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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC  20549

FORM 10-Q

(Mark One)

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

for the quarterly period ended:           September 30, 2016         

☐ 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:  0-26366

ROYAL BANCSHARES OF PENNSYLVANIA, INC.

(Exact name of the registrant as specified in its charter)

PENNSYLVANIA	23-2812193
(State or other jurisdiction of incorporation or organization)	(IRS Employer identification No.)

One Bala Plaza, Suite 522, 231 St. Asaph’s Road, Bala Cynwyd, PA 19004

(Address of principal Executive Offices)

(610)  668-4700

(Registrant’s telephone number, including area code)

 N/A

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

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

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

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

Large accelerated filer ☐	Accelerated filer ☐
Non-accelerated filer ☐ (do not check if a smaller reporting company)	Smaller reporting company ☒

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

Applicable only to corporate issuers:

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

Class A Common Stock	Outstanding at October 31, 2016
$2.00 par value	27,880,024

Class B Common Stock	Outstanding at October  31, 2016
$0.10 par value	1,924,629

TABLE OF CONTENTS

		PAGE
PART I	FINANCIAL STATEMENTS
Item 1	Financial Statements
	Consolidated Balance Sheets-unaudited	2
	Consolidated Statements of Income-unaudited	3
	Statements of Consolidated Comprehensive Income-unaudited	4
	Consolidated Statements of Changes in Shareholders’ Equity-unaudited	5
	Consolidated Statements of Cash Flows-unaudited	7
	Notes to Consolidated Financial Statement (unaudited)	9
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	47
Item 3	Quantitative and Qualitative Disclosures about Market Risk	78
Item 4	Controls and Procedures	78
PART II	OTHER INFORMATION	78
Item 1	Legal Proceedings	78
Item 1A	Risk Factors	79
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	79
Item 3	Defaults Upon Senior Securities	79
Item 4	Mine Safety Disclosures	79
Item 5	Other Information	79
Item 6	Exhibits	79
	SIGNATURES	80

1

PART I — FINANCIAL STATEMENTS

Item 1.Financial Statements

 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Consolidated Balance Sheets-unaudited

	September 30,		December 31,
	2016		2015
ASSETS	(Dollars in thousands, except share data)
Cash and due from banks	$	10,753	$	10,394
Interest-earning deposits		17,638		15,026
Total cash and cash equivalents		28,391		25,420
Investment securities available for sale (“AFS”), at fair value		168,321		224,067
Other investment, at cost		2,250		2,250
Federal Home Loan Bank (“FHLB”) stock		3,018		2,545
Loans and leases (“LHFI”)		575,818		499,103
Less allowance for loan and lease losses		10,254		9,689
Net loans and leases		565,564		489,414
Company owned life insurance		20,458		19,899
Accrued interest receivable		3,770		4,149
Other real estate owned (“OREO”), net		7,236		7,435
Premises and equipment, net		4,714		3,959
Other assets		7,646		9,145
Total assets	$	811,368	$	788,283
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities
Deposits
Non-interest bearing	$	90,709	$	83,529
Interest-bearing		501,530		494,363
Total deposits		592,239		577,892
Short-term borrowings		15,000		9,000
Long-term borrowings		85,000		81,970
Subordinated debentures		25,774		25,774
Accrued interest payable		2,240		709
Other liabilities		21,313		20,640
Total liabilities		741,566		715,985
Shareholders’ equity
Royal Bancshares of Pennsylvania, Inc. equity:
Preferred stock, Series A perpetual,  $1,000 liquidation value per share, 500,000 shares authorized, 12,205 and 18,856 shares outstanding at September 30, 2016 and  December 31, 2015		12,205		18,856
Class A common stock, par value $2 per share, authorized 40,000,000 shares; issued and outstanding, 28,228,389 and 28,204,182 at September 30, 2016 and  December 31, 2015 respectively		56,457		56,408
Class B common stock, par value $ 0.10 per share, authorized 3,000,000 shares; issued and outstanding, 1,924,629 and 1,928,289  at September 30, 2016 and  December 31, 2015 respectively		192		193
Additional paid in capital		106,975		110,494
Accumulated deficit		(98,634)		(104,879)
Accumulated other comprehensive loss		(2,916)		(3,919)
Treasury stock - at cost, shares of Class A, 356,072 and 375,333 at September 30, 2016 and  December 31, 2015 respectively		(4,979)		(5,249)
Total Royal Bancshares of Pennsylvania, Inc. shareholders’ equity		69,300		71,904
Noncontrolling interest		502		394
Total equity		69,802		72,298
Total liabilities and shareholders’ equity	$	811,368	$	788,283

The accompanying notes are an integral part of these consolidated financial statements.

2

ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Consolidated Statements of Income-unaudited

	For the three months ended				For the nine months ended
	September 30,				September 30,
(In thousands, except per share data)	2016		2015		2016		2015
Interest Income
Loans and leases, including fees	$	7,346	$	6,456	$	21,168	$	17,878
Investment securities		1,099		1,334		3,639		4,250
Deposits in banks		15		8		48		21
Total Interest Income		8,460		7,798		24,855		22,149
Interest Expense
Deposits		1,086		968		3,193		2,796
Short-term borrowings		53		5		85		5
Long-term borrowings		763		663		2,111		1,997
Total Interest Expense		1,902		1,636		5,389		4,798
Net Interest Income		6,558		6,162		19,466		17,351
Provision (credit) for loan and lease losses		578		(216)		987		(1,382)
Net Interest Income after Provision (Credit) for Loan and Lease Losses		5,980		6,378		18,479		18,733
Non-interest Income
Service charges and fees		396		298		989		832
Net gains on sales of loans and leases		71		—		71		—
Income from company owned life insurance		192		124		847		372
Net gains on the sale of AFS investment securities		280		80		1,382		652
Total other-than-temporary impairment on AFS investment securities		(35)		—		(181)		—
Other income		285		75		361		205
Total Non-interest Income		1,189		577		3,469		2,061
Non-interest Expense
Employee salaries and benefits		2,710		2,655		8,036		7,825
Loss contingency		(200)		—		(200)		—
Occupancy and equipment		705		736		2,093		2,212
Professional and legal fees		415		380		1,321		1,314
Net OREO expenses		256		263		469		371
Pennsylvania shares tax expense		154		113		393		338
FDIC and state assessments		111		158		455		533
Communications and data processing		257		214		748		607
(Credit) provision for credit losses on off-balance sheet credit exposures		(65)		(68)		(236)		282
Directors’ fees		95		114		335		349
Marketing and advertising		65		38		209		185
Insurance		87		78		270		244
Loan collection expenses		21		138		128		273
Other operating expenses		390		423		1,247		1,175
Total Non-interest Expense		5,001		5,242		15,268		15,708
Income Before Tax Expense		2,168		1,713		6,680		5,086
Income Tax Expense		25		—		85		—
Net Income	$	2,143	$	1,713	$	6,595	$	5,086
Less Net Income Attributable to Noncontrolling Interest	$	113	$	179	$	342	$	500
Net Income Attributable to Royal Bancshares of Pennsylvania, Inc.	$	2,030	$	1,534	$	6,253	$	4,586
Less Preferred Stock Series A Accumulated Dividend and Accretion	$	342	$	434	$	1,014	$	1,287
Net Income Available to Common Shareholders	$	1,688	$	1,100	$	5,239	$	3,299
Per Common Share Data:
Net Income — Basic and Diluted	$	0.06	$	0.04	$	0.17	$	0.11

The accompanying notes are an integral part of these consolidated financial statements.

3

ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Statements of Consolidated Comprehensive Income-unaudited

	For the three months ended				For the nine months ended
	September 30,				September 30,
(In thousands)	2016		2015		2016		2015
Net income	$	2,143	$	1,713	$	6,595	$	5,086
Other comprehensive income, net of tax
Unrealized (losses) gains on investment securities:
Unrealized holding (losses) gains arising during period, net of tax		(877)		1,190		2,342		1,320
Less adjustment for impaired investments, net of tax (1)		(23)		—		(119)		—
Less reclassification adjustment for gains realized in net income, net of tax (2)		185		52		912		430
Unrealized (losses) gains on investment securities		(1,039)		1,138		1,549		890
Unrecognized benefit obligation:
Reclassification adjustment for amortization (3)		(78)		(17)		(232)		(51)
Unrecognized benefit obligation expense		(78)		(17)		(232)		(51)
Unrealized gain (loss) on derivative instrument, net of tax		131		(282)		(314)		(467)
Other comprehensive (loss) income		(986)		839		1,003		372
Comprehensive income		1,157		2,552		7,598		5,458
Less net income attributable to noncontrolling interest		113		179		342		500
Comprehensive income attributable to Royal Bancshares of Pennsylvania, Inc.	$	1,044	$	2,373	$	7,256	$	4,958

(1) Gross amounts are included in total other-than-temporary impairment on AFS investment securities on the Consolidated Statements of Income in total non-interest income; amounts in the above table are net of $12 thousand and $62 thousand in taxes for the three and nine months ended September 30, 2016. See Note 15. Comprehensive Income.

(2) Gross amounts are included in net gains on the sale of AFS investment securities on the Consolidated Statements of Income in total non-interest income; amounts in the above table are net of $95 thousand and $470 thousand in taxes for the three and nine months ended September 30, 2016 and $28 thousand and $222 thousand for the three and nine months ended September 30, 2015. See Note 15. Comprehensive Income.

(3) Gross amounts are included in salaries and benefits on the Consolidated Statements of Income in non-interest expense.

The accompanying notes are an integral part of these consolidated financial statements.

4

ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ Equity

Nine months ended September 30, 2016-unaudited

													Accumulated
	Preferred								Additional				other						Total
	stock		Class A common stock			Class B common stock			paid in		Accumulated		comprehensive		Treasury		Noncontrolling		Shareholders’
(In thousands, except share data)	Series A		Shares	Amount		Shares	Amount		capital		deficit		loss		stock		Interest		Equity
Balance January 1, 2016	$	18,856	28,204	$	56,408	1,928	$	193	$	110,494	$	(104,879)	$	(3,919)	$	(5,249)	$	394	$	72,298
Net income												6,253						342		6,595
Other comprehensive income, net of reclassifications and taxes														1,003						1,003
Distributions to noncontrolling interests																		(234)		(234)
Common stock conversion from Class B to Class A			4		9	(3)		(1)				(8)								—
Repurchase of 6,651 shares of preferred stock		(6,651)								(3,341)										(9,992)
Treasury shares issued for compensation (19,261 shares)										(231)						270				39
Stock options exercised (20,000 shares)			20		40					(11)										29
Stock option expense										64										64
Balance September 30,  2016	$	12,205	28,228	$	56,457	1,925	$	192	$	106,975	$	(98,634)	$	(2,916)	$	(4,979)	$	502	$	69,802

The accompanying notes are an integral part of these consolidated financial statements.

5

ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ Equity

Nine months ended September 30,  2015-unaudited

													Accumulated
	Preferred								Additional				other						Total
	stock		Class A common stock			Class B common stock			paid in		Accumulated		comprehensive		Treasury		Noncontrolling		Shareholders’
(In thousands, except share data)	Series A		Shares	Amount		Shares	Amount		capital		deficit		loss		stock		Interest		Equity
Balance January 1, 2015	$	18,856	28,200	$	56,400	1,932	$	193	$	110,697	$	(115,864)	$	(2,492)	$	(5,571)	$	387	$	62,606
Net income												4,586						500		5,086
Other comprehensive loss, net of reclassifications and taxes														372						372
Distributions to noncontrolling interests																		(411)		(411)
Treasury shares issued for compensation (16,382 shares)										(252)						288				36
Stock option expense										57										57
Balance September 30,  2015	$	18,856	28,200	$	56,400	1,932	$	193	$	110,502	$	(111,278)	$	(2,120)	$	(5,283)	$	476	$	67,746

The accompanying notes are an integral part of these consolidated financial statements.

6

ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows-unaudited

Nine months ended September 30,

(In thousands)	2016		2015
Cash flows from operating activities:
Net income	$	6,595	$	5,086
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		394		459
Stock compensation expense		64		57
Provision (credit) for loan and lease losses		987		(1,382)
(Credit) provision for credit losses on off-balance sheet credit exposures		(236)		282
Impairment charge for OREO		143		659
Net amortization of premiums on AFS investment securities		1,123		1,164
Net accretion of net deferred fees on loans		(439)		(471)
Gains on sales of loans and leases		(71)		—
Net gains on sales of OREO		(7)		(769)
Net gains on sales of investment securities		(1,382)		(652)
Income from company owned life insurance		(847)		(372)
Other-than-temporary impairment on AFS investment securities		181		—
Changes in assets and liabilities:
Decrease in accrued interest receivable		379		934
Increase in other assets		(533)		(225)
Increase in accrued interest payable		1,531		1,442
Increase in other liabilities		909		497
Net cash provided by operating activities		8,791		6,709
Cash flows from investing activities:
Proceeds from maturities, calls and paydowns of AFS investment securities		47,659		28,084
Proceeds from sales of AFS investment securities		36,427		33,653
Purchase of AFS investment securities		(25,687)		(41,134)
(Purchase) redemption of Federal Home Loan Bank stock		(473)		77
Proceeds from sales of loans and leases		2,036		—
Net increase in loans		(79,484)		(59,106)
Additions to OREO		(243)		(418)
Proceeds from life insurance policies		748		—
Purchase of premises and equipment		(1,149)		(460)
Proceeds from sales of OREO		1,127		4,436
Net cash used in investing activities		(19,039)		(34,868)

7

ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows-unaudited (continued)

Nine months ended September 30,

	2016		2015
Cash flows from financing activities:
Net (decrease) increase in demand and NOW accounts	$	(18,083)	$	19,915
Net increase in money market and savings accounts		21,779		18,079
Net increase (decrease) in certificates of deposit		10,651		(14,655)
Net increase in short-term borrowings		6,000		9,000
Repayments of long-term borrowings		(11,970)		(10,342)
Proceeds from long-term borrowings		15,000		—
Distributions to noncontrolling interest		(234)		(411)
Issuance of treasury stock		39		—
Repurchase of preferred stock		(9,992)		—
Proceeds from stock options exercised		29		—
Net cash provided by financing activities		13,219		21,586
Net increase (decrease) in cash and cash equivalents		2,971		(6,573)
Cash and cash equivalents at the beginning of the period		25,420		30,790
Cash and cash equivalents at the end of the period	$	28,391	$	24,217
Supplemental Disclosure:
Income taxes paid	$	85	$	—
Interest paid	$	3,858	$	3,356
Transfers from loans to OREO	$	821	$	3,968
Transfers from OREO to loans	$	—	$	995

The accompanying notes are an integral part of these consolidated financial statements.

8

ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Note 1.Summary of Significant Accounting Policies

Nature of Operations

Royal Bancshares of Pennsylvania, Inc. (“Royal Bancshares”, the “Company”, “We” or “Our”), through its wholly-owned subsidiary Royal Bank America (“Royal Bank”) offers a full range of banking services to individual and corporate customers primarily located in the Mid-Atlantic states.  Royal Bank competes with other banking and financial institutions in certain markets, including financial institutions with resources substantially greater than its own.  Commercial banks, savings banks, savings and loan associations, credit unions, and brokerage firms actively compete for savings and time deposits and for various types of loans.  Such institutions, as well as consumer finance and insurance companies, may be considered competitors of Royal Bank with respect to one or more of the services it renders.

Basis of Financial Presentation

The accompanying unaudited consolidated financial statements include the accounts of Royal Bancshares of Pennsylvania, Inc. and its wholly-owned subsidiaries, Royal Investments of Delaware, Inc., including Royal Investments of Delaware, Inc.’s wholly owned subsidiary, Royal Preferred, LLC, and Royal Bank, including Royal Bank’s subsidiaries, Royal Real Estate of Pennsylvania, Inc., Royal Investments America, LLC, RBA Property LLC, Narberth Property Acquisition LLC, Rio Marina LLC, and Royal Tax Lien Services, LLC (“RTL”).  Royal Bank also has an 80% and 60% ownership interest in Crusader Servicing Corporation (“CSC”) and Royal Bank America Leasing, LP, respectively. The two Delaware trusts, Royal Bancshares Capital Trust I and Royal Bancshares Capital Trust II are not consolidated per requirements under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 810, “Consolidation” (“ASC Topic 810”). These consolidated financial statements reflect the historical information of the Company. All significant intercompany transactions and balances have been eliminated in consolidation.

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information. Applications of the principles in our preparation of the consolidated financial statements in conformity with U.S. GAAP require management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes.  These estimates and assumptions are based on information available as of the date of the consolidated financial statements; therefore, actual results could differ from those estimates. The interim financial information included herein is unaudited; however, such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary to present a fair statement of the results for the interim periods.  These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2015.  The results of operations for the three and nine month periods ended September 30, 2016 are not necessarily indicative of the results to be expected for the full year.

Reclassifications

Certain items in the 2015 consolidated financial statements and accompanying notes have been reclassified to conform to the current year’s presentation format.  There was no effect on net income for the periods presented herein as a result of the reclassification.

Accounting Policies Recently Adopted and Pending Accounting Pronouncements

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (“ASU 14-09”), which establishes a comprehensive revenue recognition standard for virtually all industries under U.S. GAAP, including those that previously followed industry-specific guidance such as the real estate, construction and software industries. The revenue standard’s core principle is built on the contract between a vendor and a customer for the provision of goods and services. It attempts

9

to depict the exchange of rights and obligations between the parties in the pattern of revenue recognition based on the consideration to which the vendor is entitled. To accomplish this objective, the standard requires five basic steps: i) identify the contract with the customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract, and (v) recognize revenue when (or as) the entity satisfies a performance obligation. The ASU is effective for public entities for annual periods beginning after December 15, 2016, including interim periods therein. Three basic transition methods are available – full retrospective, retrospective with certain practical expedients, and a cumulative effect approach. Under the third alternative, an entity would apply the new revenue standard only to contracts that are incomplete under legacy U.S. GAAP at the date of initial application (e.g. January 1, 2017) and recognize the cumulative effect of the new standard as an adjustment to the opening balance of retained earnings. That is, prior years would not be restated and additional disclosures would be required to enable users of the financial statements to understand the impact of adopting the new standard in the current year compared to prior years that are presented under legacy U.S. GAAP. Early adoption is prohibited under U.S. GAAP. In August 2015, the FASB Issued ASU 2015-14 which deferred the effective date to December 31, 2017 and the initial application date (e.g. January 1, 2018.) We do not believe ASU 2014-09 will have a material effect on its financial statements.

In June 2014, the FASB issued ASU No. 2014-12,  Compensation – Stock Compensation (Topic 718) - Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period (“ASU 2014-12”).  The amendments in ASU 2014-12 require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. A reporting entity should apply existing guidance in Topic 718, Compensation – Stock Compensation, as it relates to awards with performance conditions that affect vesting to account for such awards. The performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. If the performance target becomes probable of being achieved before the end of the requisite service period, the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service period. The total amount of compensation cost recognized during and after the requisite service period should reflect the number of awards that are expected to vest and should be adjusted to reflect those awards that ultimately vest. The requisite service period ends when the employee can cease rendering service and still be eligible to vest in the award if the performance target is achieved. The amendments in ASU 2014-12 are effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2015. Early adoption was permitted. Entities may apply the amendments in this ASU either: (a) prospectively to all awards granted or modified after the effective date; or (b) retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. The adoption of ASU 2014-12 did not have a significant impact on our consolidated financial statements.

In January 2016, the FASB issued ASU 2016-01, “Financial Instruments – Overall (Topic 825-10): “Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 amends the guidance on the classification and measurement of financial instruments.  Some of the amendments in ASU 2016-01 include the following: 1) requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; 2) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; 3) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; and 4) requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value; among others.  ASU 2016-01 also clarifies that an entity should assess the need for a valuation allowance on a deferred tax asset related to unrealized losses of investments in debt instruments recognized in OCI in combination with the entity’s other deferred tax assets. Prior to this guidance, the alternative approach used in practice evaluated the need for a valuation allowance for a deferred tax asset related to unrealized losses on debt instruments recognized in other comprehensive income separately from other deferred tax assets. This alternative approach will no longer be acceptable. For public business entities, the amendments of ASU 2016-01 are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years.  We do not believe ASU 2016-01 will have a material effect on our financial statements.

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In February 2016, the FASB issued Accounting Standards Update No. 2016-02, “Leases” (“ASU 2016-02”). From the lessee's perspective, the new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement for a lessees. From the lessor's perspective, the new standard requires a lessor to classify leases as either sales-type, finance or operating. A lease will be treated as a sale if it transfers all of the risks and rewards, as well as control of the underlying asset, to the lessee. If risks and rewards are conveyed without the transfer of control, the lease is treated as a financing lease. If the lessor doesn’t convey risks and rewards or control, an operating lease results.  The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. A modified retrospective transition approach is required for lessors for sales-type, direct financing, and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. We are currently evaluating the impact of the pending adoption of the new standard on its consolidated financial statements.

In March 2016, the FASB issued Accounting Standards Update No. 2016-05, “Derivatives and Hedging (Topic 815): Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships” (“ASU 2016-05”).  The term novation refers to replacing one counterparty to a derivative instrument with a new counterparty. That change occurs for a variety of reasons, including financial institution mergers, intercompany transactions, an entity exiting a particular derivatives business or relationship, an entity managing against internal credit limits, or in response to laws or regulatory requirements.  The amendments in ASU 2016-05 clarify that a change in the counterparty to a derivative instrument that has been designated as the hedging instrument under Topic 815, does not, in and of itself, require dedesignation of that hedging relationship provided that all other hedge accounting criteria continue to be met.  For public business entities, the amendments in this ASU 2016-05 are effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. An entity has an option to apply the amendments in ASU 2016-05 on either a prospective basis or a modified retrospective basis.  Early adoption is permitted, including adoption in an interim period. We do not believe ASU 2016-05 will have a material effect on our financial statements.

In March 2016, FASB issued Accounting Standards Update No. 2016-09, “Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting” (“ASU 2016-09”).  FASB is issuing ASU 2016-09 as part of its initiative to reduce complexity in accounting standards. The areas for simplification in this ASU 2016-09 involve several aspects of the accounting for employee share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. Some of the areas for simplification apply only to nonpublic entities. For public business entities, the amendments in ASU 2016-09 are effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted for any entity in any interim or annual period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. An entity that elects early adoption must adopt all of the amendments in the same period.  We do not believe ASU 2016-09 will have a material effect on our financial statements.

In June 2016, FASB issued Accounting Standards Update No. 2016-13, “Financial Instruments-Credit Losses (Topic 326) Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”).  The main objective of ASU 2016-13 is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in ASU 2016-13 replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates.  The amendments affect entities holding financial assets and net investment in leases that are not accounted for at fair value through net income. The amendments affect loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash.

The amendments in ASU 2016-13 affect an entity to varying degrees depending on the credit quality of the assets held by the entity, their duration, and how the entity applies current GAAP. There is diversity in practice in applying the incurred

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loss methodology, which means that before transition some entities may be more aligned, under current GAAP, than others to the new measure of expected credit losses.

The amendments in ASU 2016-13 require a financial asset (or a group of financial assets) measured at amortized cost basis to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset(s) to present the net carrying value at the amount expected to be collected on the financial asset.  The income statement reflects the measurement of credit losses for newly recognized financial assets, as well as the expected increases or decreases of expected credit losses that have taken place during the period.  The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the reported amount. An entity must use judgment in determining the relevant information and estimation methods that are appropriate in its circumstances. The allowance for credit losses for purchased financial assets with a more-than insignificant amount of credit deterioration since origination (PCD assets) that are measured at amortized cost basis is determined in a similar manner to other financial assets measured at amortized cost basis; however, the initial allowance for credit losses is added to the purchase price rather than being reported as a credit loss expense. Only subsequent changes in the allowance for credit losses are recorded as a credit loss expense for these assets. Interest income for PCD assets should be recognized based on the effective interest rate, excluding the discount embedded in the purchase price that is attributable to the acquirer’s assessment of credit losses at acquisition.

Credit losses relating to available-for-sale debt securities should be recorded through an allowance for credit losses. Available-for-sale accounting recognizes that value may be realized either through collection of contractual cash flows or through sale of the security. Therefore, the amendments limit the amount of the allowance for credit losses to the amount by which fair value is below amortized cost because the classification as available for sale is premised on an investment strategy that recognizes that the investment could be sold at fair value, if cash collection would result in the realization of an amount less than fair value. The amendments in ASU 2016-13 require that credit losses be presented as an allowance rather than as a writedown. This approach is an improvement to current GAAP because an entity will be able to record reversals of credit losses (in situations in which the estimate of credit losses declines) in current period net income, which in turn should align the income statement recognition of credit losses with the reporting period in which changes occur. Current GAAP prohibits reflecting those improvements in current period earnings. 

