Item 1A. Risk Factors.
Ownership of our common stock involves certain risks. The risks and uncertainties described below are not the only ones we face. You should carefully consider the risks described below, as well as all other information contained in this Report. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of these risks actually occurs, our business, financial condition and results of operations could be materially and adversely affected.
Risks Related to Our Business
We are subject to credit risk in connection with our lending activities, and our financial condition and results of operations may be negatively impacted by economic conditions and other factors that adversely affect our borrowers.
Our financial condition and results of operations are affected by the ability of our borrowers to repay their loans, and in a timely manner. The risks of non-payment and late payments are assessed through our underwriting and loan review procedures based on several factors including credit risks of a particular borrower, changes in economic conditions, the duration of the loan and in the case of a collateralized loan, uncertainties as to the future value of the collateral and other factors. Despite our efforts, we do and will experience loan losses, and our financial condition and results of operations will be adversely affected. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters, terrorist acts, cyber-attacks, or a combination of these or other factors.
Our loan portfolio has been significantly affected by the economic disruptions resulting from COVID-19, which contributed to our loan losses and delinquencies increasing, and we may need to significantly add to our allowance for loan losses.
The economic disruptions related to COVID-19 have resulted in a significant increase in delinquencies and loans on nonaccrual status across our loan portfolio as certain industries were particularly hard-hit by COVID-19, which adversely affected the ability of certain of our borrowers to repay their loans.
For example, in November 2021 we announced that we completed a sale to a single investor of certain problem loans. Specifically, the Company sold three loans with a book balance of $29.3 million with a write down of approximately $10.4 million. The loans sold included approximately $12.2 million of non-accruing loans and $17.1 million of performing troubled debt restructurings. The Company had classified the loans as “held for sale” at September 30, 2021 after taking write downs to reflect the anticipated sale price of such loans. Including the write down, the Company recorded a provision for loan and lease losses of approximately $10.6 million at the quarter ended September 30, 2021. The loan sale had a material negative impact on the Company’s earnings for the quarter and year ended September 30, 2021. Notwithstanding the sale of the above-mentioned loans, as of the date of the filing th e Company still retains one non-performing commercial real estate loan in the metropolitan New York area carried at a fair value of $13.3 million, classified as held for sale as of September 30, 2022, which could potentially be sold at an additional loss and could further have a material negative impact on our earnings and financial condition. Additionally the Bank is paying real estate taxes associated with the property to maintain its collateral position . It is also possible that the prior and any future impact of COVID-19 on the economy and our loan portfolio may increase our exposure to elevated loan and , and as a result, we may further increase our allowance for loan .
If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings will decrease.
We make various assumptions and judgements about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the required amount of the allowance for loan losses, we evaluate certain loans individually and establish loan loss allowances for specifically identified impairments. For all non-impaired loans, including those not individually reviewed, we estimate losses and establish loan loss allowances based upon historical and environmental loss factors. If the assumptions used in our calculation methodology are incorrect, our allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, resulting in further additions to our allowance. COVID-19 further impacted the assumptions and methodologies typically used in making allowances for loan losses, and the availability and reliability of materials and other market information, including appraisals, have been impacted by COVID-19, making assumptions more subjective. At September 30, 2022, our allowance for loan was 1.12 percent of total loans. Significant additions to our allowance could materially decrease our net income.
Our results of operations and financial condition may be adversely affected by changing economic conditions.
A return to a recessionary period, continued increased inflation, continued disruption in global and domestic supply chains, and other economic conditions could negatively impact our customers in a manner that would adversely affect our results of operations and financial condition. Volatility in the housing markets, real estate values and unemployment levels, and the deterioration of economic conditions in our market area, could affect our customers’ ability to take out loans, repay loans and adversely affect our results of operations and future growth potential in the following ways:
Loan delinquencies may increase;
Problem assets and foreclosures may increase;
Demand for our products and services may decline;
The carrying value of our OREO may decline; and
Collateral for loans made by us, especially real estate, may decline in value, in turn reducing a customer’s borrowing power, and reducing the value of assets and collateral associated with our loans.
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Changes in interest rates could adversely affect our financial condition and results of operation.
Our net income depends primarily upon our net interest income. Net interest income is the difference between interest income earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and borrowed funds. The level of net interest income is primarily a function of the average balance of our interest-earning assets, the average balance of our interest-bearing liabilities, and the spread between the yield on such assets and the cost of such liabilities. These factors are influenced by both the pricing and mix of our interest-earning assets and our interest-bearing liabilities which, in turn, are impacted by such external factors as the local economy, competition for loans and deposits, the monetary policy of the Federal Open Market Committee of the Federal Reserve Board of Governors (the “FOMC”), and market interest rates.
Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. We expect that we will periodically experience gaps in the interest rate sensitivities of our assets and liabilities. That means either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. When interest-bearing liabilities mature or re-price more quickly than interest-earning assets, an increase in market rates of interest could reduce our net interest income. Likewise, when interest-earning assets mature or re-price more quickly than interest-bearing liabilities, falling interest rates could reduce our net interest income. We are unable to predict changes in market interest rates, which are affected by many factors beyond our control, including inflation, deflation, recession, unemployment, money supply, domestic and international events and changes in the United States and other financial markets.
