UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2018

Commission file number 000-23667

HOPFED BANCORP, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (270) 885-1171.

Securities registered pursuant to Section 12(b) of the Act: None.

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

Common Stock, par value $.01 per share

(Title of Class)

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ☐    No  ☒

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ☐    No  ☒

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (subsection 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. (as defined in Rule 12b-2 of the Act).

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

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

The registrant’s voting stock is traded on the NASDAQ Stock Market. The aggregate market value of the voting stock held by non-affiliates of the registrant, computed by reference to the price ($16.58 per share) at which the stock was sold on June 29, 2018, was approximately $105,862,156. For purposes of this calculation, the term “affiliate” refers to all executive officers and directors of the registrant and all stockholders beneficially owning more than 10% of the registrant’s Common Stock.

As of the close of business on March 6, 2019, 6,648,887 shares of the registrant’s Common Stock were outstanding.

Documents Incorporated By Reference

Part II:

Annual Report to Stockholders for the year ended December 31, 2018.

PART I

HopFed Bancorp, Inc.

HopFed Bancorp, Inc. (the “Corporation”) is a bank holding company incorporated in the state of Delaware and headquartered in Hopkinsville, Kentucky. The Corporation’s principal business activities are conducted through its wholly-owned subsidiary, Heritage Bank USA, Inc. (the “Bank”), a Kentucky state chartered commercial bank engaged in the business of accepting deposits and providing mortgage, consumer, construction and commercial loans to the general public through its retail banking offices. The Bank’s business activities are primarily limited to western Kentucky and middle and western Tennessee. The Bank is subject to competition from other financial institutions. Deposits at the Bank are insured up to the applicable limits by the Federal Deposit Insurance Corporation (FDIC).

The Bank is a Kentucky commercial chartered bank and is supervised by the Kentucky Department of Financial Institutions (“KDFI”) and the FDIC. Supervision of the Corporation is conducted by the Federal Reserve Bank of Saint Louis (“FRB”).

The Bank owns JBMM, LLC, a wholly owned limited liability company which owns and manages the Bank’s foreclosed assets. The Bank owns Heritage USA Title, LLC, which sells title insurance to the Bank’s real estate loan customers. The Bank owns Fort Webb LP, LLC, which owns a limited partnership interest in Fort Webb Elderly Housing LP, LLC, a low income senior citizen housing facility in Bowling Green, Kentucky. The facility offers apartments for rent for those senior citizens who qualify and is managed by the Bowling Green, Kentucky Housing Authority.

A substantial majority of the Bank’s loans are secured by real estate in the western Kentucky and middle and west Tennessee markets. In addition, all properties reported as foreclosed real estate, which the exception of a $37,000 single-family property that is located in Mississippi, are located in the Company’s general market area. Accordingly, the ultimate ability to collect on a substantial portion of the Bank’s loan portfolio and the recovery of a substantial portion of the carrying amount of foreclosed real estate is susceptible to changes in local market conditions.

Announced Agreement to Merge

On January 7, 2019, First Financial Corporation (NASDAQ: THFF) (“First Financial”) and the Company jointly announced the execution of a definitive merger agreement under which the Company will merge into First Financial in a cash and stock transaction. Upon completion of the merger, the Bank will merge into First Financial Bank, N.A. (“First Financial Bank”), a wholly owned subsidiary of First Financial.

Under the terms of the merger agreement, which was unanimously approved by the boards of both Companies, stockholders of the Company may elect to receive either (or a combination of) 0.444 shares of First Financial common stock or $21.00 in cash for each share of the Company’s common stock owned. The transaction aggregate payout is subject to proration provisions specified in the merger agreement that provide for a targeted aggregate split of 50% of the Company’s common stock being exchanged for First Financial common stock and 50% for cash. Based upon the $43.01 closing price of First Financial common stock on January 4, 2019 and assuming that a shareholder received 50% stock and 50% cash, the purchase price would be worth $20.05 per share, with an aggregate transaction value of approximately $128.3 million. For more information, please review the Company’s 8-K/A filing with the Securities and Exchange Commission dated January 9, 2019. The proposed merger is subject to approval of both regulators of both Companies and by a vote of HopFed shareholders.

Stock Repurchase Activity

At December 31, 2018, the Company may purchase 296,380 shares of treasury stock under the currently active repurchase program. For the year ended December 31, 2018, the Company purchased 3,620 shares of common stock at a weighted average price of $14.06 per share. At December 31, 2018, the Company owns 1,341,980 shares of the Company’s common stock as treasury stock at a weighted average price of $12.45 per share. The Company’s stock repurchase program remains open but activity has been limited due to merger discussions that were held in 2018.