For public business entities that are SEC filers, the amendments in ASU 2016-13 are effective for financial statements issued for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. All entities may adopt the amendments in ASU 2016-13 earlier as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.  An entity will apply the amendments in ASU 2016-13 through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (that is,  modified-retrospective approach).  A prospective transition approach is required for debt securities for which an other-than-temporary impairment had been recognized before the effective date. The effect of a prospective transition approach is to maintain the same amortized cost basis before and after the effective date of ASU 2016-13. Amounts previously recognized in accumulated other comprehensive income as of the date of adoption that relate to  improvements in cash flows expected to be collected should continue to be accreted into income over the remaining life of the asset. Recoveries of amounts previously written off relating to improvements in cash flows after the date of adoption should be recorded in earnings when received. We are currently evaluating the impact of the amendments in ASU 2016-13 on our consolidated financial statements.

In August 2016, FASB issued Accounting Standards Update No. 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments” (“ASU 2016-15”).  Stakeholders indicated that there is diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows under Topic 230, Statement of Cash Flows, and other Topics. The following eight specific cash flow issues are addressed in ASU 2016-15: Debt prepayment or debt extinguishment costs; settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing; contingent consideration payments made after a business combination; proceeds from the settlement of insurance claims; proceeds from the settlement of corporate-owned life insurance policies (“COLI”s) (including bank-owned life insurance policies (“BOLI”s)); distributions received from equity method investees; beneficial interests in securitization transactions; and separately identifiable cash flows and application of the predominance principle. For public

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business entities, the amendments in this ASU 2016-15 are effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The amendments in ASU 2016-15 should be applied using a retrospective transition method to each period presented. If it is impracticable to apply the amendments retrospectively for some of the issues, the amendments for those issues would be applied prospectively as of the earliest date practicable. Early adoption is permitted, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. An entity that elects early adoption must adopt all of the amendments in the same period. We do not believe ASU 2016-05 will have a material effect on our financial statements.

Note 2.Regulatory Matters and Significant Risks or Uncertainties

Federal Reserve Agreement

In March 2010, we agreed to enter into a written agreement (the “Federal Reserve Agreement”) with the Federal Reserve Bank of Philadelphia (the “Federal Reserve Bank”).  In July 2013, the Board of Governors of the Federal Reserve System terminated the enforcement action under the Federal Reserve Agreement, and it was replaced with an informal non-public agreement, a memorandum of understanding (“MOU”), with the Federal Reserve Bank, effective July 17, 2013.  Included in this MOU are certain continued reporting requirements and a requirement that we receive the prior approval of the Federal Reserve Bank and the Director of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System prior to declaring or paying any dividends on our capital stock, making interest payments related to our outstanding trust preferred securities or subordinate securities, incurring or guaranteeing certain debt with an original maturity date greater than one year, and purchasing or redeeming any shares of stock. The MOU will remain in effect until stayed, modified, terminated or suspended in writing by the Federal Reserve Bank.  During the first nine months of 2016, we requested and received approval to repurchase 6,651 shares of our Series A preferred stock. As disclosed in our Current Report on Form 8-K filed on October 7, 2016, we received regulatory approval to repurchase or redeem the remaining 12,205 shares.  We intend to retire all of the remaining shares of Series A preferred stock outstanding as a result of receipt of such approvals, including purchases in privately negotiated transactions or in accordance with the redemption provisions of the Series A preferred stock. 

Dividend and Interest Restrictions

Due to the MOU, our ability to obtain lines of credit, to receive attractive collateral treatment from funding sources, and to pursue all attractive funding alternatives in this current low interest rate environment could be impacted and thereby limit liquidity alternatives.

On August 13, 2009, the Company’s Board suspended the regular quarterly cash dividends on the Series A Preferred Stock.  We made the decision to suspend the preferred cash dividends in order to support the liquidity position of Royal Bank.  The dividend in arrears on the outstanding shares of Series A preferred stock is approximately $7.1 million and includes additional dividends on arrearages.  As disclosed above, we intend to retire all of the remaining shares of the Series A Preferred stock by the end of 2016, which will eliminate future dividends.

Under the MOU, we may not declare or pay any dividends on our capital stock or make interest payments related to our outstanding trust preferred securities or subordinate securities without the prior written approval of the Federal Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System. During the first three quarters of 2016, we received approval from the Federal Reserve Bank and paid the respective quarterly interest payments on the trust preferred securities in March,  June, and September 2016.

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Note 3.Investment Securities

The carrying value and fair value of investment securities available-for-sale (“AFS”) at September 30, 2016 and December 31, 2015 are as follows:

As of September 30, 2016
			Gross		Gross
	Amortized		unrealized		unrealized
(In thousands)	cost		gains		losses		Fair value
U.S. government agencies	$	3,498	$	2	$	—	$	3,500
Mortgage-backed securities-residential		7,373		342		—		7,715
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		138,137		2,372		(469)		140,040
Non-agency		4,514		52		—		4,566
Corporate bonds		1,700		74		—		1,774
Municipal bonds		8,706		216		(55)		8,867
Other securities		1,833		—		—		1,833
Common stocks		26		—		—		26
Total available for sale	$	165,787	$	3,058	$	(524)	$	168,321

As of December 31, 2015
			Gross		Gross
	Amortized		unrealized		unrealized
(In thousands)	cost		gains		losses		Fair value
U.S. government agencies	$	26,127	$	—	$	(564)	$	25,563
Mortgage-backed securities-residential		11,002		106		(50)		11,058
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		170,764		1,524		(1,554)		170,734
Non-agency		2,729		1		(26)		2,704
Corporate bonds		1,500		56		—		1,556
Municipal bonds		9,910		73		(52)		9,931
Other securities		2,050		445		—		2,495
Common stocks		26		—		—		26
Total available for sale	$	224,108	$	2,205	$	(2,246)	$	224,067

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The amortized cost and fair value of investment securities at September 30, 2016, 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.

	As of September 30, 2016
	Amortized
(In thousands)	cost		Fair value
Within 1 year	$	—	$	—
After 1 but within 5 years		7,802		7,798
After 5 but within 10 years		5,102		5,269
After 10 years		1,000		1,074
Mortgage-backed securities-residential		7,373		7,715
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		138,137		140,040
Non-agency		4,514		4,566
Total available for sale debt securities		163,928		166,462
No contractual maturity		1,859		1,859
Total available for sale securities	$	165,787	$	168,321

Proceeds from the sales of AFS investments during the three and nine months ended September 30, 2016 were $25.7 million and $36.4 million.  Proceeds from the sales of AFS investments during the three and nine months ended September 30, 2015 were $9.2 million and $33.7 million, respectively. The following table summarizes gross realized gains and losses on the sale of securities recognized in earnings in the periods indicated:

	For the three months ended				For the nine months ended
	September 30,				September 30,
(In thousands)	2016		2015		2016		2015
Gross realized gains	$	280	$	104	$	1,426	$	676
Gross realized losses		—		(24)		(44)		(24)
Net realized gains	$	280	$	80	$	1,382	$	652

The tables below indicate the length of time individual AFS securities have been in a continuous unrealized loss position at September 30, 2016 and December 31, 2015:

September 30, 2016	Less than 12 months					12 months or longer					Total
			Gross		Number			Gross		Number			Gross		Number
			unrealized		of			unrealized		of			unrealized		of
(In thousands)	Fair value		losses		positions	Fair value		losses		positions	Fair value		losses		positions
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies	$	22,424	$	(224)	8	$	10,458	$	(245)	3	$	32,882	$	(469)	11
Municipal bonds		2,026		(49)	2		1,324		(6)	2		3,350		(55)	4
Total available for sale	$	24,450	$	(273)	10	$	11,782	$	(251)	5	$	36,232	$	(524)	15

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December 31, 2015	Less than 12 months					12 months or longer					Total
			Gross		Number			Gross		Number			Gross		Number
			unrealized		of			unrealized		of			unrealized		of
(In thousands)	Fair value		losses		positions	Fair value		losses		positions	Fair value		losses		positions
U.S. government agencies	$	6,681	$	(57)	2	$	18,882	$	(507)	6	$	25,563	$	(564)	8
Mortgage-backed securities-residential		5,140		(5)	2		2,574		(45)	1		7,714		(50)	3
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		87,020		(994)	31		15,644		(560)	5		102,664		(1,554)	36
Non-agency		1,101		(26)	1		—		—	—		1,101		(26)	1
Municipal bonds		6,080		(52)	7		—		—	—		6,080		(52)	7
Total available for sale	$	106,022	$	(1,134)	43	$	37,100	$	(1,112)	12	$	143,122	$	(2,246)	55

We evaluate declines in the fair value of securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis.  We assess whether OTTI is present when the fair value of a security is less than its amortized cost.  Under ASC Topic 320, OTTI is considered to have occurred with respect to debt securities (1) if an entity intends to sell the security; (2) if it is more likely than not an entity will be required to sell the security before recovery of its amortized cost basis; or (3) the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. During the first three quarters of 2016, we recorded impairment charges of $181 thousand on two private equity funds as a result of analyses performed on recent financial information. We did not record OTTI charges to earnings during the first three quarters of 2015.  There were no credit-related impairment losses on debt securities held at September 30, 2016 and September 30, 2015 for which a portion of OTTI was recognized in other comprehensive income. 

For all debt security types discussed below the fair value is based on prices provided by brokers and safekeeping custodians.

U.S. government issued or sponsored collateralized mortgage obligations (“Agency CMOs”):  As of September 30, 2016, we had 11 Agency CMOs with a fair value of $32.9 million and gross unrealized losses of $469 thousand.  Three of the Agency CMOs have been in an unrealized loss position for twelve months or longer and the remaining eight Agency CMOs have been in an unrealized loss position for less than twelve months.  The unrealized loss is attributable to a combination of factors, including relative changes in interest rates since the time of purchase.  The contractual cash flows for these securities are guaranteed by U.S. government agencies and U.S. government-sponsored enterprises. Based on its assessment of these factors, management believes that the unrealized losses on these debt securities are a function of changes in investment spreads and interest rate movements and not as a result of changes in credit quality.  Management expects to recover the entire amortized cost basis of these securities. We do not intend to sell these securities before recovery of their cost basis and have not determined that it is not more likely than not that we will be required to sell these securities before recovery of their cost basis.  Therefore, management has determined that these securities are not other-than-temporarily impaired at September 30, 2016.

Municipal bonds:  As of September 30, 2016 we had four municipal bonds with a fair value $3.3 million and gross unrealized losses of $55 thousand.  Two of the municipal bonds have been in an unrealized loss position for less than twelve months and two bonds have been in an unrealized loss position for twelve months or longer at September 30, 2016. Because we do not intend to sell the bonds and it is not more likely than not that we will be required to sell the bonds before recovery of their amortized cost basis, which may be maturity, we do not consider the bonds to be other-than-temporarily impaired at September 30, 2016.

We will continue to monitor these investments to determine if the discounted cash flow analysis, continued negative trends, market valuations, or credit defaults result in impairment that is other than temporary.

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Note 4.Loans and Leases

Major classifications of loans are as follows:

	September 30,		December 31,
(In thousands)	2016		2015
Commercial real estate	$	253,074	$	225,679
Construction and land development		74,885		47,984
Commercial and industrial		106,254		85,980
Multi-family		23,831		16,249
Residential real estate		49,061		51,588
Leases		62,671		64,341
Tax certificates		3,803		4,755
Consumer		2,239		2,527
Total loans, net of unearned income	$	575,818	$	499,103

We use a nine point grading risk classification system commonly used in the financial services industry as the credit quality indicator.  The first four classifications are rated Pass.  The riskier classifications include Pass-Watch, Special Mention, Substandard, Doubtful and Loss. The risk rating is related to the underlying credit quality and probability of default.  These risk ratings are used in the calculation of the allowance for loan and lease losses.

· Pass: includes credits that demonstrate a low probability of default;

· Pass-watch: a classification which includes currently performing credits that are beginning to demonstrate above average risk through declining earnings, strained cash flows, increased leverage and/or weakening market fundamentals. This class may also include new loan originations which warrant approval but may contain certain risks that require closer than usual monitoring and supervision, such as construction loans;

· Special mention: includes credits that have potential weaknesses that if left uncorrected could weaken the credit or result in inadequate protection of our position at some future date. While potentially weak, credits in this classification are marginally acceptable and loss of principal or interest is not anticipated;

· Substandard accrual: includes credits that exhibit a well-defined weakness which currently jeopardizes the repayment of debt and liquidation of collateral even though they are currently performing. These credits are characterized by the distinct possibility that we may incur a loss in the future if these weaknesses are not corrected;

· Non-accrual (substandard non-accrual, doubtful, loss): includes credits that demonstrate serious problems to the point that it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement.

All loans are assigned an initial loan risk rating by the Underwriting and Credit Administration Officer (“UCAO”).  The initial loan risk rating is approved by another member of executive management or by the appropriate loan committee approving the loan request. From time to time, and at the general direction of any of the various loan committees, the ratings may be changed based on the findings of that committee. Items considered in assigning ratings include the financial strength of the borrower and/or guarantors, the type of collateral, the collateral lien position, the type of loan and loan structure, any potential risk inherent in the specific loan type, higher than normal monitoring of the loan or any other factor deemed appropriate by any of the various committees for changing the rating of the loan. Any such change in rating is reflected in the minutes of that committee.

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The following tables present risk ratings for each loan portfolio classification at September 30, 2016 and December 31, 2015.

As of September 30, 2016
(In thousands)	Pass		Pass-Watch		Special Mention		Substandard		Non-accrual		Total
Commercial real estate	$	216,295	$	35,601	$	346	$	—	$	832	$	253,074
Construction and land development		10,068		64,673		—		—		144		74,885
Commercial and industrial		94,137		9,426		329		1,688		674		106,254
Multi-family		17,373		6,458		—		—		—		23,831
Residential real estate		48,371		106		—		—		584		49,061
Leases		60,567		197		431		—		1,476		62,671
Tax certificates		3,058		—		—		—		745		3,803
Consumer		2,166		73		—		—		—		2,239
Total loans, net of unearned income	$	452,035	$	116,534	$	1,106	$	1,688	$	4,455	$	575,818

As of December 31, 2015
(In thousands)	Pass		Pass-Watch		Special Mention		Substandard		Non-accrual		Total
Commercial real estate	$	191,320	$	31,994	$	870	$	—	$	1,495	$	225,679
Construction and land development		4,429		43,410		—		—		145		47,984
Commercial and industrial		68,998		13,971		195		2,065		751		85,980
Multi-family		15,982		267		—		—		—		16,249
Residential real estate		50,699		—		—		—		889		51,588
Leases		62,896		319		39		—		1,087		64,341
Tax certificates		3,630		—		—		—		1,125		4,755
Consumer		2,439		88		—		—		—		2,527
Total loans, net of unearned income	$	400,393	$	90,049	$	1,104	$	2,065	$	5,492	$	499,103

The following tables present an aging analysis of past due payments for each loan portfolio classification at September 30, 2016 and December 31, 2015.

As of September 30, 2016	30-59 Days		60-89 Days		Accruing
(In thousands)	Past Due		Past Due		90+ Days		Non-accrual		Current		Total
Commercial real estate	$	—	$	—	$	—	$	832	$	252,242	$	253,074
Construction and land development		—		—		—		144		74,741		74,885
Commercial and industrial		346		8		—		674		105,226		106,254
Multi-family		—		—		—		—		23,831		23,831
Residential real estate		139		107		—		584		48,231		49,061
Leases		197		431		—		1,476		60,567		62,671
Tax certificates		—		—		—		745		3,058		3,803
Consumer		—		—		—		—		2,239		2,239
Total loans, net of unearned income	$	682	$	546	$	—	$	4,455	$	570,135	$	575,818

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As of December 31, 2015	30-59 Days		60-89 Days		Accruing
(In thousands)	Past Due		Past Due		90+ Days		Non-accrual		Current		Total
Commercial real estate	$	96	$	—	$	—	$	1,495	$	224,088	$	225,679
Construction and land development		507		—		—		145		47,332		47,984
Commercial and industrial		910		592		—		751		83,727		85,980
Multi-family		—		—		—		—		16,249		16,249
Residential real estate		724		159		—		889		49,816		51,588
Leases		319		39		—		1,087		62,896		64,341
Tax certificates		—		—		—		1,125		3,630		4,755
Consumer		—		—		—		—		2,527		2,527
Total loans, net of unearned income	$	2,556	$	790	$	—	$	5,492	$	490,265	$	499,103

If interest had accrued on non-accrual loans, such income would have been approximately  $135 thousand and $450 thousand for the three and nine months ended September 30, 2016 and $142 thousand and $539 thousand for the three and nine months ended September 30, 2015, respectively.

Impaired Loans

Total cash collected on impaired loans during the September 30, 2016 and 2015 was $1.4 million and $5.9 million respectively, of which $1.3 million and $4.8 million was credited to the principal balance outstanding on such loans, respectively. Interest income recognized on a cash basis on impaired loans and leases was $0 and $97 thousand for the three months ended September 30, 2016 and 2015, respectively and $0 and $232 thousand for the nine months ended September 30, 2016 and 2015, respectively.

Troubled Debt Restructurings (“TDRs”)

The following table details our TDRs that are on an accrual status and non-accrual status at September 30, 2016 and December 31, 2015.

	As of September 30, 2016
				Non-
	Number of	Accrual		Accrual
(In thousands)	loans	Status		Status		Total TDRs
Commercial real estate	1	$	20	$	—	$	20
Construction and land development	1		—		144		144
Commercial and industrial	2		1,688		177		1,865
Residential real estate	1		84		—		84
Total	5	$	1,792	$	321	$	2,113

19

	As of December 31, 2015
				Non-
	Number of	Accrual		Accrual
(In thousands)	loans	Status		Status		Total TDRs
Commercial real estate	1	$	24	$	—	$	24
Construction and land development	1		—		145		145
Commercial and industrial	3		2,315		—		2,315
Residential real estate	1		—		92		92
Total	6	$	2,339	$	237	$	2,576

At September 30, 2016, there were no TDRs modified within the past 12 months, for which there was a payment default. We did not classify any loan modifications as TDRs during the first three quarters of 2016 and 2015.

We may obtain physical possession of real estate collateralizing residential mortgage loans or home equity loans through or in lieu of, foreclosure.  As of September 30, 2016, we have a foreclosed residential real estate property with a carrying value of $28 thousand as a result of physical possession.  In addition, as of September 30, 2016, we had residential mortgage loans with a carrying value of $317 thousand collateralized by residential real estate property for which formal foreclosure proceedings were in process.

Note 5.Allowance for Loan and Lease Losses

The following tables present the detail of the allowance and the loan portfolio disaggregated by loan portfolio classification as of September 30, 2016,  December 31, 2015, and September 30, 2015.

Allowance for Loan and Lease Losses

As of and for the three months ended September 30, 2016

			Construction
	Commercial		and land		Commercial		Multi-		Residential				Tax
(In thousands)	real estate		development		and industrial		family		real estate		Leases		certificates		Consumer		Unallocated		Total
Beginning balance	$	3,342	$	1,991	$	1,365	$	231	$	647	$	2,052	$	358	$	22	$	—	$	10,008
Charge-offs		(7)		—		—		—		—		(310)		(108)		—		—		(425)
Recoveries		17		15		32		—		4		18		6		1		—		93
(Credit) provision		(12)		160		17		36		(76)		426		29		(2)		—		578
Ending balance	$	3,340	$	2,166	$	1,414	$	267	$	575	$	2,186	$	285	$	21	$	—	$	10,254
Ending balance: related to loans individually evaluated for impairment	$	—	$	—	$	—	$	—	$	18	$	168	$	—	$	—	$	—	$	186
Ending balance: related to loans collectively evaluated for impairment	$	3,340	$	2,166	$	1,414	$	267	$	557	$	2,018	$	285	$	21	$	—	$	10,068

20

Allowance for Loan and Lease Losses

As of and for the nine months ended September 30, 2016

			Construction
	Commercial		and land		Commercial		Multi-		Residential				Tax
(In thousands)	real estate		development		and industrial		family		real estate		Leases		certificates		Consumer		Unallocated		Total
Beginning balance	$	3,622	$	1,674	$	1,513	$	171	$	586	$	1,749	$	347	$	27	$	—	$	9,689
Charge-offs		(84)		—		(108)		—		(40)		(757)		(139)		—		—		(1,128)
Recoveries		201		273		159		—		23		35		14		1		—		706
(Credit) provision		(399)		219		(150)		96		6		1,159		63		(7)		—		987
Ending balance	$	3,340	$	2,166	$	1,414	$	267	$	575	$	2,186	$	285	$	21	$	—	$	10,254
Ending balance: related to loans individually evaluated for impairment	$	—	$	—	$	—	$	—	$	18	$	168	$	—	$	—	$	—	$	186
Ending balance: related to loans collectively evaluated for impairment	$	3,340	$	2,166	$	1,414	$	267	$	557	$	2,018	$	285	$	21	$	—	$	10,068

Loans Evaluated for Impairment

As of September 30, 2016 

			Construction
	Commercial		and land		Commercial		Multi-		Residential				Tax
	real estate		development		and industrial		family		real estate		Leases		certificates		Consumer		Unallocated		Total
(In thousands)
Ending balance	$	253,074	$	74,885	$	106,254	$	23,831	$	49,061	$	62,671	$	3,803	$	2,239	$	—	$	575,818
Ending balance: individually evaluated for impairment	$	852	$	144	$	2,120	$	—	$	668	$	806	$	745	$	—	$	—	$	5,335
Ending balance: collectively evaluated for impairment	$	252,222	$	74,741	$	104,134	$	23,831	$	48,393	$	61,865	$	3,058	$	2,239	$	—	$	570,483

Allowance for Loan and Lease Losses and Loans Evaluated for Impairment

As of and for the year ended December 31, 2015

			Construction
	Commercial		and land		Commercial		Multi-		Residential				Tax
(In thousands)	real estate		development		and industrial		family		real estate		Leases		certificates		Consumer		Unallocated		Total
Beginning balance	$	4,452	$	2,292	$	1,780	$	285	$	616	$	1,429	$	667	$	38	$	149	$	11,708
Charge-offs		(622)		(264)		(566)		—		—		(612)		(471)		—		—		(2,535)
Recoveries		380		503		282		—		20		26		53		—		—		1,264
(Credit) provision		(588)		(857)		17		(114)		(50)		906		98		(11)		(149)		(748)
Ending balance	$	3,622	$	1,674	$	1,513	$	171	$	586	$	1,749	$	347	$	27	$	—	$	9,689
Ending balance: related to loans individually evaluated for impairment	$	77	$	—	$	100	$	—	$	27	$	194	$	—	$	—	$	—	$	398
Ending balance: related to loans collectively evaluated for impairment	$	3,545	$	1,674	$	1,413	$	171	$	559	$	1,555	$	347	$	27	$	—	$	9,291
Loan Balances
Ending balance	$	225,679	$	47,984	$	85,980	$	16,249	$	51,588	$	64,341	$	4,755	$	2,527	$	—	$	499,103
Ending balance: individually evaluated for impairment	$	1,469	$	145	$	2,687	$	—	$	889	$	876	$	1,125	$	—	$	—	$	7,191
Ending balance: collectively evaluated for impairment	$	224,210	$	47,839	$	83,293	$	16,249	$	50,699	$	63,465	$	3,630	$	2,527	$	—	$	491,912

21

Allowance for Loan and Lease Losses

As of and for the three months ended September 30, 2015

			Construction
	Commercial		and land		Commercial		Multi-		Residential				Tax
(In thousands)	real estate		development		and industrial		family		real estate		Leases		certificates		Consumer		Unallocated		Total
Beginning balance	$	4,208	$	1,358	$	1,705	$	300	$	584	$	1,405	$	317	$	35	$	124	$	10,036
Charge-offs		—		(39)		—		—		—		(138)		—		—		—		(177)
Recoveries		—		150		4		—		5		4		—		—		—		163
Provision (credit)		(344)		133		(301)		(113)		67		316		38		(6)		(6)		(216)
Ending balance	$	3,864	$	1,602	$	1,408	$	187	$	656	$	1,587	$	355	$	29	$	118	$	9,806
Ending balance: related to loans individually evaluated for impairment	$	—	$	145	$	—	$	—	$	28	$	131	$	18	$	—	$	—	$	322
Ending balance: related to loans collectively evaluated for impairment	$	3,864	$	1,457	$	1,408	$	187	$	628	$	1,456	$	337	$	29	$	118	$	9,484

Allowance for Loan and Lease Losses

As of and for the nine months ended September 30, 2015

			Construction
	Commercial		and land		Commercial		Multi-		Residential				Tax
(In thousands)	real estate		development		and industrial		family		real estate		Leases		certificates		Consumer		Unallocated		Total
Beginning balance	$	4,452	$	2,292	$	1,780	$	285	$	616	$	1,429	$	667	$	38	$	149	$	11,708
Charge-offs		(231)		(119)		(541)		—		—		(315)		(433)		—		—		(1,639)
Recoveries		351		402		278		—		16		20		52		—		—		1,119
Provision (credit)		(708)		(973)		(109)		(98)		24		453		69		(9)		(31)		(1,382)
Ending balance	$	3,864	$	1,602	$	1,408	$	187	$	656	$	1,587	$	355	$	29	$	118	$	9,806
Ending balance: related to loans individually evaluated for impairment	$	—	$	145	$	—	$	—	$	28	$	131	$	18	$	—	$	—	$	322
Ending balance: related to loans collectively evaluated for impairment	$	3,864	$	1,457	$	1,408	$	187	$	628	$	1,456	$	337	$	29	$	118	$	9,484

Loans Evaluated for Impairment

As of September 30, 2015

			Construction
	Commercial		and land		Commercial		Multi-		Residential				Tax
	real estate		development		and industrial		family		real estate		Leases		certificates		Consumer		Unallocated		Total
(In thousands)
Ending balance	$	210,883	$	38,864	$	82,414	$	15,222	$	54,025	$	61,954	$	5,294	$	2,560	$	—	$	471,216
Ending balance: individually evaluated for impairment	$	4,040	$	290	$	3,024	$	—	$	918	$	640	$	1,206	$	—	$	—	$	10,118
Ending balance: collectively evaluated for impairment	$	206,843	$	38,574	$	79,390	$	15,222	$	53,107	$	61,314	$	4,088	$	2,560	$	—	$	461,098

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The following tables detail the loans that were evaluated for impairment by loan classification at September 30, 2016 and December 31, 2015.