We also attempt to manage risk from changes in market interest rates, in part, by controlling the mix of interest rate sensitive assets and interest rate sensitive liabilities. However, interest rate risk management techniques are not exact. A rapid increase or decrease in interest rates could adversely affect our results of operations and financial performance.
Our high concentration of commercial real estate loans exposes us to increased lending risk.
As of September 30, 2022, the primary composition of our total loan portfolio was as follows:
commercial real estate loans of $406.9 million, or 50.2 percent of total loans;
residential real estate loans of $176.0 million, or 21.7 percent of total loans;
commercial and industrial loans of $102.7 million, or 12.7 percent of total loans;
construction and development loans of $24.9 million, or 3.1 percent of total loans; and
consumer loans of $19.8 million, or 2.4 percent of total loans.
Commercial real estate loans expose us to a greater risk of loss than do residential mortgage loans. Commercial real estate loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to residential loans. Consequently, an adverse development with respect to one commercial loan or one credit relationship exposes us to a significantly greater risk of loss compared to an adverse development with respect to one residential mortgage loan. Any significant failure to pay on time by our customers or a significant default by our customers would materially and adversely affect us.
We can give you no assurance that the economy and the real estate market in particular will grow or that any rate of growth will accelerate to historic levels. Many factors could significantly reduce or halt growth in our local economy and real estate market. Accordingly, it may become more difficult for commercial real estate borrowers to repay their loans in a timely manner, as commercial real estate borrowers’ ability to repay their loans frequently depends on the successful development and/or operation of their properties. The deterioration of one or more of our commercial real estate loans could cause a material increase in our level of nonperforming loans, which would result in a loss of revenue from these loans and could result in an increase in the provision for loan and lease losses and/or an increase in charge-offs, all of which could have a material adverse impact on our net income. We also may incur losses on commercial real estate loans due to declines in occupancy rates and rental rates, which may decrease property values and may reduce the likelihood that a borrower may find permanent financing alternatives. in the commercial real estate market in general could impact our collateral. Any of the commercial real estate market may increase the likelihood of of these loans, which could impact our loan portfolio’s performance and asset quality. If we are required to the collateral securing a loan to the debt during a period of reduced real estate values, we could incur material . Any of these events could increase our costs, require management time and attention, and materially and affect our financial condition and results of operations.
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Nonperforming assets take significant time to resolve and adversely affect our results of operations and financial condition, and could result in further losses in the future.
Our nonperforming assets could adversely affect our net income in various ways. We do not record interest income on nonaccrual loans or OREO, thereby adversely affecting our net interest income, net income and returns on assets and equity, and our loan administration costs increase, which together with reduced interest income adversely affects our efficiency ratio. When we take collateral in foreclosure and similar proceedings, we are required to mark the collateral to its then-fair market value, which may result in a loss. These nonperforming loans and other real estate owned also increase our risk profile and the level of capital our regulators believe is appropriate for us to maintain in light of such risks. The resolution of nonperforming assets requires significant time commitments from management and can be detrimental to the performance of their other responsibilities. If we experience increases in nonperforming loans and assets, our net interest income may be impacted and our loan administration costs could increase, each of which would have an effect on our net income and related ratios, such as return on assets and equity.
We engage in lending secured by real estate and may be forced to foreclose on the collateral and own the underlying real estate, subjecting us to the costs and potential risks associated with the ownership of the real property, or consumer protection initiatives or changes in state or federal law may substantially raise the cost of foreclosure or prevent us from foreclosing at all.
Since we originate loans secured by real estate, we may have to foreclose on the collateral property to protect our investment and may thereafter own and operate such property, in which case we would be exposed to the risks inherent in the ownership of real estate. Our inability to manage the amount of costs or size of the risks associated with the ownership of real estate, or write-downs in the value of our owned real property, including OREO, could have an adverse effect on our business, financial condition and results of operations.
Additionally, consumer protection initiatives or changes in state or federal law may substantially increase the time and expense associated with the foreclosure process or prevent us from foreclosing at all. If new state or federal laws or regulations are ultimately enacted that significantly raise the cost of foreclosure or raise outright barriers, such laws or regulations could have an adverse effect on our business, financial condition and results of operation.
Appraisals and other valuation techniques we use in evaluating and monitoring loans secured by real property, other real estate owned and repossessed personal property may not accurately describe the net value of the asset.
In considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made and, as real estate values may change significantly in value in relatively short periods of time (especially in periods of heightened economic uncertainty and changing interest rates), this estimate may not accurately describe the net value of the real property collateral after the loan is made. As a result, we may not be able to recover the full amount of any remaining indebtedness when we foreclose on and sell the relevant property. In addition, we rely on appraisals and other valuation techniques to establish the value of our other real estate owned, or OREO, and personal property that we acquire through foreclosure proceedings and to determine certain loan impairments. If any of these valuations are inaccurate, our combined and consolidated financial statements may not reflect the correct value of our OREO, and our allowance for loan losses may not reflect accurate loan impairments. This could have an adverse effect on our business, financial condition or results of operations.
