08/02/2021 | Press release | Distributed by Public on 08/02/2021 11:49

Quarterly Report (SEC Filing - 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

☒Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period 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 001-38084

FARMERS & MERCHANTS BANCORP, INC.

(Exact name of registrant as specified in its charter)

(419) 446-2501

Registrant's telephone number, including area code

(Former name, former address and former fiscal year, if changed since last report.)

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or Section 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.

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 ☒

Indicate the number of shares of each of the issuers' classes of common stock, as of the latest practicable date:

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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10Q

FARMERS & MERCHANTS BANCORP, INC.

INDEX

2

PART 1 - FINANCIAL INFORMATION

ITEM 1 FINANCIAL STATEMENTS

FARMERS & MERCHANTS BANCORP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

See Notes to Condensed Consolidated Unaudited Financial Statements.

Note: The December 31, 2020, Condensed Consolidated Balance Sheet has been derived from the audited Consolidated Balance Sheet as of that date.

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FARMERS & MERCHANTS BANCORP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

See Notes to Condensed Consolidated Unaudited Financial Statements

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FARMERS & MERCHANTS BANCORP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

See Notes to Condensed Consolidated Unaudited Financial Statements

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Farmers & Merchants Bancorp, Inc. and Subsidiaries

CONDENSED Consolidated StatementS of Changes TO Stockholders' Equity

For the THREE AND SIX Months Ended June 30, 2021

(000's Omitted, Except Per Share Data)

(Unaudited)

See Notes to Condensed Consolidated Unaudited Financial Statements

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Farmers & Merchants Bancorp, Inc. and Subsidiaries

CONDENSED Consolidated StatementS of Changes TO Stockholders' Equity

For the THREE and SIX Months Ended June 30, 2020

(000's Omitted, Except Per Share Data)

(Unaudited)

See Notes to Condensed Consolidated Unaudited Financial Statements

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FARMERS & MERCHANTS BANCORP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(continued)

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FARMERS & MERCHANTS BANCORP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued)

See Notes to Condensed Consolidated Unaudited Financial Statements.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS

NOTE 1 BASIS OF PRESENTATION AND OTHER

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10Q and Rule 10-01 of Regulation S-X; accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Operating results for the six months ended June 30, 2021 are not necessarily indicative of the results that are expected for the year ended December 31, 2021. The condensed consolidated balance sheet of the Company as of December 31, 2020, has been derived from the audited consolidated balance sheet of the Company as of that date. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2020.

The Company recognizes revenues as they are earned based on contractual terms, as transactions occur, or as services are provided and collectability is reasonably assured. The Company's principal source of revenue is interest income from loans and investment securities. The Company also earns noninterest income from various banking and financial services offered primarily through Farmers & Merchants State Bank. Interest income is primarily recognized on an accrual basis according to nondiscretionary formulas written in contracts, such as loan agreements or investment security contracts. The Company also earns noninterest income from various banking and financial services provided to business and consumer clients such as deposit account, debit card, and mortgage banking services. Revenue is recorded for noninterest income based on the contractual terms for the service or transaction performed.

NOTE 2 BUSINESS COMBINATION AND ASSET PURCHASE

On April 30, 2021, the Company acquired Ossian Financial Services, Inc., (OSFI), the bank holding company for Ossian State Bank, a community bank based in Ossian, Indiana. Ossian State Bank operated two full-service offices in the northeast Indiana communities of Ossian and Bluffton. Shareholders of OSFI received $67.71 in cash for each share. OSFI had 295,388 shares outstanding on April 30, 2021. Total consideration for the acquisition was approximately $20.0 million in cash. As a result of the acquisition, the Company will have an opportunity to increase its deposit base and reduce transaction costs. The Company also expects to reduce costs through economies of scale.

In 2020, the Company incurred $42.5 thousand of third-party acquisition-related costs. The expenses recognized in 2020 related to other general and administration expenses of $30.0 thousand and consulting fees of $12.5 thousand. These acquisition expenses were included in the Company's 2020 consolidated statement of income.

In 2021, the Company has incurred additional third-party acquisition-related costs of $977.5 thousand. These expenses are comprised of employee benefits of $541.5 thousand, consulting fees of $245.0 thousand, ATM expense of $11.2 thousand and other general and administrative expense of $179.8 thousand in the Company's consolidated statement of income for the quarter and six months ended June 30, 2021.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 2 BUSINESS COMBINATION AND ASSET PURCHASE (Continued)

Under the acquisition method of accounting, the total purchase was allocated to net tangible and intangible assets based on their current estimated fair values on the date of acquisition. Of the total purchase price of $20.0million, $980.2thousand has been allocated to core deposit intangible included in other assets and will be amortized over seven yearson a straight line basis. Goodwill of $8.7million which resulted from the acquisition consists largely of the synergies and economies of scale expected from combining the operations of the Company and Ossian State Bank and is deductible for tax purposes over 15 years. The following table summarizes the consideration paid for Ossian State Bank and the amounts of the assets acquired and liabilities assumed recognized at the acquisition date.

The fair value of the assets acquired includes loans with a fair value of $52.4 million. The gross principal and contractual interest due under the contracts is $58.6 million, of which $1.1 million is expected to be uncollectible. The loans have a weighted average life of 52 months.

The fair value of building and land included in premises and equipment was written down by $596 thousand with $244 thousand attributable to buildings and will be accreted over the useful life of 39 years,

The fair value for certificates of deposit incorporates a valuation amount of $59 thousand which will be accreted over 1.4 years.

Certain transferred loans evidenced deterioration of credit quality since origination and management deemed it probable, at acquisition, that all contractually required payments would not be collected.

Loans purchased with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered to be credit impaired. Evidence of credit quality deterioration as of the purchase date may include information such as past-due and nonaccrual status, borrower credit scores and recent loan to value percentages. Purchased credit-impaired loans are accounted for under the accounting guidance for loans and debt securities acquired with deteriorated credit quality (ASC 310-30) and initially measured at fair value, which includes estimated future credit losses expected to be incurred over the life of the loan. Accordingly, an allowance for credit losses related to these loans is not carried over and recorded at the acquisition date. Management estimated the cash flows expected to be collected at acquisition using our internal risk models, which incorporate the estimate of current key assumptions, such as default rates, severity and prepayment speeds.

The carrying amount of those loans is included in loans, net on the balance sheet at June 30. The amounts of loans at April 30, 2021 and June 30, 2021 are as follows:

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 2 BUSINESS COMBINATION AND ASSET PURCHASE (Continued)

Loans acquired during 2021 for which it was probable at acquisition that all contractually required payments would not be collected are as follows:

There were no allowances for loan losses reversed in 2021.

Changes in accretable yield, or income expected to be collected, are as follows:

The results of operations of Ossian State Bank have been included in the Company's consolidated financial statements since the acquisition date of April 30, 2021. The following schedule includes pro-forma results for the three and six months ended June 30, 2021 and 2020 as if the Ossian State Bank acquisitions had occurred as of the beginning of the comparable prior reporting period.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 2 BUSINESS COMBINATION AND ASSET PURCHASE (Continued)

The pro-forma information includes adjustments for interest income on loans, amortization of intangibles arising from the transaction, interest expense on deposits acquired, premises expense for the branches acquired and the related income tax effects. The pro-forma information for the quarter ended June 30, 2021 includes approximately $232 thousand, net of tax, of operating revenue from Ossian State Bank since acquisition.

The pro-forma financial information is presented for informational purposes only and is not indicative of the results of operations that actually would have been achieved had the acquisition been consummated as of that time, nor is it intended to be a projection of future results.

On January 1, 2019, the Company acquired Limberlost Bancshares, Inc. ('Limberlost'), the bank holding company for Bank of Geneva, a community bank based in Geneva, Indiana. Bank of Geneva operated six full-service offices in the northeast Indiana communities of Geneva, Berne, Decatur, Monroe, Portland and Monroeville. Shareholders of Limberlost received 1,830 shares of FMAO common stock and $8,465.00 in cash for each share. Limberlost had 1,000 shares outstanding on January 1, 2019. The share price of Farmers & Merchants Bancorp, Inc. (FMAO) stock on January 1, 2019 was $38.49. Total consideration for the acquisition was approximately $78.9 million consisting of $8.5 million in cash and $70.4 million in stock. As a result of the acquisition, the Company has had an opportunity to increase its deposit base and reduce transaction costs. The Company has also reduced costs through economies of scale.

Under the acquisition method of accounting, the total purchase was allocated to net tangible and intangible assets based on their current estimated fair values on the date of acquisition. Of the total purchase price of $78.9 million, $3.9 million has been allocated to core deposit intangible included in other assets and is being amortized over seven years on a straight line basis. Goodwill of $43.3 million resulting from the acquisition consists largely of the synergies and economies of scale expected from combining the operations of the Company and Bank of Geneva. Of that total amount, none of the purchase price is deductible for tax purposes.

Changes in accretable yield, or income expected to be collected, for the three and six months ended are as follows:

As mentioned previously, the acquisition of Bank of Geneva resulted in the recognition of $3.9 million in core deposit intangible assets which are being amortized over its remaining life of 7 years on a straight line basis.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 2 BUSINESS COMBINATION AND ASSET PURCHASE (Continued)

The amortization expense for the six months ended June 30, 2020was $364thousand of which $84thousand was related to the purchase of the Custar office in December of 2013. Of the $653thousand to be expensed in 2021, $303thousand has been expensed for the six months ended June 30, 2021. Annual amortization of core deposit intangible assets is as follows:

On November 16, 2020, FM Investment Services, a division of the Bank, purchased the assets and clients of Adams County Financial Resources (ACFR), a full-service registered investment advisory firm located in Geneva, Indiana.

ACFR was founded in 1994 by R. Lee Flueckiger and provides clients and their families with financial confidence through personalized investment planning and services. As of November 30, 2020, ACFR had approximately $83 million of assets under management and over 450 clients.

Total consideration for the purchase was $825 thousand which consisted of 40,049 shares of stock. As a result of this purchase, the Company expects an increase to noninterest income of approximately $500 thousand in 2021 with the majority of the income to be recognized in the second half of the year.

Under the acquisition method of accounting, the total purchase is allocated to net tangible and intangible assets based on their current estimated fair values on the date of acquisition. Of the total purchase price of $825 thousand, $800 thousand has been allocated to customer list intangible, included in other assets, to be amortized over 6.5 years on a straight line basis.

The following table summarizes the consideration paid for ACFR and the amounts of the assets acquired:

Of the $123 thousand to be expensed in 2021, $61 thousand has been expensed for the six months ended June 30, 2021. Annual amortization expense of customer list intangible is as follows:

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 2 BUSINESS COMBINATION AND ASSET PURCHASE (Continued)

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS

NOTE 3 SECURITIES

Mortgage-backed securities, as shown in the following tables, are all government sponsored enterprises. The amortized cost and fair value of securities, with gross unrealized gains and losses at June 30, 2021 and December 31, 2020, are as follows:

Investment securities will at times depreciate to an unrealized loss position. The Company utilizes the following criteria to assess whether impairment is other than temporary. No one item by itself will necessarily signal that a security should be recognized as an other than temporary impairment.

If the impairment is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value, thereby establishing a new cost basis. The new cost basis shall not be changed for subsequent recoveries in fair value. The amount of the write down shall be included in current earnings as a realized loss. The recovery in fair value, if any, shall be recognized in earnings when the security is sold. The table below is presented by category of security and length of time in a continuous loss position. The Company currently does not hold any securities with other than temporary impairment.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 3 SECURITIES (Continued)

Information pertaining to securities with gross unrealized losses at June 30, 2021 and December 31, 2020, aggregated by investment category and length of time that individual securities have been in a continuous loss position follows:

Unrealized losses on securities have not been recognized into income because the issuers' bonds are of high credit quality, values have only been impacted by changes in interest rates since the securities were purchased, and the Company has the intent and ability to hold the securities for the foreseeable future. The fair value is expected to recover as the bonds approach the maturity date.