	At September 30, 2016
	Unpaid
	principal		Recorded		Related
(In thousands)	balance		investment		allowance
With no related allowance recorded:
Commercial real estate	$	1,273	$	852	$	—
Construction and land development		546		144		—
Commercial and industrial		4,564		2,120		—
Residential real estate		135		84		—
Tax certificates		5,170		745		—
Total:	$	11,688	$	3,945	$	—

With an allowance recorded:
Residential real estate	$	674	$	584	$	18
Leasing		806		806		168
Total:	$	1,480	$	1,390	$	186

	At and for the year ended December 31, 2015
	Unpaid						Average		Interest
	principal		Recorded		Related		recorded		income
(In thousands)	balance		investment		allowance		investment		recognized
With no related allowance recorded:
Commercial real estate	$	1,323	$	931	$	—	$	4,144	$	335
Construction and land development		546		145		—		376		—
Commercial and industrial		2,662		2,576		—		4,314		233
Tax certificates		5,666		1,125		—		904		—
Total:	$	10,197	$	4,777	$	—	$	9,738	$	568

With an allowance recorded:
Commercial real estate	$	926	$	538	$	77	$	334	$	—
Construction and land development		—		—		—		90		—
Commercial and industrial		2,500		111		100		172		—
Residential real estate		1,033		889		27		938		—
Leases		876		876		194		243		—
Tax certificates		—		—		—		188		—
Total:	$	5,335	$	2,414	$	398	$	1,965	$	—

The following tables present the average recorded investment in impaired loans and the related interest income recognized for the three and nine months ended September 30, 2016 and 2015.

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	For the three months ended September 30, 2016						For the nine months ended September 30, 2016
	Average		Interest		Interest income		Average		Interest		Interest income
	recorded		income		recognized		recorded		income		recognized
(In thousands)	investment		recognized		cash basis		investment		recognized		cash basis
Commercial real estate	$	867	$	—	$	—	$	1,185	$	—	$	—
Construction and land development		144		—		—		145		—		—
Commercial and industrial		2,258		28		—		2,373		85		—
Residential real estate		670		—		—		765		—		—
Leasing		993		—		—		873		—		—
Tax certificates		903		—		—		991		—		—
Total:	$	5,835	$	28	$	—	$	6,332	$	85	$	—

	For the three months ended September 30, 2015						For the nine months ended September 30, 2015
	Average		Interest		Interest income		Average		Interest		Interest income
	recorded		income		recognized		recorded		income		recognized
(In thousands)	investment		recognized		cash basis		investment		recognized		cash basis
Commercial real estate	$	4,256	$	33	$	97	$	5,599	$	97	$	232
Construction and land development		471		—		—		562		—		—
Commercial and industrial		3,570		44		—		4,740		142		—
Residential real estate		927		—		—		952		—		—
Leasing		289		—		—		146		—		—
Tax certificates		1,109		—		—		1,078		—		—
Total:	$	10,622	$	77	$	97	$	13,077	$	239	$	232

Note 6.Other Real Estate Owned

At September 30, 2016,  OREO was comprised of two real estate properties acquired through, or in lieu of foreclosure in settlement of loans and 47 real estate properties acquired through foreclosure related to tax liens.  Set forth below are tables which detail the changes in OREO from January 1, 2016 to September 30, 2016 and January 1, 2015 to December 31, 2015.

	For the nine months ended September 30, 2016
(In thousands)	Loans		Tax Liens		Total
Beginning balance	$	220	$	7,215	$	7,435
Net proceeds from sales		(6)		(1,121)		(1,127)
Net gains on sales		1		6		7
Transfers in		28		793		821
Cash additions		—		243		243
Impairment charge		—		(143)		(143)
Ending balance	$	243	$	6,993	$	7,236

24

	For the year ended December 31, 2015
(In thousands)	Loans		Tax Liens		Total
Beginning balance	$	349	$	9,430	$	9,779
Net proceeds from sales		(1,735)		(4,730)		(6,465)
Net gain on sales		60		859		919
Transfers in		1,671		2,671		4,342
Cash additions		—		558		558
Transfer to loans		—		(995)		(995)
Impairment charge		(125)		(578)		(703)
Ending balance	$	220	$	7,215	$	7,435

At September 30, 2016, OREO was comprised of $215 thousand in land, $7.0 million in tax liens, and $28 thousand in residential real estate related to a single family home.  The properties acquired through the tax lien portfolio were primarily located in New Jersey. 

Note 7.Deposits

Our deposit composition as of September 30, 2016 and December 31, 2015 is presented below:

	September 30,		December 31,
(In thousands)	2016		2015
Non-interest bearing checking	$	90,709	$	83,529
NOW		42,295		42,558
Interest-bearing brokered deposits		—		25,000
Money Market		159,532		165,251
Savings		81,331		53,833
Time deposits ($250 and over)		14,211		18,066
Time deposits (less than $250)		204,161		189,655
Total deposits	$	592,239	$	577,892

Note 8.Borrowings and Subordinated Debentures

1. Advances from the Federal Home Loan Bank

As of September 30, 2016, Royal Bank had $283.3 million of available borrowing capacity at the FHLB, which is based on qualifying collateral.  Total advances from the FHLB were $65.0 million at September 30, 2016 and $54.0 million at December 31, 2015.  The advances and the line of credit are collateralized by FHLB stock, government agency securities mortgage-backed securities, and a blanket lien on certain real estate loans.  As of September 30, 2016, investment securities with a market value of $13.2 million were pledged as collateral to the FHLB for the borrowings.

Presented below are the Company’s FHLB borrowings allocated by the year in which they mature with their corresponding weighted average rates:

	As of				As of
	September 30, 2016				December 31, 2015
(Dollars in thousands)	Amount		Rate		Amount		Rate
Advances maturing in
2016	$	15,000	0.57	%	$	19,000	0.85	%
2017		25,000	1.46	%		25,000	1.46	%
2018		10,000	2.01	%		10,000	2.01	%
2021		15,000	1.40	%		—	—	%
Total FHLB borrowings	$	65,000			$	54,000

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2. Other borrowings

We had a note payable with PNC Bank (“PNC”) in the amount of $2.0 million at December 31, 2015.  The note was paid on its maturity date of August 25, 2016.  The interest rate was a variable rate equal to one month LIBOR + 15 basis points and adjusted monthly. 

At September 30, 2016 and December 31, 2015, we had additional borrowings of $35.0 million from PNC which will mature on January 7, 2018.  These borrowings have a weighted average interest rate of 3.65%. The note payable and the borrowings are secured by government agency securities and mortgage-backed securities.

Royal Bank has an additional $20.0 million in lines of credit with two local financial institutions, of which $0 was outstanding at September 30, 2016 and December 31, 2015, respectively.

3. Subordinated debentures

We have outstanding $25.8 million of Trust Preferred Securities issued through two Delaware trust affiliates, Royal Bancshares Capital Trust I (“Trust I”) and Royal Bancshares Capital Trust II (“Trust II”) (collectively, the “Trusts”).  We issued an aggregate principal amount of $12.9 million of floating rate junior subordinated debt securities to Trust I and an aggregate principal amount of $12.9 million of fixed/floating rate junior subordinated debt securities to Trust II.  Both debt securities bear an interest rate of 3.00% at September 30, 2016, and reset quarterly at 3-month LIBOR plus 2.15%.

Each of Trust I and Trust II issued an aggregate principal amount of $12.5 million of capital securities initially bearing fixed and/or fixed/floating interest rates corresponding to the debt securities held by each trust to an unaffiliated investment vehicle and issued to the Company an aggregate principal amount of $387 thousand of common securities bearing fixed and/or fixed/floating interest rates corresponding to the debt securities held by each trust.  We have fully and unconditionally guaranteed all of the obligations of the Trusts, including any distributions and payments on liquidation or redemption of the capital securities.

Under the MOU as described in “Note 2 — Regulatory Matters and Significant Risks or Uncertainties” to the Consolidated Financial Statements, the Company and its non-bank subsidiaries may not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior written approval of the Federal Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.  We received approval and paid the required interest payments in March, June, and September of 2016.

Note 9.Derivative Instruments and Hedging Activity

In the fourth quarter of 2014, we entered into a forward-starting interest rate swap agreement to hedge the risk of variability in cash flowsattributable to changes in the 3 month LIBOR rate. This particular hedging objective was to reduce the interest rate risk associated with our forecasted issuances of 3 month fixed rate debt arising from a rollover strategy of an FHLB advance, which matured in June 2016.  We have and will continue to rollover the FHLB advance through the swap expiration of June 2021. This derivative was used as part of the asset/liability management process, is linked to a specific liability and has a high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period. The derivative was designated as a cash flow hedge with the change in fair value recorded as an adjustment through other comprehensive income (loss) until the underlying forecasted transactions occur, at which time the deferred gains and losses are recognized in earnings.

26

The effects of the derivative instrument on the Consolidated Financial Statements at September 30, 2016 and December 31, 2015 and for the three and nine months ended September 30, 2016 and 2015 were as follows:

	As of September 30, 2016
	Notional
	Contract				Balance Sheet	Expiration
(In thousands)	Amount		Fair Value		Location	Date
Derivatives designated as hedging instruments
Interest rate swaps:
Effective June 24, 2016	$	15,000	$	(1,030)	Other liabilities	June 24, 2021
Total:	$	15,000	$	(1,030)

	As of December 31, 2015
	Notional
	Contract				Balance Sheet	Expiration
(In thousands)	Amount		Fair Value		Location	Date
Derivatives designated as hedging instruments
Interest rate swaps:
Effective June 24, 2016	$	15,000	$	(555)	Other liabilities	June 24, 2021
Total:	$	15,000	$	(555)

	For the three months ended September 30, 2016
	Amount of Gain		Location of Loss	Amount of Loss
	Recognized		Recognized	Recognized
	in OCI		in Income	in Income
	on Derivatives		on Derivatives	on Derivatives
(In thousands)	(Effective Portion)		(Ineffective Portion)	(Ineffective Portion)
Derivatives designated as hedging instruments
Interest rate swaps:
Effective June 24, 2016	$	131	Not Applicable	$	—
Total:	$	131		$	—

	For the nine months ended September 30, 2016
	Amount of Loss		Location of Loss	Amount of Loss
	Recognized		Recognized	Recognized
	in OCI		in Income	in Income
	on Derivatives		on Derivatives	on Derivatives
(In thousands)	(Effective Portion)		(Ineffective Portion)	(Ineffective Portion)
Derivatives designated as hedging instruments
Interest rate swaps:
Effective June 24, 2016	$	(314)	Not Applicable	$	—
Total:	$	(314)		$	—

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	For the year ended December 31, 2015
	Amount of Loss		Location of Loss	Amount of Loss
	Recognized		Recognized	Recognized
	in OCI		in Income	in Income
	on Derivatives		on Derivatives	on Derivatives
(In thousands)	(Effective Portion)		(Ineffective Portion)	(Ineffective Portion)
Derivatives designated as hedging instruments
Interest rate swaps:
Effective June 24, 2016	$	(366)	Not Applicable	$	—
Total:	$	(366)		$	—

	For the three months ended September 30, 2015
	Amount of Loss		Location of Loss	Amount of Loss
	Recognized		Recognized	Recognized
	in OCI		in Income	in Income
	on Derivatives		on Derivatives	on Derivatives
(In thousands)	(Effective Portion)		(Ineffective Portion)	(Ineffective Portion)
Derivatives designated as hedging instruments
Interest rate swaps:
Effective June 24, 2016	$	(282)	Not Applicable	$	—
Total:	$	(282)		$	—

	For the nine months ended September 30, 2015
	Amount of Loss		Location of Loss	Amount of Loss
	Recognized		Recognized	Recognized
	in OCI		in Income	in Income
	on Derivatives		on Derivatives	on Derivatives
(In thousands)	(Effective Portion)		(Ineffective Portion)	(Ineffective Portion)
Derivatives designated as hedging instruments
Interest rate swaps:
Effective June 24, 2016	$	(467)	Not Applicable	$	—
Total:	$	(467)		$	—

Note 10.Commitments, Contingencies, and Concentrations

We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers.  These financial instruments include commitments to extend credit and standby letters of credit.  Such financial instruments are recorded in the financial statements when they become payable. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.  The contract amounts of those instruments reflect the extent of involvement we have in particular classes of financial instruments.

Our exposure to credit loss in the event of non-performance by the other party to commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments.  We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments.

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The contract amounts are as follows:

	September 30,		December 31,
(In thousands)	2016		2015
Financial instruments whose contract amounts represent credit risk:
Open-end lines of credit	$	75,620	$	72,988
Commitments to extend credit		31,745		8,497
Standby letters of credit and financial guarantees written		257		515

In March 2016, we commenced renovations on our 3-story building in Narberth, Pennsylvania. It is the site of Royal Bank’s main branch location.  The branch will remain open during construction.  We expect the project to be completed later this year for an approximate cost of $1.4 million.  It  is our intention to lease the second and third floors as a revenue source.

Legal Proceedings

From time to time, we are a party to routine legal proceedings within the normal course of business.  Such routine legal proceedings in the aggregate are believed by management to be immaterial to our financial condition or results of operations.

Note 11.Shareholders’ Equity

1. Preferred Stock

On February 20, 2009, as part of the Capital Purchase Program (“CPP”) established by the U.S. Department of the Treasury (“Treasury”), we issued to Treasury 30,407 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A, without par value per share (the “Series A preferred stock”), and a liquidation preference of $1,000 per share.  In conjunction with the purchase of the Series A preferred stock, Treasury received a warrant to purchase 1,104,370 shares of our Class A common stock.  The aggregate purchase price for the Series A preferred stock and warrant was $30.4 million in cash.  The Series A preferred stock qualifies as Tier 1 capital and originally paid cumulative dividends at a rate of 5% per annum.  In February 2014, the cumulative dividend rate on the Series A Preferred Stock increased to 9% per annum.  The Series A preferred stock may generally be redeemed by us at any time following consultation with our primary banking regulators.  The warrant issued to Treasury has a 10-year term and is immediately exercisable upon its issuance, with an exercise price, subject to anti-dilution adjustments, equal to $4.13 per share of the common stock.  As a result of the shareholders’ rights offering in 2014, the number of warrants to purchase the Company’s Class A common stock adjusted to 1,368,040 and the warrant exercise price decreased to $3.33 per share of the common stock.

In the second quarter of 2014, we received approval from the Federal Reserve Bank to bid up to $14.0 million, which was raised in a private placement, to purchase shares of the Series A preferred stock in an auction of such shares conducted by the Treasury.  The Series A preferred stock was priced in the auction at $1,207.11 per share for all 30,407 shares of Series A preferred stock outstanding. We were allocated 11,551 shares of Series A preferred stock for repurchase at the clearing price of $1,207.11.

During the first nine months of 2016, we received approval from the Federal Reserve Bank to repurchase 6,651 shares of the outstanding Series A preferred stock for $10.0 million or a weighted average price of $1,502.39  per share.  We utilized existing cash on-hand to complete the repurchase, and after taking into consideration the repurchase price, we eliminated approximately $260 thousand in dividends in arrears.  As disclosed previously, we have received regulatory approval to repurchase or redeem the remaining 12,205 shares.  We intend to retire all of the remaining shares of Series A preferred stock outstanding as a result of receipt of such approvals, including purchases in privately negotiated transactions or in accordance with the redemption provisions of the Series A preferred stock. 

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2. Common Stock

Our Class A common stock trades on the NASDAQ Global Market under the symbol RBPAA.  There is no market for our Class B common stock.  The Class B shares may not be transferred in any manner except to the holder’s immediate family.  Class B shares may be converted to Class A shares at the rate of 1.15 to 1.  Shareholders are entitled to one vote for each Class A share and ten votes for each Class B share held.  Holders of either class of common stock are entitled to conversion equivalent per share dividends when declared.

3. Payment of Dividends

Under the Pennsylvania Business Corporation Law, the Company may pay dividends only if it is solvent and would not be rendered insolvent by the dividend payment. There are also restrictions set forth in the Pennsylvania Banking Code of 1965 (the “Code”) and in the Federal Deposit Insurance Act (“FDIA”) affecting the payment of dividends to the Company by Royal Bank.  Under the Code, no dividends may be paid by a bank except from “accumulated net earnings” (generally retained earnings).  In addition, dividends paid by Royal Bank to the Company would be prohibited if the effect thereof would cause Royal Bank’s capital to be reduced below applicable minimum capital requirements. 

On August 13, 2009, the Company’s Board suspended the regular quarterly cash dividends on the Series A preferred stock.  The Company’s Board took this action in consultation with the Federal Reserve Bank of Philadelphia as required by regulatory policy guidance.  In February 2014, the preferred cumulative dividend rate prospectively increased to 9% per annum.As of September 30, 2016, the Series A preferred stock dividend in arrears, which includes additional dividends on arrearages, was approximately $7.1 million and has not been recognized in the consolidated financial statements.  In the event we declared the preferred dividend in arrears our capital ratios would be negatively affected; however, they would remain above the required minimum ratios.  Under the Federal Reserve Bank MOU as described in “Note 2 — Regulatory Matters and Significant Risks or Uncertainties” to the Consolidated Financial Statements, the Company may not declare or pay any dividends without the prior written approval of the Federal Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.  As mentioned previously, we intend to retire all of the remaining shares of the Series A Preferred stock by the end of 2016, thus eliminating future dividends.

Note 12.Regulatory Capital Requirements

The Company and Royal Bank are subject to various regulatory capital requirements administered by the federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s and Royal Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. 

In July 2013, the federal bank regulatory agencies adopted final rules to revise the agencies’ capital adequacy guidelines and prompt corrective action rules, which were designed to enhance such requirements and implement the revised standards of the Basel Committee on Banking Supervision, commonly referred to as Basel III. The July 2013 final rules generally implement higher minimum capital requirements, add a new common equity tier 1 capital requirement, and establish criteria that instruments must meet to be considered common equity tier 1 capital, additional tier 1 capital or tier 2 capital. The new minimum capital to risk-adjusted assets requirements are a common equity tier 1 capital ratio of 4.5% (6.5% to be considered “well capitalized”) and a tier 1 capital ratio of 6.0%, increased from 4.0% (and increased from 6.0% to 8.0% to be considered “well capitalized”); the total capital ratio remains at 8.0% under the new rules (10.0% to be considered “well capitalized”).

Under the new rules, in order to avoid limitations on capital distributions (including dividend payments and certain discretionary bonus payments to executive officers), a banking organization must hold a capital conservation buffer comprised of common equity tier 1 capital above its minimum risk-based capital requirements in an amount greater than 2.5% of total risk-weighted assets. The new minimum capital requirements were effective on January 1, 2015. The capital

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conservation buffer requirements phase in over a three-year period beginning January 1, 2016.  Effective January 1, 2019 the capital conservation buffer will effectively raise the minimum required common equity tier 1 capital ratio to 7.0%, the tier 1 capital ratio to 8.5%, and the total capital to 10.0%.  Management believes that as of September 30, 2016, the Company and Royal Bank would meet all capital adequacy requirements under the Basel III rules on a fully phased in basis as if all such requirements were currently in effect.  As of September 30, 2016, the Company and Royal Bank satisfied the criteria for a well-capitalized institution.

In connection with a prior bank regulatory examination, the FDIC concluded, based upon its interpretation of the Call Report instructions and under regulatory accounting principles (“RAP”), that income from Royal Bank’s tax lien business should be recognized on a cash basis, not an accrual basis.  Royal Bank’s current accrual method is in accordance with U.S. GAAP.  Royal Bank disagrees with the FDIC’s conclusion and filed the Call Report for September 30, 2016 and the previous 24 quarters in accordance with U.S. GAAP.  The change in the method of revenue recognition for the tax lien business for regulatory accounting purposes affects Royal Bank’s and the Company’s capital ratios as shown below.  The resolution of this matter will be decided by additional joint regulatory agency guidance which includes the Federal Reserve Bank, the FDIC, and the OCC.

The table below sets forth Royal Bank’s capital ratios under RAP based on the FDIC’s interpretation of the Call Report instructions:

	At September 30, 2016
									To be well capitalized
					For capital				under prompt corrective
	Actual				adequacy purposes				action provision
(Dollars in thousands)	Amount		Ratio		Amount		Ratio*		Amount		Ratio
Total capital (to risk-weighted assets)	$	90,551	14.794	%	$	52,792	8.625	%	$	61,208	10.000	%
Tier 1 capital (to risk-weighted assets)	$	82,868	13.539	%	$	40,550	6.625	%	$	48,966	8.000	%
Tier 1 capital (to average assets, leverage)	$	82,868	10.354	%	$	32,015	4.000	%	$	40,019	5.000	%
Common equity Tier 1 (to risk-weighted assets)	$	65,242	10.659	%	$	31,369	5.125	%	$	39,785	6.500	%

*Ratios related to risk-weighted assets include the capital conservation buffer of 0.625%.

The tables below reflect the adjustments to the net income as well as the capital ratios for Royal Bank under U.S. GAAP:

	For the nine
	months ended
(In thousands)	September 30, 2016
RAP net income	$	4,410
Tax lien adjustment, net of noncontrolling interest		1,560
U.S. GAAP net income	$	5,970

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	At September 30, 2016
	As reported		As adjusted
	under RAP		for U.S. GAAP
Total capital (to risk-weighted assets)	14.794	%	15.016	%
Tier 1 capital (to risk-weighted assets)	13.539	%	13.761	%
Tier 1 capital (to average assets, leverage)	10.354	%	10.530	%
Common equity Tier 1 (to risk-weighted assets)	10.659	%	10.889	%

The tables below reflect the Company’s capital ratios:

	At September 30, 2016
										To be well capitalized
					For capital					under the Federal
	Actual				adequacy purposes				Reserve's regulations
(Dollars in thousands)	Amount		Ratio		Amount		Ratio*		Amount		Ratio
Total capital (to risk-weighted assets)	$	100,544	16.361	%	$	53,003	8.625	%	$	61,453	10.00	%
Tier 1 capital (to risk-weighted assets)	$	90,606	14.744	%	$	40,713	6.625	%	$	36,872	6.00	%
Tier 1 capital (to average assets, leverage)	$	90,606	11.220	%	$	32,303	4.000	%		N/A	N/A
Common equity Tier 1 (to risk-weighted assets)	$	55,124	8.970	%	$	31,495	5.125	%		N/A	N/A

*Ratios related to risk-weighted assets include capital conservation buffer of 0.625%.

The Company has filed the Consolidated Financial Statements for Bank Holding Companies-FR Y-9C (“FR Y-9C”) as of September 30, 2016 consistent with U.S. GAAP and the FR Y-9C instructions.  In the event that a similar adjustment for RAP purposes would be required by the Federal Reserve on the holding company level, the adjusted ratios are shown in the table below.