The concentration of our commercial real estate loan portfolio subjects us to heightened regulatory scrutiny .
The FDIC, the FRB and the OCC have promulgated joint guidance on sound risk management practices for financial institutions with concentrations in commercial real estate lending. Under the joint guidance, a financial institution that, like us, is actively involved in commercial real estate lending should perform a risk assessment to identify concentrations. A financial institution may have a concentration in commercial real estate lending if, among other factors: (i) total reported loans for construction, land development, and other land represent 100 percent or more of total risk-based capital or (ii) total reported loans for construction, land development and other land and loans secured by multifamily and non-owner occupied non-farm residential properties (excluding loans secured by owner-occupied properties) represent 300 percent or more of total risk-based capital and the institution’s commercial real estate loan portfolio has increased by 50 percent or more during the prior 36 month period. In such event, management should employ heightened risk management practices, including board and management oversight and strategic planning, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing.
Our total reported loans for construction, land development and other land represented 15.0 percent of risk-based capital at September 30, 2022, as compared to 35.7 percent of capital at September 30, 2021. This ratio is below the regulatory commercial real estate concentration guideline level of 100 percent for land and construction loans. Our total reported commercial real estate loans to total risk-based capital was 250.8 percent at September 30, 2022, as compared to 298.88 percent of capital at September 30, 2021. This ratio is below the regulatory commercial real estate concentration guideline level of 300 percent for all investor real estate loans.
Strong competition within our market area could hurt our profits and slow our growth.
The banking and financial services industry in our market area is highly competitive. We may not be able to compete effectively in our markets, which could adversely affect our results of operations. The increasingly competitive environment is a result of changes in regulation, advances in technology and product delivery systems, and consolidation among financial service providers. Larger institutions, and institutions with an on-line presence, have greater resources and access to capital markets, with higher lending limits, higher rates of interest on deposits, more advanced technology and broader suites of services. Competition at times requires increases in deposit rates and decreases in loan rates, and adversely impact our net interest margin.
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Climate change and related legislative and regulatory initiatives may materially affect the Company ’ s business and results of operations.
The effects of climate change continue to create an alarming level of concern for the state of the global environment. As a result, the global business community has increased its political and social awareness surrounding the issue, and the United States has entered into international agreements in an attempt to reduce global temperatures, such as reentering the Paris Agreement. Further, the U.S. Congress, state legislatures and federal and state regulatory agencies continue to propose numerous initiatives to supplement the global effort to combat climate change. Similar and even more expansive initiatives are expected under the current administration, including potentially increasing supervisory expectations with respect to banks’ risk management practices, accounting for the effects of climate change in stress testing scenarios and systemic risk assessments, revising expectations for credit portfolio concentrations based on climate-related factors and encouraging investment by banks in climate-related initiatives and lending to communities disproportionately impacted by the effects of climate change. The lack of empirical data surrounding the credit and other financial risks posed by climate change render it difficult, or even impossible, to predict how specifically climate change may impact our financial condition and results of operations; however, the physical effects of climate change may also directly impact us. Specifically, and more frequent weather may impact the real property, and/or the value of the real property, securing the loans in our portfolios. Additionally, if insurance obtained by our borrowers is to cover any sustained to the collateral, or if insurance coverage is otherwise to our borrowers, the collateral securing our loans may be impacted by climate change, natural and related events, which could impact our financial condition and results of operations. Further, the effects of climate change may impact regional and local economic activity, which could lead to an effect on our customers and impact the communities in which we operate. Overall, climate change, its effects and the resulting, unknown impact could have a material effect on our financial condition and results of operations.
Risks Related to the Merger
The consummation of the recently-announced merger with First Bank is contingent upon the satisfaction of a number of conditions, including shareholder and regulatory approvals, that may be outside of our control and that we may be unable to satisfy or obtain or which may delay the consummation of the merger or result in the imposition of conditions that could cause the parties to abandon the Merger.
As noted in “ Note 21 – Subsequent Events ” in “—Notes to Consolidated Financial Statements”, on December 13, 2022, Malvern Bancorp, Malvern Bank and First Bank entered into an Agreement and Plan of Merger (the “Merger Agreement”), pursuant to which, and subject to the terms and conditions of the Merger Agreement, Malvern Bancorp will merge with and into First Bank immediately followed by the merger of Malvern Bank with and into First Bank, with First Bank continuing as the surviving corporation in each case (collectively, the “Merger”).
Before the transactions contemplated in the Merger Agreement can be completed, approvals must be obtained from regulatory authorities, shareholders and other customary closing conditions must have been satisfied or waived. The required regulatory approvals may require changes to the terms of the transactions contemplated by the Merger Agreement. There can be no assurance that our or First Bank’s regulators will not impose any additional conditions, limitations, obligations or restrictions on the parties, or that they will not have the effect of delaying or preventing the completion of the Merger, imposing additional material costs on or materially limiting the revenues of the surviving entity following the Merger or otherwise reducing the anticipated benefits of the Merger.
