group since February 1, 2021 (the date of acquisition).

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(17.) SEGMENT REPORTING (Continued)

	Banking			All Other			Consolidated Totals
Three months ended June 30, 2020
Net interest income (expense)	$	34,798		$	(617	)	$	34,181
Provision for credit losses		(3,746	)		—			(3,746	)
Noninterest income		7,082			2,631			9,713
Noninterest expense		(23,607	)		(2,968	)		(26,575	)
Income (loss) before income taxes		14,527			(954	)		13,573
Income tax (expense) benefit		(2,860	)		419			(2,441	)
Net income (loss)	$	11,667		$	(535	)	$	11,132
Six months ended June 30, 2020
Net interest income (expense)	$	68,540		$	(1,235	)	$	67,305
Provision for credit losses		(17,661	)		—			(17,661	)
Noninterest income		13,897			5,726			19,623
Noninterest expense		(47,333	)		(6,912	)		(54,245	)
Income (loss) before income taxes		17,443			(2,421	)		15,022
Income tax (expense) benefit		(2,719	)		(44	)		(2,763	)
Net income (loss)	$	14,724		$	(2,465	)	$	12,259

- 43 -

ITEM 2.      Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q should be read in conjunction with the more detailed and comprehensive disclosures included in our Annual Report on Form 10-K for the year ended December 31, 2020. In addition, please read this section in conjunction with our Consolidated Financial Statements and Notes to Consolidated Financial Statements contained herein.

FORWARD LOOKING INFORMATION

Statements and financial analysis contained in this Quarterly Report on Form 10-Q that are based on other than historical data are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations or forecasts of future events and include, among others:

• statements with respect to the beliefs, plans, objectives, goals, guidelines, expectations, anticipations, and future financial condition, results of operations and performance of Financial Institutions, Inc. (the “Parent” or “FII”) and its subsidiaries (collectively, the “Company,” “we,” “our” or “us”); and

• statements preceded by, followed by or that include the words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “projects” or similar expressions.

These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date. Forward-looking statements involve significant risks and uncertainties and actual results may differ materially from those presented, either expressed or implied, in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended December 31, 2020 (the “Form 10-K”), including, but not limited to, those presented in the Management’s Discussion and Analysis of Financial Condition and Results of Operations. Factors that might cause such material differences include, but are not limited to:

• The COVID-19 pandemic, and governmental and individual efforts to contain the pandemic, have had a significant negative impact on the U.S. and global economy which has and will continue to adversely affect our business, financial condition and results of operations;

• If we experience greater credit losses than anticipated, earnings may be adversely impacted;

• Geographic concentration may unfavorably impact our operations;

• Our commercial business and mortgage loans increase our exposure to credit risks;

• Our indirect and consumer lending involves risk elements in addition to normal credit risk;

• Lack of seasoning in portions of our loan portfolio could increase risk of credit defaults in the future;

• We accept deposits that do not have a fixed term, and which may be withdrawn by the customer at any time for any reason;

• We are subject to environmental liability risk associated with our lending activities;

• We operate in a highly competitive industry and market area;

• Changes to and replacement of the LIBOR Benchmark Interest Rate may adversely affect our business, financial condition, and results of operations;

• Legal and regulatory proceedings and related matters, such as the action brought by a putative class of consumers against us as described in Part II, Item 1, “Legal Proceedings,” could adversely affect us and the banking industry in general;

• Any future FDIC insurance premium increases may adversely affect our earnings;

• We are highly regulated, and any adverse regulatory action may result in additional costs, loss of business opportunities, and reputational damage;

• The policies of the Federal Reserve have a significant impact on our earnings;

• Our insurance brokerage subsidiary is subject to risk related to the insurance industry;

• Our investment advisory and wealth management operations are subject to risk related to the regulation of the financial services industry and market volatility;

• We make certain assumptions and estimates in preparing our financial statements that may prove to be incorrect, which could significantly impact our results of operations, cash flows and financial condition, and we are subject to new or changing accounting rules and interpretations, and the failure by us to correctly interpret or apply these evolving rules and interpretations could have a material adverse effect;

• The value of our goodwill and other intangible assets may decline in the future;

• We may be unable to successfully implement our growth strategies, including the integration and successful management of newly-acquired businesses;

• Acquisitions may disrupt our business and dilute shareholder value;

• Our tax strategies and the value of our deferred tax assets and liabilities could adversely affect our operating results and regulatory capital ratios;

- 44 -

MANAGEMENT’S DISCUSSION AND ANALYSIS

• Liquidity is essential to our businesses;

• We rely on dividends from our subsidiaries for most of our revenue;

• If our risk management framework does not effectively identify or mitigate our risks, we could suffer losses;

• We face competition in staying current with technological changes and banking alternatives to compete and meet customer demands;

• We rely on other companies to provide key components of our business infrastructure;