	For the nine
	months ended
(In thousands)	September 30, 2016
U.S. GAAP net income	$	6,253
Tax lien adjustment, net of noncontrolling interest		(1,560)
RAP net income	$	4,693

	At September 30, 2016
	As reported		As adjusted
	under U.S. GAAP		for RAP
Total capital (to risk-weighted assets)	16.361	%	16.143	%
Tier 1 capital (to risk-weighted assets)	14.744	%	14.439	%
Tier 1 capital (to average assets, leverage)	11.220	%	10.981	%
Common equity Tier 1 (to risk-weighted assets)	8.970	%	8.736	%

Note 13.Pension Plan

We have a noncontributory nonqualified defined benefit pension plan (“Pension Plan”) covering certain eligible employees.  Our Pension Plan provides retirement benefits under pension trust agreements.  The benefits are based on

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years of service and the employee’s compensation during the highest three consecutive years during the last 10 years of employment.

Net periodic defined benefit pension expense for the three and nine months ended September 30, 2016 and 2015 included the following components:

	For the three months ended				For the nine months ended
	September 30,				September 30,
(In thousands)	2016		2015		2016		2015
Service cost	$	11	$	17	$	35	$	49
Interest cost		143		135		428		403
Amortization of prior service cost		—		22		—		68
Amortization of actuarial loss		43		46		129		140
Net periodic benefit cost	$	197	$	220	$	592	$	660

We plan to fund a substantial portion of the pension plan obligations through existing Company owned life insurance policies.  The cash surrender value for these policies was approximately $4.4 million and $3.8 million as of September 30, 2016 and December 31, 2015, respectively. The accumulated benefit obligation was $15.1 million as of September 30, 2016 compared to $14.9 million at December 31, 2015. 

Note 14.Earnings Per Common Share

We follow the provisions of FASB ASC Topic 260, “Earnings per Share” (“ASC Topic 260”).  Basic earnings per share (“EPS”) excludes dilution and is computed by dividing income available to common shareholders by the weighted average common shares outstanding during the period.  We have two classes of common stock currently outstanding. The classes are A and B, of which one share of Class B is convertible into 1.15 shares of Class A.  Diluted EPS takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock using the if-converted method. For the three and nine months ended September 30, 2016 and 2015,  68,139 and 101,655 options to purchase shares of common stock, respectively, were anti-dilutive in the computation of diluted EPS, as the exercise price exceeded average market price in each of those periods.  Additionally, warrants to purchase 1,368,040 shares of Class A common stock were also anti-dilutive.

Basic and diluted EPS are calculated as follows:

	For the three months ended September 30, 2016
	Income		Average shares	Per share
(In thousands, except for per share data)	(numerator)		(denominator)	Amount
Basic EPS
Income available to common shareholders	$	1,688	30,086	$	0.06
Diluted EPS
Income available to common shareholders	$	1,688	30,158	$	0.06

	For the three months ended September 30, 2015
	Income		Average shares	Per share
(In thousands, except for per share data)	(numerator)		(denominator)	Amount
Basic EPS
ncome available to common shareholders	$	1,100	30,043	$	0.04
Diluted EPS
Income available to common shareholders	$	1,100	30,074	$	0.04

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	For the nine months ended September 30, 2016
	Income		Average shares	Per share
(In thousands, except for per share data)	(numerator)		(denominator)	Amount
Basic EPS
Income available to common shareholders	$	5,239	30,077	$	0.17
Diluted EPS
Income available to common shareholders	$	5,239	30,157	$	0.17

	For the nine months ended September 30, 2015
	Income		Average shares	Per share
(In thousands, except for per share data)	(numerator)		(denominator)	Amount
Basic EPS
Income available to common shareholders	$	3,299	30,038	$	0.11
Diluted EPS
Income available to common shareholders	$	3,299	30,045	$	0.11

Note 15.Comprehensive Income

FASB ASC Topic 220, “Comprehensive Income” (“ASC Topic 220”), requires the reporting of all changes in equity during the reporting period except investments from and distributions to shareholders.  Net income is a component of comprehensive income (loss) with all other components referred to in the aggregate as other comprehensive income.  Unrealized gains and losses on AFS securities is an example of another comprehensive income (loss) component.

	For the nine months ended September 30, 2016
			Tax
	Before tax		expense		Net of tax
(In thousands)	amount		(benefit)		amount
Unrealized gains on investment securities:
Unrealized holding gains arising during period	$	3,776	$	1,434	$	2,342
Less adjustment for impaired investments		(181)		(62)		(119)
Less reclassification adjustment for gains
realized in net income		1,382		470		912
Unrealized gains on investment securities		2,575		1,026		1,549
Unrecognized benefit obligation expense:
Reclassification adjustment for amortization		(232)		—		(232)
Unrecognized benefit obligation		(232)		—		(232)
Unrealized loss on derivative instrument		(475)		(161)		(314)
Other comprehensive income, net	$	1,868	$	865	$	1,003

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	For the nine months ended September 30, 2015
			Tax
	Before tax		expense		Net of tax
(In thousands)	amount		(benefit)		amount
Unrealized gains on investment securities:
Unrealized holding gains arising during period	$	2,011	$	691	$	1,320
Less reclassification adjustment for gains
realized in net income		652		222		430
Unrealized gains on investment securities		1,359		469		890
Unrecognized benefit obligation expense:
Reclassification adjustment for amortization		(51)		—		(51)
Unrecognized benefit obligation		(51)		—		(51)
Unrealized loss on derivative instrument		(708)		(241)		(467)
Other comprehensive income, net	$	600	$	228	$	372

The other components of accumulated other comprehensive loss included in shareholders’ equity at September 30, 2016 and December 31, 2015 are as follows:

	September 30,		December 31,
(In thousands)	2016		2015
Unrecognized benefit obligation	$	(3,909)	$	(3,677)
Unrealized gains on AFS investments		1,673		124
Unrealized loss on derivative instrument		(680)		(366)
Accumulated other comprehensive loss	$	(2,916)	$	(3,919)

Note 16.Fair Value of Financial Instruments

Under FASB ASC Topic 820 “Fair Value Measurements and Disclosures” (“ASC Topic 820”), fair values are based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When available, management uses quoted market prices to determine fair value.  If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates. If observable market-based inputs are not available, we use unobservable inputs to determine appropriate valuation adjustments using discounted cash flow methodologies.

Management uses its best judgment in estimating the fair value of our financial instruments; however, there are inherent weaknesses in any estimation technique.  Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts we could have realized in a sales transaction on the dates indicated.  The estimated fair value amounts have been measured as of their respective period end and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates.  As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different from the amounts reported at each period-end.

ASC Topic 820 provides guidance for estimating fair value when the volume and level of activity for an asset or liability has significantly declined and for identifying circumstances when a transaction is not orderly. ASC Topic 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair value hierarchy under ASC Topic 820 are as follows:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

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Level 2:

Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability. Level 2 includes debt securities with quoted prices that are traded less frequently then exchange-traded instruments. Valuation techniques include matrix pricing which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices.

Level 3:

Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.  We did not have transfers of financial instruments within the fair value hierarchy during the three and nine months ended September 30, 2016 and 2015.

Items Measured on a Recurring Basis

Our available for sale investment securities are recorded at fair value on a recurring basis.

Fair value for Level 1 securities are determined by obtaining quoted market prices on nationally recognized securities exchanges.  Level 1 securities include common stocks.

Level 2 securities include obligations of U.S. government-sponsored agencies and debt securities with quoted prices, which are traded less frequently than exchange-traded instruments, whose value is determined using matrix pricing with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.  The prices were obtained from third party vendors.  This category generally includes our mortgage-backed securities and CMOs issued by U.S. government and government-sponsored agencies, non-agency CMOs, and corporate and municipal bonds.  Additionally, Level 2 includes derivative instruments whose valuations are based on observable market data.

Level 3 securities include investments in five private equity funds which are predominantly invested in real estate.  The value of the private equity funds are derived from the funds’ financials and K-1 filings.  We also review the funds’ asset values and its near-term projections.

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For financial assets and liabilities measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2016 and December 31, 2015 are as follows:

	Fair Value Measurements Using:
	Quoted Prices
	in Active		Significant
	Markets for		Other		Significant
	Identical		Observable		Unobservable
As of September 30, 2016	Assets		Inputs		Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Assets:
Investment securities available for sale
U.S. government agencies	$	—	$	3,500	$	—	$	3,500
Mortgage-backed securities-residential		—		7,715		—		7,715
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		—		140,040		—		140,040
Non-agency		—		4,566		—		4,566
Corporate bonds		—		1,774		—		1,774
Municipal bonds		—		8,867		—		8,867
Other securities		—		—		1,833		1,833
Common stocks		26		—		—		26
Total investment securities available for sale	$	26	$	166,462	$	1,833	$	168,321
Liabilities:
Derivative instruments
Interest rate swaps	$	—	$	1,030	$	—	$	1,030

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	Fair Value Measurements Using:
	Quoted Prices
	in Active		Significant
	Markets for		Other		Significant
	Identical		Observable		Unobservable
As of December 31, 2015	Assets		Inputs		Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Assets:
Investment securities available for sale
U.S. government agencies	$	—	$	25,563	$	—	$	25,563
Mortgage-backed securities-residential		—		11,058		—		11,058
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		—		170,734		—		170,734
Non-agency		—		2,704		—		2,704
Corporate bonds		—		1,556		—		1,556
Municipal bonds		—		9,931		—		9,931
Other securities		—		—		2,495		2,495
Common stocks		26		—		—		26
Total investment securities available for sale	$	26	$	221,546	$	2,495	$	224,067
Liabilities:
Derivative instruments
Interest rate swaps	$	—	$	555	$	—	$	555

The following tables present additional information about assets measured at fair value on a recurring basis and for which the Company has utilized Level 3 inputs to determine fair value for the three and nine months ended September 30, 2016 and 2015:

(In thousands)	Other securities
Investment Securities Available for Sale	2016		2015
Beginning balance July 1,	$	1,877	$	3,006
Total gains/(losses) - (realized/unrealized):
Included in earnings-net gains on sale and OTTI		10		4
Included in other comprehensive income		—		(9)
Purchases		—		—
Sales and calls		(54)		(4)
Transfers in and/or out of Level 3		—		—
Ending balance September 30,	$	1,833	$	2,997

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(In thousands)	Other securities
Investment Securities Available for Sale	2016		2015
Beginning balance January 1,	$	2,495	$	4,034
Total gains/(losses) - (realized/unrealized):
Included in earnings-net gains on sale and OTTI		945		319
Included in other comprehensive income		(445)		(551)
Purchases		104		4
Sales and calls		(1,266)		(809)
Transfers in and/or out of Level 3		—		—
Ending balance September 30,	$	1,833	$	2,997

Items Measured on a Nonrecurring Basis

Non-accrual loans and TDRs are evaluated for impairment on an individual basis under FASB ASC Topic 310 “Receivables”.  The impairment analysis includes current collateral values, known relevant factors that may affect loan collectability, and risks inherent in different kinds of lending.  When the collateral value or discounted cash flows less costs to sell is less than the carrying value of the loan a specific reserve (valuation allowance) is established. Loans held for sale are carried at the lower of cost or fair value. OREO is carried at the lower of cost or fair value.  Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the real estate.  Additionally, for collateral acquired from tax liens, fair value may be established using brokers opinions due to their lower carrying value.  These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.

For financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2016 and December 31, 2015 are as follows:

	Fair Value Measurements Using:
	Quoted Prices
	in Active		Significant
	Markets for		Other		Significant
	Identical		Observable		Unobservable
As of September 30, 2016	Assets		Inputs		Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Assets
Impaired loans and leases	$	—	$	—	$	1,950	$	1,950
Other real estate owned		—		—		1,308		1,308

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	Fair Value Measurements Using:
	Quoted Prices
	in Active		Significant
	Markets for		Other		Significant
	Identical		Observable		Unobservable
As of December 31, 2015	Assets		Inputs		Inputs
(In thousands)	Level 1		Level 2		Level 3		Fair Value
Assets
Impaired loans and leases	$	—	$	—	$	5,946	$	5,946
Other real estate owned		—		—		2,384		2,384

The following tables present additional quantitative information about assets measured at fair value on a nonrecurring basis and for which we have utilized Level 3 inputs to determine fair value at September 30, 2016 and December 31, 2015:

	Qualitative Information about Level 3 Fair Value Measurements
As of September 30, 2016			Valuation		Range
(In thousands)	Fair Value		Techniques	Unobservable Input	(WeightedAverage)
Impaired loans and leases	$	1,950	Appraisal of	Appraisal adjustments	0.0%	-	-20.8%	(-14.9%)
			collateral (1)	Liquidation expenses	0.0%	-	-12.8%	(-4.2%)
Other real estate owned		1,308	Appraisal of	Appraisal adjustments	0.0%	-	-52.6%	(-15.5%)
			collateral (1)	Liquidation expenses	0.0%	-	-5.6%	(-5.6%)

	Qualitative Information about Level 3 Fair Value Measurements
As of December 31, 2015			Valuation		Range
(In thousands)	Fair Value		Techniques	Unobservable Input	(WeightedAverage)
Impaired loans and leases	$	5,946	Appraisal of	Appraisal adjustments	0.0%	-	-62.3%	(-13.7%)
			collateral (1)	Liquidation expenses	0.0%	-	-15.4%	(-6.5%)
Other real estate owned		2,384	Appraisal of	Appraisal adjustments	0.0%	-	-54.1%	(-17.1%)
			collateral (1)	Liquidation expenses	0.0%	-	-14.7%	(-6.0%)

(1) Appraisals may be adjusted for qualitative factors such as interior condition of the property and liquidation expenses.

The following methods and assumptions were used to estimate the fair values of our financial instruments at September 30, 2016 and December 31, 2015. The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of our assets and liabilities.  Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between our disclosures and those of other companies may not be meaningful.  The methodologies for estimating the fair value of financial instruments that are measured on a recurring or nonrecurring basis are discussed above.

Cash and cash equivalents (carried at cost):

The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets’ fair values.

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Securities:

Management uses quoted market prices to determine fair value of securities (level 1).  If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates (level 2). If observable market-based inputs are not available, we use unobservable inputs to determine appropriate valuation adjustments by reviewing the private equities funds’ financials and K-1 filings (level 3).

Other Investment (carried at cost):

This investment includes the Solomon Hess SBA Loan Fund, which we invested in to partially satisfy Royal Bank’s community reinvestment requirement.  Shares in this fund are not publicly traded and therefore have no readily determinable fair market value.  An investor can have its investment in the Fund redeemed for the balance of its capital account at any quarter end with 60 days notice to the Fund.  The investment in this Fund is recorded at cost.  We do not record this investment at fair value on a recurring basis, as this investment’s carrying amount approximates fair value.

Restricted investment in bank stock (carried at cost):

The carrying amount of restricted investment in bank stock approximates fair value, and considers the limited marketability of such securities.

Loans receivable (carried at cost):

The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the loans.  Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal.   Generally, for variable rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying values.

Impaired loans (generally carried at fair value):

Impaired loans are accounted for under ASC Topic 310. Impaired loans are those in which we have measured impairment generally based on the fair value of the loan’s collateral.  Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based on the expected proceeds.  These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.

Accrued interest receivable and payable (carried at cost):

The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.

Deposit liabilities (carried at cost):

The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts).  Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Long-term debt (carried at cost):

Fair values of FHLB advances and other long-term borrowings are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity.  These prices obtained from this active market represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party.

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Subordinated debt (carried at cost):

Fair values of junior subordinated debt are estimated using discounted cash flow analysis, based on market rates currently offered on such debt with similar credit risk characteristics, terms and remaining maturity.

Derivative instruments:

We have contracted with a third party vendor to provide periodic valuations for our interest rate derivatives to determine the fair value of our interest rate swaps. The vendor utilizes standard valuation methodologies applicable to interest rate derivatives such as discounted cash flow analysis and extensions of the Black-Scholes model. Such valuations are based upon readily observable market data and are therefore considered Level 2 valuations by the Company.

Off-balance sheet financial instruments (disclosed at cost):

Fair values of our off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account, the remaining terms of the agreements and the counterparties’ credit standing.  They are not shown in the table because the amounts are immaterial.

The tables below indicate the fair value of our financial instruments at September 30, 2016 and December 31, 2015.

					Fair Value Measurements
					At September 30, 2016
					Quoted Prices
					in Active		Significant
					Markets for		Other		Significant
					Identical		Observable		Unobservable
	Carrying		Estimated		Assets		Inputs		Inputs
(In thousands)	amount		fair value		Level 1		Level 2		Level 3
Financial Assets:
Cash and cash equivalents	$	28,391	$	28,391	$	28,391	$	—	$	—
Investment securities available for sale		168,321		168,321		26		166,462		1,833
Other investment		2,250		2,250		—		—		2,250
Federal Home Loan Bank stock		3,018		3,018		—		—		3,018
Loans, net		565,564		560,238		—		—		560,238
Accrued interest receivable		3,770		3,770		—		3,770		—
Financial Liabilities:
Demand deposits		90,709		90,709		—		90,709		—
NOW and money markets		201,827		201,827		—		201,827		—
Savings		81,331		81,331		—		81,331		—
Time deposits		218,372		216,304		—		216,304		—
Short-term borrowings		15,000		15,000		15,000		—		—
Long-term borrowings		85,000		83,706		—		83,706		—
Subordinated debt		25,774		26,864		—		26,864		—
Accrued interest payable		2,240		2,240		—		2,240		—
Derivative Instruments (Liability):
Interest rate swaps		1,030		1,030		—		1,030		—

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					Fair Value Measurements
					At December 31, 2015
					Quoted Prices
					in Active		Significant
					Markets for		Other		Significant
					Identical		Observable		Unobservable
	Carrying		Estimated		Assets		Inputs		Inputs
(In thousands)	amount		fair value		Level 1		Level 2		Level 3
Financial Assets:
Cash and cash equivalents	$	25,420	$	25,420	$	25,420	$	—	$	—
Investment securities available for sale		224,067		224,067		26		221,546		2,495
Other investment		2,250		2,250		—		—		2,250
Federal Home Loan Bank stock		2,545		2,545		—		—		2,545
Loans, net		489,414		484,961		—		—		484,961
Accrued interest receivable		4,149		4,149		—		4,149		—
Financial Liabilities:
Demand deposits		83,529		83,529		—		83,529		—
NOW and money markets		207,809		207,809		—		207,809		—
Interest-bearing brokered deposits		25,000		25,000		—		25,000		—
Savings		53,833		53,833		—		53,833		—
Time deposits		207,721		207,110		—		207,110		—
Short-term borrowings		9,000		9,000		9,000		—		—
Long-term borrowings		81,970		80,258		—		80,258		—
Subordinated debt		25,774		26,789		—		26,789		—
Accrued interest payable		709		709		—		709		—
Derivative Instruments (Liability):
Interest rate swaps		555		555		—		555		—

Limitations

The fair value estimates are made at a discrete point in time based on relevant market information and information about the financial instruments.  Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors.

These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision.  Changes in assumptions could significantly affect the estimates.  Further, the foregoing estimates may not reflect the actual amount that could be realized if all or substantially all of the financial instruments were offered for sale.  This is due to the fact that no market exists for a sizable portion of the loan, deposit and off balance sheet instruments.

In addition, the fair value estimates are based on existing on-and-off balance sheet financial instruments without attempting to value anticipated future business and the value of assets and liabilities that are not considered financial instruments.  Other significant assets that are not considered financial assets include premises and equipment.  In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the estimates.

Finally, reasonable comparability between financial institutions may not be likely due to the wide range of permitted valuation techniques and numerous estimates which must be made given the absence of active secondary markets for many of the financial instruments.  This lack of uniform valuation methodologies introduces a greater degree of subjectivity to these estimated fair values.

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Note 17.Segment Information

FASB ASC Topic 280, “Segment Reporting” (“ASC Topic 280”) established standards for public business enterprises to report information about operating segments in their annual financial statements and requires that those enterprises report selected information about operating segments in subsequent interim financial reports issued to shareholders.  It also established standards for related disclosure about products and services, geographic areas, and major customers.  Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision makers in deciding how to allocate and assess resources and performance.  Our chief operating decision makers are the CEO and the CFO. We have identified our reportable operating segments as “Community Banking” and “Tax Liens”.

Community banking

Our community banking segment consists of commercial and retail banking and equipment leasing. The community banking business segment includes Royal Bank and Royal Bank Leasing and generates revenue from a variety of products and services provided by those entities.  Royal Bank and Royal Bank Leasing have similar economic characteristics in that earnings are predominantly derived from net interest income.   For example, commercial lending is dependent upon the ability of Royal Bank to fund cash needed to make loans with retail deposits and other borrowings and to manage interest rate and credit risk.

Tax liens

At September 30, 2016, Royal Bank’s tax liens segment includes its 80% and 100% ownership interest in CSC and RTL, respectively. Our tax liens segment consisted of purchasing delinquent tax certificates from local municipalities at auction and then processing those liens to either encourage the property holder to pay off the lien, or to foreclose and sell the property.  The tax liens segment earns income based on interest rates (determined at auction) and penalties assigned by the municipality along with gains on sale of foreclosed properties. CSC is liquidating its assets under an orderly, long term plan.  RTL ceased acquiring tax certificates at public auctions in 2010.

The following tables present selected financial information for reportable business segments for the three and nine months ended September 30, 2016 and 2015.

	For the three months ended September 30, 2016
	Community
(In thousands)	Banking		Tax Liens		Consolidated
Total assets	$	798,996	$	12,372	$	811,368
Total deposits	$	592,239	$	—	$	592,239
Interest income	$	8,417	$	43	$	8,460
Interest expense		1,752		150		1,902
Net interest income (expense)	$	6,665	$	(107)	$	6,558
Provision for loan and lease losses		549		29		578
Total non-interest income		1,177		12		1,189
Total non-interest expense		4,842		159		5,001
Income tax expense		25		—		25
Net income (loss)	$	2,426	$	(283)	$	2,143
Noncontrolling interest	$	125	$	(12)	$	113
Net income (loss) attributable to Royal Bancshares	$	2,301	$	(271)	$	2,030

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	For the three months ended September 30, 2015
	Community
(In thousands)	Banking		Tax Liens		Consolidated
Total assets	$	745,853	$	16,058	$	761,911
Total deposits	$	553,764	$	—	$	553,764
Interest income	$	7,625	$	173	$	7,798
Interest expense		1,447		189		1,636
Net interest income (expense)	$	6,178	$	(16)	$	6,162
(Credit) provision for loan and lease losses		(254)		38		(216)
Total non-interest income		503		74		577
Total non-interest expense		4,897		345		5,242
Income tax expense		—		—		—
Net income (loss)	$	2,038	$	(325)	$	1,713
Noncontrolling interest	$	179	$	—	$	179
Net income (loss) attributable to Royal Bancshares	$	1,859	$	(325)	$	1,534

	For the nine months ended September 30, 2016
	Community
(In thousands)	Banking		Tax Liens		Consolidated
Total assets	$	798,996	$	12,372	$	811,368
Total deposits	$	592,239	$	—	$	592,239
Interest income	$	24,663	$	192	$	24,855
Interest expense		4,932		457		5,389
Net interest income (expense)	$	19,731	$	(265)	$	19,466
Provision for loan and lease losses		924		63		987
Total non-interest income		3,422		47		3,469
Total non-interest expense		14,455		813		15,268
Income tax benefit		85		—		85
Net income (loss)	$	7,688	$	(1,093)	$	6,595
Noncontrolling interest	$	394	$	(52)	$	342
Net income (loss) attributable to Royal Bancshares	$	7,294	$	(1,041)	$	6,253

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	For the nine months ended September 30, 2015
	Community
(In thousands)	Banking		Tax Liens		Consolidated
Total assets	$	745,853	$	16,058	$	761,911
Total deposits	$	553,764	$	—	$	553,764
Interest income	$	21,642	$	507	$	22,149
Interest expense		4,169		629		4,798
Net interest income	$	17,473	$	(122)	$	17,351
(Credit) provision for loan and lease losses		(1,451)		69		(1,382)
Total non-interest income		1,863		198		2,061
Total non-interest expense		14,819		889		15,708
Income tax expense		—		—		—
Net income (loss)	$	5,968	$	(882)	$	5,086
Noncontrolling interest	$	551	$	(51)	$	500
Net income (loss) attributable to Royal Bancshares	$	5,417	$	(831)	$	4,586

Interest income earned by the community banking segment related to the tax liens segment was approximately  $150 thousand and $189 thousand for the three month periods ended September 30, 2016 and 2015, respectively, and $457 thousand and $629 thousand for the nine month periods ended September 30, 2016 and 2015, respectively.

Note 18.Federal Home Loan Bank Stock

As a member of the FHLB, we are required to purchase and hold stock in the FHLB to satisfy membership and borrowing requirements.  The stock can only be sold to the FHLB or to another member institution, and all sales of FHLB stock must be at par. As a result of these restrictions, there is no active market for the FHLB stock. At September 30, 2016 and December 31, 2015, FHLB stock totaled $3.0 million and $2.5 million, respectively.