Below are the gross realized gains and losses for the three and six months ended June 30, 2021 and June 30, 2020.

The net realized gains on sales and related tax expense is a reclassification out of accumulated other comprehensive income (loss). The net realized gains are included in net gains on sale of available-for-sale securities and the related tax expense is included in income taxes in the condensed consolidated statements of income and comprehensive income (loss).

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 3 SECURITIES (Continued)

The amortized cost and fair value of debt securities at June 30, 2021, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

Investments with a carrying value of $78.5 million and $83.2 million at June 30, 2021 and December 31, 2020, respectively, were pledged to secure public deposits and securities sold under repurchase agreements.

Other securities include Federal Home Loan Bank of Cincinnati and Indianapolis stock in the amount of $6.1 million as of June 30, 2021 and $5.8 million as of December 31, 2020 in addition to Ohio Equity Fund for Housing Limited Partnership of $348 thousand as of June 30, 2021 and $151 thousand as of December 31, 2020.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS

Loan balances as of June 30, 2021 and December 31, 2020 are summarized below:

Other loans primarily fund public improvement in the Bank's service area.

The distribution of fixed rate loans and variable rate loans by major loan category is as follows as of June 30, 2021:

As of June 30, 2021 and December 31, 2020 one to four family residential mortgage loans amounting to $36.5 million and $38.0 million, respectively, have been pledged as security for future loans and existing loans the Bank has received from the Federal Home Loan Bank.

Unless listed separately, Other loans are included in the Commercial and Industrial category for the remainder of the tables in this Note 4.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

The following table represents the contractual aging of the recorded investment (in thousands) in past due loans by portfolio classification of loans as of June 30, 2021 and December 31, 2020, net of deferred loan fees and costs:

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

The following table presents the recorded investment in nonaccrual loans by class of loans as of June 30, 2021 and December 31, 2020:

Following are the characteristics and underwriting criteria for each major type of loan the Bank offers:

Consumer Real Estate: Purchase, refinance, or equity financing of one to four family owner occupied dwelling. Success in repayment is subject to borrower's income, debt level, character in fulfilling payment obligations, employment, and others.

Agricultural Real Estate: Purchase of farm real estate or for permanent improvements to the farm real estate. Cash flow from the farm operation is the repayment source and is therefore subject to the financial success of the farm operation.

Agricultural: Loans for the production and housing of crops, fruits, vegetables, and livestock or to fund the purchase or re-finance of capital assets such as machinery and equipment and livestock. The production of crops and livestock is especially vulnerable to commodity prices and weather. The vulnerability to commodity prices is offset by the farmer's ability to hedge their position by the use of the future contracts. The risk related to weather is often mitigated by requiring crop insurance.

Commercial Real Estate: Construction, purchase, and refinance of business purpose real estate. Risks include potential construction delays and overruns, vacancies, collateral value subject to market value fluctuations, interest rate, market demands, borrower's ability to repay in orderly fashion, and others. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer's ability to repay in a changing rate environment before granting loan approval.

Commercial and Industrial: Loans to proprietorships, partnerships, or corporations to provide temporary working capital and seasonal loans as well as long term loans for capital asset acquisition. Risks include adequacy of cash flow, reasonableness of projections, financial leverage, economic trends, management ability and estimated capital expenditures during the fiscal year. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer's ability to repay in a changing rate environment before granting loan approval. Included in commercial loans for 2021 and 2020 are Paycheck Protection Program (PPP) loans, administered by the Small Business Administration (SBA), in the amounts of $47.0 million and $36.2 million, respectively. The PPP provides loans to eligible businesses through financial institutions like the Bank, with loans being eligible for forgiveness of some or all of the principal amount by the SBA if the borrower meets certain requirements. The SBA guarantees repayment of the loans to the Bank if the borrower's loan is not forgiven and is then not repaid by the customer. Therefore, there is no allowance for loan losses related to these loans.

Consumer: Funding for individual and family purposes. Success in repayment is subject to borrower's income, debt level, character in fulfilling payment obligations, employment, and others.

Other: Primarily funds public improvements in the Bank's service area. Repayment ability is based on the continuance of the taxation revenue as the source of repayment.

The Bank uses a nine tier risk rating system to grade its loans. The grade of a loan may change during the life of the loan.

The risk ratings are described as follows.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

Loans may be rated 3 when there is no recent information on which to base a current risk evaluation and the following conditions apply:

At inception, the loan was properly underwritten and did not possess an unwarranted level of credit risk;

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

The following table represents the risk category of loans by portfolio class, net of deferred fees and costs, based on the most recent analysis performed as of June 30, 2021 and December 31, 2020:

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

For consumer residential real estate, and other, the Company also evaluates credit quality based on the aging status of the loan, as was previously stated, and by payment activity. The following tables present the recorded investment in those classes based on payment activity and assigned risk grading as of June 30, 2021 and December 31, 2020.

Information about impaired loans as of June 30, 2021, December 31, 2020 and June 30, 2020 are as follows:

There were $5.7 thousand of additional funds available to be advanced in connection with impaired loans as of June 30, 2021.

The Bank had approximately $5.5 million of its impaired loans classified as troubled debt restructured (TDR) as of June 30, 2021, $6.5 million as of December 31, 2020 and $6.4 million as of June 30, 2020.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

Modification programs focused on payment pattern changes and/or modified maturity dates with most receiving a combination of the two concessions. The modifications did not result in the contractual forgiveness of principal. During the second quarter of 2021, one new loan was considered a TDR which resulted in payment changes from a monthly payment to monthly interest only payments on May 3, 2021. Two loans were also paid off in June 2021. In the second quarter of 2020, three new loans were considered TDR and were given a rate concession along with the amortization extended. During the year to date 2020, there were 5 new loans considered TDR with one of the loans subsequently paid off in May. Interest was paid current at the time of all modifications. Consequently, the financial impact of the modifications was immaterial to the ALLL.

The following tables represent three and six months ended June 30, 2021 and 2020:

For the three and six month periods ended June 30, 2021 and 2020, there were no TDRs that subsequently defaulted after modification.

For the six month period ended June 30, 2021, there was one impaired commercial real estate loan of $86 thousand and one impaired commercial loan of $480 thousand that were classified as TDR paid off as well as three impaired commercial loans of $809 thousand that were classified as TDR charged off. There was one impaired commercial real estate loan of $481 thousand that was classified as TDR paid off for the six month period ended June 30, 2020.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

For the majority of the Bank's impaired loans, the Bank will apply the fair value of collateral or use a measurement incorporating the present value of expected future cash flows discounted at the loan's effective rate of interest. To determine fair value of collateral, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained. Until such time that updated appraisals are received, the Bank may discount the collateral value used.

The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off, whether a partial or full loan balance. A charge-off in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 90 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. A broker's price opinion or appraisal will be completed on all home loans in litigation and any deficiency will be charged off before reaching 150 days delinquent. Commercial and agricultural credits are charged down at 120 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-off may be realized as further unsecured positions are recognized.

The following tables present loans individually evaluated for impairment by class of loans for the three and six months ended June 30, 2021 and June 30, 2020 and for the year ended December 31, 2020.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

As of June 30, 2021, the Company had $198 thousand foreclosed residential real estate property obtained by physical possession and $100 thousand of consumer mortgage loans secured by residential real estate properties for which foreclosure proceedings are in process according to local jurisdictions. This compares to the Company having $71 thousand of foreclosed residential real estate property obtained by physical possession and $910 thousand of consumer mortgage loans secured by residential real estate properties for which foreclosure proceeding are in process according to local jurisdictions as of December 31, 2020. As of June 30, 2020, the Company had no foreclosed residential real estate property obtained by physical possession and $854 thousand of consumer mortgage loans secured by residential real estate properties for which foreclosure proceedings were in process according to local jurisdictions.

The Allowance for Loan and Lease Losses (ALLL) has a direct impact on the provision expense. An increase in the ALLL is funded through recoveries and provision expense. The following tables summarize the activities in the allowance for credit losses.

The Company segregates its ALLL into two reserves: The ALLL and the Allowance for Unfunded Loan Commitments and Letters of Credit (AULC). When combined, these reserves constitute the total Allowance for Credit Losses (ACL).

The ALLL does not include an accretable yield of $2.2 million and $1.7 million as June 30, 2021 and December 31, 2020 respectively, related to the acquisitions of Bank of Geneva in 2019 and Ossian State Bank in 2021 as previously discussed in Note 2.

The AULC is reported within other liabilities on the balance sheet while the ALLL is netted within the loans, net asset line. The ACL presented above represents the full amount of reserves available to absorb possible credit losses.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

The following table breaks down the activity within ACL for each loan portfolio classification and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs.

Additional analysis, presented in thousands, related to the allowance for credit losses for the three and six months ended June 30, 2021 and June 30, 2020 in addition to the ending balances as of December 31, 2020 is as follows:

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 5 EARNINGS PER SHARE

Basic earnings per share are calculated using the two-class method. The two-class method is an earnings allocation formula under which earnings per share is calculated from common stock and participating securities according to dividends declared and participation rights in undistributed earnings. Under this method, all earnings distributed and undistributed, are allocated to participating securities and common shares based on their respective rights to receive dividends. Unvested share-based payment awards that contain non-forfeitable rights to dividends are considered participating securities (i.e. unvested restricted stock), not subject to performance based measures. Basic earnings per share is calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding. Application of the two-class method for participating securities results in a more dilutive basic earnings per share as the participating securities are allocated the same amount of income as if they are outstanding for purposes of basic earnings per share. There is no additional potential dilution in calculating diluted earnings per share, therefore basic and diluted earnings per share are the same amounts. Other than the restricted stock plan, the Company has no other employee stock based compensation plans.

Beginning in 2020, the Compensation Committee of the Company has determined that it is appropriate to award shares of the common stock of the Company to Outside Directors and Employees that are officers of the Company or the Bank who also serve as Directors of the Company and the Bank as a portion of their retainer for services rendered as Directors of the Company and the Bank. The Committee believes that it is appropriate to award the Directors shares equal to a specific dollar amount, rounded to the nearest whole share on an annual basis commencing on June 5, 2020 and thereafter on the first Friday of June in each year. Directors receive a prorated dollar value of shares for a partial year of service. The value for the shares is to be based upon the closing price for shares on June 4, 2020 and thereafter on the first Thursday in June in each year. On June 5, 2020, each Director received approximately $4,000 which equated to 176 shares. On June 4, 2021, ten Directors received approximately $6,000 worth of shares which equated to 272 shares while four Directors received a prorated dollar value of shares. The use of stock for Directors' retainer, does not have an effect on diluted earnings per share as it is immediately vested.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS

Fair values of financial instruments are management's estimate of the values at which the instruments could be exchanged in a transaction between willing parties. These estimates are subjective and may vary significantly from amounts that would be realized in actual transactions. In addition, other significant assets are not considered financial assets including deferred tax assets, premises, equipment and intangibles. Further, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the estimates.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

The estimated fair values, and related carrying or notional amounts, for on and off-balance sheet financial instruments as of June 30, 2021 and December 31, 2020 are reflected below.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

Fair Value Measurements

In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities in active markets that the Company has the ability to access.

Available-for-sale securities, when quoted prices are available in an active market, securities are valued using the quoted price and are classified as Level 1.

Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

Available-for-sale securities classified as Level 2 are valued using the prices obtained from an independent pricing service. The prices are not adjusted. Securities of obligations of state and political subdivisions are valued using a type of matrix, or grid, pricing in which securities are benchmarked against the treasury rate based on credit rating. Substantially all assumptions used by the independent pricing service are observable in the marketplace, can be derived from observable data, or are supported by observable levels at which transactions are executed in the marketplace.

Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability. The Bank holds some local municipals that the Bank evaluates based on the credit strength of the underlying project. The fair value is determined by valuing similar credit payment streams at similar rates.

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Company's assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset.

The following summarizes financial assets measured at fair value on a recurring basis as of June 30, 2021 and December 31, 2020, segregated by level or the valuation inputs within the fair value hierarchy utilized to measure fair value:

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

The following tables represent the changes in the Level 3 fair-value category of which unobservable inputs are relied upon as of the three and six month periods ended June 30, 2021 and June 30, 2020.

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

Most of the Company's available-for-sale securities, including any bonds issued by local municipalities, have CUSIP numbers or have similar characteristics of those in the municipal markets, making them marketable and comparable as Level 2.

The Company also has assets that, under certain conditions, are subject to measurement at fair value on a non-recurring basis. At June 30, 2021 and December 31, 2020, such assets consist primarily of collateral dependent impaired loans. Collateral dependent impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Company estimates the fair value of the loans based on the present value of expected future cash flows using management's best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals.)

At June 30, 2021 and December 31, 2020, fair value of collateral dependent impaired loans categorized as Level 3 was $7.5 million and $7.7 million, respectively. The specific allocation for impaired loans was $961.3 thousand and $1.7 million as of June 30, 2021 and December 31, 2020, respectively, which are accounted for in the allowance for loan losses (see Note 4).

Other real estate is reported at either the lower of the fair value of the real estate minus the estimated costs to sell the asset or the cost of the asset. The determination of fair value of the real estate relies primarily on appraisals from third parties. If the fair value of the real estate, minus the estimated costs to sell the asset, is less than the asset's cost, the deficiency is recognized as a valuation allowance against the asset through a charge to expense. The valuation allowance is therefore increased or decreased, through charges or credits to expense, for changes in the asset's fair value or estimated selling costs.

The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements:

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

The following table presents impaired loans as recorded at fair value on June 30, 2021 and December 31, 2020:

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ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 7 FEDERAL FUNDS PURCHASED AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

The Company had no federal funds purchased as of June 30, 2021 and December 31, 2020. During the same time periods, the Company also had $29.9 million and $30.2 million in securities sold under agreement to repurchase.

NOTE 8 PROPOSED BUSINESS COMBINATION

On May 4, 2021, the Company announced they have signed an agreement and plan of reorganization and merger (the Agreement) whereby F&M will acquire Perpetual Federal Savings Bank, ('PFSB'), in a stock and cash transaction. PFSB operates one full-service office in Urbana, Ohio. At March 31, 2021, PFSB reported $391 million in total assets, $326 million in loans, $305 million in deposits and $79 million in tangible equity. PFSB is taxed as an S-Corporation. The expected closing date is October 1, 2021.

Subject to the terms of the Agreement, which has been unanimously approved by the Board of Directors of each company, PFSB shareholders will elect to receive either 1,776 shares of FMAO stock or $41.20 per share in cash for each PFSB share owned, subject to adjustment based upon 1,833,000 shares of FMAO to be issued in the merger. At March 31, 2021, PFSB reported 2,470,032 shares of common stock outstanding. Based on FMAO's closing share price as of May 3, 2021 of $24.22, the implied aggregate acquisition value equals $103.7 million.

In 2021, the Company incurred $248.1 thousand of third-party acquisition related costs. These expenses are comprised of consulting fees of $91.8 thousand and other general and administrative expense of $156.3 thousand in the Company's consolidated statement of income for the three and six months ended June 30, 2021.

NOTE 9 RECENT ACCOUNTING PRONOUNCEMENTS

In June 2016, the Financial Accounting Standards Board ('FASB') issued Accounting Standards Update ('ASU') No. 2016-13 'Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.' This ASU requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances. The ASU requires enhanced disclosures to help investors and other financial statement users better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization's portfolio. These disclosures include qualitative and quantitative requirements that provide additional information about the amounts recorded in the financial statements. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration.

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

NOTE 9 RECENT ACCOUNTING PRONOUNCEMENTS (Continued)

The ASU was effective for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019 (i.e., January 1, 2020, for calendar year entities). FASB subsequently approved a delay in adoption for Smaller Reporting Companies. The Company has completed an analysis to determine that it qualifies as a Smaller Reporting Company. As such, adoption can be postponed until periods beginning after December 15, 2022 (i.e., January 1, 2023, for calendar year entities). Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018.

The Company has contracted with an external advisor and has formed a committee to determine the methodology to be used. Most importantly, the Company is gathering as much data as possible to enable management to review scenarios and determine which calculations will produce the most reliable results. The Company began working with the third-party service provider to review parallel reports starting in June 2019. The Company has not adopted ASU 2016-13 in calendar year 2021 and management is currently evaluating when or if they would elect to early adopt ASU 2016-13.

NOTE 10 SUBSEQUENT EVENT

On July 30, 2021, the Company announced the completion of a private placement of $35 million aggregate principal amount of its 3.25% fixed-to-floating rate subordinated notes due July 30, 2031 (the 'Notes') to various accredited investors (the 'Offering'). The price for the Notes was 100% of the principal amount of the Notes. The Notes are intended to qualify as Tier 2 capital for regulatory purposes. The Company intends to use the net proceeds from the Offering for general corporate purposes, including financing acquisitions and organic growth.

Interest on the Notes will accrue at a rate equal to (i) 3.25% per annum from the original issue date to, but excluding, the five-yearanniversary, payable semi-annually in arrears, and (ii) a floating rate per annum equal to a benchmark rate, which is expected to be the Three-Month Term SOFR (as defined in the Notes), plus a spread of 263 basis points from and including the five-year anniversary until maturity, payable quarterly in arrears. Beginning on or after the fifth anniversary of the issue date through maturity, the Notes may be redeemed, at the Company's option, on any scheduled interest payment date. Any redemption will be at a redemption price equal to 100% of the principal amount of Notes being redeemed, plus accrued and unpaid interest.

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

OVERVIEW

The first half of 2021 has been a time of expansion and handling one-time events impacting both revenue and expense. A great deal of the focus for 1^st quarter remained with COVID-19 related items. While much of the forgiveness from the Paycheck Protection Program (PPP) was received in 4^th quarter 2020, we continued to work with our remaining customers to process the forgiveness requests and payments. At the same time, we began the requests for additional funding under the additional PPP opportunities. Farmers & Merchant's (F&M) Commercial Division saw PPP loan activity begin to slow in the 2^nd quarter. F&M shifted to working with our PPP Second Draw clients and the forgiveness process. F&M is very proud of the PPP program and the impact it has had on our clients and their employees. The PPP program at F&M has impacted 18,094 jobs. Most COVID-19 restrictions were lifted in the second quarter and many of the F&M client base returned to full schedules. F&M did assist clients with deferrals or modifications that were negatively impacted by COVID-19. As of the end of the second quarter, only two loans are currently under principal deferrals. These loans will resume principal repayment in the 3^rd quarter. The Bank received over $300 thousand in accelerated net fee income from the most recent round (2021 originations) of PPP loans during the second quarter. The activities surrounding the originations and forgiveness of PPP loans account for a portion of the one-time events occurring in 2021.

Acquisition costs are categorized as one-time when looking at the individual acquisition. Two actual acquisitions had associated costs with them in the first half of 2021. The acquisition of Ossian Financial Services, Inc (Ossian) had expenses of $977.5 thousand during the first half of 2021 and Perpetual Federal Savings (Perpetual) have begun to occur and total $248.1 thousand so far in 2021. The Company is excited to have expanded its coverage in Indiana with the two new offices and finalized on May 1, 2021 with the software conversion occurring mid-month. The Company is currently seeking regulatory approvals for the Perpetual deal and plans are to close the beginning of the fourth quarter with software conversion occurring shortly thereafter. Each acquisition involves a different structure with Ossian, an all cash deal; and Perpetual, a stock and cash deal. Additional detail can be found in the financial statements presented. These two acquisitions will account for expansion of both our footprint and our assets by over half a billion dollars by year end 2021.

Our commercial clients are most impacted by the lack of employees and a shortage or delay of materials. F&M's 2^nd quarter commercial pipeline of closings, draws and opportunities remained strong. Some pipeline activity was delayed due to supply chain issues that have occurred in many sectors. The loan activity has come from across the F&M footprint, including Loan Production Offices (LPO) in Muncie, Indiana; Oxford, Ohio; and West Bloomfield, Michigan.

The 2021 planting season for our market area was favorable as crops were planted timely and growing conditions have been good. Commodity prices have continued to be strong providing an optimistic profit potential for grain farmers. The livestock industry in our portfolio has been stable. Agri-business appear to be stable to strong as they have also benefited from stronger commodity prices. Overall, the agriculture portfolio remains healthy and concerns manageable.

Home loan rates remain low though the volume of refinancing loans has slowed as compared to the same time in 2020. Turn times have become more manageable and the Bank focused on home equity lines as an opportunity for growth. Inventory in many of our markets remain low which contributes to the decrease in activity overall. Increased lumber prices have impacted the remodeling and new build; however, we have seen input prices begin to decrease. It is likely the third and fourth quarter gain on sales will be lower than 2020's; though for the 2^nd quarter 2021 gains were 2 ½ times the same quarter 2020 and almost 3 ½ times on a year-to-date basis.

Additional expenses that would categorize closely to one-time events, were the divestiture of four offices. Three of the offices were in communities of which two offices were present. The review of our office structure spurred from the Company's strategic plan focusing on improving operating efficiency. Office closure expenses are expected to be close to $700 thousand in the first twelve months following closure with total savings expected to be over $760 thousand, netting a year one savings overall and significant savings going forward. This will allow the Company to use the savings to fund expansion and transformation of existing offices. ATM's remain at the locations and all have ceased operations as of the end of the second quarter 2021.

Surpassing the year mark with operating our Company with COVID-19 protocols, the Company resumed full 'normal' operations on June 1^st. We now look back on the lessons learned and the practices and procedures that have been changed as compared to pre-COVID-19. Following is a brief synopsis of the modifications that have become a part of normal operations.

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Please see section titled COVID-19 for additional information related to actions taken.

Unlike many other institutions, the Bank has continued to experience strong organic loan growth outside of PPP and acquired loans over the first half of 2021: 11.9% with PPP loans and acquired loans included and 3.9% with $51.8 million of PPP loans and $52.4 million of Ossian acquisition loans excluded over December 31, 2020 levels. Commercial real estate and consumer portfolios were the largest contributors. Overall, the credit portfolio has remained strong. Past dues over 30 days for the second quarter were 0.12%, the lowest since 2018.

Net interest earnings increased by $2.4 million as compared to first half 2020. The improvement was due to growth in the balance sheet as the Company continues to operate in the low rate environment preceded by the national prime rate drop of 150 basis points in the first quarter of 2020. The year-to-date net interest margin decreased 6 basis points to 3.27% as compared to March 31, 2021. The asset yield decreased by 10 basis points on a year-to-date basis and 18 basis points when comparing to prior quarter. Cost of funds decreased 5 basis points on a year-to-date basis and 9 basis points when comparing the 2^nd quarter's cost to first quarter 2021. An additional factor in the drop was the increase of liquidity over the time frame driven by stimulus checks, tax refunds and the overall savings attitude of our depositors. The additional liquidity decreased the asset yield as the loan to deposit ratio dropped and the increased liquidity was placed in lower earning securities and overnight funds. Further discussion of the balance sheet composition movements and the impact on the earnings can be viewed in the Material Results of Operations section that follows.