Uncertainties about the effect of the Merger may impair our ability to attract, retain and motivate key personnel until the Merger is consummated and for a period of time thereafter, and could cause customers and others that deal with us to seek to change their existing business relationships with us. It is not unusual for competitors to use mergers as an opportunity to target the merging parties’ customers and to hire certain of their employees. Employee retention may be particularly challenging during the pendency of the Merger, as employees may experience uncertainty about their roles with the surviving entity following the Merger.
The Merger Agreement contains provisions that restrict our ability to, among other things, initiate, solicit, knowingly encourage or knowingly facilitate, inquiries or proposals with respect to, or, subject to certain exceptions generally related to our Board of Directors’ exercise of fiduciary duties, engage in any negotiations concerning, or provide any confidential information relating to, any alternative acquisition proposals. These provisions, which include payment of a termination fee of $5,900,000 (the “Termination Fee”) payable to First Bank, which, under certain circumstances, may discourage any potential competing acquirer having an interest in acquiring us from proposing a transaction, or may result in the offer of a lower per share price to acquire us than might otherwise have been proposed.
The value to be recognized by our shareholders from the Merger is subject to material uncertainties.
The Merger Agreement provides that upon the closing of the Merger our shareholders will receive per share of common stock of Malvern, $7.80 in cash and 0.7733 shares of common stock, par value $5.00 per share, of First Bank, subject to adjustment in accordance with the terms of the Merger Agreement if Malvern’s adjusted shareholders’ equity as of the tenth day prior to the closing of the Merger does not equal or exceed $140,000,000. The cash consideration and exchange ratio for the conversion of our common stock into common stock of First Bank (the “First Bank Common Stock”) were set based upon information available to the boards of directors and financial advisors of each company at the time of Merger Agreement was entered into. The market price of our common stock and of First Bank Common Stock fluctuates constantly in response to a variety of factors that are inherently unpredictable and outside of our control, including changes in our and First Bank’s business, operations and prospects, and regulatory considerations, the historical and anticipated future financial results of our respective banking operations and general market and economic developments affecting the United States and international businesses and financial markets. The substantial differences between our business and the business of First Bank will subject our shareholders to new and different risks than those they are familiar with. A period of months may transpire between the date that our shareholders are asked to approve the Merger and the earliest date the Merger can be , during which time the price of the Company’s common stock and First Bank Common Stock will continue to fluctuate and Malvern’s adjusted shareholders’ equity may continue to fluctuate. As a result, at the time that our shareholders must decide whether to approve the Merger Agreement, they may not necessarily know the precise value of the merger consideration they will receive, which could be materially different than the value of the merger consideration at the of the Merger.
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Failure to complete the proposed Merger could negatively impact our business, financial results and stock price.
If the proposed Merger is not completed for any reason, our ongoing business may be adversely affected and, without realizing any of the benefits of having completed the Merger, we would be subject to a number of related risks, including the following:
We may be required, under certain circumstances, to pay First Bank the Termination Fee under the Merger Agreement and reimbursement of First Bank's fees and expenses up to $350,000, which may adversely affect our financial performance and the price of our common stock;
We will have incurred substantial expenses and will be required to pay significant costs relating to the Merger, whether or not it is completed, such as legal, accounting, due diligence, financial advisor and printing fees;
The Merger Agreement places certain restrictions on the conduct of our business prior to completion of the Merger, which may adversely affect our ability to execute certain of our business strategies and cause certain other projects to be delayed or abandoned;
Matters relating to the Merger require substantial commitments of time and resources by our management team that could have been devoted to the pursuit of other opportunities beneficial to us as an independent company; and
We may be subject to negative reactions from the financial markets and from our customers and employees that could materially affect our business, financial results and stock price; the market price of our common stock could decline to the extent that current market prices of our common stock reflect a market assumption that the Merger will be completed.
Litigation could prevent or delay the closing of the proposed Merger or otherwise negatively impact our business and operations.
We may be subject to legal proceedings related to the agreed terms of the proposed Merger, the manner in which the Merger was considered and approved by our board of directors or any failure to complete the Merger or perform our obligations under the Merger Agreement. Such litigation, regardless of the merits, could delay or block the consummation of the Merger, have an adverse effect on our financial condition and impose material costs on us or the surviving entity. One of the conditions to the closing of the Merger is that no regulation, judgment, decree, injunction or other order of a governmental authority (including any federal, state or local court or administrative or regulatory agency) which prohibits the consummation of the Merger be in effect. If any plaintiff were successful in obtaining an injunction prohibiting us or First Bank from completing the Merger on the agreed upon terms, then such injunction may prevent the Merger from becoming or from becoming within the expected timeframe.
O perational, Compliance and Legal Risks
The fair value of our loans held-for-sale and investment securities can fluctuate due to market conditions outside of our control.
As of September 30, 2022, the fair value of loans held-for-sale was $13.8 million, which primarily consisted of one commercial real estate loan in the New York metropolitan area with a fair value of $13.3 million, and two residential loans with a carrying value of $548,000. The fair value of our investment available-for-sale securities portfolio was $49.8 million as of September 30, 2022.