FHLB stock is held as a long-term investment and its value is determined based on the ultimate recoverability of the par value. We evaluate impairment quarterly. The decision of whether impairment exists is a matter of judgment that reflects management’s view of the FHLB’s long-term performance, which includes factors such as the following: (1) its operating performance, (2) the severity and duration of declines in the fair value of its net assets related to its capital stock amount, (3) its liquidity position, and (4) the impact of legislative and regulatory changes on the FHLB.  Based on the capital adequacy and the liquidity position of the FHLB, management believes that the par value of its investment in FHLB stock will be recovered.  Accordingly, there is no other-than-temporary impairment related to the carrying amount of our FHLB stock as of September 30, 2016.

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

The following discussion and analysis is intended to assist in understanding and evaluating the changes in the financial condition and earnings performance of the Company and its subsidiaries for the three and nine months ended September 30, 2016 and 2015. This discussion and analysis should be read in conjunction with the Company’s consolidated financial statements and notes thereto for the year ended December 31, 2015, included in the Company’s Form 10-K for the year ended December 31, 2015.

FORWARD-LOOKING STATEMENTS

From time to time, Royal Bancshares of Pennsylvania, Inc. (the “Company”, “We”, “Our’) may include forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products, and similar matters in this and other filings with the Securities and Exchange Commission. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. When we use words such as “believes,” “expects,” “anticipates”, “could”, “intend”, “may”, “plan” or similar expressions, we are making forward-looking statements. In order to comply with the terms of the safe harbor, we note that a variety of factors could cause our actual results and experience to differ materially from the anticipated results or other expectations expressed in our forward-looking statements. The risks and uncertainties that may affect the operations, performance, development and results of our business include the following: general economic conditions, including their impact on capital expenditures; interest rate fluctuations; business conditions in the banking industry; the regulatory environment: the nature, extent, and timing of governmental actions and reforms; rapidly changing technology and evolving banking industry standards; competitive factors, including increased competition with community, regional and national financial institutions; changes in generally accepted accounting principles; new service and product offerings by competitors and price pressures and similar items.

All forward-looking statements contained in this report are based on information available as of the date of this report.  These statements speak only as of the date of this report, even if subsequently made available by us on our website, or otherwise.  We expressly disclaim any obligation to update any forward-looking statement to reflect future events or developments.

CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and general practices within the financial services industry.  Applications of the principles in preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes.  These estimates and assumptions are based on information available as of the date of the consolidated financial statements; therefore, actual results could differ from those estimates.

Note 1 to the Company’s Consolidated Financial Statements (included in Item 8 of the Form 10-K for the year ended December 31, 2015) lists significant accounting policies used in the development and presentation of our consolidated financial statements.  The following discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other quantitative and qualitative factors that are necessary for an understanding and evaluation of the Company and its results of operations.  We completed an internal review of this financial information.  This review requires substantive judgment and estimation. As disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015, we have identified other-than-temporary impairment (“OTTI”) on investment securities, accounting for allowance for loan and lease losses (“allowance”), the valuation of other real estate owned (“OREO”), the valuation allowance of deferred tax assets, fair value measurements, and the pension benefit obligation as among the most critical accounting policies and estimates.  These critical accounting policies and estimates are important to the presentation of our financial condition and results of operations, and they require difficult, subjective or complex judgments as a result of the need to make estimates. 

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Financial Highlights and Business Results

We are a Pennsylvania business corporation and a bank holding company registered under the Federal Bank Holding Company Act of 1956, as amended (the “BHCA”). We are supervised by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”).  Our legal headquarters are located at One Bala Plaza, Suite 522, 231 St. Asaph’s Road, Bala Cynwyd, Pennsylvania, 19004.  The principal activities of the Company are supervising Royal Bank America (“Royal Bank”), which engages in a general banking business principally in Montgomery, Chester, Bucks, Philadelphia and Berks counties in Pennsylvania and in central and southern New Jersey and Delaware. The Company also has a wholly owned non-bank subsidiary, Royal Investments of Delaware, Inc., which is engaged in investment activities.

Our results of operations depend primarily on net interest income. Its level is a function of the average balance of interest-earning assets, the average balance of interest-bearing liabilities, and the spread between the yield on assets and liabilities.  In turn, these factors are influenced by the pricing and mix of our interest-earning assets and funding sources.  Additionally, net interest income is affected by market and economic conditions, which influence rates on loan and deposit growth. 

Interest-earning assets consist principally of loans and investment securities, while interest-bearing liabilities consist primarily of deposits and borrowings. Refer to the “Net Interest Income and Net Interest Margin” sections below for additional information on interest yield and cost. Royal Bank principally generates commercial real estate loans primarily secured by first mortgage liens, commercial and industrial loans, construction loans for commercial real estate projects and residential home development, land development loans, and leases. We are liquidating our tax lien portfolio. At September 30, 2016, commercial real estate and multi-family loans, commercial and industrial loans, construction and land development loans, and leases comprised 48%, 18%, 13%, and 11%, respectively, of the total loan portfolio. Construction loans and land development loans can have more risk associated with them, especially during the construction phase of the project, and require specific monitoring.   Net income is also affected by the provision for loan and lease losses and the level of non-interest income as well as by non-interest expenses, including salary and benefits, occupancy expenses and other operating expenses.

Consistent quality loan growth contributed to our 2016 year to date results as we serve our four key constituents:  customers, shareholders, co-workers, and community.As a community bank, we have been experiencing the same external headwinds as our competitors for high quality commercial loans and less expensive core deposits.  Both loan and deposit pricing will continue to be a challenge as we navigate a flattening yield curve.  We have seen improvement in our risk profile as illustrated by our ratio of non-performing loans to total loans, which is 0.77% at September 30, 2016.  We remain focused on modernizing the ways customers access our products and services.  During 2016, we introduced a tablet version of our consumer mobile app as well a mobile app for our corporate customers, which includes our cash management suite of products.  We are also working on enhancements to our website which will improve navigation and functionality.  We recently added first position residential mortgages through a new arrangement with a local mortgage company experienced in providing and servicing residential mortgages for community banks as we remain committed to providing a wide range of consumer and commercial products.

During 2016, we received regulatory approval to repurchase 6,651 shares of our Series A Preferred stock and recently received regulatory approval to repurchase or redeem the remaining 12,205 shares outstanding.  It is our intention to retire the remaining outstanding shares by the end of 2016 and eliminate the associated future dividends rate of 9%. 

In March 2016, we commenced renovations on our 3-story building in Narberth, Pennsylvania. It is the site of Royal Bank’s main branch location.  The branch will remain open during construction.  We expect the project to be completed later this year for an approximate cost of $1.4 million.  It  is our intention to lease the second and third floors as a revenue source.

Consolidated Net Income

Net income attributable to the Company was $2.0 million, or $0.06 per diluted share, for the three months ended September 30, 2016 compared to net income of $1.5 million, or $0.04 per diluted share, for the three months ended September 30, 2015. For the nine months ended September 30, 2016, net income attributable to the Company was $6.3 million, or $0.17 

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per diluted share, compared to $4.6 million, or $0.11 per diluted share, for the same period in 2015.  Factors that positively contributed to the net income results for the three months ended September 30, 2016 as compared to the three months ended September 30, 2015 were:

· Net interest income increased $396 thousand, or 6.4%, due to an increase of $65.7 million in average interest-earning assets and a shift from investment securities into higher-yielding loans.

· We recorded $273 thousand in income related to a beneficiary payment from a bank owned life insurance (“BOLI”) policy.

· Net gains on the sale of investment securities grew $200 thousand.

· We reversed a $200 thousand contingency accrual related to a former OREO property.

· Loan collection expenses declined $117 thousand.

Partially offsetting these positive items was a $794 thousand increase from a credit to a provision to the allowance for loan and lease losses.  We recorded a provision to the allowance of $578 thousand in the third quarter of 2016 compared to a credit to the allowance of $216 thousand in the third quarter of 2015.  The 2016 provision was primarily due to growth in the loan portfolio, specific reserves on the leasing portfolio, and net charge-off activity within the leasing and tax certificate portfolios.

Factors that positively contributed to the net income results for the nine months ended September 30, 2016 as compared to the nine months ended September 30, 2015 were:

· Net interest income increased $2.1 million, or 12.2%, due to an increase of $69.5 million in average interest-earning assets and a shift from investment securities into higher-yielding loans.

· Net gains on the sale of investment securities increased $730 thousand.

· Income from Company owned life insurance policies grew  $475 thousand.

· The provision for unfunded loan commitments declined $518 thousand.

· We recorded $273 thousand in income related to a beneficiary payment from a BOLI policy.

· We reversed a $200 thousand contingency accrual related to a former OREO property.

· Occupancy and equipment expenses decreased $119 thousand. 

Partially offsetting these positive items was a $2.4 million increase from a credit to a provision to the allowance for loan and lease losses, OTTI charges of $181 thousand on two private equity investments, and increases of $211 thousand, $141 thousand and $98 thousand in salaries and benefits, communications and data processing expenses, and net OREO expenses, respectively.  We recorded a provision to the allowance of $987 thousand during the first nine months of 2016 compared to a credit to the allowance of $1.4 million during the first nine months of 2015.  The 2016 provision was primarily due to growth in the loan portfolio, specific reserves on the leasing portfolio, and net charge-off activity within the leasing and tax certificate portfolios.

Interest Income

Total interest income of $8.5 million for the third quarter of 2016 increased $662 thousand, or 8.5%, from the comparable quarter of 2015. The growth in interest income was related to a $65.7 million increase in average interest-earning assets.  Average interest-earning assets amounted to $762.2 million for the third quarter of 2016 compared to $696.5 million for the third quarter of 2015. Average loan and lease balances grew $102.4 million, or 22.3%, from $459.5 million for the third quarter of 2015 to $561.9 million for the third quarter of 2016.  Average investment securities declined $30.6 million, or 14.0%, to $188.2 million for the third quarter of 2016 from $218.8 million for the comparable quarter of 2015. Average cash equivalents decreased $6.1 million, or 33.4%, to $12.1 million for the third quarter of 2016 compared to $18.2 million for the third quarter of 2015.  Quarter over quarter, interest income on loans and leases increased $890 thousand, or 13.8%, while interest income on investment securities decreased $235 thousand, or 17.6%.  During the twelve month period from October 1, 2015 to September 30, 2016, we have strategically sold investment securities with lower yields, shorter maturities, or extension risk in a rising rate environment. In the third quarter of 2015, we sold the majority of the corporate bonds to minimize the credit risk within our portfolio.  The cash flows from these transactions along with principal and

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interest payments on the investment portfolio were reinvested in loans and leases and government sponsored mortgage-backed securities and collateralized mortgage obligations (“CMOs”).

Total interest income for the nine months ended September 30, 2016 rose $2.7 million, or 12.2%, to $24.9 million from  $22.2 million for the first nine months of 2015. The growth in interest income was related to a $69.5 million increase in average interest-earning assets along with a seven basis point increase in the average yield on such assets.  Average interest-earning assets amounted to $753.8 million for the first nine months of 2016 compared to $684.3 million for the first nine months of 2015. Additionally, the growth in interest-earning assets was accompanied by a change in the composition of such assets.  Average loan and lease balances grew $100.5 million, or 23.0%, from $437.2 million for the first nine months of 2015 to $537.7 million for the first nine months of 2016.  Average investment securities declined $27.5 million, or 11.9%, to $202.9 million for the first three quarters of 2016 from $230.4 million for the comparable period of 2015. Average cash equivalents decreased $3.5 million, or 20.9%, to $13.2 million for the first nine months of 2016 compared to $16.7 million for the first nine months of 2015.  Year over year, interest income on loans and leases increased $3.3 million, or 18.4%, while interest income on investment securities decreased $611 thousand, or 14.4%. During the past year, we have strategically sold investment securities with lower yields or extension risk in a rising rate environment. We also had $22.6 million in government agency bonds called during the first three quarters of 2016, which impacts the year over year comparison.  In the third quarter of 2015, we sold the majority of the corporate bonds to minimize the credit risk within our portfolio.  The cash flows from these transactions along with principal and interest payments on the investment portfolio were reinvested in loans and leases and government sponsored mortgage-backed securities and collateralized mortgage obligations (“CMOs”).

For the third  quarter of 2016, the yield on average interest-earning assets of 4.42% amounted to a slight decrease of two basis points from the yield of 4.44% for the prior year’s third quarter. Despite the increase in interest income on loans, the average yield on loans declined 37 basis points (5.20% in 2016 versus 5.57% in 2015). The decrease in loan yield reflects the competitive pricing environment we are experiencing for high quality loans. The average yield on investments declined ten basis points quarter over quarter (2.32% in 2016 versus 2.42% in 2015). 

For the nine months ended September 30, 2016, the yield on average interest-earning assets of 4.40% amounted to an increase of seven basis points from the yield of 4.33% for the comparable period in 2015. Despite the increase in interest income on loans, the average yield on loans declined 21 basis points (5.26% in 2016 versus 5.47% in 2015). The decrease in loan yield reflects the competitive pricing environment we are experiencing for high quality loans. The average yield on investments declined seven basis points quarter over quarter (2.40% in 2016 versus 2.47% in 2015). 

Interest Expense

Total interest expense of $1.9 million in the third quarter of 2016 increased $266 thousand, or 16.3%, from the comparable quarter of 2015. The increase in interest expense was primarily associated with an increase in interest expense on average savings accounts and average borrowings.  For the third quarter of 2016, average interest-bearing liabilities of $625.1 million increased $51.4 million, or 9.0%, from $573.7 million for the comparable period in 2015. For the three months ended September 30, 2016, average interest bearing deposits increased $42.8 million, or 9.3%, to $502.7 million, while average borrowings increased $8.7 million, or 7.6%, to $122.4 million from the comparable quarter of 2015.  Average NOW and money market accounts and savings accounts grew $3.3 million and $47.3 million to $213.9 million and $79.9 million, respectively, quarter over quarter. During the third quarter of 2015, we initiated a savings account campaign and were able to successfully grow our customer relationships and deposits. Average certificates of deposit (“CDs”) amounted to $208.9 million, which represented a decrease of $7.8 million, or 3.6% from the comparable quarter of 2015. For the third quarter of 2016, the interest paid on the average interest-bearing deposits increased $118 thousand, or 12.2%.

The interest paid on average borrowings increased $148 thousand, or 22.2% from the comparable quarter of 2015. We have one interest rate swap that was tied to a rollover strategy of an FHLB advance that matured on June 24, 2016. We have and will continue to rollover the FHLB advance every three months through the swap expiration of June 2021. The interest expense associated with the swap was $75 thousand for the third quarter of 2016.  Additionally, in the third quarter of 2016, we chose to benefit from the flattening yield curve and borrowed a $15.0 million FHLB advance for five years.  This advance will allow us to guarantee  an interest rate spread on $15.0 million in five year fixed rate loans. 

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For the first three quarters of 2016, total interest expense of $5.4 million increased $591 thousand, or 12.3%, from the comparable period of 2015. The increase in interest expense was primarily associated with an increase in interest expense on average interest-bearing deposits.  For the first nine months of 2016, average interest-bearing liabilities of $620.9 million increased $53.5 million, or 9.4%, from $567.4 million for the comparable period in 2015.  For the nine months ended September 30, 2016, average interest bearing deposits increased $51.6 million, or 11.4%, to $502.6 million, while average borrowings increased $1.9 million, or 1.6%, to $118.3 million from the comparable period of 2015.  Average NOW and money market accounts and savings accounts grew $17.1 million and $46.8 million to $222.8 million and $71.5 million, respectively, year over year. As mentioned previously, the launch of our savings account campaign in the third quarter of 2015 had a significant impact on the year over year growth in savings accounts. For the first three quarters of 2016, average CDs amounted to $208.3 million, which represented a decrease of $12.3 million, or 5.6% from the comparable period of 2015. For the first nine months of 2016, the interest paid on the average interest-bearing deposits increased $397 thousand, or 14.2%.  The interest paid on average borrowings increased $194 thousand, or 9.7% from the comparable quarter of 2015.  As mentioned previously, our interest rate swap became effective in June 2016.  The interest expense associated with the interest rate swap was $81 thousand for the first nine months of 2016. Additionally, we borrowed a $15.0 million FHLB advance for five years which also increased the interest expense on average borrowings.

The average interest rate paid on average total interest-bearing liabilities during the third quarters of 2016 and 2015 amounted to 1.21% and 1.13%, respectively. During the third quarter of 2016 the average interest rate paid on average interest-bearing deposits was 0.86% compared to 0.84% during the comparable quarter of 2015.  Despite the decline in average balances for CDs quarter versus quarter, the average rate paid on this deposit classification increased six basis points (1.44% in 2016 versus 1.38% in 2015).  Additionally, the average rates paid on savings accounts increased 28 basis points (0.71% in 2016 versus 0.43% in 2015).  The increases in the average rates paid on average interest-bearing deposits reflect the competitive pricing in our market area for all deposit product types and the retail savings promotion. The average interest rate paid for borrowings during the third quarter of 2016 was 2.65%, which amounted to an increase of 32 basis points from the average rate paid of 2.33% during the third quarter of 2015.  Short-term borrowing rates and the subordinated debt rate were directly impacted by the Federal Reserve Bank’s rate increase in December 2015. Additionally, the average borrowing rate paid was negatively impacted by the interest rate swap and the new $15.0 million advance mentioned previously.

The average interest rate paid on average total interest-bearing liabilities during the first nine months of 2016 and 2015 amounted to 1.16% and 1.13%, respectively. During the first three quarters of 2016, the average interest rate paid on average interest-bearing deposits was 0.85% compared to 0.83% during the same period in 2015.  Despite the decline in average balances for CDs year versus year, the average rate paid on this deposit classification increased six basis points (1.42% in 2016 versus 1.36% in 2015).  Additionally, the average rates paid on savings and NOW and money market accounts increased 42 basis points (0.70% in 2016 versus 0.28% in 2015) and three basis points (0.36% in 2016 versus 0.33% in 2015), respectively.  The increases in the average rates paid on average interest-bearing deposits reflect the competitive pricing in our market area for all deposit product types and the retail savings promotion.  The average interest rate paid for borrowings during the first three quarters of 2016 was 2.48%, which amounted to an increase of 18 basis points from the average rate paid of 2.30% during the first three quarters of 2015. As mentioned previously, short-term borrowing rates and the subordinated debt rate were directly impacted by the Federal Reserve Bank’s rate increase in December 2015. Additionally, the average borrowing rate paid was negatively impacted by the interest rate swap and the new $15.0 million advance mentioned previously.

Net Interest Income and Margin

Net interest income for the quarter ended September 30, 2016 amounted to $6.6 million, resulting in an increase of $396 thousand, or 6.4%, from the comparable quarter of 2015. The growth in net interest income wasimpacted by the growth in average loan balances.  This growth was partially offset by the increase in the average rate paid on average interest-bearing liabilities. Quarter over quarter, average loans and leases outstanding increased $102.4 million, or 22.3%, while average investments declined $30.6 million, or 14.0%.  The average rate paid on average savings balances grew 28 basis points while the corresponding balances grew $47.3 million.

Net interest income for the nine months ended September 30, 2016 was $19.5 million and increased $2.1 million, or 12.2%, from $17.4 million for the comparable period in 2015. Growth in average interest-earning assets and the change in the

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average interest-earning asset composition led to the increase in net interest income.  Year over year, average loans and leases outstanding increased $100.5 million, or 23.0%, while average investments declined $27.5 million, or 11.9%.  Increases were recognized in multiple commercial loan classes and the leasing portfolio.  Partially mitigating the improvement in net interest income was a $325 thousand increase in the interest paid on average savings balances, which grew $46.8 million year over year.

The net interest margin for the third quarter of 2016 was 3.42%, which decreased nine basis points from 3.51% for the comparable quarter of 2015. The average yield on interest-earning assets for the third  quarter of 2016 was 4.42% compared to 4.44% for the same period in 2015.  The average rates paid on average savings accounts and CDs went up by 28 and six basis points, respectively. We have been experiencing competitive pricing pressure in our market area to retain deposits.  Additionally, the average rate paid on average borrowings increased 32 basis points due to an $8.7 million increase in the average balance coupled with higher rates paid. Short-term deposit rates paid and the subordinated debt rate were directly impacted by the flattening of the yield curve and the Federal Reserve Bank’s rate increase in December 2015.  Additionally, the average borrowing rate paid was negatively impacted by the interest rate swap and the new $15.0 million advance mentioned previously.

The net interest margin for the nine months ended September 30, 2016 was 3.45%, which grew six basis points from 3.39% for the comparable period of 2015. The average yield on interest-earning assets for the first three quarters of 2016 was 4.40% compared to 4.33% for the same period in 2015.  Overall funding costs were 1.16% and 1.13% for the first three quarters of 2016 and 2015, respectively.  During the first nine months of 2016, we saw an increase in average rates paid on all interest-bearing deposit product types.  The average rates paid on average savings, CDs, and NOW and money market accounts went up by 42, six, and three basis points, respectively. As mentioned previously, we have been experiencing competitive pricing pressure in our market area to retain and grow deposits.  Additionally, the average rate paid on average borrowings increased 18 basis points. Short-term deposit rates paid and the subordinated debt rate were directly impacted by the flattening of the yield curve and the Federal Reserve Bank’s rate increase in December 2015. Additionally, the average borrowing rate paid was negatively impacted by the interest rate swap and the new $15.0 million advance mentioned previously.

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The following tables represent the average daily balances of assets, liabilities and shareholders’ equity and the respective interest-earning assets and interest-bearing liabilities, as well as average rates for the periods indicated.  The loans outstanding include non-accruing loans.  The yields are presented on an annualized basis.

	For the three months ended						For the three months ended
	September 30, 2016						September 30, 2015
(In thousands, except percentages)	Average Balance		Interest		Yield/Rate			Average Balance		Interest	Yield/Rate
Cash equivalents	$	12,107	$	15	0.49	%	$	18,184	$	8	0.17	%
Investment securities		188,194		1,099	2.32	%		218,767		1,334	2.42	%
Loans and leases		561,904		7,346	5.20	%		459,543		6,456	5.57	%
Total interest earning assets		762,205		8,460	4.42	%		696,494		7,798	4.44	%
Non-earning assets		49,734						43,722
Total average assets	$	811,939					$	740,216
Interest-bearing deposits
NOW and money markets	$	213,926	$	185	0.34	%	$	210,652	$	182	0.34	%
Savings		79,851		143	0.71	%		32,589		35	0.43	%
Certificates of deposit		208,902		758	1.44	%		216,653		751	1.38	%
Total interest bearing deposits		502,679		1,086	0.86	%		459,894		968	0.84	%
Borrowings		122,432		816	2.65	%		113,767		668	2.33	%
Total interest bearing liabilities		625,111		1,902	1.21	%		573,661		1,636	1.13	%
Non-interest bearing deposits		89,749						79,791
Other liabilities		25,171						20,889
Shareholders' equity		71,908						65,875
Total average liabilities and equity	$	811,939					$	740,216
Net interest income			$	6,558					$	6,162
Net interest margin					3.42	%					3.51	%

	For the nine months ended						For the nine months ended
	September 30, 2016						September 30, 2015
(In thousands, except percentages)	Average Balance		Interest		Yield/Rate			Average Balance		Interest	Yield/Rate
Cash equivalents	$	13,246	$	48	0.48	%	$	16,754	$	21	0.17	%
Investment securities		202,856		3,639	2.40	%		230,361		4,250	2.47	%
Loans and leases		537,656		21,168	5.26	%		437,188		17,878	5.47	%
Total interest earning assets		753,758		24,855	4.40	%		684,303		22,149	4.33	%
Non-earning assets		48,730						45,214
Total average assets	$	802,488					$	729,517
Interest-bearing deposits
NOW and money markets	$	222,761	$	595	0.36	%	$	205,646	$	508	0.33	%
Savings		71,537		377	0.70	%		24,765		52	0.28	%
Certificates of deposit		208,256		2,221	1.42	%		220,564		2,236	1.36	%
Total interest bearing deposits		502,554		3,193	0.85	%		450,975		2,796	0.83	%
Borrowings		118,321		2,196	2.48	%		116,456		2,002	2.30	%
Total interest bearing liabilities		620,875		5,389	1.16	%		567,431		4,798	1.13	%
Non-interest bearing deposits		86,189						75,563
Other liabilities		23,339						21,646
Shareholders' equity		72,085						64,877
Total average liabilities and equity	$	802,488					$	729,517
Net interest income			$	19,466					$	17,351
Net interest margin					3.45	%					3.39	%

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Rate Volume Analysis

The following table sets forth a rate/volume analysis, which segregates in detail the major factors contributing to the change in net interest income for the three and nine months ended September 30, 2016, as compared to the respective period in 2015, into amounts attributable to both rates and volume variances.