2015 HopFed Bancorp, Inc. Employee Stock Ownership Plan

On March 2, 2015, the Company implemented the HopFed Bancorp, Inc. 2015 Employee Stock Ownership Plan (the “ESOP”) which covers substantially all employees who are at least 21 years old with at least one year of employment with the Bank. Bank contributions used to make the ESOP loan payment replaced matching and profit sharing contributions to the Bank’s 401(k) Plan. The Company’s Board of Directors selected three individuals to serve as trustees, Messrs. Peck, Duvall and Dr. Thomas I. Miller.

On March 2, 2015, the ESOP purchased an initial block of 600,000 shares from the Company at a cost of $7,884,000 using the proceeds of the ESOP Loan. In accordance with the ESOP loan documents, the common stock purchased by the ESOP serves as collateral for the ESOP loan. The repayment of the ESOP loan is from discretionary contributions by the Bank to the ESOP and by dividends paid on unearned shares held in the trust over a period ending no later than December 9, 2026. The interest rate on the ESOP Loan is 3.0%. The administrative trustee has custody of the common shares owned by the ESOP.

ESOP shares are allocated among participants as the ESOP loan is repaid. The ESOP shares receive dividend payments and dividends on unearned shares may be used to make the ESOP loan payment and for distributions to individuals who are no longer employed by the Bank. For the years ended December 31, 2018 and December 31, 2017, the Company incurred compensation expense of $633,000 and $706,000, respectively, to fund the ESOP loan payment. For the years ended December 31, 2018 and December 31, 2017, the Company’s ESOP released 51,856 and 64,032 shares of stock, respectively, to individual employees participating in the plan at December 31, 2018 and December 31, 2017, respectively.

Federal Taxation

The Corporation and the Bank file a consolidated federal income tax return on a calendar year basis. The Company is subject to the federal tax laws and regulations that apply to corporations generally.

Kentucky Taxation

Kentucky corporations, such as the Corporation, are subject to the Kentucky corporation income tax and the Kentucky corporation license (‘franchise”) tax. The income tax is imposed based on the following rates: 4% of the first $50,000 of net taxable income allocated or apportioned to Kentucky; 5% of the next $50,000; and 6% of taxable net income over $100,000. All dividend income received by a corporation is excluded for purposes of arriving at taxable net income.

Tennessee Taxation

The Company and all subsidiaries are subject to Tennessee Franchise and Excise tax on apportioned capital and apportioned income.

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Heritage Bank USA, Inc.

State banks are not subject to the Kentucky corporation tax.

The Commonwealth of Kentucky imposes both a “Kentucky Bank Franchise Tax” and “Local Deposits Franchise Tax”. The Kentucky Bank Franchise Tax is an annual tax equal to 1.1% of net capital after apportionment, if applicable. The value of the net capital is calculated annually by deducting from total capital an amount equal to the same percentage of total as the book value of Unites States obligations bears to the book value of the total assets of the financial institution. The Bank, as a financial institution, is exempt from both corporate income and license taxes.

Competition

The Bank faces significant competition both in originating mortgage and other loans and in attracting deposits. The Bank competes for loans based on the types of loans originated, the rates charged and the terms offered on our loan products, the deposit products and rates offered and the convenience and quality of services it provides to customers. The Bank also competes by offering products tailored to the local communities that we serve. Its competition in originating real estate loans comes primarily from other savings institutions, commercial banks and mortgage bankers making loans secured by real estate located in the Bank’s market area. Commercial banks, credit unions and finance companies provide vigorous competition in consumer lending.

At June 30, 2018, the Bank had an 11.0% share of the deposit market in its combined markets. The Bank’s most significant competition for deposits across its entire market area was Community Financial Services Bank with a deposit rate share of 12.1% and Planters Bank of Kentucky with a deposit market share of 10.2%. At June 30, 2018, U.S. Bank N/A held a deposit market share of 8.0%, F&M Bank of Clarksville, Tennessee held a market share of 7.4% and Regions Bank of Birmingham, Alabama held a market share rate of 7.1%. In addition, each market contains other community banks that provide competitive products and services within individual markets.

Employees

As of December 31, 2018, the Company and the Bank had 220 full-time equivalent employees, none of whom is represented by a collective bargaining agreement. Management considers the Bank’s relationships with its employees to be good.

Executive Officers of the Registrant

John E. Peck. Mr. Peck has served as President and Chief Executive Officer of both the Company and the Bank since July 2000. Prior to that, Mr. Peck was President and Chief Executive Officer of United Commonwealth Bank and President of Firstar Bank-Calloway County. Mr. Peck was a past Board Member and Chairman of the Christian County Chamber of Commerce, Jennie Stuart Hospital and Murray-Calloway County Hospital. Mr. Peck holds a Bachelor of Science of Business Administration with a concentration in Finance from the University of Louisville. Mr. Peck is a graduate of the Louisiana State University School of Banking. Mr. Peck is a member and serves on the finance committee of the First Baptist Church of Hopkinsville.