• A breach in security of our or third-party information systems, including the occurrence of a cyber incident or a deficiency in cybersecurity, or a failure by us to comply with New York State cybersecurity regulations, may subject us to liability, result in a loss of customer business or damage our brand image;

• We are subject to interest rate risk, and a rising rate environment may reduce our income and result in higher defaults on our loans, whereas a falling rate environment may result in earlier loan prepayments than we expect, which may reduce our income;

• The soundness of other financial institutions could adversely affect us;

• We may need to raise additional capital in the future and such capital may not be available on acceptable terms or at all;

• We may not pay or may reduce the dividends on our common stock;

• We may issue debt and equity securities or securities convertible into equity securities, any of which may be senior to our common stock as to distributions and in liquidation, which could dilute our current shareholders or negatively affect the value of our common stock;

• Our certificate of incorporation, our bylaws, and certain banking laws may have an anti-takeover effect;

• The market price of our common stock may fluctuate significantly in response to a number of factors;

• We may not be able to attract and retain skilled people;

• We use financial models for business planning purposes that may not adequately predict future results;

• We depend on the accuracy and completeness of information about or from customers and counterparties;

• Our business may be adversely affected by conditions in the financial markets and economic conditions generally; and

• Severe weather, natural disasters, public health emergencies and pandemics, acts of war or terrorism, and other external events could significantly impact our business.

We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and advise readers that various factors, including those described above, could affect our financial performance and could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected. See also Item 1A, Risk Factors, in the Form 10-K for further information. Except as required by law, we do not undertake, and specifically disclaim any obligation to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

GENERAL

The Parent is a financial holding company headquartered in New York State, providing diversified financial services through its subsidiaries, Five Star Bank (the “Bank”), SDN Insurance Agency, LLC (“SDN”), Courier Capital, LLC (“Courier Capital”) and HNP Capital, LLC (“HNP Capital”). The Company offers a broad array of deposit, lending and other financial services to individuals, municipalities and businesses in Western and Central New York through its wholly-owned New York-chartered banking subsidiary, the Bank. Our indirect lending network includes relationships with franchised automobile dealers in Western and Central New York, the Capital District of New York and Northern and Central Pennsylvania. SDN provides a broad range of insurance services to personal and business clients. Courier Capital and HNP Capital provide customized investment advice, wealth management, investment consulting and retirement plan services to individuals, businesses, institutions, foundations and retirement plans.

Our primary sources of revenue are net interest income (interest earned on our loans and securities, net of interest paid on deposits and other funding sources) and noninterest income, particularly fees and other revenue from insurance, investment advisory and financial services provided to customers or ancillary services tied to loans and deposits. Business volumes and pricing drive revenue potential, and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth, and competitive conditions within the marketplace. We are not able to predict market interest rate fluctuations with certainty and our asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on our results of operations and financial condition.

Our business strategy has been to maintain a community bank philosophy, which consists of focusing on and understanding the individualized banking and other financial needs of individuals, municipalities and businesses of the local communities surrounding our primary service area. We believe this focus allows us to be more responsive to our customers’ needs and provide a high level of personal service that differentiates us from larger competitors, resulting in long-standing and broad-based banking relationships. Our core customers are primarily small- to medium-sized businesses, individuals and community organizations who prefer to build banking, insurance and wealth management relationships with a community bank that combines high quality, competitively-priced products and services with personalized service. Because of our identity and origin as a locally operated bank, we believe that our level of personal service provides a competitive advantage over larger banks, which tend to consolidate decision-making authority outside local communities.

- 45 -

MANAGEMENT’S DISCUSSION AND ANALYSIS

A key aspect of our current business strategy is to foster a community-oriented culture where our customers and employees establish long-standing and mutually beneficial relationships. We believe that we are well-positioned to be a strong competitor within our market area because of our focus on community banking needs and customer service, our comprehensive suite of deposit, loan, insurance and wealth management products typically found at larger banks, our highly experienced management team and our strategically located banking centers. We have evolved to meet changing customer needs by opening what we refer to as financial solution center branches. These financial solution center branches have a smaller footprint than our traditional branches, focus on technology to provide solutions that fit our customer preferences for transacting business with us, and are staffed by certified personal bankers who are trained to meet a broad array of customer needs. In recent years, we have opened four financial solution centers in the Rochester and Buffalo markets. We believe that the foregoing factors all help to grow our core deposits, which supports a central element of our business strategy - the growth of a diversified and high-quality loan portfolio.

EXECUTIVE OVERVIEW

Summary of 2021 Second Quarter Results

Net income increased $9.1 million to $20.2 million for the second quarter of 2021 compared to $11.1 million for the second quarter of 2020. Net income available to common shareholders for the second quarter of 2021 was $19.8 million, or $1.25 per diluted share, compared with $10.8 million, or $0.67 per diluted share, for the second quarter of last year. Return on average common equity was 17.34% and return on average assets was 1.52% for the second quarter of 2021 compared to 10.11% and 0.97%, respectively, for the second quarter of 2020.