	For the three months ended							For the nine months ended
	September 30,							September 30,
	2016 vs. 2015							2016 vs. 2015
	Increase (decrease)							Increase (decrease)
(In thousands)	Volume		Rate		Total			Volume		Rate		Total
Interest income
Interest-earning deposits	$	(8)	$	15	$	7	$	(12)	$	39	$	27
Total short term earning assets		(8)		15		7		(12)		39		27
Investment securities		(180)		(55)		(235)		(490)		(121)		(611)
Loans and leases
Commercial demand loans		649		(15)		634		1,506		171		1,677
Commercial mortgages		558		(209)		349		1,778		(479)		1,299
Residential and home equity loans		33		(3)		30		144		55		199
Leases receivables		87		(19)		68		578		(94)		484
Tax certificates		(30)		(101)		(131)		(118)		(196)		(314)
Consumer loans		(3)		1		(2)		(4)		3		(1)
Loan fees		(58)		—		(58)		(54)		—		(54)
Total loans and leases		1,236		(346)		890		3,830		(540)		3,290
Total increase (decrease) in interest income	$	1,048	$	(386)	$	662	$	3,328	$	(622)	$	2,706
Interest expense
Deposits
NOW and money market	$	2	$	1	$	3	$	44	$	43	$	87
Savings		73		35		108		180		145		325
Certificates of deposit		(27)		34		7		(128)		113		(15)
Total deposits		48		70		118		96		301		397
Borrowings
Borrowings		53		69		122		31		93		124
Subordinated debentures		—		26		26		—		70		70
Total borrowings		53		95		148		31		163		194
Total increase in interest expense	$	101	$	165	$	266	$	127	$	464	$	591
Total increase (decrease) in net interest income	$	947	$	(551)	$	396	$	3,201	$	(1,086)	$	2,115

Provision (Credit) for Loan and Lease Losses

We recorded  a provision for loan and lease losses of $578 thousand and $987 thousand for the three and nine months ended September 30, 2016. We recorded credits to the allowance of $216 thousand and $1.4 million for the three and nine months ended September 30, 2015.  The 2016 provision was primarily attributable to growth in the loan and lease portfolio, specific reserves within the leasing portfolio, and net charge-off activity within the leasing and tax certificate portfolios. Net charge-offs for the leasing portfolio were $292 thousand and $722 thousand for the three and nine months ended September 30, 2016, respectively, compared to $134 thousand and $295 thousand for the corresponding periods in 2015. 

Non-interest Income

Non-interest income for the third quarter of 2016 was $1.2 million compared to $577 thousand for the comparable quarter of 2015 resulting in an increase of $612 thousand.  During the third quarter of 2016, we received $748 thousand in insurance proceeds related to a former employee covered by a BOLI policy.  We recorded $273 thousand in income from these proceeds.  The quarterly improvement in non-interest income was also impacted by a $200 thousand increase in the net gains on the sale of AFS investment securities  and  $71 thousand in gains on the sale of leases.  Net gains on the sale of investment securities increased from $80 thousand for the three months ended September 30, 2015 to $280 thousand

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for the three months ended September 30, 2016.  We did not sell any loans or leases in the third quarter of 2015. Partially mitigating the improvement in non-interest income was OTTI on investment securities of $35 thousand related to one private equity investment.  The OTTI charge was the result of recently issued financial statements which showed deterioration in the values of the underlying assets.    There was no OTTI on investment securities in the third quarter of 2015.

Non-interest income for the first nine months of 2016 was $3.5 million and increased $1.4 million from  $2.1 million for the first nine months of 2015.  Net gains on the sale of AFS investment securities grew $730 thousand to $1.4 million for the first three quarters of 2016 compared to $652 thousand for the comparable period in 2015.  Included in the $1.4 million of net gains on investment securities were distributions from two private equity investments that resulted in net gains of $1.1 million. Income from Company owned life insurance policies grew $475 thousand from $372 thousand for the first nine months of 2015 to $847 thousand for the first nine months of 2016.  As previously mentioned we recorded $273 thousand in income related to BOLI death benefit proceeds.  Partially mitigating the improvement in non-interest income was OTTI on investment securities of $181 thousand related to two private equity investments.  The OTTI charges were the result of recently issued financial statements which showed a deterioration in the values of the underlying assets.  There was no OTTI on investment securities in the first three quarters of 2015.

Non-interest Expense

Non-interest expense was $5.0 million for the third quarter of 2016 compared to $5.2 million for the third quarter of 2015 and decreased $241 thousand, or 4.6%, quarter over quarter.  Contributing to the decrease in non-interest expense for the third quarter of 2016 was the reversal of a $200 thousand contingency accrual for a previously owned OREO property.  During the third quarter of 2016, management determined that the contingency accrual was no longer required. Loan collection expenses declined $117 thousand, and the FDIC and state assessment charges decreased $47 thousand.  Partially mitigating these improvements was a quarter over quarter increase in salaries and benefits of $55 thousand, which was fully integrated into our 2016 plan.  

Non-interest expense was $15.3 million for the first nine months of 2016 and decreased $440 thousand, or 2.8%, from  $15.7 million for the first nine months of 2015.   During the first three quarters of 2016, we recorded a credit for unfunded loan commitments of $236 thousand compared to a provision for unfunded loan commitments of $282 thousand for the first three quarters of 2015.  The improvement of $518 thousand was the result of a decline in the historical loss rates applied in the calculation of the reserve for unfunded loan commitments.  As cited previously in 2016, we reversed a $200 thousand contingency accrual related to a formerly owned OREO property. Occupancy and equipment expenses declined $119 thousand from $2.2 million for the first nine months of 2015 to $2.1 million for the first nine months of 2016. The decline in occupancy and equipment costs was mostly attributable to the sale of a Company-owned building in the fourth quarter of 2015.  Partially mitigating these improvements was a year over year planned increase of $211 thousand in salaries and benefits ($8.0 million in 2016 versus $7.8 million in 2015).  Communications and data processing expenses increased $141 thousand from $607 thousand for the nine months ended September 30, 2015 to $748 thousand for the nine months ended September 30, 2016 as a result of technology investments. Additionally, net OREO expenses increased $98 thousand ($469 thousand in 2016 versus $371 thousand in 2015).  Net gains on the sales of OREO decreased $762 thousand and was partially offset by decreases in OREO impairment charges and OREO expenses of  $516  thousand and $148 thousand, respectively.  We recorded net gains on the sale of OREO of $7 thousand in the first three quarters of 2016 compared to $769 thousand in net gains on the sale of OREO for the first three quarters of 2015. 

Income Tax Expense

The Company is subject to both a federal income and alternative minimum taxes (“AMT”).  For the three and nine months ended September 30, 2016, we recorded a provision for income taxes of $25 thousand and $85 thousand for estimated AMT compared to $0 for the three and nine months ended September 30, 2015.  The AMT limits the utilization of net operating loss carryforwards to 90% while federal income tax allows for 100% utilization of the net operating loss carryforwards. Our effective tax rate is the provision for federal income taxes expressed as a percentage of income or loss before federal income taxes. The effective tax rate for the three and nine months ended September 30, 2016 was 1.2% and 1.3%, respectively. The effective income tax rates differ from the statutory rate of 34% primarily due to the utilization of

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net operating loss carryforwards, non-taxable income related to cash surrender life insurance, state and local income taxes and non-taxable income.

As of September 30, 2016, we had net deferred tax assets totaling $5.7 million. We recognize deferred tax assets and liabilities for the future tax consequences related to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. These deferred tax assets can only be realized if we generate sufficient taxable income in the future.  If we cannot, a valuation allowance is established. We regularly evaluate the realizability of deferred tax asset positions. In determining whether a valuation allowance is necessary, we consider the level of taxable income in prior years to the extent that carry backs are permitted under current tax laws, as well as estimates of future pre-tax book income, taxable income and tax planning strategies that would, if necessary, be implemented. Based on the analysis of the DTA at December 31, 2015, management concluded that it is more likely than not that a portion of the net DTA will be realized by the Company.  As a result of this conclusion, in 2015 we released $5.4 million of our valuation allowance previously recorded on the net DTA and credited income tax expense. As of September 30, 2016, no additional increase or decrease in the valuation allowance for future tax benefits was required based on management’s assessment. We currently maintain a valuation allowance for certain state net operating losses and other deferred tax assets that may not be realized. We expect to realize the remaining deferred tax assets over the allowable carry back and/or carry forward periods. However, if an unanticipated event occurs that materially changes pre-tax book income and taxable income in future periods, an increase or decrease in the valuation allowance may become necessary and such change in the valuation allowance could be material to the Company’s financial statements.

Results of Operations by Business Segments

Under FASB ASC Topic 280, “Segment Reporting” (“ASC Topic 280”), management of the Company has identified two reportable operating segments, “Community Banking” and “Tax Liens”.  Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision makers in deciding how to allocate and assess resources and performance.  Our chief operating decision makers are the Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”).  

	For the three months ended September 30, 2016
	Community
(In thousands)	Banking		Tax Liens		Consolidated
Total assets	$	798,996	$	12,372	$	811,368
Total deposits	$	592,239	$	—	$	592,239
Interest income	$	8,417	$	43	$	8,460
Interest expense		1,752		150		1,902
Net interest income (expense)	$	6,665	$	(107)	$	6,558
Provision for loan and lease losses		549		29		578
Total non-interest income		1,177		12		1,189
Total non-interest expense		4,842		159		5,001
Income tax expense		25		—		25
Net income (loss)	$	2,426	$	(283)	$	2,143
Noncontrolling interest	$	125	$	(12)	$	113
Net income (loss) attributable to Royal Bancshares	$	2,301	$	(271)	$	2,030

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	For the three months ended September 30, 2015
	Community
(In thousands)	Banking		Tax Liens		Consolidated
Total assets	$	745,853	$	16,058	$	761,911
Total deposits	$	553,764	$	—	$	553,764
Interest income	$	7,625	$	173	$	7,798
Interest expense		1,447		189		1,636
Net interest income (expense)	$	6,178	$	(16)	$	6,162
(Credit) provision for loan and lease losses		(254)		38		(216)
Total non-interest income		503		74		577
Total non-interest expense		4,897		345		5,242
Income tax expense		—		—		—
Net income (loss)	$	2,038	$	(325)	$	1,713
Noncontrolling interest	$	179	$	—	$	179
Net income (loss) attributable to Royal Bancshares	$	1,859	$	(325)	$	1,534

	For the nine months ended September 30, 2016
	Community
(In thousands)	Banking		Tax Liens		Consolidated
Total assets	$	798,996	$	12,372	$	811,368
Total deposits	$	592,239	$	—	$	592,239
Interest income	$	24,663	$	192	$	24,855
Interest expense		4,932		457		5,389
Net interest income (expense)	$	19,731	$	(265)	$	19,466
Provision for loan and lease losses		924		63		987
Total non-interest income		3,422		47		3,469
Total non-interest expense		14,455		813		15,268
Income tax benefit		85		—		85
Net income (loss)	$	7,688	$	(1,093)	$	6,595
Noncontrolling interest	$	394	$	(52)	$	342
Net income (loss) attributable to Royal Bancshares	$	7,294	$	(1,041)	$	6,253

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	For the nine months ended September 30, 2015
	Community
(In thousands)	Banking		Tax Liens		Consolidated
Total assets	$	745,853	$	16,058	$	761,911
Total deposits	$	553,764	$	—	$	553,764
Interest income	$	21,642	$	507	$	22,149
Interest expense		4,169		629		4,798
Net interest income	$	17,473	$	(122)	$	17,351
(Credit) provision for loan and lease losses		(1,451)		69		(1,382)
Total non-interest income		1,863		198		2,061
Total non-interest expense		14,819		889		15,708
Income tax expense		—		—		—
Net income (loss)	$	5,968	$	(882)	$	5,086
Noncontrolling interest	$	551	$	(51)	$	500
Net income (loss) attributable to Royal Bancshares	$	5,417	$	(831)	$	4,586

Community Bank Segment

Royal Bank America

Royal Bank commenced operation as a Pennsylvania state-chartered bank in 1963. Royal Bank is the successor of the Bank of King of Prussia, the principal ownership of which was acquired by the Tabas family in 1980. The deposits of Royal Bank are insured by the FDIC to the highest amount permitted by law.  Royal Real Estate of Pennsylvania, Inc., RBA Property LLC, Narberth Property Acquisition LLC, and Rio Marina LLC are wholly owned subsidiaries of Royal Bank.  Royal Bank also has an 80% and 60% ownership interest in Crusader Servicing Corporation (“CSC”) and Royal Bank America Leasing, LP, respectively.  CSC and Royal Bank’s wholly owned subsidiary Royal Tax Lien Services, LLC, were formed to purchase and service delinquent tax liens. 

Royal Bank derives its income principally from interest charged on loans and leases, interest earned on investment securities, and fees received in connection with the origination of loans and other services.  Royal Bank’s principal expenses are interest expense on deposits and borrowings and operating expenses.  Operating revenues, deposit growth, principal payments on and maturities and sales of investment securities, loan and OREO sales and the repayment of outstanding loans provide the majority of funds for activities.

Royal Bank conducts business operations as a commercial bank offering traditional consumer and business deposit products and services (excluding trust) and commercial and consumer loans, including home equity and small business loans. Fee income services such as a suite of cash management products, remote deposit capture, mobile deposits, and payroll and merchant services have been greatly improved or expanded. Services may be added or deleted from time to time. Royal Bank’s business and services are not subject to significant seasonal fluctuations.

Service Area: Royal Bank’s primary service area includes Pennsylvania, primarily Montgomery, Chester, Bucks, Delaware, Berks and Philadelphia counties, and central and southern New Jersey. This area includes residential areas and industrial and commercial businesses of the type usually found within a major metropolitan area. Royal Bank serves this area from two loan production offices and thirteen retail branches located throughout Montgomery, Philadelphia, Delaware and Berks counties and Camden County, New Jersey. Royal Bank also considers New York, Maryland, and Delaware as a part of its service area for certain products and services. Royal Bank has loans in 17 states and Washington, DC via loan originations with service area borrowers and/or participations with other lenders who have broad experience in those respective markets. Royal Bank’s headquarters are located at 732 Montgomery Avenue, Narberth, Pennsylvania 19072.

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Competition:  The financial services industry in our service area is extremely competitive. Competitors within our service area include banks and bank holding companies with greater resources. Many competitors have substantially higher legal lending limits. In addition, savings banks, savings and loan associations, credit unions, money market and other mutual funds, brokerage firms, mortgage companies, leasing companies, finance companies and other financial services companies offer products and services similar to those offered by Royal Bank, on competitive terms.

Employees: Royal Bank employed approximately 117 people on a full-time equivalent basis as of September 30, 2016.

Deposits: At September 30, 2016, total deposits of Royal Bank were distributed among demand deposits (16%), money market, savings and NOW accounts (47%) and time deposits (37%). At September 30, 2016, deposits of $597.3 million increased $8.4 million from $588.9 million at year end 2015. Included in Royal Bank’s deposits are approximately $5.0 million of intercompany deposits that are eliminated through consolidation.

Lending: At September 30, 2016, Royal Bank, including its subsidiaries, had a total net loan and lease portfolio of $565.6 million, representing 70% of total assets. The loan portfolio is categorized into commercial and industrial, commercial real estate mortgages, residential mortgages (including home equity lines of credit), construction and development, tax certificates, leases and consumer loans.  At September 30, 2016, net loans and leases increased $76.2 million, or 15.6%, from year end 2015 due to new loan originations, loan participation purchases, and loan purchases, which were partially offset by pay downs, payoffs, charge-offs, an increase in the allowance for loan and lease losses, and transfers to OREO.

Business results: Total assets of Royal Bank were $807.0 million at September 30, 2016 compared to $783.9 million at year end 2015.  Royal Bank recorded net income of $2.1 million and $6.0 million for the three and nine months ended September 30, 2016, respectively, compared to $1.6 million and $4.6 million for the three months and nine months ended September 30, 2015. Royal Bank’s total interest income for the quarter and nine months ended September 30, 2016 was $8.5 million and $24.8 million compared to $7.8 million and $22.1 million for the quarter and nine months ended September 30, 2015. The increase in interest income was primarily attributed to an increase in average interest-earning assets and a change in its composition. For the three and nine months ended September 30, 2016, the average balance for investments declined $29.5 million and $26.5 million while average loans outstanding, which typically earn a higher yield than investment securities, increased $102.4 million and $100.5 million, respectively. Interest expense was $1.9 million and $5.4 million for the quarter and nine months ended September 30, 2016 compared to $1.6 million and $4.8 million for the quarter and nine months ended September 30,  2015.  

The $492 thousand improvement in net income quarter versus quarter was mainly attributable to a $410 thousand increase in net interest income, $273 thousand in BOLI death benefit income, the reversal of a $200 thousand contingency accrual, a $157 thousand increase in the net gains on the sale of investment securities, and a $117 thousand decrease in loan collection expenses.  Partially mitigating these items was a $794 thousand increase in the provision for loan and lease losses.  For the third quarter of 2016, Royal Bank recorded a provision for loan and lease losses of $578 thousand compared to a credit to the allowance for loan and lease losses of $216 thousand in the third quarter of 2015. The provision was the result of growth in the loan and lease portfolio, net charge-offs, and specific reserves.

The $1.4 million improvement in net income year over year was mainly attributable to a $2.1 million increase in net interest income. The 2016 period also benefited from a $518 thousand decline in the provision for unfunded loan commitments due to a decline in the historical loss rates applied in the calculation of the reserve for such commitments. For the nine months ended September 30, 2016, we recorded a credit for unfunded loan commitments of $236 thousand compared to a provision of $282 thousand in the same period of 2015.Additionally, income on Company owned life insurance policies increased $475 thousand in the 2016 period and we received $273 thousand in a BOLI death benefit payment.    Additionally, net gains on the sale of investment securities increased $252 thousand year over year and we reversed a $200 thousand contingency accrual related to a former OREO property. Partially offsetting the year over year improvements was a $2.4 million increase in the provision for loan and lease losses and a planned increase in salaries and benefits of $211 thousand. For the first three quarters of 2016, Royal Bank recorded a provision for loan and lease losses of $987 thousand compared to a credit to the allowance for loan and lease losses of $1.4 million for the first three quarters of 2015. The provision was the result of growth in the loan and lease portfolio, net charge-offs, and specific reserves. The above amounts reflect the consolidated totals for Royal Bank and its subsidiaries.  The subsidiaries included in these

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amounts are Royal Investments America, Royal Real Estate, Royal Bank America Leasing, Royal Tax Lien Services, Crusader Servicing Corporation, RBA Property LLC, Narberth Property Acquisitions, and Rio Marina LLC.

Royal Investments of Delaware

On June 30, 1995, the Company established a special purpose Delaware investment company, Royal Investments of Delaware (“RID”), as a wholly owned subsidiary. Legal headquarters are at 1105 N. Market Street, Suite 1300, Wilmington, Delaware. RID buys, holds and sells investment securities.

Business results: For the three and nine months ended September 30, 2016, RID reported net income of $179 thousand and $974 thousand, respectively compared to net income of $160 thousand and $690 thousand for the three and nine months ended September 30, 2015. The $284 thousand increase year over year was related to a $479 thousand increase in gains on the sale of investment securities.  Partially offsetting this increase was an OTTI charge of $157 thousand related to one private equity investment.  The OTTI charge was due to recent activity and recently issued financial statements, which showed a deterioration in the values of the underlying assets.  At September 30, 2016 total assets of RID were $22.6 million, of which $4.8 million was held both in cash and cash equivalents and in investment securities. Total assets were $26.2 million at December 31, 2015.  The amounts shown above include the activity related to RID’s wholly owned subsidiary Royal Preferred LLC.  Royal Bank previously extended loans to RID, secured by securities and as per the provisions of Regulation W.  At September 30, 2016 no loans were outstanding.

Royal Preferred LLC

On June 16, 2006, the Company, through its wholly owned subsidiary RID, established Royal Preferred LLC as a wholly owned subsidiary. Royal Preferred LLC was formed to purchase a subordinated debenture from Royal Bank America.  At September 30, 2016 and December 31, 2015, Royal Preferred LLC had total assets of $17.1 million and $21.2 million, respectively. 

Royal Bancshares Capital Trust I and II

On October 27, 2004, the Company formed two Delaware trust affiliates, Royal Bancshares Capital Trust I and Royal Bancshares Capital Trust II, in connection with the sale of an aggregate of $25.0 million of a private placement of trust preferred securities. The interest rates for the debt securities associated with the Trusts at September 30, 2016 were 3.00%.

Under the MOU as described in “Note 2 – Regulatory Matters and Significant Risks or Uncertainties” to the Consolidated Financial Statements, the Company and its non-bank subsidiaries may not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior written approval of the Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve System.  We received approval and paid the required interest payments in the first three quarters of 2016.

Royal Bank America Leasing, LP

On July 25, 2005, the Company, through its wholly owned subsidiary Royal Bank, formed Royal Bank America Leasing, LP (“Royal Leasing”). Royal Bank holds a 60% ownership interest in Royal Leasing. Legal headquarters are at 550 Township Line Road, Blue Bell, Pennsylvania. Royal Leasing was formed to originate small business financing leases. Royal Leasing originates the leases through its internal sales staff and through independent brokers located throughout its business area. In general, Royal Leasing will portfolio individual leases in amounts up to $250 thousand. Leases originated in amounts in excess of $250 thousand are held in the portfolio, sold or brokered to other leasing companies.

Business results: At September 30, 2016,  total assets of Royal Leasing were $62.6 million and include  $60.5 million in net leases.  Total assets were $65.1 million at December 31, 2015.  For the three and nine months ended September 30, 2016, Royal Leasing had net income prior to partner distributions of $545 thousand and $1.5 million, respectively, compared to $725 thousand and $2.2 million, respectively, for the three and nine months ended September 30, 2015. The quarter over quarter decline of $179 thousand was effected by an increase to the provision for lease losses of $113 thousand. The year over year decline of $760 thousand was impacted by an increase to the provision for lease losses of

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$708 thousand. The increase in the provision for lease losses for the three and nine months ended September 30, 2016 was related to growth within the portfolio and net-charge-off activity and specific reserves on non-performing leases.  Royal Bank has extended loans to RBA Leasing at market interest rates, secured by the lease portfolio of RBA Leasing and as per the provisions of Regulation W. At September 30, 2016, the amount due Royal Bank from RBA Leasing was $57.1 million.

Royal Investments America

On June 23, 2003, the Company, through its wholly owned subsidiary Royal Bank, established Royal Investments America, LLC (“RIA”) as a wholly owned subsidiary. Legal headquarters are at 732 Montgomery Avenue, Narberth, Pennsylvania. RIA was formed to invest in equity real estate ventures subject to limitations imposed by the FDIC and Pennsylvania Department of Banking by regulation.

Business results: At September 30, 2016 and December 31, 2015, total assets of RIA were $6.5 million and $6.1 million, respectively.  For the quarter and nine months ended September 30, 2016, RIA had a net loss of $1  thousand and net income of $431 thousand, respectively, compared to $5  thousand and $115 thousand for the quarter and nine months ended September 30, 2015, respectively.  The increase in net income for 2016 was predominantly related to gains on the sale of investment securities of $3 thousand and $400 thousand for the three and nine months ended September 30, 2016.  During 2016, Royal Bank recorded an OTTI charge of $24 thousand on a private equity investment.  The OTTI charge was due to recent activity and recently issued financial statements, which showed a deterioration in the values of the underlying assets.  There was no OTTI charge during the first three quarters of 2015.  Royal Bank had previously extended loans to RIA at market interest rates, secured by the loan portfolio of RIA and as per the provisions of Regulation W. At September 30, 2016, there were no outstanding loans from Royal Bank to RIA.

Tax Lien Segment

Crusader Servicing Corporation

The Company, through its wholly owned subsidiary Royal Bank, holds an 80% ownership interest in Crusader Servicing Corporation (“CSC”). Its legal headquarters are at 732 Montgomery Avenue, Narberth, Pennsylvania.  CSC acquired, through auction, delinquent property tax liens in various jurisdictions, assuming a lien position that is generally superior to any mortgage liens on the property, and obtaining certain foreclosure rights as defined by local statute. CSC is currently being liquidated under an orderly, long term plan adopted by CSC management. 