Michael L. Woolfolk. Mr. Woolfolk has served as Executive Vice President and Chief Operations Officer of the Bank since August 2000. Mr. Woolfolk was appointed to the Board of Directors of the Company on August 15, 2012. Prior to that, he was President of First-Star Bank-Marshall County, President and Chief Executive Officer of Bank of Marshall County and President of Mercantile Bank. Mr. Woolfolk is a member of First Baptist Church of Hopkinsville.

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Billy C. Duvall. Mr. Duvall has served as Senior Vice President, Chief Financial Officer and Treasurer of the Company and the Bank since June 1, 2001. Prior to that, he was an Auditor with Rayburn, Betts & Bates, P.C., independent public accountants and nine years as a Principal Examiner with the National Credit Union Administration. Mr. Duvall holds a Bachelor of Business Administration from Austin Peay State University in Accounting and Finance. Mr. Duvall is a Certified Public Accountant of Virginia. Mr. Duvall is the past Board Chairman for the Pennyroyal Mental Health Center, a member of the Hopkinsville Kiwanis Club, and a member of Southside Church of Christ in Hopkinsville.

Bailey “Chip” Knight. Mr. Knight was promoted to Chief Credit Officer on January 15, 2016. Mr. Knight has served as a Market President and Senior Lender of the Company since April 2, 2012. In his position as Market President, Mr. Knight was responsible for all retail and lending functions in the Cheatham County, Tennessee market. As Senior Lender, Mr. Knight’s responsibilities included relationships with the Company’s largest commercial lending clients as well as assisting other commercial loan officers in the calling and structuring of loan agreements. Prior to April 2012, Mr. Knight was the Regional Executive and Team Lead with Capital Bank and GreenBank, where he was responsible for all retail and lending functions in eight offices located in Northern Middle Tennessee. Mr. Knight has over 25 years of commercial banking experience, all in Middle Tennessee and is a lifelong resident of Montgomery County, Tennessee.

Limitations on Capital Distributions. The FRB has issued a policy statement on the payment of cash dividends by bank holding companies, which provides that a bank holding company should pay cash dividends only to the extent that the holding company’s net income for the past year is sufficient to cover both the cash dividends and a rate of earnings retention that is consistent with the holding company’s capital needs, asset quality and overall financial condition. The FRB also indicated that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends. In a recent Supervisory Letter, the FRB staff has stated that, as a general matter, bank holding companies should eliminate cash dividends if net income available to shareholders for the past four quarters, net of dividends previously paid, is not sufficient to fully fund the dividend. Furthermore, under the federal prompt corrective action regulations, the FRB may prohibit a bank holding company from paying any dividends if the holding company’s bank subsidiary is classified as “undercapitalized.”

Seasonality of Revenues and Expenses

The Company’s business is not materially affected by seasonality fluctuations in our business cycle. The Company’s financial health is substantially affected by the overall business cycle and market interest rates.

Supervision and Regulation

Set forth below is a brief description of certain laws that relate to the regulation of the Company and the Bank. The description does not purport to be complete and is qualified in its entirety by reference to applicable laws and regulations.

Regulation of the Company

General. The Company is a bank holding company registered with the FRB. We are subject to examination and supervision by the FRB pursuant to the Bank Holding Company Act of 1956, as amended (the “BHCA”), and are required to file reports and other information regarding our business operations and the business operations of our subsidiaries with the FRB.

Under the BHCA, the Company must obtain the prior approval of the FRB before it may acquire control of another bank or bank holding company, merge or consolidate with another bank holding company, acquire all or substantially all of the assets of another bank or bank holding company, or acquire direct or indirect ownership or control of any voting shares of any bank or bank holding company if, after such acquisition, the Company would directly or indirectly own or control more than 5% of such shares.

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Non-Banking Activities. In general, the BHCA and the FRB’s regulations limit the nonbanking activities permissible for bank holding companies to those activities that the FRB has determined to be so closely related to banking or managing or controlling banks to be a proper incident thereto. A bank holding company that elects to be treated as a financial holding company, however, may engage in, and acquire companies engaged in, activities that are considered “financial in nature,” as defined by the Gramm-Leach-Bliley Act and FRB regulations. These activities include, among other things, securities underwriting, dealing and market-making, sponsoring mutual funds and investment companies, insurance underwriting and agency activities, and merchant banking.

General. A bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the policy of the FRB that a bank holding company should stand ready to use available resources to provide adequate capital to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the FRB to be an unsafe and unsound banking practice or a violation of the FRB regulations, or both.

Regulatory Capital Requirements. The FRB has adopted regulatory capital regulations pursuant to which it assesses the adequacy of capital in examining and supervising a bank holding company and in analyzing applications to it under the BHCA. The Federal Reserve’s regulatory capital requirements are similar to those imposed on the Bank by the FDIC. See “Regulation of the Bank – Regulatory Capital Requirements.” The FRB, however, has adopted a policy statement that exempts bank holding companies with less than $1.0 billion in consolidated assets that are not engaged in significant non-banking or off-balance sheet activities and that do not have a material amount of debt or equity securities registered with the SEC from its regulatory capital requirements. As long as their bank subsidiaries are well capitalized, such bank holding companies need only maintain a pro forma debt to equity ratio of less than 1.0 in order to pay dividends and repurchase stock and to be eligible for expedited treatment on applications.