Net income for both periods was significantly impacted by the benefit (provision) for credit losses. The increase in net income for the second quarter of 2021 was driven by a $4.6 million benefit for credit losses as compared to a provision of $3.7 million in the second quarter of 2020. Continued improvement in the national unemployment forecast, positive trends in qualitative factors and lower net charge-offs resulted in a release of credit loss reserves and the corresponding benefit for credit losses in the quarter.

Net interest income totaled $37.7 million in the second quarter of 2021, up from $34.2 million in the second quarter of 2020. The increase was primarily the result of an increase in interest-earning assets, the positive impact of PPP loan forgiveness in the second quarter of 2021, and a decrease in interest expense. The decrease in interest expense was primarily due to a favorable shift in deposit categories, with a lower allocation of time deposits, coupled with a lower interest-bearing cost of funds.  Average Federal Reserve interest-earning cash, average investment securities and average loans were up $157.1 million, $290.3 million and $251.8 million, respectively, in the second quarter of 2021 compared to the same quarter in 2020. 

The provision for credit losses - loans was a $3.9 million benefit in the second quarter of 2021 compared to a provision of $3.7 million in the second quarter of 2020. Net recoveries during the recent quarter were $394 thousand compared to net charge-offs of $786 thousand in the second quarter of 2020. Net charge-offs (recoveries) expressed as an annualized percentage of average loans outstanding were (0.04)% during the second quarter of 2021 compared with 0.09% in the second quarter of 2020. See the “Allowance for Credit Losses - Loans” and “Non-Performing Assets and Potential Problem Loans” sections of this Management’s Discussion and Analysis for further discussion regarding the change in the provision (benefit) for credit losses - loans and the decrease in net charge-offs.

Noninterest income totaled $10.2 million in the second quarter of 2021, compared to $9.7 million in the second quarter of 2020. The increase in noninterest income for the second quarter was primarily due to increases in service charges on deposits, investment advisory income, insurance income, income from investments in limited partnerships and card interchange income, partially offset by decreases in income (loss) from derivative instruments, net and net gain (loss) on investment securities. Service charges on deposits was $807 thousand higher than the second quarter of 2020, primarily due to our COVID-19 relief initiatives of temporarily waiving or eliminating fees during the second quarter of 2020. Investment advisory income was $635 thousand higher than the second quarter of 2020, due to an increase in assets under management, driven by a combination of market gains, new customer accounts and contributions to existing accounts. Insurance income was $328 thousand higher than the second quarter of 2020 primarily due to the Landmark Group acquisition in 2021. Income from investments in limited partnerships of $238 thousand was recognized in the second quarter of 2021 as compared to a loss of $244 thousand in the second quarter of 2020. Card interchange income of $1.1 million was recognized in the second quarter of 2021 as compared to $819 thousand in the second quarter of 2020. Income (loss) from derivative instruments, net was $2.5 million lower than the second quarter of 2020. Income from derivative instruments, net is based on the number and value of interest rate swap transactions executed during the quarter combined with the impact of changes in the fair market value of borrower-facing trades. A lower level of interest swap transactions was executed during the quarter and fair market values were negatively impacted by the second quarter decrease in longer-term rates. Net gain (loss) on investment securities was a loss of $3 thousand in the second quarter of 2021 compared to a net gain of $674 thousand in the second quarter of 2020.

Noninterest expense totaled $26.9 million in the second quarter of 2021, compared to $26.6 million in the second quarter of 2020. The increase in noninterest expense was primarily the result of increases in computer and data processing expense, partially offset by a decrease in salaries and employee benefits expense. Computer and data processing expense increased primarily due to increased investments in technology, including costs related to the Bank’s online and mobile platform, Five Star Bank Digital Banking, launched in the second quarter of 2020. The decrease in salaries and employee benefits expense reflects the 2020 streamlining of retail branches to better align with shifting customer needs and preferences, including the decision to close a total of seven branches.

The regulatory Common Equity Tier 1 Ratio and Total Risk-Based Capital Ratio were 10.38%, and 13.54%, respectively, at June 30, 2021. See the “Liquidity and Capital Management” section of this Management’s Discussion and Analysis for further discussion regarding regulatory capital and the Basel III capital rules.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Buffalo Branch Openings

Two new Five Star Bank branches opened in the City of Buffalo in June of 2021, consistent with the Company’s long-term strategy to expand in the urban markets of Buffalo and Rochester. The branches are in vibrant commercial corridors at 451 Elmwood Avenue and 2222 Seneca Street, extending the reach of Five Star Bank’s distribution system in both northern and southern directions from the existing downtown branch.