With respect to our loans held-for-sale, various assumptions are used in connection with calculating the fair value of such loans and the ultimate exit price for such loans might differ materially from the fair value estimates. Factors beyond our control can significantly influence the fair value of loans held-for-sale in our portfolio and can cause potential adverse changes. These factors include, but are not limited to, general market conditions, changes in market interest rates, as well as all of the various other risks and assumptions noted throughout this Report with respect to market and other changes that can impact our loan portfolio in general. Additionally, and as mentioned elsewhere in this Report, loans made to our borrowers in the New York metropolitan area have been particularly affected by COVID-19 and otherwise, and commercial real estate properties in the New York metropolitan area have suffered declines in occupancy rates and rental rates, as well as general decreases in property values. Any weakening of the commercial real estate market in this market may impact the one loan in the New York metropolitan area with a fair value of $13.3 million. Any of these factors (including the ultimate sale price of any loans held-for-sale), among others, could cause realized and/or unrealized losses in future periods, which could have a material effect on us and our financial condition.
With respect to our investment securities portfolio, we have historically adopted a conservative investment strategy, with concentrations of securities that are backed by government sponsored enterprises. Factors beyond our control can significantly influence the fair value of securities in our portfolio and can cause potential adverse changes to the fair value of these securities. These factors include, but are not limited to, rating agency actions in respect of the securities, defaults by the issuer or with respect to the underlying securities, and changes in market interest rates and continued instability in the capital markets. Any of these factors, among others, could cause other-than-temporary impairments and realized and/or unrealized losses in future periods and declines in other comprehensive income, which could have a material adverse effect on us. The process for determining whether impairment of a security is other-than-temporary usually requires complex, subjective judgments about the future financial performance and liquidity of the issuer and any collateral underlying the security in order to assess the probability of receiving all contractual principal and interest payments on the security.
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Our financial instruments expose us to certain market risks and may increase the volatility of earnings and AOCI.
We hold certain financial instruments measured at fair value. For those financial instruments measured at fair value, we are required to recognize the changes in the fair value of such instruments in earnings or accumulated other comprehensive income (“AOCI”) each quarter. Therefore, any increases or decreases in the fair value of these financial instruments have a corresponding impact on reported earnings or AOCI. Fair value can be affected by a variety of factors, many of which are beyond our control, including our credit position, interest rate volatility, capital markets volatility, and other economic factors. Accordingly, we are subject to mark-to-market risk and the application of fair value accounting may cause our earnings and AOCI to be more volatile than would be suggested by our underlying performance.
Our business strategy could be adversely affected if we are not able to attract and retain skilled employees or if we lose the services of our senior management team.
Our ability to grow will depend upon our ability to continue to attract, hire and retain skilled employees. The unanticipated loss of members of our senior management team, including in connection with the Merger could have a material adverse effect on our results of operations and ability to execute our strategic goals. Our success will also depend on the ability of our officers and key employees to continue to implement and improve our operational and other systems, to manage multiple, concurrent customer relationships and to hire, train and manage our employees. COVID-19, along with general economic conditions, has made it more difficult to retain existing employees and to attract new employees. Paying increased salaries to retain employees may negatively impact our financial condition.
We operate in a highly regulated environment and are subject to extensive laws and regulations.
We are subject to extensive regulation, supervision and examination by the FRB, our primary federal regulator, the OCC, the Bank’s primary federal regulator, and by the FDIC, as insurer of the Bank’s deposits. Such regulation and supervision govern the activities in which an institution and its holding company may engage and are intended primarily for the protection of the insurance fund and the depositors and borrowers of the Bank. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, the classification of our assets and determination of the level of our allowance for loan losses. We are also subject to regulation and enforcement by the SEC, as a publicly-traded reporting company, and by Nasdaq, the stock exchange where our common stock is listed. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, or any enforcement or related action, may have a material impact on our operations and financial condition. Additionally, being subject to such regulations and oversight, and being subject to any enforcement or related actions, increases the professional fees we incur in connection with legal, accounting and audit expense, which could in turn impact our financial condition.
On October 18, 2022 the FDIC adopted a final rule to increase initial base deposit insurance assessment rates for insured depository institutions by 2 basis points, beginning with the first quarterly assessment period of 2023. The increased assessment rate schedules would remain in effect unless and until the reserve ratio of the Deposit Insurance Fund meets or exceeds 2 percent. As a result of the new rule, the FDIC insurance costs of insured depository institutions, including Malvern Bank, would generally increase.
A new accounting standard will likely require us to increase our allowance for loan losses and may have a material adverse effect on our financial condition and results of operations.
The Financial Accounting Standards Board (“FASB”) has adopted a new accounting standard, the Current Expected Credit Loss (“CECL”), that will be effective for the Company and the Bank for fiscal years beginning October 1, 2023. The CECL standard will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans and recognize the expected credit losses as allowances for loan losses. This will change the current method of providing allowances for loan losses that are probable, which would likely require us to increase our allowance for loan losses, and to greatly increase the types of data we would need to collect and review to determine the appropriate level of the allowance for loan losses. Any increase in our allowance for loan losses or expenses incurred to determine the appropriate level of the allowance for loan losses may have a material adverse effect on our financial condition and results of operations.