Net income improved 11.03% in comparing first half 2021 to first half 2020 and earnings per share increased 10.4% in the same comparison. The higher net income was mainly driven by two factors: higher noninterest income and lower interest expense. As mentioned previously, interest expense decreased by 46.3% and $2.8 million on a year-to-date basis compared to first half 2020 on 18.6% higher average balances in 2021. Noninterest income increased 39.9% and $2.6 million over the same period 2020. Gain on sales of both 1-4 family mortgage loans and fixed rate agricultural loans were the biggest contributors. 1-4 family mortgage activity remains strong though beginning to slow compared to the last three quarters of 2020. We expect additional slowing the last half of the year as refinancing has slowed, housing prices have increased, and inventory of available homes is low throughout most of the Bank's market area. Interchange fees on debit card transactions also increased 33.8% and $622.6 thousand as compared to first half 2020. This supported the increase in noninterest income and overall net income.

The Company has worked diligently to manage during volatile times and the increase in our size and footprint has helped establish diversity of revenue streams and insulated our earnings. While we report and recognize the many one-time costs incurred by our strategic focus, we continue to realize the long-term benefits of our strategies. Our historical prudent approach to lending has continued to demonstrate its benefits in our credit quality. The relationships we have with our customers, employees, shareholders and communities has allowed our belief in our mission to 'help people live their best lives' be realized. The light at the end of the tunnel is beginning to widen and the Company remains well capitalized and plans to continue in our strategic vision of expansion. The last two years has shown us the benefits from such growth are real.

COVID-19: Lessons learned and carried forward

Shareholders

Dividend declaration

The Company expects to continue to maintain the payment of its quarterly dividend consistent with its past practices. We are sensitive to the needs of our long-time shareholders that utilize these funds to supplement their living expenses, especially in this low interest rate environment. Dividends declared during the first half at $0.34 per share increased by 6.25% over the same period last year.

Annual Meeting

The Company held its Annual Meeting on April 15,2021. The meeting was held virtually with presentations which reviewed the 2020 performance and included an outlook for 2021. In-person attendance was limited to the Chairman, President & CEO, CFO, Corporate Secretary and Asst. Corporate Secretary following social distancing protocols. Shareholders were encouraged to vote digitally or by phone due to concern of timely receipt of mailed proxies. A question answer period was also made available. An external vendor assisted the Company's technology department to coordinate the meeting with the technology involved. The Company is exploring the options for next year's annual meeting given the success of this method of communication based on comments received and the consistent high voter turnout in the 70's percent. A big concern was the delay of proxy materials received and votes returned due to the slowness of the mail service. Additional digitalization for those who would prefer communication digitally is being pursued.

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Communities

Offices

With the health of our employees and customers being our top concern, as of March 20, 2020 the Bank temporarily suspended branch lobby hours to the public for walk-in transactions. Appointments could be made at branches to complete all needed paperwork and transactions. Drive-thru services remained open as well as all ATM's and ITM's to complete needed transactions. To assure branches remained open, employees were divided into teams who rotated every three days to two weeks as a means to practice social distancing while limiting any possible exposure. During the month of May 2020, the retail re-open team developed an employee handbook which focused on opening protocols, employee training, health and wellness and facility signage. Branch re-openings began on June 3^rd with the last branches re-opening on June 15^th. Offices returned to a hub structure at yearend whereby at least one office in each of three regions remained fully open and the remaining offices in the region converted to by appointment for the lobby and drive-ups remained fully functional. All offices removed the lobby restrictions after the holidays on February 1, 2021 and are fully operational. Masking is optional, separation protection and social distancing remain in place at all locations. Internal controls have not been significantly modified due to COVID-19.

Small Business

Farmers & Merchants Commercial Division entered the first quarter of 2021 in familiar territory of PPP activity while COVID-19 restrictions continued to increase over the winter months. These restrictions impacted the commercial and retail sectors of the markets we serve. Small Business Administration (SBA) rolled out the PPP second draw program as well as the first draw program for those borrowers that did not or were not able to participate in the first draw program in 2020. SBA issued further guidance and calculations for Schedule C borrowers. This change caused many Sole Proprietors, Single Member LLCs, and Self Employed (1099) who were not previously eligible to be able to participate. SBA also issued further guidance on and calculations for Schedule F Borrowers. This change caused many farmers who were not previously eligible to be able to participate. 2021 PPP second draw applications have exceeded the number of applications in the first draw program. F&M has 993 loans closed totaling $43.5 million. Fees associated with PPP second draw are estimated at $3.2 million. Slightly over $300 thousand of accelerated fees were collected in the first half of 2021. F&M has also made great progress with PPP first draw forgiveness, only 2 of the 947 PPP first draw loans remain to apply for forgiveness. F&M is very proud of the PPP program and the impact it has had on our clients and their employees. The PPP program at F&M has impacted 18,094 jobs.

Consumers

Home Loan

With the Federal Reserve rate drops of 150 basis points in March 2020 (100 basis points of which was directly related to the effects of the virus on the economy), a surge in home loan activity has occurred. Much of the activity is refinance related and the Bank has experienced the highest amount of applications in its history, both in number of and dollar amount. Given the nature of the programs, the results were recorded in the following quarters of 2020. The Bank sells most of its home loans into the secondary market through Freddie Mac.

Following is the update of those activities related to COVID-19 as of June 30, 2021. Existing loans on our books for which the Bank has received inquiries into forbearance agreements, totaled over 100 as of June 30th. Of these inquiries, 98 customers entered into agreements totaling just over $9.1 million. 30 loans were in-house making up $2.2 million in principal balance and 68 were secondary market loans which we service with balances totaling over $6.9 million. Of the 30 in-house loans, no loans remain in a repayment plan, no loans are in forbearance. and the other 27 have transitioned back to regular payments as of June 30th. Of the 68 secondary market loans, two loans are in a repayment plan and one loan is in forbearance as of June 30th. All loans expected to be transitioned back to regular payments by the end of August. We remain ready to assist our customers through this difficult time in the best manner possible.

Retail Loans

The Bank is offering its 'Skip-a-Pay' program to consumers with installment loans, which allows the customer to skip the payment and extend the maturity of the contract for the payment period. We are allowing two payments to be skipped upon request with an additional one possible at the end of the initial request upon review. Normally, the Bank would charge a fee for this program - the fee has been waived. The Bank would also normally require the interest for the period to be collected and that requirement is currently waived. Interest is a part of the extended maturity payments. We have offered assistance to customers representing 151 loans currently with loan balances totaling $2.05 million. 141 represents the total number of

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loans that have been extended for those customers that have returned the extension documents representing approximately $2 million and 263 extended months.

Waiving of late payment fees for our customers was introduced on March 16, 2020 and ceased on June 30, 2020. As of June 30th, the Bank has foregone fees of $307 thousand on loans to help our customers. Of the $307 thousand, $131 thousand was related to two past due commercial loans. As a community bank, it is, by definition, what we should do.

Depositors

The Bank's most popular checking account, which includes requirements to earn a reward, removed the requirement of debit card transactions to be completed during a cycle for the months of April and May in 2020. In the Bank's geographical area, the states issued 'stay at home' guidelines and many of our customers were concerned with being able to complete the requirement. This impacted almost 11.6 thousand accounts and represented just under $101 million in average account balances. The product includes the option of attaching a savings account for which the same requirements were waived and impacted an additional almost 7 thousand accounts and $113.1 million in average account balances, calculated as of June 30, 2020. Overall, typically 80-85% of our customers meet all the requirements. The waiving of the debit card transactions allowed those customers to receive the reward and possibly an additional 77.5% of the previous non-qualifiers which represented the other 15-20% in total. With the removal of the 'stay at home' guidelines, the debit card transaction requirement was reinstated beginning with the June cycle on May 29, 2020. During the months of April and May, most individuals still met their debit card transaction requirement with the 'stay at home' order in place. We have learned how to manage these changes and adapt programs quickly if needed for future implementation.

The Bank stopped assessing the Regulation D ('Reg D') fee on savings accounts and has not reimplemented the fee yet as of June 30, 2021. Reg D assesses a fee when a depositor has exceeded more than six 'not-in-person' withdrawals in a month.

Employees

The Bank continued paying employees their full pay through March 31, 2020. During this time period, accumulated PTO and vacation time were frozen and not required to be used to receive full pay. The Bank continues to promote social distancing by encouraging employees who can work remotely to do so and in other cases, departments have been dispersed to keep the team separated. Beginning April 1, 2020, the Bank is following The Families First Coronavirus Response Act (FFCRA) which requires employers to provide their employees with paid sick leave and extended family and medical leave for specified reasons related to COVID-19. These provisions were in effect until December 31, 2020. Qualifying reasons for leave related to COVID-19 include the employee: (1) being subject to a quarantine order, (2) being advised by a healthcare provider to self-quarantine, (3) experiencing COVID-19 symptoms and is seeking a medical diagnosis, (4) caring for an individual subject to a quarantine order, (5) caring for his or her child whose school or place of care is closed or (6) experiencing any other substantially-similar condition specified by the U.S. Department of Health and Human Services. All time off related to the above reasons was documented within our time and attendance system. The Bank will be able to reduce its employer tax for up to two weeks (80 hours, or a part-time employee's two-week equivalent).

In January 2021, we made the decision to extend FFCRA leave for employees through March 31, 2021. The Families First Coronavirus Response Act (FFCRA) expired in December 2020 and was permitted to be extended by companies on a voluntary basis. All social distancing, masking requirements and safety protocols were extended into 2021 by the Bank. On March 17, 2021, the Pandemic Team extended FFCRA through April 30, 2021 to allow for employees to use FFCRA to cover vaccination appointments and time off due to vaccine side effects. In June, masking became voluntary and the daily survey of symptoms was discontinued in July when the State of Ohio no longer required employers to track.

The Bank will continue to segregate departments to multiple locations when possible to limit risk of loss of a whole department with exposure of any spread of contagious illness or other potential hazards. The Bank has also developed a remote work policy to aid in the segregation. The use of virtual meetings will continue as in many instances it is more efficient than in-person. Training is another area where virtual will continue to be another method of communication that allows for implementation at the team members' availability.

Financial - Exposures

Given the timing of the outbreak of the COVID-19 pandemic in the United States, management believes that the main impact on the Company's performance of 2020 was a factor in the economic qualitative adjustment for the calculation of the allowance for loan loss. Subsequently, the loan lossprovisionwas increased which also included an increase due to loan growth. The COVID-19 pandemic represents an unprecedented challenge to the global economy in general and the financial services sector in particular. However, there is still significant uncertainty regarding the overall length of the pandemic and

51

the aggregate impact that it will have on global and regional economies, including uncertainties regarding the potential positive effects of governmental actions taken in response to the pandemic. With so much uncertainty, it is impossible for the Bank to accurately predict the impact that the pandemic will have on the Company's primary markets and the overall extent to which it will affect the Company's financial condition and results of operations during 2021. At a minimum, the actions taken by the Company to assist its customers experiencing challenges from the pandemic, such as through the Bank's 'Skip-a-Pay' program, the waiver of late payment fees, and the entry into loan forbearance agreements, did have an impact on the Company's 2020 performance. Nonetheless, management believes that the Company's current regulatory capital position remains adequate to face the coming challenges in 2021.