Regulation of the Bank

General. As a Kentucky-chartered commercial bank, the Bank is subject to regulation, supervision and examination by the KDFI and by the FDIC, which insures its deposits to the maximum extent permitted by law. The federal and state laws and regulations applicable to banks regulate, among other things, the scope of their business, their investments, the reserves required to be kept against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for certain loans. The laws and regulations governing the Bank generally have been promulgated to protect depositors and the FDIC, not for the purpose of protecting stockholders. This regulatory structure also gives the federal and state banking agencies extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulation, whether by the KDFI, the FDIC or the United States Congress, could have a material impact on the Company, the Bank and their operations.

Regulatory Capital Requirements. The FDIC has promulgated capital adequacy requirements for state-chartered banks that, like the Bank, are not members of the Federal Reserve System. Effective January 1, 2015, the regulatory capital rules were substantially revised to conform to the international regulatory standards agreed to by the Basel Committee on Banking Supervision in the accord often referred to as “Basel III”. The final Basel III capital rule applies to all depository institutions as well as to all top-tier bank and savings and loan holding companies that are not subject to the FRB’s Small Bank Holding Company Policy Statement.

Under the FDIC’s revised regulatory capital regulations, the Bank is required to meet four minimum capital standards: (1) a “Tier 1” or “core” capital leverage ratio equal to at least 4% of total adjusted assets, (2) a common equity Tier 1 (“CET1”) capital ratio equal to 4.5% of risk-weighted assets, (3) a Tier 1 risk-based ratio equal to 6% of risk-weighted assets, and (4) a total capital ratio equal to 8% of total risk-weighted assets. CET1 capital is defined as common stock instruments, retained earnings, any common equity Tier 1 minority interest and, unless an institution has made an “opt-out” election, accumulated other comprehensive income, net of goodwill and certain other intangible assets. Tier 1 or core capital is defined as CET1 capital plus certain qualifying subordinated interests and grandfathered capital instruments. The Bank and Corporation made the opt-out election.

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Total capital consists of Tier 1 capital plus Tier 2 or supplementary capital items, which include allowances for loan losses in an amount of up to 1.25% of risk-weighted assets, qualifying subordinated instruments and certain grandfathered capital instruments. An institution’s risk-based capital requirements are measured against risk-weighted assets, which equal the sum of each on-balance-sheet asset and the credit-equivalent amount of each off-balance-sheet item after being multiplied by an assigned risk weight.

In addition to higher capital requirements, the Basel III capital rule requires banking organizations to maintain a capital conservation buffer of at least 2.5% of risk-weighted assets over and above the minimum risk-based capital requirements. Institutions that do not maintain the required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital buffer requirement will be phased in over four years beginning January 1, 2016. The fully phased-in capital buffer requirement will effectively raise the minimum required risk-based capital ratios to 7% CET1 capital, 8.5% Tier 1 capital and 10.5% total capital on a fully phased-in basis. The capital conservation buffer at December 31, 2017 is 1.25%. In assessing an institution’s capital adequacy, the FDIC takes into consideration not only the above numeric factors but also qualitative factors, and has the authority to establish higher capital requirements for individual institutions where necessary.

Prompt Correction Action. Under applicable Federal statute, the federal bank regulatory agencies are required to take “prompt corrective action” with respect to institutions that do not meet specified minimum capital requirements. Under the FDIC’s prompt corrective action regulations, as amended to incorporate the new regulatory capital standards implemented by the final Basel III capital rule, an institution is deemed to be “well-capitalized” if it has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 8% or greater, a Tier 1 leverage ratio of 5% or greater, and a CET1 risk-based ratio of 6.5% or greater and is not subject to a regulatory order, agreement, or directive to meet and maintain a specific capital level for any capital measure.

An institution is “adequately capitalized” if it has a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 6% or greater, a Tier 1 leverage ratio of 4% or greater, and a CET1 risk-based ratio of 4.5% or greater and the institution does not meet the definition of a “well-capitalized” institution. An institution is “under-capitalized” if it does not meet one or more of the “adequately-capitalized” tests. An institution is deemed to be “significantly under-capitalized” if it has a total risk-based capital ratio that is less than 6%, a Tier 1 risk-based capital ratio that is less than 4%, a Tier 1 leverage ratio that is less than 3%, or a CET1 risk-based ratio of less than 3%. An institution is deemed to be “critically under-capitalized” if it has a ratio of tangible equity, as defined in the regulations, to total assets that is equal to or less than 2%.