Uncertainty relating to the LIBOR determination process and LIBOR discontinuance may adversely affect our results of operations.
LIBOR is the reference rate used for many of our transactions, including our lending and borrowing and our purchase and sale of securities that we use to manage risk related to such transactions. However, a reduced volume of interbank unsecured term borrowing coupled with recent legal and regulatory proceedings related to rate manipulation by certain financial institutions has led to international reconsideration of LIBOR as a financial benchmark. The United Kingdom Financial Conduct Authority (“FCA”), which regulates the process for establishing LIBOR, announced in July 2017 that the sustainability of LIBOR cannot be guaranteed. The administrator for LIBOR announced on March 5, 2021 that it will permanently cease to publish most LIBOR settings beginning on January 1, 2022 and cease to publish the overnight, one-month, three-month, six-month and 12-month USD LIBOR settings on July 1, 2023. Accordingly, the FCA has stated that is does not intend to persuade or compel banks to submit to LIBOR after such respective dates. Until such time, however, FCA panel banks have agreed to continue to support LIBOR.
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The market transition away from LIBOR to an alternative reference rate is complex and could have a range of adverse effects on the Company’s business, financial condition, and results of operations. In particular, any such transition could:
adversely affect the interest rates paid or received on, and the revenue and expenses associated with, the Company’s floating rate obligations, loans, deposits and other financial instruments tied to LIBOR rates, or other securities or financial arrangements given LIBOR’s role in determining market interest rates globally;
adversely affect the value of the Company’s floating rate obligations, loans, deposits and other financial instruments tied to LIBOR rates, or other securities or financial arrangements given LIBOR’s role in determining market interest rates globally;
prompt inquiries or other actions from regulators in respect of the Company’s preparation and readiness for the replacement of LIBOR with an alternative reference rate;
result in disputes, litigation or other actions with counterparties regarding the interpretation and enforceability of certain fallback language in LIBOR-based securities; and
require the transition to or development of appropriate systems and analytics to effectively transition our risk management processes from LIBOR-based products to those based on the applicable alternative pricing benchmark.
In addition, the implementation of LIBOR reform proposals may result in increased compliance costs and operational costs, including costs related to continued participation in LIBOR and the transition to a replacement reference rate or rates. We cannot reasonably estimate the expected cost.
We are dependent on our information technology and telecommunications systems and third-party servicers, and cyber-attacks, systems failures, interruptions or breaches of security could have a material adverse effect on us.
Information technology systems are critical to our business. We use various technology systems to manage our customer relationships, general ledger, securities, deposits, and loans. We have established policies and procedures to prevent or limit the impact of system failures, interruptions, and security breaches (including privacy breaches), but such events may still occur and may not be adequately addressed if they do occur. In addition, any compromise of our systems could deter customers from using our products and services. Although we rely on security systems to provide security and authentication necessary to effect the secure transmission of data, these precautions may not protect our systems from compromises or breaches of security.
We also outsource a majority of our data processing to certain third-party providers. If these third-party providers encounter difficulties, or if we have difficulty communicating with them, our ability to adequately process and account for transactions could be affected, and our business operations could be adversely affected. Threats to information security also exist in the processing of customer information through various other vendors and their personnel.
The occurrence of any system failures, interruption, or breach of security could damage our reputation and result in a loss of customers and business, thereby subjecting us to additional regulatory scrutiny, or could result in financial loss or expose us to litigation and possible financial liability. Furthermore, we may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures arising from operational and security risks or cyber-attacks. Any of these events could have a material adverse effect on our financial condition and results of operations.
Legislative changes may increase our tax expense.
In 2019 New Jersey adopted legislation that increased our state income tax liability and could increase our overall tax expense. The legislation imposed a temporary surtax on corporations earning New Jersey allocated income in excess of $1 million of 2.5 percent for tax years beginning on or after January 1, 2018 through December 31, 2019, and of 1.5 percent for tax years beginning on or after January 1, 2020 through December 31, 2021. However, in 2020, this surtax was extended through December 31, 2023, at the 2.5 percent level. The legislation also required combined filing for members of an affiliated group for years beginning on or after January 1, 2019, changing New Jersey’s current status as a separate return state, and limits, to varying degrees related to the Company’s size, operating area and organizational structure, the deductibility of dividends received. These changes are not temporary. Although regulations implementing the legislative changes have not yet been issued, it is possible that the Company will lose the benefit of at least certain of its tax management strategies and, if so, our total tax expense will increase.
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Beginning January 1, 2023, the Pennsylvania corporate net income tax rate will decrease 1 percentage point to 8.99 percent. Each year thereafter the rate will decrease 0.5 percentage points until it reaches 4.99 percent at the beginning of 2031. Additionally, the law includes a provision that will increase the amount of capital investment pass-through business owners can deduct on their individual income tax returns the year the investments were made.