The Company used green and energy efficient materials during the construction of these two new branches. Materials sourced for the Elmwood Avenue and Seneca Street branches received certifications from Cradle to Cradle, Declare, Forest Stewardship Council, Green Square and GreenGuard. Additionally, materials with a high percentage of recycled content were used when possible.

Operational, Accounting and Reporting Impacts Related to the COVID-19 Pandemic

The COVID-19 pandemic has negatively impacted the global economy, including our operating footprint of Western and Central New York. In response to this crisis, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was passed by Congress and signed into law on March 27, 2020. The CARES Act provided an estimated $2.2 trillion to fight the COVID-19 pandemic and stimulate the economy by supporting individuals and businesses through loans, grants, tax changes, and other types of relief. Some of the provisions applicable to the Company include, but are not limited to:

• Accounting for Loan Modifications - The CARES Act provided that a financial institution may elect to suspend (1) the application of GAAP for certain loan modifications related to COVID-19 that would otherwise be categorized as a troubled debt restructuring (“TDR”) and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes.

• Paycheck Protection Program - The CARES Act established the Paycheck Protection Program (“PPP”), an expansion of the Small Business Administration’s (“SBA”) 7(a) loan program and the Economic Injury Disaster Loan Program (“EIDL”), administered directly by the SBA. On December 27, 2020, the Consolidated Appropriations Act, 2021 provided approximately $284 billion for PPP loans in an additional round of funding under the program and extended the PPP through March 31, 2021. This additional round of PPP loan funding is authorized for first-time borrowers and for second draws be certain borrowers who have previously received PPP loans.  On March 30, 2021, the PPP Extension Act of 2021 was signed into law, which extended the program to May 31, 2021.

• Mortgage Forbearance - Under the CARES Act, a borrower with a federally backed mortgage loan that is experiencing financial hardship due to COVID-19 may request a forbearance through September 30, 2021.

Also, in response to the COVID-19 pandemic, the Board of Governors of the Federal Reserve System (“FRB”), the Federal Deposit Insurance Corporation (“FDIC”), the National Credit Union Administration (“NCUA”), the Office of the Comptroller of the Currency (“OCC”), and the Consumer Financial Protection Bureau (“CFPB”), in consultation with the state financial regulators (collectively, the “agencies”) issued a joint interagency statement (issued March 22, 2020; revised statement issued April 7, 2020). Some of the provisions applicable to the Company include, but are not limited to:

• Accounting for Loan Modifications - Loan modifications that do not meet the conditions of the CARES Act may still qualify as a modification that does not need to be accounted for as a TDR. The agencies confirmed with FASB staff that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not TDRs. This includes short-term (e.g., six months) modifications such as payment deferrals, fee waivers, extensions of repayment terms, or insignificant delays in payment.

• Past Due Reporting - With regard to loans not otherwise reportable as past due, financial institutions are not expected to designate loans with deferrals granted due to COVID-19 as past due because of the deferral. A loan’s payment date is governed by the due date stipulated in the legal agreement. If a financial institution agrees to a payment deferral, these loans would not be considered past due during the period of the deferral.

• Nonaccrual Status and Charge-offs - During short-term COVID-19 modifications, these loans generally should not be reported as nonaccrual or as classified.

Effective March 23, 2020 through July 9, 2020, for consumer customers, the Bank waived early CD penalty fees for withdrawals up to $20,000 (limited to one penalty-free withdrawal per CD account); eliminated all insufficient funds (overdrafts) and returned item fees; eliminated all Pay by Phone fees; waived all late fees; offered the opportunity for monthly mortgage, home equity loan or home equity line payment relief; offered the opportunity to defer unsecured consumer loans or lines of credit and secured consumer loans and lines of credit payments; and offered unsecured personal loans up to $5,000, up to 60 months at 2.95% APR subject to credit approval.  ATM access fees were reinitiated on September 19, 2020.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

As part of the first round of PPP loans we have helped more than 1,700 customers obtain more than $270 million in loans as of December 31, 2020. Of those loans, we have helped customers complete the forgiveness process for approximately $183 million of loans in the first six months of 2021. Also, during the first six months of 2021, we have helped customers obtain approximately $107 million of new PPP loans under the second round of the PPP. Additionally, as of June 30, 2021, approximately 3% of our commercial loan and mortgage customers, 1% of our residential real estate loans and lines customers and less than 1% of our indirect loans customers have active payment deferrals in accordance with the previously noted loan modifications under the CARES Act or agencies guidelines.

RESULTS OF OPERATIONS

Net Interest Income and Net Interest Margin

Net interest income is our primary source of revenue, comprising 77% of revenue during the six months ended June 30, 2021. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities and repricing frequencies.

We use interest rate spread and net interest margin to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds (“net free funds”), principally noninterest-bearing demand deposits and shareholders’ equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis.

The following table reconciles interest income