The Company has a limited exposure to many sectors of the economy that will likely be impacted for an extended period such as the travel, restaurant, hospitality, energy and retail industries. The Bank does not have any direct exposure to the energy industry and hotels, entertainment and food related businesses are less than 10% of our overall loan portfolio. In addition, the Bank's hotel customers are financially strong business owners, operating brand name hotels in compelling locations. The Bank, along with many other financial institutions, had increased its provision for loan losses in 2020 as compared to 2019 by approximately $5.8 million. The Bank continued to make increases adding $1.7 million in the first quarter of 2021. The Bank has plans to lessen the increase for the remainder of 2021, lowering the provision expense to $641 thousand in the second quarter 2021. Future provision will be provided for loan growth, though the Bank is fully prepared to make additional provisions as warranted by the COVID-19 situation and any lingering aftereffects.

NATURE OF ACTIVITIES

Farmers & Merchants Bancorp, Inc. (the 'Company') is a financial holding company incorporated under the laws of Ohio in 1985. Our subsidiaries are The Farmers & Merchants State Bank (the 'Bank'), a community bank operating in Northwest Ohio since 1897, and Farmers & Merchants Risk Management, Inc., a captive insurance company formed in December 2014 and located in Nevada. We report our financial condition and net income on a consolidated basis and we have only one segment.

Our executive offices are located at 307 North Defiance Street, Archbold, Ohio 43502, and our telephone number is (419) 446-2501. The Bank operates twenty-eight full-service banking offices throughout Northwest Ohio and Northeast Indiana and a drive-up facility in Archbold. The Bank also operates three Loan Production Offices (LPOs), one in each state of Ohio, Indiana and Michigan.

As of June 30, 2021, the Bank discontinued operations in four offices, three in Ohio and one in Indiana. Existing customers of those offices will continue to be serviced by other nearby offices.

The Farmers & Merchants State Bank engages in general commercial banking and savings business including commercial, agricultural and residential mortgage, consumer and credit card lending activities. The largest segment of the lending business relates to commercial, both real estate and non-real estate. The type of commercial business ranges from small business to multi-million dollar companies. The loans are a reflection of business located within the Banks' market area. Because the Bank's offices are located in Northwest Ohio and Northeast Indiana, a substantial amount of the loan portfolio is comprised of loans made to customers in the farming industry for such items as farm land, farm equipment, livestock and operating loans for seed, fertilizer, and feed. Other types of lending activities include loans for home improvements, and loans for the purchase of autos, trucks, recreational vehicles, motorcycles, and other consumer goods.

The Bank also provides checking account services, as well as savings and time deposit services such as certificates of deposits. In addition, Automated Teller Machines (ATMs) or Interactive Teller Machines (ITMs) are provided at most branch locations along with other independent locations in the market area. ITMs operate as an ATM with the addition of remote teller access to assist the user. The Bank has custodial services for Individual Retirement Accounts (IRAs) and Health Savings Accounts (HSAs). The Bank provides on-line banking access for consumer and business customers. For consumers, this includes bill-pay, on-line statement opportunities and mobile banking. For business customers, it provides the option of electronic transaction origination such as wire and Automated Clearing House (ACH) file transmittal. In addition, the Bank offers remote deposit capture or electronic deposit processing and merchant credit card services. Mobile banking was added in 2012 and has been widely accepted and used by consumers. Upgrades to our digital products and services continue to occur in both retail and business lines. The Bank continues to offer new suites of products as customer preferences change and the Bank adapts and adopts new technologies. The Bank continues to offer products that also meet the needs of our more traditional customers.

The Bank has established underwriting policies and procedures which facilitate operating in a safe and sound manner in accordance with supervisory and regulatory guidance. Within this sphere of safety and soundness, the Bank's practice has been to not promote innovative, unproven credit products which may not be in the best interest of the Bank or its customers.

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The Bank does offer a hybrid mortgage loan. Hybrid loans are loans that start out as a fixed rate mortgage but after a set number of years automatically adjust to an adjustable rate mortgage. The Bank offers a three year fixed rate mortgage after which the interest rate will adjust annually. The majority of the Bank's adjustable rate mortgages are of this type. In order to offer longer term fixed rate mortgages, the Bank does participate in the Freddie Mac, Farmer Mac and Small Business Lending programs. The Bank also normally retains the servicing rights on these partially or 100% sold loans. In order for the customer to participate in these programs they must meet the requirements established by those agencies. In addition, the Bank does sell some of its longer term fixed rate agricultural mortgages into the secondary market with the aid of brokers.

The Bank does not have a program to fund sub-prime loans. Sub-prime loans are characterized as a lending program or strategy that targets borrowers who pose a significantly higher risk of default than traditional retail banking customers.

All loan requests are reviewed as to credit worthiness and are subject to the Bank's underwriting guidelines as to secured versus unsecured credit. Secured loans are in turn subject to loan to value (LTV) requirements based on collateral types as set forth in the Bank's Loan Policy. In addition, credit scores of those seeking consumer credit are reviewed and if they do not meet the Bank's Loan Policy guidelines an additional officer approval is required.

Consumer Loans:

Commercial/Agriculture:

Accounts Receivable:

Up to 80% LTV less retainages and greater than 90 days.

Inventory:

Equipment:

Real Estate:

F&M Investment Services, the brokerage department of the Bank, opened for business in April 1999. Securities are offered through Raymond James Financial Services, Inc. In November of 2020, FM Investment Services purchased the assets and clients of Adams County Financial Resources (ACFR) which is discussed in further detail in Note 2 to the Company's financial statements. Securities are offered through Raymond James Financial Services, Inc.

In December of 2014, the Company became a financial holding company within the meaning of the Bank Holding Company Act of 1956 as amended (the 'Act'), in order to provide the flexibility to take advantage of the expanded powers available to a financial holding company under the Act. Our subsidiary bank is in turn regulated and examined by the Ohio Division of Financial Institutions and the Federal Deposit Insurance Corporation. The activities of our bank subsidiary are also subject to other federal and state laws and regulations. The Company also formed a captive insurance company (the 'captive') in December 2014 which is located in Nevada and regulated by the State of Nevada Division of Insurance.

The Bank's primary market includes communities located in the Ohio counties of Defiance, Fulton, Hancock, Henry, Lucas, Williams, Wood and in the Indiana counties of Adams, Allen, DeKalb, Jay, Steuben and Wells. In our banking activities, we compete directly with other commercial banks, credit unions, farm credit services, and savings and loan institutions in each of

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our operating localities. In a number of our locations, we compete against entities which are much larger than us. The primary factors in competing for loans and deposits are the rates charged as well as location and quality of the services provided.

At June 30, 2021, we had 377 full time equivalent employees. The employees are not represented by a collective bargaining unit. We provide our employees with a comprehensive benefit program, some of which is contributory. We consider our employee relations to be good.

RECENT REGULATORY DEVELOPMENTS

The Bank remains attentive to the current regulatory environment in light of the regulatory agencies' risk-based approach to examinations. Regulatory changes and the complexity of new and amended rules have resulted in challenges and uncertainties which could pose an increased risk of noncompliance. Various significant mortgage rules require monitoring by means of testing, validation of results, additional training, and further research or consultation to assist with ongoing compliance.

The global spread of the Coronavirus (COVID-19) and resulting declaration of a world-wide pandemic have impacted the financial services industry and banking operations in the United States (US) and world-wide. The financial services sector is identified as a Critical Infrastructure Sector by the Department of Homeland Security during the COVID-19 response efforts. How basic business operations can be conducted has undergone a rapid and dramatic change. At the same time continuity of business operations involves promoting safety and security of customers and employees, providing a quality customer experience, and maintaining effective delivery systems and channels of communication. Regulatory guidance has been issued to manage and mitigate the unprecedented impact of the COVID-19 pandemic on business operations. Regulatory agencies promote prudent and practical efforts to assist customers and communities during this national emergency. Such assistance to alleviate the financial impact on affected customers involved modification of loan terms for existing borrowers, waiver of certain fees and charges, providing small dollar loans, and offering forbearance and payment deferrals on mortgage loan obligations due to financial hardship. Legislation enacted in March 2020 has provided the Families First Coronavirus Response Act (FFCRA) and CARES Act. The FFCRA which was effective through December 31, 2020, provided for a paid leave for employees (of employers with fewer than 500 employees) who had to quarantine due to the coronavirus, were caring for a sick family member, or caring for a child out of school. It significantly expanded existing protections currently available to employees who take leave to care for a sick family member. The CARES Act, among other matters, resulted in expansion of SBA Lending Programs; provided for a financial election to suspend GAAP principles and regulatory determinations for COVID-19 related loan modifications that would otherwise be deemed Trouble Debt Restructuring; gave the FDIC authority to establish a temporary Debt Guarantee Program for bank liabilities; delayed Current Expected Credit Losses (CECL) compliance; reduced the Community Bank Leverage Ratio to 8% to eliminate risk-based capital compliance for banks under $10 billion; required credit furnishers that agree to deferred loan payments, forbearance on a delinquent account, or any other relief during the national emergency to report accounts as current to Credit Reporting Agencies; and defined forbearance requirements and terms for single family and multi-family loans backed by federal government agencies or government sponsored entities due to COVID-19 financial hardship. Of immediate and significant importance was the rollout of the SBA Paycheck Protection Program (PPP). The PPP authorized lending of up to $350 billion in 100% guaranteed 7(a) loans to cover payroll costs, interest on mortgage payments, rent obligations, and utilities. The PPP provided a guaranteed loan for which a portion of the loan up to or equal to 8 weeks of covered payroll and specific operating expenses can be forgiven. The maximum loan size was capped at the lessor of 250% of the average monthly payroll costs or $10 million.

In April 2020, legislation known as the Paycheck Protection Program and Health Care Enhancement Act provided additional funding to replenish and supplement key programs under the CARES Act. Included in this legislation was the extension of the PPP with an additional $320 billion in funding. At least $60 billion of this funding was to be set aside for small and midsize banks and community lenders. Since April, the SBA has issued various Interim Final Rules to supplement and clarify matters involving the PPP. The Paycheck Protection Program Flexibility Act of 2020 (PPPFA) was enacted in early June 2020. This provided more flexibility to Borrowers regarding use of PPP loan funds. Certain provisions were retroactive to the date of the CARES Act and all PPP loans. Among these provisions were the extension of the covered period of the loan, extension of the forgiveness period, deferral of payments based on the loan forgiveness period, reduction in the minimum that must be spent for payroll costs, extended date by which employees must be rehired, and removal of restrictions on payroll tax deferral. The term for subsequent PPO loans made after enactment of the PPPFA was extended to five years from two. A primary focus is now directed to aiding PPP borrowers in navigating the loan forgiveness process.

FFCRA requirements to provide paid leave to employees ended on December 31, 2020. Due to the extended duration of the COVID-19 pandemic, employers subject to FFCRA could voluntarily extend the paid leave option until March 31, 2021. If the employer has elected to voluntarily apply the FFCRA extension, employees eligible for leave in 2020 and did not use the

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leave may take the leave in 2021. Under the American Rescue Plan of 2021 enacted in March 2021, for those employers who voluntarily extend the paid leave option, paid leave was reset starting April 1, 2021. If employees previously exhausted their paid leave under FFCRA, they may be entitled to an additional 10 days/80 hours for use. Additionally, the PPP was reauthorized with passage of the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act. It was originally intended to run through March 31, 2021 and was subsequently extended to May 31, 2021. Under the new legislation, $284 billion in funding for first and second-time PPP loan borrowers was provided to the SBA. Three categories of businesses are eligible to apply for PPP: 1) qualified business that did not receive a PPP loan during the first funding round; 2) previous PPP loan recipients who need a second loan and meet certain criteria; previous PPP loan recipients who returned all or a portion of their original loans and want to apply to additional funding. To be eligible, any business applying for PPP must have been in operation since at least February 15, 2020. Specific eligibility criteria apply to first-time PPP borrowers and previous PPP loan recipients. For 2021, PPP provides expanded coverage for expenditures in addition to covered payroll and specific operating expenses. For second-time loan recipients, the maximum loan amount was reduced from $10 million to $2 million. A loan recipient is eligible for full loan forgiveness if at least 60% of the loan amount is spent on payroll costs. Funds must be spent over a covered period of the loan recipients' choosing between eight and 24 weeks after loan origination to be eligible for forgiveness. Depending on the continued duration of COVID-19 spread, further legislation and regulatory guidance may continue due to the economic impact on customers, businesses, communities, and industry sectors.