The prompt corrective action regulations provide for the imposition of a variety of requirements and limitations on institutions that fail to meet the above capital requirements. In particular, the FDIC may require any savings institution that is not “adequately capitalized” to take certain action to increase its capital ratios. If the savings institution’s capital is significantly below the minimum required levels of capital or if it is unsuccessful in increasing its capital ratios, the institution’s activities may be restricted

Deposit Insurance. The Bank’s deposits are insured to applicable limits by the FDIC. Under the Dodd-Frank Act, the maximum deposit insurance amount is $250,000. The Dodd-Frank Act increased the minimum target Deposit Insurance Fund ratio from 1.15% of estimated insured deposits to 1.35% of estimated insured deposits. The FDIC must seek to achieve the 1.35% ratio by June 30, 2020. It is intended that insured institutions with assets of $10 billion or more will fund the increase.

The FDIC has adopted a risk-based premium system that provides for quarterly assessments based on an insured institution’s risk rating. The assessment base is the institution’s average consolidated assets less average tangible equity. Prior to July 1, 2016, insured institutions were assigned to one of four risk categories based on their examination ratings and capital ratios, and annual assessment rates ranged from 2.5 to 45 basis points of an insured institution’s assessment base.

Effective July 1, 2016, the FDIC amended its assessment regulations for banks with less than $10 billion in assets to replace the previous risk categories with updated financial ratios that are designed to better predict the risk of failure of insured institutions. The amended rules became effective during the first quarter after the reserve ratio of the Deposit Insurance Fund reached 1.15% and will remain in effect until the reserve ratio reaches 2.0%.

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The base deposit insurance rates for institutions with assets of less than $10 billion now range from 1.5 to 30 basis points of an institution’s assessment base. Under the amended rules, the FDIC uses an institution’s weighted average CAMELS component ratings and the following financial measures to determine deposit insurance assessments: Tier 1 leverage ratio; ratio of net income before taxes to total assets; ratio of non-performing loans to gross assets; and ratio of other real estate owned to gross assets. In addition, assessments take into consideration an institution’s brokered deposit ratio, one-year asset growth and a loan mix index, which measures the extent to which an institution’s total assets include higher risk loans. Assessments are based on an insured institution’s classification among four risk categories determined from their examination ratings and capital and other financial ratios. The institution is assigned to a category and the category determines its assessment rate, subject to certain specified risk adjustments.

Insured institutions deemed to pose less risk to the deposit insurance fund pay lower assessments, while greater risk institutions pay higher assessments. In February 2011, the FDIC published a final rule under the Dodd-Frank Act to reform the deposit insurance assessment system. Under such final rule, assessments are based on an institution’s average consolidated total assets minus average tangible equity instead of deposits, which was the FDIC’s prior practice. The rule revised the assessment rate schedule to establish assessments ranging from 2.5 to 45 basis points, based on an institution’s risk classification and possible risk adjustments. The FDIC has authority to increase insurance assessments. Any significant increases would have an adverse effect on the operating expenses and results of operations of the Bank. Management cannot predict what assessment rates will be in the future.

Dividends. The KDFI limits the amount of dividends that can be paid by a state chartered commercial bank to its holding company. The limit is established by adding the current year’s net income plus the prior two years net income. The Bank must reduce the amount of accumulated net income over the last two years plus the current year by the amount of dividends paid to the Corporation during the same period of time. At December 31, 2018, the Bank could pay an additional cash dividend of approximately $8.0 million to the Corporation without the prior approval of the KDFI. Future earnings of the Bank appropriated to bad debt reserves and deducted for federal income tax purposes are not available for payment of dividends or other distributions to the Company without payment of taxes at the then current tax rate by the Bank on the amount of earnings removed from the reserves for such distributions.

Transactions with Affiliates and Insiders. Generally, transactions between commercial banks or its subsidiaries and its affiliates are required to be on terms as favorable to the commercial bank as transactions with non-affiliates. In addition, certain of these transactions, such as loans to an affiliate, are restricted to a percentage of the savings bank’s capital. Affiliates of the Bank include the Company and any company that is under common control with the Bank. In addition, a commercial bank may not acquire the securities of most affiliates. The KDFI and FDIC have the discretion to treat subsidiaries of commercial banks as affiliates on a case-by-case basis.

Certain transactions with directors, officers or controlling persons are also subject to conflict of interest regulations enforced by the KDFI and FDIC. These conflict of interest regulations and other statutes also impose restrictions on loans to such persons and their related interests. Among other things, such loans must generally be made on terms that are substantially the same as for loans to unaffiliated individuals.

Reserve Requirements. Pursuant to regulations of the FRB, all FDIC-insured depository institutions must maintain average daily reserves at specified levels against their transaction accounts. The Bank met these reserve requirements at December 31, 2018.