Business results:  CSC recorded net losses of $58 thousand and $262 thousand for the three and nine months ended September 30, 2016 compared to $2 thousand and $256 thousand for the same periods in 2015, respectively.   Net OREO expenses increased  $61 thousand and $16 thousand during the three and nine months ended September 30, 2016 and impacted the increase in the net loss for 2016. At September 30, 2016, total assets of CSC were $4.6 million, of which $1.2 million was held in tax liens and $3.4 million was in OREO, while at December 31, 2015 total assets were $4.7 million, of which $1.2 million was held in tax liens and $3.2 million was held in OREO. Royal Bank has extended loans to CSC at market interest rates, secured by the tax lien portfolio of CSC and as per the provisions of Regulation W.  At September 30, 2016, the amount due Royal Bank from CSC was $5.4 million.

Royal Tax Lien Services, LLC

The Company, through its wholly owned subsidiary Royal Bank, wholly owns Royal Tax Lien Services, LLC (“RTL”). Its legal headquarters is located at 732 Montgomery Avenue, Narberth, Pennsylvania 19072.  RTL was formed to purchase and service delinquent tax certificates.  RTL typically acquired delinquent property tax liens through public auctions in various jurisdictions, assuming a lien position that is generally superior to any mortgage liens that are on the property, and obtaining certain foreclosure rights as defined by local statute.  RTL ceased acquiring tax certificates at public auctions in 2010.

Business results:   RTL recorded net losses of $225 thousand and $830 thousand for the three and nine months ended September 30, 2016 compared to $323 thousand and $626 thousand for the comparable periods in 2015.The quarter over quarter decrease in net loss of $99 thousand was impacted by the reversal of a $200 thousand contingency accrual for a previously owned OREO property.  Management determined that the contingency was no longer required. Partially

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mitigating this improvement were an $89 thousand decline in net interest income and a $34 thousand increase in net OREO expenses.  The year over year increase in net loss of $203 thousand was effected by a $205 thousand increase in net OREO expenses and a $205 thousand decline in net interest income. Net OREO expenses was negatively impacted by a $606 thousand decrease in net gains on the sales of OREO and was partially offset by a $309 thousand decline in OREO impairment.  RTL had net interest expense of $96 thousand for the nine months ended September 30, 2016 compared to net interest income of $108 thousand for the same period in 2015.  The net interest income reduction is related to the decline in average lien balances. Partially mitigating the increase in net loss year over year was the reversal of the $200 thousand contingency accrual cited previously. At September 30, 2016, total assets of RTL were $7.8 million, of which $2.6 million was held in tax liens and $3.6 million was held in OREO as compared to total assets at December 31, 2015 of $9.4 million, of which $3.2 million was held in tax liens and $4.0 million was held in OREO. 

Royal Bank has extended loans to RTL at market interest rates, secured by the tax lien portfolio of RTL and as per the provisions of Regulation W.  At September 30, 2016, the amount due Royal Bank from RTL was $3.2 million.

FINANCIAL CONDITION

Consolidated Assets

Total consolidated assets at September 30, 2016 were $811.4 million, an increase of $23.1 million, or 2.9%, from December 31, 2015.  This growth was mainly attributed to a $76.2 million increase in loans and leases that was partially offset by a reduction of $55.7 million in investment securities.  Cash flows from investment securities sales, calls, and payments were reinvested in loans and leases.  

Cash and Cash Equivalents

Total cash and cash equivalents of $28.4 million at September 30, 2016 increased $3.0 million from $25.4 million at December 31, 2015 due to deposit growth.  It is anticipated that a portion of the cash will continue to be utilized to fund new loan originations.

Investment Securities

AFS investment securities of $168.3 million at September 30, 2016, dropped $55.7 million, or 24.9%, from the level at December 31, 2015.  The decline was primarily due to the sales and calls of investment securities.  The majority of the incoming cash flows from the investment portfolio were used to fund loan growth.  FHLB stock was $3.0 million and $2.5 million at September 30, 2016 and December 31, 2015. 

The AFS investment portfolio had a net unrealized gain of $2.5 million at September 30, 2016 compared to a net unrealized loss of $41 thousand at December 31, 2015.  The improvement in the net unrealized gain was directly related to a $1.9 million increase in the net unrealized gain on U.S. Agency CMOs and a $566 thousand improvement in the net unrealized loss on U.S. government agency bonds. U.S. Agency CMOs carry lower coupons and their market value was positively impacted by the 67 basis point decrease in the 10-year Treasury yield from 2.27% at December 31, 2015 to 1.60% at September 30, 2016.  The unrealized loss on U.S. government agency bonds was $564 thousand at December 31, 2015 compared to a net unrealized gain of $2 thousand at September 30, 2016.  During 2016, $22.7 million in U.S. government agency bonds were called at par which eliminated the net unrealized loss on those bonds. In 2016, we recorded OTTI impairment of $181 thousand on two private equity funds based on recently issued financial statements, which showed deterioration in the values of the underlying assets.  We did not record OTTI charges for any of the investment securities during the first three quarters 2015.   

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The carrying value and fair value of investment securities available-for-sale (“AFS”) at September 30, 2016 and December 31, 2015 are as follows:

As of September 30, 2016
			Gross		Gross
	Amortized		unrealized		unrealized
(In thousands)	cost		gains		losses		Fair value
U.S. government agencies	$	3,498	$	2	$	—	$	3,500
Mortgage-backed securities-residential		7,373		342		—		7,715
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		138,137		2,372		(469)		140,040
Non-agency		4,514		52		—		4,566
Corporate bonds		1,700		74		—		1,774
Municipal bonds		8,706		216		(55)		8,867
Other securities		1,833		—		—		1,833
Common stocks		26		—		—		26
Total available for sale	$	165,787	$	3,058	$	(524)	$	168,321

As of December 31, 2015
			Gross		Gross
	Amortized		unrealized		unrealized
(In thousands)	cost		gains		losses		Fair value
U.S. government agencies	$	26,127	$	—	$	(564)	$	25,563
Mortgage-backed securities-residential		11,002		106		(50)		11,058
Collateralized mortgage obligations:
Issued or guaranteed by U.S. government agencies		170,764		1,524		(1,554)		170,734
Non-agency		2,729		1		(26)		2,704
Corporate bonds		1,500		56		—		1,556
Municipal bonds		9,910		73		(52)		9,931
Other securities		2,050		445		—		2,495
Common stocks		26		—		—		26
Total available for sale	$	224,108	$	2,205	$	(2,246)	$	224,067

Investment securities within the AFS portfolio are marked to market monthly and any resulting gains or losses are recorded in other comprehensive income, net of taxes, within the equity section of the balance sheet as shown in “Note 15 - Comprehensive Income (Loss)” to the Consolidated Financial Statements. When a loss is deemed to be other-than-temporary but we do not intend to sell the security and it is not more likely than not that we will have to sell the security before recovery of its cost basis, we will recognize the credit component of an OTTI charge in earnings and the remaining portion in other comprehensive income.

Loans and Leases

We originate loans primarily in the greater Philadelphia metropolitan area as well as selected locations throughout the Mid-Atlantic region. We have a concentration of credit risk in commercial real estate and construction and land development loans at September 30, 2016.  The loans receivable portfolio is segmented into commercial loans, construction and development loans, residential loans, leases, tax certificates, and consumer loans. The commercial loan segment consists of the following classes: commercial real estate loans, multi-family real estate loans, and other commercial loans, which are also generally known as commercial and industrial loans or commercial business loans. The construction and development loan segment consists of the following classes: residential construction and commercial construction loans. Residential construction loans are made for the acquisition of and/or construction on a lot or lots on which a residential dwelling is to be built. Commercial construction loans are made for the purpose of acquiring, developing and/or constructing a commercial structure. The residential loan segment consists of the following classes: one- to four-family first lien residential mortgage loans, home equity lines of credit, and home equity loans. We classify our leases as finance leases, in accordance with FASB ASC Topic 840, “Leases”. The difference between our gross investment in the lease and

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the cost or carrying amount of the leased property, if different, is recorded as unearned income, which is amortized to income over the lease term by the interest method. The tax certificate segment includes delinquent property tax certificates that have been acquired through public auctions in various jurisdictions. The tax certificates assume a lien position that is generally superior to any mortgage liens that are on the property and have certain foreclosure rights as defined by state law. The tax certificates are predominantly in New Jersey. We ceased acquiring new tax certificates in 2010. Consumer loans includes cash secured and unsecured loans and lines of credit.

Commercial Loans: The commercial real estate loan portfolio consists primarily of loans secured by office buildings, retail and industrial use buildings, strip shopping centers, mixed-use and other properties used for commercial purposes primarily located in our market area. Although terms for commercial real estate and multi-family loans vary, the underwriting standards generally allow for terms up to 10 years with the interest rate being reset in the sixth year and with monthly amortization not greater than 25 years and loan-to-value (“LTV”) ratios of not more than 80%. Interest rates are either fixed or adjustable and are based upon the prime rate or a borrowing rate from the Federal Home Loan Bank of Pittsburgh plus a margin. Prepayment fees are charged on most loans in the event of early repayment. Generally, the personal guarantees of the principals are obtained as additional collateral for commercial real estate and multi-family real estate loans.

Commercial and multi-family real estate loans generally present a higher level of risk than loans secured by one- to four-family residences. This greater risk is due to several factors, including the concentration of principal in a limited number of loans and borrowers, the effect of general economic conditions on income producing properties and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by commercial and multi-family real estate is typically dependent upon the successful operation of the related real estate project. If the cash flow from the project is reduced (for example, if leases are not obtained or renewed, a bankruptcy court modifies a lease term, or a major tenant is unable to fulfill its lease obligations), the borrower’s ability to repay the loan may be impaired.

Our commercial business loans generally have been made to small and mid-sized businesses predominantly located in our market area. The commercial business loans are either a revolving line of credit or for a fixed term of generally 10 years or less. Interest rates are adjustable, indexed to a published prime rate of interest, or fixed. Generally, equipment, machinery, real property or other corporate assets secure such loans. Personal guarantees from the business principals are generally obtained as additional collateral. Generally, commercial business loans are characterized as having higher risks associated with them than single-family residential loans.

Our underwriting procedures include evaluations of the stability of the property’s cash flow history, future operating projections, current and projected occupancy levels, location and physical condition. Generally, we require a debt service ratio (the ratio of net cash flows from operations before the payment of debt service to debt service) of not less than 120%. We also evaluate the credit and financial condition of the borrower, and if applicable, the guarantor. Appraisal reports prepared by independent appraisers are obtained on each loan to substantiate the property’s market value, and are reviewed prior to the closing of the loan.

Construction and Development Loans: We originate construction loans to builders and developers predominantly in our market area. Construction and development loans are riskier than other loan types because they are more speculative in nature. Deteriorating economic or environmental conditions can negatively affect a project. Construction loans are also more difficult to evaluate and monitor. In order to mitigate some of the risks inherent in construction lending, limits are placed on the number of units that can be built on a speculative basis based upon the reputation and financial position of the builder, his/her present obligations, the location of the property and prior sales in the development and the surrounding area. Additionally, the construction budget is reviewed prior to loan origination and the properties under construction are inspected. During the construction phase of a real estate project, the loan requires interest payments only. Construction loans generally are for 12 to 18 months with LTV ratios of not more than 75%.

Residential Loans: Our residential mortgages were acquired in recent years in pool purchases and are secured mainly by properties located in our primary market and surrounding areas. We originate home equity loans and home equity lines of credit in our market area with a maximum amount of $1.25 million. The collateral must be the borrower’s primary residence and the LTV ratio may not be more than 80%. Home equity lines of credit are variable rate and are indexed to

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the prime rate. Our home equity loans have a fixed rate and are either first or second liens.  We have originated some home equity lines of credit or home equity loans for second homes.  In financing second homes, we must have a first lien position, the LTV does not exceed 65%, and the maximum amount is $750 thousand. 

Consumer Loans: We originate cash-secured and unsecured loans and lines of credit to individuals. Unsecured loans and lines of credit have a maximum amount of $15 thousand. Unsecured consumer loans generally have a higher interest rate than residential loans because they have additional credit risk associated with them.

Total loans and leases of $575.8 million increased $76.7 million, or 15.4%, from the level at December 31, 2015.  The following table represents loan balances by type:

	September 30,		December 31,
(In thousands)	2016		2015
Commercial real estate	$	253,074	$	225,679
Construction and land development		74,885		47,984
Commercial and industrial		106,254		85,980
Multi-family		23,831		16,249
Residential real estate		49,061		51,588
Leases		62,671		64,341
Tax certificates		3,803		4,755
Consumer		2,239		2,527
Total loans, net of unearned income	$	575,818	$	499,103

Credit Classification Process and Credit Risk Management

We use a nine point grading risk classification system commonly used in the financial services industry. The first four classifications are rated Pass. The riskier classifications include Pass-Watch, Special Mention, Substandard, Doubtful and Loss. During the underwriting process, the Underwriting and Credit Administration Officer (“UCAO”) assigns each loan with an initial risk rating, which is approved by the appropriate loan committee. From time to time, and at the general direction of any of the various loan committees, the ratings may be changed based on the findings of that committee. Items considered in assigning ratings include the financial strength of the borrower and/or guarantors, the type of collateral, the collateral lien position, the type of loan and loan structure, any potential risk inherent in the specific loan type, higher than normal monitoring of the loan or any other factor deemed appropriate by any of the various committees for changing the rating of the loan. Any such change in rating is reflected in the minutes of that committee.

The loan review function is outsourced to a third party vendor which examines credit quality and portfolio management. The loan review vendor applies our loan rating system to specific credits and reviews approximately 50% of the total commercial loan portfolio. Emphasis is on the larger new and seasoned loan relationships and includes criticized and classified loans. Additionally, the loan review vendor ensures that all critical industry segments are adequately represented in their review. The loan review vendor will also review loans specifically requested by management. Upon completion of a loan review, a copy of any review receiving an adverse classification by the reviewer is presented to the Classified, Charge-off and Impairment Committee (“CCIC”) for discussion. The UCAO is the primary bank officer dealing with the third party vendor during the reviews.

Loans on the Company’s Special Assets Committee list are also subject to loan review even though they are receiving the daily attention of an assigned individual and the attention of the Special Assets Committee.  A watch list is maintained and reviewed at each meeting of CCIC. CCIC was formed to formalize the process and documentation required to classify, remove from classification, impair or charge-off a loan. The CCIC, which is comprised of the CEO, CFO, UCAO, Chief Lending Officer (“CLO”), and Chief Accounting Officer (“CAO”) meet as required and provide regular updated reports to the Board of Directors. Loans are added to the watch list, even though the loans may be current or less than 30 days

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delinquent if they exhibit elements of substandard creditworthiness. The watch list contains a statement for each loan as to why it merits special attention, and this list is distributed to the Board of Directors on a quarterly basis. Loans may be removed from the watch list if the CCIC determines that exception items have been resolved or creditworthiness has improved. Additionally, if loans become serious collection matters and are listed on the Company’s monthly delinquent loan or Special Assets Committee lists, they may be removed from the watch list.  Minutes outlining the CCIC’s findings and recommendations are issued after each meeting for follow-up by individual loan officers.

Non-accrual Loans

The composition of non-accrual loans is as follows:

	As of September 30, 2016				As of December 31, 2015
	Loan		Specific		Loan		Specific
(In thousands)	balance		reserves		balance		reserves
Non-accrual loans
Commercial real estate	$	832	$	—	$	1,495	$	77
Construction and land development		144		—		145		—
Commercial and industrial		674		—		751		100
Residential real estate		584		18		889		27
Leases		1,476		168		1,087		194
Tax certificates		745		—		1,125		—
Total non-accrual loans	$	4,455	$	186	$	5,492	$	398

Non-accrual loan activity for the first three quarters of 2016 is set forth below:

	For the nine months ended September 30, 2016
					Payments
	Beginning				and other				Transfers to		Ending
(In thousands)	balance		Additions		decreases		Charge-offs		OREO		balance
Commercial real estate	$	1,495	$	—	$	(579)	$	(84)	$	—	$	832
Construction and land development		145		—		(1)		—		—		144
Commercial and industrial		751		189		(158)		(108)		—		674
Residential real estate		889		32		(269)		(40)		(28)		584
Leases		1,087		2,126		(980)		(757)		—		1,476
Tax certificates		1,125		831		(279)		(139)		(793)		745
Total non-accrual loans	$	5,492	$	3,178	$	(2,266)	$	(1,128)	$	(821)	$	4,455

Total non-accrual loans at September 30, 2016 were $4.5 million compared to $5.5 million at December 31, 2015.  The decline of $1.0 million was the result of a $2.3 million reduction in existing non-accrual loan balances through payments, payoffs or a return to accruing status, $1.1 million in charge-offs mostly related to specific reserves, and $821 thousand in transfers to OREO, which were partially offset by additions to non-accrual loans of $3.2 million. During the first quarter of 2016, one performing troubled debt restructuring (“TDR”) in the amount of $181 thousand became non-accrual because it was past due its maturity date.  The remainder of the additions to non-accrual loans were mainly in leases and the tax certificate portfolio. The tax certificate portfolio accounted for approximately 97% of the transfers to OREO. 

Typically, loans are restored to accrual status when the loan is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectability of the total contractual principal and interest is no longer in doubt.

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Impaired Loans

We identify a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. Impaired loans include TDRs. For all classes of loans receivable, with the exception of tax certificates, the accrual of interest income is discontinued on a loan when management believes that the borrower’s financial condition is such that collection of principal and interest is doubtful or when a loan becomes 90 days past due. Excess proceeds received over the principal amounts due on impaired non-accrual loans are recognized as income on a cash basis.  We recognize income under the accrual basis when the principal payments on the loans become current and the collateral on the loan is sufficient to cover the outstanding obligation to the Company. If these factors do not exist, we do not recognize interest income. If interest had accrued on non-accrual loans, such income would have been approximately $135 thousand and $450 thousand for the three and nine months ended September 30, 2016 and $142 thousand and $539 thousand for the three and nine months ended September 30, 2015, respectively.  At September 30, 2016, we did not have any loans past due 90 days or more on which interest continues to accrue.

The following is a summary of information pertaining to impaired loans and leases:

	September 30,		December 31,
(In thousands)	2016		2015
Impaired loans and leases with a valuation allowance	$	1,390	$	2,414
Impaired loans without a valuation allowance		3,945		4,777
Total impaired loans and leases	$	5,335	$	7,191
Valuation allowance related to impaired loans	$	186	$	398

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	For the nine months ended
	September 30,
(In thousands)	2016		2015
Average investment in impaired loans and leases	$	6,332	$	13,077
Interest income recognized on impaired loans and leases	$	85	$	471
Interest income recognized on a cash basis on impaired loans and leases	$	—	$	232

Troubled Debt Restructurings

A loan modification is deemed a TDR when two conditions are met: 1) the borrower is experiencing financial difficulty and 2) concessions are made by the Company that would not otherwise be considered for a borrower or collateral with similar credit risk characteristics.  All loans classified as TDRs are considered to be impaired.  TDRs are returned to an accrual status when the loan is brought current, has performed in accordance with the contractual restructured terms for a reasonable period of time (generally six months) and the ultimate collectability of the total contractual restructured principal and interest is no longer in doubt.  At September 30, 2016, we had five TDRs, with a total carrying value of $2.1 million. At December 31, 2015, we had six TDRs with a total carrying value of $2.6 million.  The reduction in TDRs was related to payments received and the negotiated settlement of one TDR which had a carrying value of $68 thousand at December 31, 2015.  As a result of the settlement, we received $60 thousand in principal and recorded a charge-off of $8 thousand.  Our policy for TDRs is to recognize income on currently performing restructured loans under the accrual method.    

	As of September 30, 2016
				Non-
	Number of	Accrual		Accrual
(In thousands)	loans	Status		Status		Total TDRs
Commercial real estate	1	$	20	$	—	$	20
Construction and land development	1		—		144		144
Commercial and industrial	2		1,688		177		1,865
Residential real estate	1		85		—		85
Total	5	$	1,793	$	321	$	2,114

Allowance for Loan and Lease Losses

Our loan and lease portfolio (the “credit portfolio”) is subject to varying degrees of credit risk. We maintain an allowance to absorb losses in the loan and lease portfolio.  The allowance is based on the review and evaluation of the loan and lease portfolio, along with ongoing, quarterly assessments of the probable losses inherent in that portfolio. The allowance represents an estimation made pursuant to FASB ASC Topic 450, “Contingencies” (“ASC Topic 450”) or FASB ASC Topic 310, “Receivables” (“ASC Topic 310”).  The adequacy of the allowance is determined through evaluation of the credit portfolio, and involves consideration of a number of factors, as outlined below, to establish a prudent level.

Determination of the allowance is inherently subjective and requires significant estimates, including estimated losses on pools of homogeneous loans and leases based on historical loss experience and consideration of current economic trends, which may be susceptible to significant change. Loans and leases deemed uncollectible are charged against the allowance, while recoveries are credited to the allowance. Management adjusts the level of the allowance through the provision for loan and lease losses, which is recorded as a current period expense. Our systematic methodology for assessing the appropriateness of the allowance includes: (1) general reserves reflecting historical loss rates by loan type, (2) specific reserves for risk-rated credits based on probable losses on an individual or portfolio basis and (3) qualitative reserves based upon current economic conditions and other risk factors.

The loan portfolio is stratified into loan classifications that have similar risk characteristics. The general allowance is based upon historical loss rates using a weighted three-year rolling average of the historical loss experienced within each loan classification. The qualitative factors used to adjust the historical loss experience address various risk characteristics of

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our loan and lease portfolio include evaluating: (1) trends in delinquencies and other non-performing loans, (2) changes in the risk profile related to large loans in the portfolio, (3) changes in the growth trends of categories of loans comprising the loan and lease portfolio, (4) concentrations of loans and leases to specific industry segments, and (5) changes in economic conditions on both a local and national level, (6) quality of loan review and board oversight, (7) changes in lending policies and procedures, and (8) changes in lending staff.  Each factor is assigned a value to reflect improving, stable or declining conditions based on management’s best judgment using relevant information available at the time of the evaluation. Adjustments to the factors are supported through documentation of changes in conditions in a report accompanying the allowance calculation. 

The specific reserves are determined utilizing standards required under ASC Topic 310. A loan is considered impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. Non-accrual loans and loans restructured under a troubled debt restructuring are evaluated for impairment on an individual basis considering all known relevant factors that may affect loan collectability such as the borrower’s overall financial condition, resources and payment record, support available from financial guarantors and the sufficiency of current collateral values (current appraisals or rent rolls for income producing properties), and risks inherent in different kinds of lending (such as source of repayment, quality of borrower and concentration of credit quality). Non-accrual loans that experience insignificant payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed.

Impairment is measured on a loan by loan basis for commercial and industrial loans, commercial real estate loans and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent.  The estimated fair values of substantially all of our impaired loans are measured based on the estimated fair value of the loan’s collateral. We obtain third-party appraisals on the fair value of real estate collateral.  Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property. For commercial and industrial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable aging or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Once a loan is determined to be impaired it will be deducted from the portfolio and the net remaining balance will be used in the general and qualitative analysis.  A specific reserve is established for an impaired loan if its carrying value exceeds its estimated fair value.

The amount of the allowance is reviewed and approved by the CFO, CLO, and Chief Risk Officer (“CRO”) on at least a quarterly basis. Management believes that the allowance at September 30, 2016 is adequate. However, its determination requires significant judgment, and estimates of probable losses inherent in the credit portfolio can vary significantly from the amounts actually observed. While management uses available information to recognize probable losses, future changes to the allowance may be necessary based on changes in the credits comprising the portfolio and changes in the financial condition of borrowers, such as may result from changes in economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the credit portfolio and the allowance. Such review may result in additional provisions based on their judgment of information available at the time of each examination. 