The Coronavirus Response and Relief Supplemental Appropriations Act, passed by Congress in December 2020, extended certain provisions of the CARES Act affecting the Company into 2021. Key banking provisions under this legislation include the following:

In December 2020, new Qualified Mortgage (QM) Definition rules were issued by the Consumer Financial Protection Bureau. One set of rules revised the General QM definition and another set added the definition of a Seasoned QM Loan. Both QM Loan rules had an effective date of March 1, 2021. The revised General QM rule replaced the General QM loans definition of a 43% debt-to-income (DTI) limit with a focus on the loan pricing and whether the Annual Percentage Rate exceeds the average prime offer rate by less than 2.25 percentage points. Compliance with the revised General QM Loan rule had a mandatory compliance date of July 1, 2021. The existing Temporary Government Sponsored Entity (GSE) QM option was set to expire as of the mandatory compliance date for the revised General QM Rule. Subsequently, the CFPB issued a final rule published in the Federal Register on April 30, 2021 which delayed and extended the mandatory compliance date for the revised General QM rule to October 1, 2022. At the present time, the Company has the option to comply with either the original DTI-based General QM Loan definition or the revised price-based new General QM Loan definition. Since the Company sells fixed rate consumer mortgage loans to the Federal Home Loan Mortgage Corporation, it must remain attentive to their current loan underwriting requirements and how they evolve in the extended interim period.

With regard to all regulatory matters, the Bank remains committed in making good faith efforts to comply with technical requirements of the laws, rules, regulations, and guidance from both federal and state agencies which govern its activities.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, and the Company follows general practices within the financial services industry in which it operates. At times the application of these principles requires management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements and accompanying notes.

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These assumptions, estimates and judgments are based on information available as of the date of the financial statements. As this information changes, the financial statements could reflect different assumptions, estimates and judgments. Certain policies inherently have a greater reliance on assumptions, estimates and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Examples of critical assumptions, estimates and judgments are when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not required to be recorded at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability must be recorded contingent upon a future event. These policies, along with the disclosures presented in the notes to the condensed consolidated financial statements and in the management discussion and analysis of the financial condition and results of operations, provide information on how significant assets and liabilities are valued and how those values are determined for the financial statements. Based on the valuation techniques used and the sensitivity of financial statement amounts to assumptions, estimates, and judgments underlying those amounts, management has identified the determination of the ALLL, the valuation of its Mortgage Servicing Rights and the valuation of real estate acquired through or in lieu of loan foreclosures ('OREO Property') as the accounting areas that require the most subjective or complex judgments, and as such could be the most subject to revision as new information becomes available.

OREO Property held for sale is initially recorded at fair value at the date of foreclosure. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of cost or fair value minus estimated costs to sell.

Costs of holding foreclosed real estate are charged to expense in the current period, except for significant property improvements, which are capitalized. Valuations are periodically performed by management and a write-down is recorded by a charge to non-interest expense if the carrying value exceeds the fair value minus estimated costs to sell.

The net income from operations of foreclosed real estate held for sale is reported either in noninterest income or noninterest expense depending upon whether the property is in a gain or loss position overall. At June 30, 2021 OREO property holdings were $198 thousand. OREO totaled $71 thousand and $135 thousand as of December 31, 2020 and June 30, 2020 respectively.

The ALLL and ACL represents management's estimate of probable credit losses inherent in the Bank's loan portfolio, unfunded loan commitments, and letters of credit at the report date. The ALLL methodology is regularly reviewed for its appropriateness and is approved annually by the Board of Directors. This written methodology is consistent with Generally Accepted Accounting Principles which provides for a consistently applied analysis.

The Bank's methodology provides an estimate of the probable credit losses either by calculating a specific loss per credit or by applying a composite of historical factors over a relevant period of time with current internal and external factors which may affect credit collectability. Such factors which may influence estimated losses are the conditions of the local and national economy, local unemployment trends, and abilities of lending staff, valuation trends of fixed assets, and trends in credit delinquency, classified credits, and credit losses.

Inherent in most estimates is imprecision. The Bank's ALLL may include a margin for imprecision with an unallocated portion. Bank regulatory agencies and external auditors periodically review the Bank's methodology and adequacy of the ALLL. Any required changes in the ALLL or loan charge-offs by these agencies or auditors may have a material effect on the ALLL. For more information regarding the estimates and calculations used to establish the ALLL please see Note 4 to the consolidated financial statements provided herewith.

The Bank is also required to estimate the value of its mortgage servicing rights. The Bank's mortgage servicing rights relating to fixed rate single-family mortgage loans that it has sold without recourse but services for others for a fee represent an asset on the Bank's balance sheet. The valuation is completed by an independent third party.

The expected and actual rates of mortgage loan prepayments are the most significant factors driving the potential for the impairment of the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced.

The Bank's mortgage servicing rights relating to loans serviced for others represent an asset. This asset is initially capitalized and included in other assets on the Company's consolidated balance sheet. The mortgage servicing rights are then amortized as noninterest expense in proportion to, and over the period of the estimated future net servicing income of the underlying mortgage servicing rights. There are a number of factors, however, that can affect the ultimate value of the mortgage servicing rights to the Bank. The expected and actual rates of mortgage loan prepayments are the most significant factors driving the potential for the impairment of the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced, meaning that the present

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value of the mortgage servicing rights is less than the carrying value of those rights on the Bank's balance sheet. Therefore, in an attempt to reflect an accurate expected value to the Bank of the mortgage servicing rights, the Bank receives a valuation of its mortgage servicing rights from an independent third party. The independent third party's valuation of the mortgage servicing rights is based on relevant characteristics of the Bank's loan servicing portfolio, such as loan terms, interest rates and recent national prepayment experience, as well as current national market interest rate levels, market forecasts and other economic conditions. For purposes of determining impairment, the mortgage servicing assets are stratified into like groups based on loan type, term, new versus seasoned and interest rate. Management, with the advice from its third-party valuation firm, reviewed the assumptions related to prepayment speeds, discount rates, and capitalized mortgage servicing income on a quarterly basis. Changes are reflected in the following quarter's analysis related to the mortgage servicing asset. In addition, based upon the independent third party's valuation of the Bank's mortgage servicing rights, management then establishes a valuation allowance by each stratum, if necessary, to quantify the likely impairment of the value of the mortgage servicing rights to the Bank. The estimates of prepayment speeds and discount rates are inherently uncertain, and different estimates could have a material impact on the Bank's net income and results of operations. The valuation allowance is evaluated and adjusted quarterly by management to reflect changes in the fair value of the underlying mortgage servicing rights based on market conditions. The accuracy of these estimates and assumptions by management and its third party valuation specialist can be directly tied back to the fact that management has only been required to record minor valuation allowances through its income statement over time based upon the valuation of each stratum of servicing rights.

MATERIAL CHANGES IN FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

The Company plans to continue in its growth mode in 2021 led by loan growth from within our newer markets. The Bank is focused on funding the loan growth with the least expensive source of deposits, sale of securities or borrowings. Growing deposits will also be a focus especially in our newer markets. The Bank offers the Insured Cash Sweep ('ICS') product accessed through the Promontory network of financial institutions which helps to reduce the amount of pledged securities. This has provided more availability for runoff of securities by the Bank if warranted to fund loan growth.

Liquidity in terms of cash and cash equivalents ended $24.6 million lower as of June 30, 2021 than it was at yearend December 31, 2020. An increase in deposits helped to fund the $154.0 million increase in net loans since yearend 2020. All loan portfolios with the exception of the other portfolio increased compared to December 31, 2020

In comparing to the same prior year period, the June 30, 2021 (net of deferred fees and cost) loan balances of $1.5 billion accounted for $113.7 million or 8.5% increase when compared to 2020's $1.3 billion. The year over year improvement was made up of a combined increase of 14.0% in commercial and industrial related loans (comprised of 17.3% in commercial real estate loans and a decrease of 3.3% in non-real estate commercial loans). PPP loans of approximately $41.0 million and $87.2 million are included in the non-real estate commercial portfolio as of June 30, 2021 and June 30, 2020, respectively. Consumer real estate loans increased by 12.1%, consumer loans by 12.5% and other loans by 39.5%. Agricultural related loans decreased 8.7% year over year (comprised of 2.5% in agricultural real estate and 6.2% in non-real estate agricultural loans). The Company credits the growth not only to the OFSI acquisition but also to the strong team of lenders focused on providing customers valuable localized services and thereby increasing our market share.

The chart below shows the breakdown of the loan portfolio category as of June 30, for the last three years, net of deferred fees and costs.

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The following is a contractual maturity schedule by major category of loans excluding fair value adjustments as of June 30, 2021.

While the security portfolio has been utilized to fund loan growth for the last three years, additional sources have been cultivated during 2019, 2020, and 2021. The security portfolio increased $99.7 million in the first six months of 2021 from yearend 2020 and $171.2 million from June 2020. The amount of pledged investment securities decreased by $6.7 million as compared to yearend and $10.9 million as compared to June 30, 2020. Liquidity is improved with the additional option of selling unpledged investment securities if needed to fund loan growth or other initiatives. As of June 30, 2021, pledged investment securities totaled $76.5 million. The current portfolio is in a net unrealized gain position of $966.9 thousand.

For the Bank, an additional $5.2 million is also available from the Federal Home Loan Bank based on current amounts of pledged collateral. At the present time, only 1-4 family and home equity portfolios are pledged. Additional borrowings would be available if additional portfolios (i.e. commercial real estate) were pledged.

With the exception of FHLB stocks, carried at cost, which is shown as other securities, all of the Company's security portfolio is categorized as 'available-for-sale' and as such is recorded at fair value.

Management feels confident that liquidity needs for future growth can be met through additional maturities and/or sales from the security portfolio, increased deposits and additional borrowings. For short term needs, the Bank has $163.2 million of unsecured borrowing capacity through its correspondent banks.

Overall total assets increased 13.5% since yearend 2020 and grew 21.4% since June 30, 2020. The largest growth in both periods was in the loan portfolios and securities. Cash and cash equivalents also increased significantly compared to June 30, 2020.

Deposits accounted for the largest growth within liabilities, up 16.2% or $257.9 million since yearend and 25.5% or $377.0 million over June 30, 2020 balances. As stated previously, the growth of deposits correlated to a flight to safety as the stock market continues to experience some volatility. Core deposits continue to drive the increase which provide the opportunity to generate additional noninterest income. This growth aided the increased liquidity position and funded the loan growth for the periods along with usage of purchased Federal Funds for daily borrowings.

Shareholders' equity increased by $1.4 million as of the second quarter of 2021 compared to yearend 2020. Earnings exceeded dividend declarations during the six months ended June 30, 2021. Accumulated other comprehensive income decreased in unrealized gain position by $4.9 million from December 2020 to an unrealized gain of $764 thousand on June 30, 2021. Dividends declared remained the same as third and fourth quarter 2020 and first quarter 2021 at $0.17 per share. Compared to June 30, 2020, shareholders' equity increased 4.3% or $10.3 million. Profits were higher year-to-date June 2021 than year-to-date June 2020 by $983 thousand.