Federal Home Loan Bank System. The Federal Home Loan Bank System consists of 12 district Federal Home Loan Banks subject to supervision and regulation by the Federal Housing Finance Board (“FHFB”). The Federal Home Loan Banks provide a central credit facility primarily for member institutions. As a member of the FHLB, the Bank is required to acquire and hold shares of capital stock in the FHLB in an amount at least equal to 1% of the aggregate unpaid principal of its home mortgage loans, home purchase contracts, and similar obligations at the beginning of each year, or 5% of its advances (borrowings) from the FHLB, whichever is greater. The Bank was in compliance with this requirement, with a $4.4 million investment in FHLB stock at December 31, 2018.

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Bank Secrecy Act. The Bank Secrecy Act (“BSA”), as amended by the USA Patriot Act of 2001 and its related regulations, requires insured depository institutions to have policies, procedures, and controls to detect, prevent, and report money laundering and terrorist financing. The statute and regulations also provide for information sharing, subject to conditions, between federal law enforcement agencies and financial institutions, as well as among financial institutions, for counter-terrorism purposes. Federal banking regulators are required, when reviewing bank holding company acquisition and bank merger applications, to take into account the effectiveness of the anti-money laundering activities of the applicants. The bank regulatory agencies have increased the regulatory scrutiny of BSA and anti-money laundering programs maintained by financial institutions. Significant penalties and fines, as well as other supervisory enforcement action, may be imposed on a financial institution for non-compliance with these requirements.

Consumer Protection Laws. In connection with our deposit-taking lending and other activities, the Bank is subject to a number of federal and state laws designed to protect consumers and promote lending and other financial services to various sectors of the economy and population. The Consumer Financial Protection Bureau issues regulations and standards under these federal consumer protection laws, which include, among others, the Home Mortgage Disclosure Act, the Real Estate Settlement Procedures Act, the Equal Credit Opportunity Act, the Truth in Lending Act, the Electronic Fund Transfer Act, the Truth in Savings Act, and the Fair Credit Reporting Act. The Bank is examined by the FDIC for compliance with these consumer protection rules.

In addition, customer privacy statutes and regulations limit the ability of the Bank to disclose nonpublic consumer information to non-affiliated third-parties. These laws require the Bank to provide notice to our customers regarding privacy policies and practices and to give our customers an option to prevent the Company from sharing their non-public personal information with non-affiliated third parties or with our affiliates.

Community Reinvestment Act. All insured depository institutions have a responsibility under the Community Reinvestment Act (the “CRA”) and related federal regulations to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. In connection with its examination of the Bank, the FDIC is required to assess our record of compliance with the CRA. Such assessment is reviewed by the FRB and/or the FDIC when the Company or the Bank makes application for approval of an expansionary proposal, such as a merger or other acquisition of another bank or the opening of a new branch office. The Bank received a “satisfactory” CRA rating in its most recent assessment by the FDIC.

Available Information The Company’s filings with the Securities and Exchange Commission (“SEC”), including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments thereto, are available on the Company’s website as soon as reasonably practicable after the reports are filed with or furnished to the SEC. Copies can be obtained free of charge in the “Investor Relations” section of the Company’s website at www.bankwithheritage.com.

Forward-Looking Statements

This Annual Report on Form 10-K, including all documents incorporated herein by reference, contains forward-looking statements. Additional written or oral forward-looking statements may be made by the Company from time to time in filings with the Securities and Exchange Commission or otherwise. The words “believe,” “expect,” “seek,” and “intend” and similar expressions identify forward-looking statements, which speak only as of the date the statement is made. Such forward-looking statements are within the meaning of that term in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements may include, but are not limited to, projections of income or loss, expenditures, acquisitions, plans for future operations, financing needs or plans relating to services of the Company, as well as assumptions relating to the foregoing. Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Future events and actual results could differ materially from those set forth in, contemplated by or underlying the forward-looking statements. The Company does not undertake, and specifically disclaims, any obligation to publicly release the results of revisions, which may be made to forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

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The Company could experience an increase in loan losses, which would reduce the Company’s earnings. Our loan portfolio includes loans with a higher risk of loss which could lead to higher loan losses and non-accrual assets.

We originate commercial real estate loans, construction and development loans, consumer loans, loans secured by farmland, multi-family properties and residential mortgage loans primarily within our market area. Commercial real estate, commercial, farmland, and construction and development loans tend to involve larger loan balances to a single borrower or groups of related borrowers and are most susceptible to a risk of loss during a downturn in the business cycle. These loans also have historically had greater credit risk than other loans for the following reasons:

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Rapidly changing interest rate environments could reduce our net interest margin, net interest income, fee income and net income.

Interest and fees on loans and securities, net of interest paid on deposits and borrowings, are a large part of our net income. Interest rates are the key drivers of the Company’s net interest margin and subject to many factors beyond the control of management. As interest rates change, net interest income is affected. Rapid increases in interest rates in the future could result in interest expense increasing faster than interest income because of mismatches in the maturities of the Company’s assets and liabilities. Furthermore, substantially higher rates generally reduce loan demand and may result in slower loan growth. Decreases or increases in interest rates could have a negative effect on the spreads between interest rates earned on assets and the rates of interest paid on liabilities, and therefore decrease net interest income. See “Quantitative and Qualitative Disclosures about Market Risk”.