Any changes in administration could also lead to changes in federal tax laws as well as changes in regulatory requirements and oversight. We are subject to changes in tax law that could increase our effective tax rates. These law changes may be retroactive to previous periods and as a result could negatively affect our current and future financial performance. An increase in our corporate tax rate could have an unfavorable impact on our earnings and capital generation abilities. Similarly, our clients could experience varying effects from changes in tax laws and such effects, whether positive or negative, may have a corresponding impact on our business and the economy as a whole. In addition, changes to regulatory requirements and oversight could increase our costs of regulatory compliance and may significantly affect the markets in which we do business, the markets for and value of our loans and investments, and our ongoing operations, costs and profitability.
Increasing scrutiny and evolving expectations from customers, regulators, investors, and other stakeholders with respect to our environmental, social and governance practices may impose additional costs on us or expose us to new or additional risks.
Companies are facing increasing scrutiny from customers, regulators, investors, and other stakeholders related to their environmental, social and governance (“ESG”) practices and disclosure. Investor advocacy groups, investment funds and influential investors are also increasingly focused on these practices, especially as they relate to the environment, health and safety, diversity, labor conditions and human rights. Increased ESG related compliance costs could result in increases to our overall operational costs. Failure to adapt to or comply with regulatory requirements or investor or stakeholder expectations and standards could negatively impact our reputation, ability to do business with certain partners, and our stock price. New government regulations could also result in new or more stringent forms of ESG oversight and expanding mandatory and voluntary reporting, diligence, and disclosure.
Risks Related to COVID-19
The global COVID-19 pandemic led to periods of significant volatility in financial, real estate, commodities and other markets and it could harm our business and results of operations.
In December 2019, a COVID-19 outbreak was reported in China, and, in March 2020, the World Health Organization declared it a pandemic. Since that time, COVID-19 has had many variants and spread throughout the United States, including in the regions and communities in which the Company operates. In response, many state and local governments, including the Commonwealth of Pennsylvania and the State of New Jersey, instituted various emergency restrictions that substantially limited the operation of non-essential businesses and the activities of individuals. These restrictions resulted, and if implemented again could continue to result, in significant adverse effects on our borrowers and many different types of small and mid-sized businesses within the Company’s client base, particularly those in the retail, hotel, construction, commercial real estate, medical, leisure, hospitality and food and beverage industries, among others, and resulted in a significant number of layoffs and furloughs of employees nationwide and in the regions and communities in which we operate.
The ultimate effect of COVID-19, its variants, and related events, including those described above and those not yet known or knowable, could have a negative effect on the stock price, business prospects, financial condition and results of operations of the Company, including as a result of quarantines, market volatility, market downturns, changes in consumer behavior, business closures, deterioration in the credit quality of borrowers or the inability of borrowers to satisfy their obligations to the Company (and any related forbearances or restructurings that may be implemented), declines in the value of collateral securing outstanding loans, branch or office closures and business interruptions.
COVID-19 resulted in authorities implementing numerous measures to try to contain the virus, such as quarantines and shelter in place orders. These measures may be implemented again and could adversely affect our business, operations and financial condition, as well as the business, operations and financial conditions of our customers and business partners. The Company maintains a Telework Policy that allows for a modified work schedule of in-person and remote working. We may decide to take further related actions as may be required by government authorities or that we determine are in the best interests of our employees and customers. There is no certainty that such measures will be sufficient to mitigate the risks posed by COVID-19 or its variants, or otherwise be satisfactory to government authorities.
We are subject to increasing credit risk as a result of COVID-19, which could adversely impact our profitability.
Our business depends on our ability to successfully measure and manage credit risk. We are exposed to the risk that the principal of, or interest on, a loan will not be paid timely or at all or that the value of any collateral supporting a loan will be insufficient to cover our outstanding exposure. In addition, we are exposed to risks resulting from changes in economic and industry conditions and risks inherent in dealing with loans and borrowers. As the overall economic climate in the U.S., generally, and in our market areas specifically, experienced, and may continue to experience, material disruption due to COVID-19 and its resulting variants, our borrowers have had, and may continue to have, difficulties in repaying their loans. Governmental actions providing payment relief to borrowers and guarantors affected by COVID-19 could preclude our ability to initiate foreclosure proceedings in certain circumstances and, as a result, the collateral we hold may decrease in value or become illiquid, and the level of our loans, charge-offs and could rise and require significant additional provisions for loan . Additional factors related to the credit quality of certain commercial real estate and multifamily residential loans included the duration of state and local on for non-payment of rent or other fees, which could be implemented again. The payment on these loans that are secured by income producing properties are typically dependent on the operation of the related real estate property and may subject us to risks from conditions in the real estate market or the general economy.
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Bank regulatory agencies and various governmental authorities urged financial institutions to work prudently with borrowers who are or may be unable to meet their contractual payment obligations because of the effects of COVID-19. We have worked to support our borrowers to mitigate the impact of COVID-19 on them and on our loan portfolio, including through loan modifications that defer payments for those who experienced a hardship as a result of COVID-19. Although regulatory guidance provides that such loan modifications are exempt from the calculation and reporting of troubled debt restructurings (“TDRs”) and loan delinquencies, we cannot predict whether any such loan modifications may ultimately have an adverse impact on our profitability in future periods. Our inability to successfully manage the increased credit risk caused by COVID-19 could have a material adverse effect on our business, financial condition and results of operations.