Basel III regulatory capital requirements became effective in 2016. The Bank and Company include a capital conservation buffer as a part of the transition provision. For calendar year 2016, the applicable required capital conservation buffer percentage of 0.625% was the base above which institutions avoid limitations on distributions and certain discretionary bonus payments. For the calendar year 2017, the applicable required capital conservation buffer percentage was 1.25%. For 2018, the capital conservation buffer percentage increased to 1.875%. The total buffer requirement increased to 2.5% for calendar year 2019. As of June 30, 2021, the Company and the Bank are both positioned well above the 2019 requirement.

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The Holding Company has sufficient liquidity to maintain its dividend policy without relying on the upstreaming of dividends from the Bank.

The Bank continues to be well-capitalized in accordance with Federal regulatory capital requirements as the capital ratios below show:

MATERIAL CHANGES IN RESULTS OF OPERATIONS

Comparison of Results of Interest Earnings and Expenses for three month periods ended June 30, 2021 and 2020

Interest Income

When comparing second quarter 2021 to second quarter 2020, average loan balances with the acquisition of OFSI grew $98.1 million with PPP loans decreasing $13.7 million. This represented a 7.4% increase in a one-year time period. Interest income on loan balances experienced an increase of $67 thousand as compared to the quarter ended June 30, 2020. Net fee income for the PPP loans is recognized on a straight line basis over 24 months for the first draw and 60 months for the second draw and will be accelerated upon payoff. PPP loan income for the quarter included interest income of $135 thousand and net fee income of $615 thousand.

The available-for-sale securities portfolio increased in average balances by $172.9 million when comparing to the previous year while the income increased $141 thousand over second quarter. Federal funds sold and interest-bearing deposits increased in average balances by $94.5 million as compared to the same quarter in 2020 with increased income of $49 thousand for the current quarter. Refer to Note 2 Business Combination and Asset Purchase for information on assets acquired from OFSI.

The overall total average balance of the Bank's earning assets increased and interest income for the quarter comparisons was higher for second quarter 2021 by 1.5% or $257 thousand as compared to second quarter 2020. Decreases in the prime lending rate between the periods contributed to a decrease in rate yield.

Annualized yield, for the quarter ended June 30, 2021, was 3.53% as compared to 4.25% for the quarter ended June 30, 2020. The following charts demonstrate the value of increased loan balances in the balance sheet mix, as well as the impact on the changes in interest rates. The yields on tax-exempt securities and the portion of the tax-exempt IDB loans included in loans have been tax adjusted based on a 21% tax rate in the charts to follow.

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Change in Interest Income Quarter to Date June 30, 2021 Compared to June 30, 2020

Interest Expense

Adding to the higher interest income for the quarter was the decrease in interest expense in 2021 of $1.1 million or 42.4% compared to second quarter 2020. Since 2020, average interest-bearing deposit balances have increased $243.9 million or 21.6% and the Company recognized $978 thousand less in interest expense for the most recent quarter. The prime rate dropped 150 basis points in March of 2020 and management has adjusted deposit rates accordingly. Interest expense on FHLB borrowings was down $142 thousand in the second quarter 2021 over the same time frame in 2020 due to borrowings taken on from the Limberlost acquisition being repaid in addition to the related fair value amortization completed in April 2021. Interest expense on fed funds purchased and securities sold under agreement to repurchase was down $24 thousand compared to second quarter 2020. Liabilities assumed from OFSI can be seen in Note 2.

Change in Interest Expense Quarter to Date June 30, 2021 Compared to June 30, 2020

Overall, net interest spread for the second quarter 2021 was 25 basis points lower than last year. As the following chart indicates, the decline in yields on interest earning assets was more than the decline in the cost of funds when comparing to the same period a year ago.

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Net Interest Income

Net interest income increased $1.4 million for the second quarter 2021 over the same time frame in 2020 with the increase in interest income of $257 thousand combined with the lower interest expense of $1.1 million, as previously mentioned. As the new loans added in 2020 and 2021 generate more income, management expects the benefits of the Company's strategy of repositioning the balance sheet to continue to widen this margin as measured in dollars. In terms of net interest margin rate, the Bank recognizes competition for deposits may again increase and put pressure on the margin which may lead to a tightening.

Comparison of Noninterest Results of Operations for three month periods ended June 30, 2021 and 2020

Provision Expense

The ALLL has a direct impact on the provision expense. The increase in the ALLL is funded through recoveries and provision expense. The following tables both deal with the allowance for credit losses. The first table breaks down the activity within ALLL for each loan portfolio class and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs. The second table discloses how much of the ALLL is attributed to each class of the loan portfolio, as well as the percent that each particular class of the loan portfolio represents to the entire loan portfolio in the aggregate. The consumer loan portfolio accounted for the largest component of charge-offs and recoveries for second quarter of 2021. For second quarter 2020, the commercial and industrial and consumer loan portfolios accounted for both the largest component of charge-offs while the consumer portfolio accounted for the largest component of recoveries for the second quarter 2020. The commercial real estate portfolio is currently creating a large impact on the ALLL due to the loan growth.

Total provision for loan losses was $928 thousand lower for the second quarter 2021 as compared to the same quarter 2020. Provision for loan loss has stabilized during the second quarter of 2021. There is still some uncertainty related to COVID-19 and its effects on the ability of individuals, businesses and other entities to meet their financial obligation; therefore, it is prudent to incorporate the impact of COVID-19 in the evaluation of the adequacy of Allowance for Loan and Lease Losses (ALLL). The restaurant and hospitality sectors have been hit especially hard. Risk in the Consumer and 1-4 Family Portfolio has increased but the full impact still remains unknown. Increases to the Bank's ALLL for the second quarter of 2021, centered around current customers and businesses that are particularly vulnerable and qualitative factors were adjusted accordingly. Management continues to monitor asset quality, making adjustments to the provision as necessary. Loan charge-offs were $199 thousand lower in second quarter 2021 than the same quarter 2020. Recoveries were $9 thousand lower in second quarter 2021 as compared to second quarter 2020. Combined net charge-offs were $190 thousand lower in second quarter 2021 than the same time period 2020.

Past due loans, which include no deferrals related to COVID-19, decreased $1.9 million at June 30, 2021 as compared to June 30, 2020. The majority of the change is attributed to the decrease of past due balances in the consumer real estate, agricultural and agricultural real estate portfolios with an increase in the commercial and industrial and commercial real estate portfolios.

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The following table breaks down the activity within the ALLL for each loan portfolio class and shows the contribution provided by both recoveries and the provision, along with the reduction of the allowance caused by charge-offs. The time period covered is for three months ended June 30, 2021, 2020, and 2019.

The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off of a loan, whether partial loan balance or full loan balance. The Bank is also following the guidelines established under the CARES Act. A charge down in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. Commercial and agricultural credits are charged down at 120 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-offs may be realized as further unsecured positions are recognized.

Loans classified as nonaccrual were lower as of June 30, 2021 at $7.0 million as compared to $8.5 million as of June 30, 2020. The consumer real estate portfolio decreased $1.5 million while the commercial real estate and commercial and industrial portfolios decreased a combined $86 thousand. The agricultural real estate and agricultural portfolios increased a combined $132 thousand as compared to June 30, 2020.

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In determining the allocation for impaired loans, the Bank applies the appraised market value of the collateral securing the asset, reduced by applying a discount for estimated costs of collateral liquidation. In some instances where the discounted market value is less than the loan amount, a specific impairment allocation is assigned, which may be reduced or eliminated by the write down of the credit's active principal outstanding balance.

For the majority of the Bank's impaired loans, including all collateral dependent loans, the Bank will apply the appraised market value methodology. However, the Bank may also utilize a measurement incorporating the present value of expected future cash flows discounted at the loan's effective rate of interest. To determine appraised market value, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated appraisals are received, the Bank may discount the collateral value used.

The following table presents the balances for allowance for loan losses by loan type for six months ended June 30, 2021 and June 30, 2020.

Noninterest Income

Noninterest income was up $701 thousand for the second quarter 2021 over the same time frame in 2020. The Company has seen an increase in its mortgage production volume and the gain on the sale of these loans was $591 thousand higher for the second quarter 2021 over the same period in 2020. Loan originations on loans held for sale for the second quarter 2021 were $29.5 million with proceeds from sale at $29.9 million for 2021 compared to 2020's second quarter activity of $70.7 million in originations and $62.5 million in sales. Loan originations driven by the refinance activity associated with the reduction in interest rates has slowed. The mortgages sold were both 1-4 family and agricultural real estate loans originated for sale.

Combined service fees increased by $110 thousand as compared to second quarter 2020. Debit card income increased by $246 thousand, bank owned life insurance cash surrender value increased $73 thousand and credit card fees increased $44 thousand. Also contributing to the increase was service charge income and overdraft and returned check charges which increased $59 and $111 thousand respectively compared to second quarter 2020. Service fee income for 1-4 family and agricultural real estate loans decreased by $106 thousand, mortgage release fees decreased $104 thousand, servicing rights income decreased $199 thousand.

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The impact of mortgage servicing rights, both to income and expense, is shown in the following table which reconciles the value of mortgage servicing rights. The capitalization runs through noninterest income while the amortization thereof is included in non-interest expense. For the second quarter of 2021 and 2020, mortgage servicing rights caused a net $19 and $68 thousand in income, respectively. The first six months of 2021 and 2020, mortgage servicing rights caused a net $143 and $111 thousand of income, respectively. The higher capitalized additions for the first six months of 2021 are attributed to a higher loan origination level of 1-4 families. A lower interest rate environment has helped to generate the mortgage refinance activity. For loans of 15 years and less, the value was 1.131% in the second quarter 2021 versus 0.538% in second quarter 2020. For loans over 15 years, the value was 1.191% versus a lower 0.716% for the same periods respectively. The carrying value is greater than the market value of $3.1 million which created the need to establish a $317 thousand valuation allowance during second quarter 2021.

Noninterest Expense

For the second quarter 2021, noninterest expenses were $2.7 million higher than for the same quarter in 2020. Salaries, wages, and employee benefits (includes normal merit increases, restricted stock expense, incentive payout and all employee benefits) increased $1.2 million in total. This was comprised of increased salaries of $496 thousand and increased benefits of $697 thousand with $542 thousand acquisition related. Consulting fees increased $177 thousand over second quarter 2020 with $292 thousand related to the acquisition of Ossian and Perpetual. FDIC assessment expenses were up $132 thousand due to Small Bank Credits being applied in 2020. During the second quarter 2021, the Bank also recognized a loss of $217 thousand which is included in the Net (Gain) Loss on Sale of Other Assets Owned line of the consolidated statement of income for the sale of buildings. Other general and administrative expenses increased $649 thousand as compared to second quarter 2020 with $230 thousand acquisition related while the remainder was primarily attributable to the Company's overall growth for the year.

Income Taxes

Income tax expense was $158 thousand higher for the second quarter 2021 compared to the same quarter in 2020. Effective tax rates were 20.93% and 19.46% for second quarter 2021 and 2020 respectively. The higher effective income tax rate for second quarter 2021 accounted for $92 thousand of the increase and was the result of increased Indiana income tax.

Net Income

Results overall, net income in the second quarter of 2021 was up $179 thousand as compared to the same quarter last year. Second quarter 2021 included a decrease of $928 thousand of loan loss provision as compared to second quarter 2020. The Company has done an exceptional job of growing loans while keeping past dues low. The Company remains strong, stable, and well capitalized and has the capacity to continue to cover the increased costs of expansion.