Liquidity needs could adversely affect the Company’s results of operations and financial condition.

The Company relies on dividends from the Bank as a primary source of funds. The Bank’s primary source of funds is customer deposits and cash flows from investment instruments and loan repayments. While scheduled loan repayments are a relatively stable source, they are subject to the ability of the borrowers to repay their loans. The ability of the borrowers to repay their loans can be adversely affected by a number of factors including:

Cash flows from the investment portfolio may be affected by changes in interest rates, resulting in excessive levels of cash flow during periods of declining interest rates and lower levels of cash flow during periods of rising interest rates. Deposit levels may be affected by a number of factors, including both the national market and local competitive interest rate environment, local and national economic conditions, natural disasters and other various events. Accordingly, the Company may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Such sources include the FHLB advances, brokered deposits and federal funds lines of credit from correspondent banks. The Company may also pledge investments as collateral to borrow money from third parties. In certain cases, the Company may sell investment instruments for sizable losses to meet liquidity needs, hurting net income. While the Company believes that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity needs.

We could face risk from our inability to diversify into high growth markets.

The Company’s management considers growth in the nearby Nashville, Tennessee, market critical for our future success. With the potential for our largest current market to experience an economic downturn, market diversification is vital to the future prosperity of our Company.

The financial industry is very competitive.

We face competition in attracting and retaining deposits, making loans, and providing other financial services throughout our market area. Our competitors include other community banks, regional and super-regional banking institutions, national banking institutions, and a wide range of other financial institutions such as credit unions, government-sponsored enterprises, mutual fund companies, insurance companies, brokerage companies, and other non-bank businesses. Many of these competitors have substantially greater resources as compared to the Company.

11

Inability to hire or retain certain key professionals, management and staff could adversely affect our revenues and net income.

We rely on key personnel to manage and operate our business, including major revenue generating functions such as our loan and deposit portfolios. The loss of key staff may adversely affect our ability to maintain and manage these portfolios effectively, which could negatively affect our revenues. In addition, loss of key personnel could result in increased recruiting, hiring, and training expenses, resulting in lower net income.

Management’s analysis of the necessary funding for the allowance for loan loss account may be incorrect or may suddenly change, resulting in lower earnings.

The funding of the allowance for loan loss account is the most significant estimate made by management in its financial reporting to shareholders and regulators. If negative changes to the performance of the Company’s loan portfolio were to occur, management may find it necessary or be required to fund the allowance for loan loss account through additional charges to the Company’s provision for loan loss expense. These changes may occur suddenly and be dramatic in nature. These changes are likely to affect the Company’s financial performance, capital levels and stock price.

The Company is subject to extensive regulation that could limit or restrict its activities.

The Company operates in a highly regulated industry and is subject to examination, supervision, and comprehensive regulation by various federal agencies, including the KDFI and the FDIC. The Company’s regulatory compliance is costly and certain types of activities, including the payment of dividends, mergers and acquisitions, investments, loans and interest rates charged and interest rates paid on deposits and locations of offices are subject to regulatory approval and may be limited by regulation. The Company is also subject to regulatory capital rules established by its regulators, which require it and the Bank to maintain adequate capital to support its and the Bank’s growth.

The laws and regulations applicable to the banking industry could change at any time, and the Company cannot predict the effects of these changes on its business and profitability. The Sarbanes-Oxley Act of 2002, and the related rules and regulations promulgated by the Securities and Exchange Commission and NASDAQ National Market that are now and will be applicable to the Company, have increased the scope, complexity, and cost of corporate governance, reporting and disclosure practices. As a result, the Company has experienced, and may continue to experience, greater compliance cost.

On July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act is having a broad impact on the financial services industry, including significant regulatory and compliance changes. Many of the requirements called for in the Dodd-Frank Act are being implemented over time and most are subject to implementing regulations over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act are implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on our operations is unclear. The regulatory changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage requirements, increase our regulatory compliance burden or otherwise adversely affect our business.

Further, we may be required to invest significant management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements under the Dodd-Frank Act. Failure to comply with the new requirements may negatively affect our results of operations and financial condition. While we cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, these changes could be materially adverse to our investors.

12

Even though the Company’s common stock is currently traded on The NASDAQ National Market, the trading volume in the Company’s common stock has been low and the sale of substantial amounts of its common stock in the public market could depress the price of the Company’s common stock.

The trading volume of the Company’s common stock on The NASDAQ National Market is relatively low when compared with larger companies listed on The NASDAQ National Market or other stock exchanges. Thinly traded stocks, such as the Company’s, can be more volatile than stocks trading in an active public market. Because of this, the Company stockholders may not be able to sell their shares at the volumes, prices, or times they desire.