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Changes in the allowance were as follows:

	For the three months ended				For the nine months ended
	September 30,				September 30,
(In thousands)	2016		2015		2016		2015
Balance at period beginning	$	10,008	$	10,036	$	9,689	$	11,708
Charge-offs
Commercial real estate		(7)		—		(84)		(231)
Construction and land development		—		(39)		—		(119)
Commercial and industrial		—		—		(108)		(541)
Residential real estate		—		—		(40)		—
Leases		(310)		(138)		(757)		(315)
Tax certificates		(108)		—		(139)		(433)
Total charge-offs		(425)		(177)		(1,128)		(1,639)
Recoveries
Commercial real estate		17		—		201		351
Construction and land development		15		150		273		402
Commercial and industrial		32		4		159		278
Residential real estate		4		5		23		16
Leases		18		4		35		20
Tax certificates		6		—		14		52
Consumer		1		—		1		—
Total recoveries		93		163		706		1,119
Net charge-offs		(332)		(14)		(422)		(520)
Provision (credit) for loan and lease losses		578		(216)		987		(1,382)
Balance at period end	$	10,254	$	9,806	$	10,254	$	9,806

An analysis of the allowance by loan type is set forth below:

	At September 30, 2016				At December 31, 2015
			Percent of				Percent of
			outstanding				outstanding
			loans in each				loans in each
	Allowance		category to		Allowance		category to
(In thousands, except percentages)	amount		total loans		amount		total loans
Commercial real estate	$	3,340	44.0	%	$	3,622	45.2	%
Construction and land development		2,166	13.0	%		1,674	9.6	%
Commercial and industrial		1,414	18.4	%		1,513	17.2	%
Multi-family		267	4.1	%		171	3.3	%
Residential real estate		575	8.5	%		586	10.3	%
Leases		2,186	10.9	%		1,749	12.9	%
Tax certificates		285	0.7	%		347	1.0	%
Consumer		21	0.4	%		27	0.5	%
Total allowance	$	10,254	100.00	%	$	9,689	100.0	%

The allowance increased $565 thousand from $9.7 million at December 31, 2015 to $10.3 million at September 30, 2016. The increase in the allowance was directly related to a provision for loan and lease losses of $987 thousand which was primarily attributable to growth in the loan portfolio, specific reserves within the leasing portfolio and net charge-off activity within the leasing and tax certificates portfolios.  For the nine months ended September 30, 2016 we recorded total charge-offs of $1.1 million, which were mostly related to specific reserves. Net charge-offs for the leasing portfolio were $722 thousand in the first three quarters of 2016. During 2016, we received a $283 thousand recovery on a loan relationship that had been previously charged-off.  The allowance was 1.78% of total loans and leases at September 30, 2016 compared to 1.94% at December 31, 2015.    

Other Real Estate Owned

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At September 30, 2016, OREO was comprised of two real estate properties acquired through, or in lieu of foreclosure in settlement of loans and 47 real estate properties acquired through foreclosure related to tax liens.  Set forth below is a table which details the changes in OREO from December 31, 2015 to September 30, 2016.

	For the nine months ended September 30, 2016
(In thousands)	Loans		Tax Liens		Total
Beginning balance	$	220	$	7,215	$	7,435
Net proceeds from sales		(6)		(1,121)		(1,127)
Net gains on sales		1		6		7
Transfers in		28		793		821
Cash additions		—		243		243
Impairment charge		—		(143)		(143)
Ending balance	$	243	$	6,993	$	7,236

At September 30, 2016, OREO was comprised of $215 thousand in land, $7.0 million related to 47 properties acquired through foreclosure related to tax liens, and $28 thousand in residential real estate related to a single family home.  During 2016, we sold the last condominium related to a construction project in Minneapolis, Minnesota.  We received our pro rata share of net proceeds in the amount of $6 thousand and recorded a net gain of $1 thousand. During the same period, we transferred to OREO a single family home with a value of $28 thousand. 

During the first three quarters of 2016, we transferred tax liens of $793 thousand to OREO which represented nine properties and added $243 thousand in lien redemptions on existing properties. During the same period we sold 21 tax lien properties, received proceeds of $1.1 million, and recorded a net gain of $6 thousand as a result of these sales. Additionally, we recorded impairment charges of $143 thousand during the first nine months of 2016 related to the tax lien properties. At December 31, 2015, OREO assets acquired through the tax lien portfolio were $7.2 million and were comprised of 60 properties.

Non-performing Assets

The following table presents the principal amounts of non-accrual loans and other real estate owned:

	At September 30,			At December 31,
(Amounts in thousands)	2016			2015
Non-accrual loans	$	3,710		$	4,367
Non-accrual tax certificates		745			1,125
Total non-accrual loans (1)		4,455			5,492
Other real estate owned-loans		243			220
Other real estate owned-tax certificates		6,993			7,215
Total other real estate owned		7,236			7,435
Total non-performing assets	$	11,691		$	12,927
Non-performing assets to total assets		1.44	%		1.64	%
Total non-accrual loans to total loans		0.77	%		1.10	%
ALLL to total non-accrual loans		230.17	%		176.42	%
ALLL to total loans		1.78	%		1.94	%

(1) Generally, a loan is placed on non-accruing status when it has been delinquent for a period of 90 days or more.

Deposits

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Total deposits, our primary source of funds, were $592.2 million at September 30, 2016 and increased $14.3 million, or 2.5%, from $577.9 million at December 31, 2015.  Demand deposits, savings accounts, and time deposits increased $7.2 million, $27.5 million, and $10.7 million, respectively.  During the third quarter of 2016, the $25.0 million brokered checking deposit arrangement with a regional financial institution was terminated.  Additionally, NOW and money market accounts declined $263 thousand and $5.7 million, respectively.

The following table represents ending deposit balances by type:

	September 30,		December 31,
(In thousands)	2016		2015
Non-interest bearing checking	$	90,709	$	83,529
NOW		42,295		42,558
Interest-bearing brokered deposits		—		25,000
Money Market		159,532		165,251
Savings		81,331		53,833
Time deposits ($250 and over)		14,211		18,066
Time deposits (less than $250)		204,161		189,655
Total deposits	$	592,239	$	577,892

Borrowings

Total borrowings, which include trust preferred securities, increased $9.1 million from $116.7 million at December 31, 2015 to $125.8 million at September 30, 2016.   Our $15.0 million interest rate swap that was tied to a maturing FHLB advance became effective in June 2016. We will continue to rollover the $15.0 million FHLB advance every 90–days through the swap expiration of June 2021. Additionally, in the third quarter of 2016, we chose to benefit from the flattening yield curve and borrowed a $15.0 million FHLB advance for five years.  This advance will allow us to guarantee an interest rate spread on $15.0 million in five year fixed rate loans.    Partially offsetting the increase in FHLB advances was the $2.0 million payoff of an amortizing bullet loan with another financial institution.  The interest paid on average borrowings increased $148 thousand, or 22.2% from the comparable quarter of 2015.

Shareholders’ Equity

Shareholders’ equity attributable to the Company decreased $2.6 million, or 3.6%, from $71.9 million at December 31, 2015.   During 2016, we received approval from the Federal Reserve Bank to repurchase 6,651 shares of the outstanding Series A preferred stock for $10.0 million or a weighted average price of $1,502.39 per share. As disclosed in our Current Report on Form 8-K filed on October 7, 2016, we received regulatory approval to repurchase or redeem the remaining 12,205 shares.  We intend to retire all of the remaining shares of Series A preferred stock outstanding as a result of receipt of such approvals, including purchases in privately negotiated transactions or in accordance with the redemption provisions of the Series A preferred stock. Partially offsetting the decrease in preferred stock was net income of $6.3 million and an improvement in accumulated other comprehensive loss of $1.0 million.  The improvement in accumulated other comprehensive loss was mostly related to an increase in the valuation of the investment portfolio which was partially offset by a decline in the value of our interest rate swap.

CAPITAL ADEQUACY

We and Royal Bank are subject to various regulatory capital requirements administered by the federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s and Royal Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

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In July 2013, the federal bank regulatory agencies adopted final rules to revise the agencies’ capital adequacy guidelines and prompt corrective action rules, which were designed to enhance such requirements and implement the revised standards of the Basel Committee on Banking Supervision, commonly referred to as Basel III. The July 2013 final rules generally implement higher minimum capital requirements, add a new common equity tier 1 capital requirement, and establish criteria that instruments must meet to be considered common equity tier 1 capital, additional tier 1 capital or tier 2 capital. The new minimum capital to risk-adjusted assets requirements are a common equity tier 1 capital ratio of 4.5% (6.5% to be considered “well capitalized”) and a tier 1 capital ratio of 6.0%, increased from 4.0% (and increased from 6.0% to 8.0% to be considered “well capitalized”); the total capital ratio remains at 8.0% under the new rules (10.0% to be considered “well capitalized”).

Under these rules, in order to avoid limitations on capital distributions (including dividend payments and certain discretionary bonus payments to executive officers), a banking organization must hold a capital conservation buffer comprised of common equity tier 1 capital above its minimum risk-based capital requirements in an amount greater than 2.5% of total risk-weighted assets. The new minimum capital requirements were effective on January 1, 2015. The capital conservation buffer requirements phase in over a three-year period beginning January 1, 2016.   Effective January 1, 2019 the capital conservation buffer will effectively raise the minimum required common equity tier 1 capital ratio to 7.0%, the tier 1 capital ratio to 8.5%, and the total capital ratio to 10.0%.  Management believes that as of September 30, 2016, the Company and Royal Bank would meet all capital adequacy requirements under the Basel III rules on a fully phased in basis as if all such requirements were currently in effect. 

In December 2013, Federal banking regulators issued rules for complying with the Volcker Rule provision of the Dodd-Frank Act. Royal Bank does not engage in, and does not expect to engage in, any transactions that are considered “covered activities” as defined by the Volcker Rule. Therefore, Royal Bank does not have any additional compliance obligations under the Volcker Rule.

At September 30, 2016 and December 31, 2015, the Company and Royal Bank met and compared favorably to the minimum capital adequacy requirements of Tier 1 and total capital to risk-weighted assets and the minimum Tier 1 leverage ratio, as defined by banking regulation.  Royal Bank also met the criteria for a well-capitalized institution. Management believes that, under current regulations, we will continue to meet its minimum capital requirements in the foreseeable future.

In connection with a prior bank regulatory examination, the FDIC concluded, based upon its interpretation of the Consolidated Reports of Condition and Income (the “Call Report”) instructions and under regulatory accounting principles (“RAP”), that income from Royal Bank’s tax lien business should be recognized on a cash basis, not an accrual basis.  Royal Bank’s current accrual method is in accordance with U.S. GAAP.  Royal Bank disagrees with the FDIC’s conclusion and filed the Call Report for September 30, 2016 and the previous 24 quarters in accordance with U.S. GAAP.  A change in the method of revenue recognition for the tax lien business for regulatory accounting purposes affects Royal Bank’s capital ratios as shown below.  The resolution of this matter will be decided by additional joint regulatory agency guidance which includes the Federal Reserve Bank, the FDIC, and the OCC.

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The table below sets forth Royal Bank’s capital ratios under RAP, based on the FDIC’s interpretation of the Call Report instructions:

	Actual				For capital adequacy purposes				To be well capitalized under prompt corrective action provision
(Dollars in thousands)	Amount		Ratio		Amount		Ratio*		Amount		Ratio
Total capital (to risk-weighted assets)
At September 30, 2016	$	90,551	14.794	%	$	52,792	8.625	%	$	61,208	10.000	%
At December 31, 2015	$	87,354	15.802	%	$	44,225	8.000	%	$	55,281	10.000	%
Tier 1 capital (to risk-weighted assets)
At September 30, 2016	$	82,868	13.539	%	$	40,550	6.625	%	$	48,966	8.000	%
At December 31, 2015	$	80,410	14.546	%	$	33,169	6.000	%	$	44,225	6.000	%
Tier 1 capital (to average assets, leverage)
At September 30, 2016	$	82,868	10.354	%	$	32,015	4.000	%	$	40,019	5.000	%
At December 31, 2015	$	80,410	10.589	%	$	30,374	4.000	%	$	37,968	5.000	%
Common equity Tier 1 (to risk-weighted assets)
At September 30, 2016	$	65,242	10.659	%	$	31,369	5.125	%	$	39,785	6.500	%
At December 31, 2015	$	58,824	10.641	%	$	24,876	4.500	%	$	35,933	6.500	%

*Ratios related to risk-weighted assets include the capital conservation buffer of 0.625%.

The tables below reflect the adjustments to the net loss as well as the capital ratios for Royal Bank under U.S. GAAP:

	For the nine months ended		For the year ended
(In thousands)	September 30, 2016		December 31, 2015
RAP net income	$	4,410	$	9,161
Tax lien adjustment, net of noncontrolling interest		1,560		1,973
U.S. GAAP net income	$	5,970	$	11,134

	At September 30, 2016				At December 31, 2015
	As reported		As adjusted		As reported		As adjusted
	under RAP		for U.S. GAAP		under RAP		for U.S. GAAP
Total capital (to risk-weighted assets)	14.794	%	15.016	%	15.802	%	16.109	%
Tier 1 capital (to risk-weighted assets)	13.539	%	13.761	%	14.546	%	14.853	%
Tier 1 capital (to average assets, leverage)	10.354	%	10.530	%	10.589	%	10.824	%
Common equity Tier 1 (to risk-weighted assets)	10.659	%	10.889	%	10.641	%	10.962	%

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The tables below reflect the Company’s capital ratios:

	Actual				For capital adequacy purposes				To be well capitalized under the Federal Reserve's regulations
(Dollars in thousands)	Amount		Ratio		Amount		Ratio*		Amount		Ratio
Total capital (to risk-weighted assets)
At September 30, 2016	$	100,544	16.361	%	$	53,003	8.625	%	$	61,453	10.000	%
At December 31, 2015	$	103,355	18.574	%	$	44,516	8.000	%	$	55,645	10.000	%
Tier 1 capital (to risk-weighted assets)
At September 30, 2016	$	90,606	14.744	%	$	40,713	6.000	%	$	36,872	6.000	%
At December 31, 2015	$	95,316	17.129	%	$	33,387	6.000	%	$	33,387	6.000	%
Tier 1 capital (to average assets, leverage)
At September 30, 2016	$	90,606	11.220	%	$	32,303	4.000	%		N/A	N/A
At December 31, 2015	$	95,316	12.444	%	$	30,638	4.000	%		N/A	N/A
Common equity Tier 1 (to risk-weighted assets)
At September 30, 2016	$	55,124	8.970	%	$	31,495	4.500	%		N/A	N/A
At December 31, 2015	$	52,115	9.366	%	$	25,040	4.500	%		N/A	N/A

*Ratios related to risk-weighted assets include the capital conservation buffer of 0.625%.

The Company has filed the Consolidated Financial Statements for Bank Holding Companies-FR Y-9C (“FR Y-9C”) as of September 30, 2016 consistent with U.S. GAAP and the FR Y-9C instructions.  In the event that a similar adjustment for RAP purposes would be required by the Federal Reserve on the holding company level, the adjusted ratios are shown in the table below. 

	For the nine months ended		For the year ended
(In thousands)	September 30, 2016		December 31, 2015
U.S. GAAP net income	$	6,253	$	10,993
Tax lien adjustment, net of noncontrolling interest		(1,560)		(1,973)
RAP net income	$	4,693	$	9,020

	At September 30, 2016				At December 31, 2015
	As reported under U.S. GAAP		As adjusted for RAP		As reported under U.S. GAAP		As adjusted for RAP
Total capital (to risk-weighted assets)	16.361	%	16.143	%	18.574	%	18.277	%
Tier 1 capital (to risk-weighted assets)	14.744	%	14.439	%	17.129	%	16.710	%
Tier 1 capital (to average assets, leverage)	11.220	%	10.981	%	12.444	%	12.127	%
Common equity Tier 1 (to risk-weighted assets)	8.970	%	8.736	%	9.366	%	9.040	%

LIQUIDITY & INTEREST RATE SENSITIVITY

Liquidity is the ability to ensure that adequate funds will be available to meet our financial commitments as they become due.  In managing our liquidity position, all sources of funds are evaluated, the largest of which is deposits.  Also taken into consideration are securities maturing in one year or less, other short-term investments and the repayment of loans. These sources provide alternatives to meet our short-term liquidity needs.  Longer liquidity needs may be met by issuing longer-term deposits and by raising additional capital.  The liquidity ratios are specifically defined as the ratio of net cash, available FHLB and other lines of credit, and unpledged marketable securities relative to both total deposits and total liabilities.  Our policy is to maintain a liquidity ratio equal to or greater than 12% and 10% of total deposits and total liabilities, respectively.  At September 30, 2016, our liquidity ratios were more than four times the policy minimums.    

Our funding decisions can be influenced by unplanned events, which include, but are not limited to, the inability to fund asset growth, difficulty renewing or replacing funds that mature, the ability to maintain or draw down lines of credit with other financial institutions, significant customer withdrawals of deposits, and market disruptions. We have a liquidity

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contingency plan in the event liquidity falls below an acceptable level, however, events could arise that may render sources of liquid funds unavailable in the future when required.  Our Asset and Liability Committee (“ALCO”) meets monthly to monitor liquidity management. 

On August 13, 2009, the Company’s Board of Directors suspended the regular quarterly cash dividends on the Series A Preferred Stock. The Company’s Board of Directors took this action in consultation with the Federal Reserve Bank of Philadelphia as required by recent regulatory policy guidance. As of September 30, 2016 the Series A Preferred stock dividend in arrears, which includes additional dividends on arrearages, was approximately $7.1 million and has not been recognized in the consolidated financial statements.    

Interest rate sensitivity is a function of the re-pricing characteristics of our assets and liabilities.  These include the volume of assets and liabilities re-pricing, the timing of re-pricing, and the interest rate sensitivity gaps, which are a continual challenge in a changing rate environment.  In managing our interest rate sensitivity positions, we seek to develop and implement strategies to control exposure of net interest income to risks associated with interest rate movements.  The interest rate sensitivity report examines the positioning of the interest rate risk exposure in a changing interest rate environment.  Ideally, the rate sensitive assets and liabilities will be maintained in a matched position to minimize interest rate risk.  The interest rate sensitivity analysis is an important management tool; however, it does have some inherent shortcomings.  It is a “static” analysis.  Although certain assets and liabilities may have similar maturities or re-pricing, they may react in different degrees to changes in market interest rates.  Additionally, re-pricing characteristics of certain assets and liabilities may vary substantially within a given period.

The following table summarizes re-pricing intervals for interest-earning assets and interest-bearing liabilities as of September 30, 2016, and the difference or “gap” between them on an actual and cumulative basis for the periods indicated. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities.  During a period of falling interest rates, a positive gap would tend to adversely affect net interest income, while a negative gap would tend to result in an increase in net interest income.  During a period of rising interest rates, a positive gap would tend to result in an increase in net interest income while a negative gap would tend to affect net interest income adversely.  At September 30, 2016, we were in an asset sensitive position of $14.1 million, which indicates that within one year the re-pricing  of  assets is sooner than the re-pricing of liabilities.  The Company has exposure to rising rates as $161.0 million in assets re-price after five years.

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(In millions)	Days						1 to 5		Over 5		Non-rate
Assets (1)	0 – 90			91 – 365			Years		Years		Sensitive		Total
Interest-earning deposits in banks	$	17.6		$	—		$	—	$	—	$	10.8	$	28.4
Investment securities AFS		17.6			29.6			84.0		34.1		3.0		168.3
Loans: (2)
Fixed rate		31.5			45.3			225.3		126.9		(10.3)		418.7
Variable rate		145.7			—			1.2		—		—		146.9
Total loans		177.2			45.3			226.5		126.9		(10.3)		565.6
Other assets (3)		—			21.0			—		—		28.1		49.1
Total Assets	$	212.4		$	95.9		$	310.5	$	161.0	$	31.6	$	811.4
Liabilities & Capital
Deposits:
Non-interest bearing deposits	$	—		$	—		$	—	$	—	$	90.7	$	90.7
Interest-bearing deposits		31.0			92.9			159.3		—		—		283.2
Certificate of deposits		24.0			80.5			109.9		4.0		—		218.4
Total deposits		55.0			173.4			269.2		4.0		90.7		592.3
Borrowings		40.8			25.0			60.0		—		—		125.8
Other liabilities		—			—			—		—		23.5		23.5
Capital		—			—			—		—		69.8		69.8
Total liabilities & capital	$	95.8		$	198.4		$	329.2	$	4.0	$	184.0	$	811.4
Net  interest rate  GAP	$	116.6		$	(102.5)		$	(18.7)	$	157.0	$	(152.4)
Cumulative interest rate  GAP	$	116.6		$	14.1		$	(4.6)	$	152.4
GAP to total  assets		14	%		(13)	%
GAP to total equity		167	%		(147)	%
Cumulative GAP to total assets		14	%		2	%
Cumulative GAP to total equity		167	%		20	%

(1) Interest earning assets are included in the period in which the balances are expected to be repaid and/or re-priced as a result of anticipated prepayments, scheduled rate adjustments, and contractual maturities.

(2) Reflects principal maturing within the specified periods for fixed rate loans and re-pricing for variable rate loans; includes non-performing loans.

(3) Includes FHLB stock.

The method of analysis of interest rate sensitivity in the table above has a number of limitations.  Certain assets and liabilities may react differently to changes in interest rates even though they re-price or mature in the same time periods. The interest rates on certain assets and liabilities may change at different times than changes in market interest rates, with some changes in advance of changes in market rates and some lagging behind changes in market rates.  Also, certain assets have provisions, which limit changes in interest rates each time the interest rate changes and for the entire term of the loan.  Prepayments and withdrawals experienced in the event of a change in interest rates may deviate significantly from those assumed in the interest rate sensitivity table.  Additionally, the ability of some borrowers to service their debt may decrease in the event of an interest rate increase.

The Company’s exposure to interest rate risk is mitigated somewhat by a portion of the Company’s loan portfolio consisting of floating rate loans, which are tied to the prime lending rate but which have interest rate floors and no interest rate ceilings.  Although the Company is originating fixed rate loans, a portion of the loan portfolio continues to be comprised of floating rate loans with interest rate floors. At September 30, 2016, floating rate loans with floors and without floors were $118.5 million and $28.4 million, respectively.

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REGULATORY ACTIONS

Federal Reserve Memorandum of Understanding

As previously disclosed, in March 2010, the Company agreed to enter into a written agreement (the “Federal Reserve Agreement”) with the Federal Reserve Bank of Philadelphia (the “Federal Reserve Bank”).  Effective July 17, 2013, the Board of Governors of the Federal Reserve System terminated the enforcement action under the Federal Reserve Agreement, and it was replaced with an informal non-public agreement, a memorandum of understanding (“MOU”), with the Federal Reserve Bank.  Included in the MOU are certain continued reporting requirements and a requirement that the Company receive the prior approval of the Federal Reserve Bank prior to declaring or paying any dividends on the Company’s capital stock, making interest payments related to the Company’s outstanding trust preferred securities or subordinate securities, incurring or guaranteeing certain debt with an original maturity date greater than one year, and purchasing or redeeming any shares of stock.  The MOU will remain in effect until stayed, modified, terminated, or suspended in writing by the Federal Reserve Bank.

ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information presented in the Liquidity and Interest Rate Sensitivity section of the Management’s Discussion and Analysis of Financial Condition and Results Operations of this Report is incorporated herein by reference.

ITEM 4 – CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

The Company maintains a set of disclosure controls and procedures that are designed to ensure that information required to be disclosed in reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities Exchange Commission’s rules and forms. As of the end of the period covered by this report, the Company evaluated, under the supervision and with the participation of our management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) of the Exchange Act. Based on that evaluation, our CEO and CFO concluded, subject to the limitations on effectiveness described in Item 9A in our Annual Report on Form 10-K for the year ended December 31, 2015, that the Company’s disclosure controls and procedures were effective at September 30, 2016.

(b) Changes in Internal Control Over Financial Reporting

There have been no changes in the Company’s internal control over financial reporting during the third quarter of 2016 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

There are inherent limitations to the effectiveness of any controls system. A controls system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that its objectives are met. Further, the design of a control system must reflect the fact that there are limits on resources, and the benefits of controls must be considered relative to their costs and their impact on the business model. We intend to continue to improve and refine our internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1.Legal Proceedings.

From time to time, the Company is a party to routine legal proceedings within the normal course of business.  Such routine legal proceedings in the aggregate are believed by management to be immaterial to the Company's financial condition or results of operations.  All non-routine legal proceedings are described in Item 3 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

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Item 1A.Risk Factors.

There have been no material changes from risk factors as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015.

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds.

None

Item 3.Defaults Upon Senior Securities.

None

Item 4.Mine Safety Disclosures.

None

Item 5.Other Information.

None

Item 6.Exhibits.  

(a)

3.1	Articles of Incorporation of the Company. (Incorporated by reference to Exhibit 3.1 of the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2013.)
3.21	Bylaws of the Company (Incorporated by reference to Exhibit 3(ii) to the Company’s Annual Report on Form 10-K filed with the Commission on March 30, 2009.)
31.1	Section 302 Certification Pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 signed by F. Kevin Tylus, Principal Executive Officer of Royal Bancshares of Pennsylvania on November 8, 2016.
31.2	Section 302 Certification Pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 signed by Michael S. Thompson, Principal Financial Officer of Royal Bancshares of Pennsylvania on November 8, 2016.
32.1	Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by F. Kevin Tylus, Principal Executive Officer of Royal Bancshares of Pennsylvania on November 8, 2016.
32.2	Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, signed by Michael S. Thompson, Principal Financial Officer of Royal Bancshares of Pennsylvania on November 8, 2016.
101	Interactive Data File

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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.

ROYAL BANCSHARES OF PENNSYLVANIA, INC

(Registrant)

Dated: November 8, 2016

/s/ Michael S. Thompson

Michael S. Thompson

Principal Financial and Accounting Officer

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