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Comparison of Results of Interest Earnings and Expenses for six month periods ended June 30, 2021 and 2020

Interest Income

Higher loan balances of $95.2 million did not create an improvement in the interest income for the first six months of 2021 as compared to the first six months of 2020. PPP average loan balances increased approximately $14 million year over year. Interest income in total fell 1.3% or $442 thousand with interest income from loans accounting for $204 thousand of the decrease. Contributing to the overall decline was also a decrease in securities income of $203 thousand and a decrease from Fed Funds sold and interest-bearing deposits of $35 thousand over 2020. The asset yield decreased by 63 basis points to 3.61% for the first six months of 2021 compared to the first six months of 2020's 4.44%.

PPP loan interest income recognized was $234.7 thousand for the first six months of 2021 with net fee income of $1.5 million compared to $169.9 thousand of loan interest income and $318.2 thousand of net fee income for 2020. The growth factor contribution is shown in the charts which follow.

The average interest earning asset base was $335.3 million higher in the first six months 2021 than the first six months of 2020, an increase of approximately 21.4%.

The yields on tax-exempt securities and the portion of the tax-exempt IDB loans included in loans have been tax adjusted based on a 21% tax rate in the charts to follow.

Change in Interest Income Year to Date June 30, 2021 Compared to June 30, 2020

Interest Expense

Interest expense was lower for the first six months of 2021 compared to the first six months of 2020. At $3.3 million, the first six months of 2021 was down $2.8 million as compared to the same time period 2020 or 46.3%.

The average balance of interest-bearing liabilities was higher by $214.2 million in 2021 than the first six months of 2020. Interest bearing deposits increased $225.0 million while Fed Funds purchased and securities sold under agreement to repurchase decreased by a combined $4.5 million. The higher balance coupled with the slight variation of the balance sheet mix, resulted in a 58 basis points decrease in the cost of funds at 0.48% for the first six months of 2021 as compared to 2020's 1.06%.

The change chart below shows the decreased cost was driven more by rate than volume.

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Change in Interest Expense Year to Date June 30, 2021 Compared to June 30, 2020

Net Interest Income

Overall, net interest spread figures for the first six months of 2021 were down from 2020 by 25 basis points and down 54 basis points from 2019. Net interest margin for the first six months of 2021 was lower than the same periods of 2020 and 2019. As the chart below illustrates, lower yields on loan and investment income were only partially offset by lower interest expense resulting in total net interest margin down 40 basis points since the first six months of 2020 and under the first six months of 2019 by 76 basis points.

Net interest income was up $2.4 million in the first six months of 2021 over the same time frame in 2020 due to the lower interest expense offset by the decrease in interest income as previously mentioned. As the new loans added in 2020 and 2021 generate more income, management expects the benefits of the Company's strategy of repositioning the balance sheet to continue to widen this margin as measured in dollars. In terms of net interest margin rate, the Bank recognizes competition for deposits may again increase and put pressure on the margin which may lead to a tightening.

Comparison of Results of Noninterest Earnings and Expenses for six month periods ended June 30, 2021 and 2020

Provision Expense

Total provision for loan losses was $658 thousand lower for the first six months 2021 than for the first six months 2020 attributable primarily to the lessened uncertainties associated with COVID-19 and its effects on the ability of individuals, businesses and other entities to meet their financial obligations. Therefore, it is prudent to incorporate the impact of COVID-19 in the evaluation of the adequacy of Allowance for Loan and Lease Losses (ALLL). The restaurant and hospitality sectors have been hit especially hard. Risk in the Consumer and 1-4 Family Portfolio has increased but the full impact remains unknown. Increases to the Bank's ALLL for the first six months of 2021, centered around current customers and businesses that are particularly vulnerable and qualitative factors were adjusted accordingly. Management continues to monitor asset quality, making adjustments to the provision as necessary. Loan charge-offs were $650 thousand higher in the first six months of 2021 compared to the same period 2020. Recoveries were $18 thousand higher in the first six months of 2021 as compared to first six months of 2020. Combined net charge-offs were $632 thousand higher in the six months ended June

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2021 as compared to the same time period 2020. Management continues to evaluate the potential financial implications resulting from COVID-19 and adjusts ALLL qualitative factors as necessary.

The following table breaks down the activity within the ALLL for each loan portfolio class and shows the contribution provided by both recoveries and the provision, along with the reduction of the allowance caused by charge-offs. The time period covered is for six months ended June 30, 2021, 2020, and 2019.

In comparing past due balances of loans 30+ days, June 30, 2021 balances were $1.7 million as compared to June 30, 2020 balances of $3.6 million. Net charge-offs were higher at $926 thousand for the first six months of 2021 compared to the first six months of 2020's $294 thousand.

Noninterest Income

Noninterest income for the first six months of 2021 increased over the first six months of 2020 by $2.6 million. Gain on sale of loans showed a $1.4 million increase over the first six months of 2020 with the surge in refinance activity due to interest rate reductions. Combined service fees increased by $1.1 million with increased debit card income of $623 thousand which included a Mastercard growth credit of $151 thousand, servicing rights income of $255 thousand and bank owned life

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insurance cash surrender value increases of $133 thousand. Service charge income increased by $105 thousand while overdraft and returned check income decreased by $136 thousand. The Company did sell some of its available-for-sale securities in first six months of both years and recognized a gain of $293 thousand in 2021 and $270 thousand in 2020.

Noninterest Expense

Through the first six months of 2021, noninterest expenses were $4.4 million higher than in the first six months of 2020. 2021 included $1.2 million of third party acquisition related costs incurred with the Ossian and Perpetual transactions. The six months of 2021 included an increase of $663 thousand in salaries and wages in addition to an increase of $1.0 million in employee benefits. The addition of the acquired offices, normal merit increases, a one time expense for 2020 employer pension match and increased employer taxes have impacted 2021. The increases were offset by decreased restricted stock expense and medical costs. 2021 included acquisition costs of $542 thousand in the employee benefits line of the Company's consolidated statement of income.

Data processing fees, which included a credit for product upgrades in the amount of $100 thousand, were $83 thousand higher than last year. A seven year contract extension was signed in the third quarter of 2016 which has helped reduce the expense while adding new products and services to better align with our customers' expectations in the coming years. Consulting fees increased $261 thousand with $337 thousand acquisition related. The increase in FDIC assessments for 2021 was due to Small Bank Credits being applied in 2020. 2021 included a loss on the sale of buildings in the amount of $217 thousand.

General and administrative expenses were up $1.1 million over the first six months of 2020. Acquisition costs of $336 thousand were included in this line for 2021. One of the largest increases was for provision for unfunded loans for $378 thousand which was partially related to the decreased balances on lines of credit due to PPP. Loan and collection expense increased $152 thousand while legal fees increased $327 thousand over 2020 with $223 thousand related to the acquisitions. Overdraft related expenses were $73 thousand less than 2020.

Income Taxes

Income tax expense was $246 thousand higher for the first six months of 2021 compared to the first six months of 2020. Effective tax rates were 19.39% and 19.32% for the first six months of 2021 and 2020 respectively. The slightly higher effective tax rate for the first six months of 2021 equaled an increase in income tax expense of $9 thousand with the remainder driven from increased earnings.

Net Income

Overall, net income through the first six months of 2021 was up $983 thousand as compared to the first six months of 2020. Decreased interest expense of $2.8 million and increased noninterest income of $2.6 million were the largest contributors to the increased net income for 2021.

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FORWARD LOOKING STATEMENTS

Statements contained in this portion of the Company's report may be forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by the use of words such as 'intend,' 'believe,' 'expect,' 'anticipate,' 'should,' 'planned,' 'estimated,' and 'potential.' Such forward-looking statements are based on current expectations, but actual results may differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents filed by the Company with the Securities and Exchange Commission from time to time. Other factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in interest rates, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Bank's market area, changes in relevant accounting principles and guidelines and other factors over which management has no control, including, but not limited to, the ongoing impact of the COVID-19 pandemic. The forward-looking statements are made as of the date of this report, and the Company assumes no obligation to update the forward-looking statements or to update the reasons why actual results differ from those projected in the forward-looking statements.

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ITEM 3 QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the exposure to loss resulting from changes in interest rates and equity prices. The primary market risk to which the Company is subject is interest rate risk. The majority of our interest rate risk arises from the instruments, positions and transactions entered into for purposes other than trading such as loans, available for sale securities, interest bearing deposits, short term borrowings and long term borrowings. Interest rate risk occurs when interest bearing assets and liabilities re-price at different times as market interest rates change. For example, if fixed rate assets are funded with variable rate debt, the spread between asset and liability rates will decline or turn negative if rates increase.

Interest rate risk is managed within an overall asset/liability framework. The principal objectives of asset/liability management are to manage sensitivity of net interest spreads and net income to potential changes in interest rates.

Funding positions are kept within predetermined limits designed to ensure that risk-taking is not excessive and that liquidity is properly managed. In the event that our asset/liabilities management strategies are unsuccessful, our profitably may be adversely affected. The Company employs a sensitivity analysis utilizing interest rate shocks to help in this analysis.

The shocks presented below assume an immediate change of rate in the percentages and directions shown covering a twelve month period:

The net interest margin represents the forecasted twelve month margin. The Company also reviews shocks with a 4.0% fluctuation with a delayed time frame of 10 months and over a 24 month time frame. It also shows the effect rate changes will have on both the margin and net interest income. The goal of the Company is to lengthen the term of some of the Bank's fixed rate liabilities or sources of funds to decrease the exposure to a rising rate environment. Of course, customer desires also impact the Bank's ability to attract longer term deposits.

The shock chart currently shows a widening in net interest margin over the next twelve months in a rising rate environment and a tightening in a falling rate environment. With the rate decreases in the first quarter of 2020, the model predicts an expansion of net interest income at any level in a rising rate environment. The rising rate scenarios are predicted to expand the net interest margin and produce higher levels of net interest income. Cost of funds are at 0.44% for the quarter and 0.48% for the year so the lowest shock of 100 basis points is where the Bank can take partial advantage and reprice some funds to match the level of shock. Once the shocks are falling over 100 basis points, the cost of funds cannot lower to match and the loss on net interest income continues to build. The average duration of the majority of the assets is outside the 12 month shock period. The majority of the newer loans added to the commercial real estate portfolio begin with an initial fixed rate period of three to five years whose variable adjustment is outside of the current shock time frame. The Bank continues to adjust its assumptions by including decay rates and key rate ties on certain deposit accounts and continues to review and modify those rates as the index rates change. All shocks are within risk exposure guidelines at all levels. The effect of the rate shocks may be mitigated to the extent that not all lines of business are directly tied to an external index and actual balance sheet composition may differ from prediction.

Overall, the Company must concentrate on increasing loan spreads on variable loans and extend the duration on cost of funds where possible.

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ITEM 4 CONTROLS AND PROCEDURES

As of the end of the period covered by this quarterly report on Form 10-Q, an evaluation was performed under the supervision and with the participation of the Company's management including the CEO and CFO, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on that evaluation, the Company's management, including the CEO and CFO, concluded that the Company's disclosure controls and procedures were effective as of the end of the period covered by this report. There have been no changes in the Company's internal control over financial reporting that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

PART II OTHER INFORMATION

ITEM 1 LEGAL PROCEEDINGS

None

ITEM 1A RISK FACTORS

There have been no material changes in the Company's risk factors from those disclosed in the Company's Annual Report on Form 10-K for the yearended December 31, 2020.

ITEM 2 UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Treasury stock repurchased the quarter ended June 30, 2021.

ITEM 3 DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4 MINE SAFETY DISCLOSURES

Not applicable

ITEM 5 OTHER INFORMATION

None

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ITEM 6 EXHIBITS

⁽¹⁾ Pursuant to Rule 406T of Regulation S-T, the interactive Data Files in Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

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SIGNATURES

SIGNATURES

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

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