The impact of COVID-19 on the metropolitan New York area commercial real estate market was, and continues to be, particularly uncertain. Loans made to our borrowers in the New York area have been particularly affected by COVID-19. We may continue to incur losses on commercial real estate loans due to any prior and future declines in occupancy rates and rental rates and decreases in property values. The Bank currently has one $13.3 million non-accrual commercial real estate loan held for sale in the metropolitan New York area. The effects of COVID-19 variants create further ambiguity on the strength or likelihood of a full financial recovery or a full recovery in the commercial real estate market, and the expiration of federal and state stimulus programs, eviction moratoriums, and other support programs may present additional challenges. Changing consumer and business preferences related to shopping, travel, and returning to the office have led and may continue to lead to medium-and long-term income and valuation challenges in certain commercial real estate sectors. Any further weakening of the commercial real estate market may increase the likelihood of of these loans, which could impact our loan portfolio’s performance and asset quality. If we are required to the collateral securing a loan to the debt during a period of reduced real estate values, we could incur material . Any of these events could increase our costs, require management time and attention, and materially and affect us.
Interest rate volatility stemming from COVID-19 and related events could negatively affect our net interest income, lending activities, deposits and profitability.
Our net interest income, lending activities, deposits and profitability could be negatively affected by volatility in interest rates caused by uncertainties and other matters stemming from COVID-19 and related events. In March 2020, the FRB lowered the target range for the federal funds rate to a range from 0 to 0.25 percent, citing concerns about the impact of COVID-19 on markets and stress in certain sectors. More recently, the FRB has continued to increase the federal funds rates to combat inflation. A prolonged period of extremely volatile and unstable market conditions may increase our funding costs and negatively affect market risk mitigation strategies. Higher income volatility from changes in interest rates and spreads to benchmark indices could cause a loss of future net interest income and a decrease in current fair market values of our assets. Fluctuations in interest rates will impact both the level of income and expense recorded on most of our assets and liabilities and the market value of all interest-earning assets and interest-bearing liabilities, which in turn could have a material effect on our net income, operating results, and financial condition.
Unpredictable future developments related to or resulting from COVID-19 could materially and adversely affect our business and results of operations.
Given the ongoing and dynamic nature of the circumstances, it is not possible to predict the ultimate impact of COVID-19 and its variants on the stock price, business prospects, financial condition or results of operations of the Company. Any future development is highly uncertain and cannot be predicted, including the scope and duration of the pandemic and new COVID-19 variants, the continued effectiveness of any work from home arrangements, third party providers’ ability to support our operation, and any actions taken by governmental authorities and other third parties in response. We are continuing to monitor COVID-19 and related risks, although the development and fluidity of the situation precludes any specific prediction as to its ultimate impact on us. However, if COVID-19 continues to spread, evolve, or otherwise results in a continuation or worsening of the current economic and commercial environments, our business, financial condition, results of operations and cash flows as well as our regulatory capital and liquidity ratios could be materially adversely affected and many of the risks described herein will be heightened.
Our prior participation in the SBA PPP loan program could expose us to risks related to noncompliance with the Paycheck Protection Program ( “ PPP ” ), which could have a material adverse impact on our business, financial condition and results of operations.
The Company was a participating lender in the PPP, a loan program administered through the SBA, which was created to help eligible businesses, organizations and self-employed persons fund their operational costs during COVID-19. Under this program, the SBA guaranteed 100% of the amounts loaned under the PPP. As previously announced, the Company subsequently sold the entirety of its PPP loan portfolio; however, we may be required to repurchase, and as a result be exposed to credit risk, on sold PPP loans in certain circumstances if a determination is made by the SBA that there was a deficiency by the Bank with respect to the manner in which the loan was originated, funded, or serviced.
General Risk Factors
Our risk management framework may not be effective in mitigating risk and reducing the potential for significant losses.
Our risk management framework is designed to effectively manage and mitigate risk while minimizing exposure to potential losses. We seek to identify, measure, monitor, report and control our exposure to risk, including strategic, market, liquidity, compliance and operational risks. While we use a broad and diversified set of risk monitoring and mitigation techniques, these techniques are inherently limited because they cannot anticipate the existence or future development of currently unanticipated or unknown risks. Recent economic conditions and heightened legislative and regulatory scrutiny of the financial services industry, among other developments, have increased our level of risk. Accordingly, we could suffer losses as a result of our failure to properly anticipate and manage these risks.
We could be adversely affected by failure in our internal controls.
A failure in our internal controls could have a significant negative impact not only on our earnings, but also on the perception that customers, regulators and investors may have of us. We continue to devote a significant amount of effort, time and resources to continually strengthening our controls and ensuring compliance with complex accounting standards and banking regulations. Compliance with increased or new standards and regulations applicable to our Company may entail management spending increased time addressing such standards and regulations. Further, the Company may be required to expend additional capital resources on professional advisors, which could increase operational expenses and therefore negatively impact our net income.