The Company cannot predict the effect, if any, that future sales of its common stock in the market, or availability of shares of its common stock for sale in the market, will have on the market prices of the Company’s common stock. The Company, therefore, can give no assurance that sales of substantial amounts of its common stock in the market, or the potential for large amounts of sale in the market, would not cause the price of its common stock to decline or impair the Company’s ability to raise capital through sales of its common stock.

The market price of the Company’s common stock may fluctuate in the future, and these fluctuations may be unrelated to its performance. General market prices declines or overall market volatility in the future could adversely affect the price of the Company’s common stock, and the current market price may not be indicative of future market prices.

The Company conducts virtually all of its business activities in a geographically concentrated area of Middle and West Tennessee and Western Kentucky.

The Company operates eighteen offices located in Middle Tennessee and Western Kentucky. The Company maintains significant business relationships in the markets in which it operates as well as the communities adjoining our offices. Therefore, the Company’s success is directly tied to the economic viability of our markets which may not be representative of the country as a whole. While the Company believes that its credit quality has been strong given the current environment, continued economic stress in the market may result in an increase in non-performing loans and charge offs. Given the limited geographic footprint of our Company, the economic conditions in our marketplace may not be reflective of the entire nation.

If the interest rates rapidly increase the yield curve continues to flatten, our net interest margin will decline and net income may be negatively impacted.

Because of significant competitive pressures in our market and the negative impact of these pressures on our deposit and loan pricing, coupled with the fact that a significant portion of our loan portfolio has variable rate pricing that moves in concert with changes to the One Year Constant Maturity Treasury, Prime Rate or the London Interbank Offered Rate (LIBOR) the interest margin may be negatively impacted. Management anticipates that the current trend of a flatter yield curve, where short-term rates increase more rapidly than long term rates, will continue. A flatter yield curve will put pressure on the Company’s net interest margin, possible resulting in lower levels of net income.

13

Holders of HopFed Capital Trust I have rights that are senior to those of the Company’s common shareholders.

The Company has issued trust preferred securities from a special purpose trust and accompanying junior subordinated debentures. At December 31, 2018, the Company had outstanding trust preferred securities of $10.3 million. Payments of the principal and interest on the trust preferred securities are conditionally guaranteed by the Company. Further, the accompanying junior subordinated debentures the Company issued to the trusts are senior to our common stock. As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on common stock and, in the event of the Company’s dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made to the Company’s common shareholders. The Company has the right to defer distributions on its junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no dividends may be paid on its common stock. If our consolidated financial condition deteriorates or if we do not receive required regulatory approvals, we may be required to defer distributions on our junior subordinated debentures.

New capital requirements for bank holding companies and depository institutions may negatively impact our results of operations.

In July 2013, the Board of Governors of the Federal Reserve Bank approved the final rule for BASEL III capital requirements for all commercial banks charted in the U.S. Under the final rule, minimum requirements have increased for both the quantity and quality of capital held by banking organizations. Consistent with the international Basel framework, the rule includes a new minimum ratio of CET1 capital to risk-weighted assets of 4.5% and a CET1 capital conservation buffer of 2.5% of risk-weighted assets that will apply to all supervised financial institutions. The rule also raises the minimum ratio of tier 1 capital to risk-weighted assets from 4.0% percent to 6.0% percent and includes a minimum leverage ratio of 4.0% for all banking organizations. The transition period for implementation of Basel III was January 1, 2015, through December 31, 2018. At December 31, 2016, the Company met all capital requirements set forth by Basel III as required at the final implementation date of December 31, 2018.

The application of more stringent capital requirements for the Corporation and the Bank may, among other things, result in lower returns on invested capital, require the raising of additional capital, and result in regulatory actions if we were to be unable to comply with such requirements. Furthermore, the imposition of liquidity requirements in connection with the implementation of Basel III could result in our having to lengthen the term and increase the cost of our funding, restructure our business models and/or increase our holdings of liquid assets. Implementation of changes to asset risk weightings for risk based capital calculations, items included or deducted in calculating regulatory capital and/or additional capital conservation buffers could result in management modifying its business strategy and could limit our ability to make distributions, including paying dividends or buying back shares.

A failure in our operational systems or infrastructure, or those of third-parties, could impair our liquidity, disrupt our businesses, result in the unauthorized disclosure of confidential information, damage our reputation and cause financial losses.

Our businesses are dependent on their ability to process and monitor, on a daily basis, a large number of transactions, many of which are highly complex, across numerous and diverse markets. These transactions, as well as the information technology services we provide to clients, often must adhere to client-specific guidelines, as well as legal and regulatory standards. Due to the breadth of our client base and our geographical reach, developing and maintaining our operational systems and infrastructure is challenging, particularly as a result of rapidly evolving legal and regulatory requirements and technological shifts.

Our financial, accounting, data processing or other operating systems and facilities may fail to operate properly or become disabled as a result of events that are wholly or partially beyond our control, such as a spike in transaction volume, cyber-attack or other unforeseen catastrophic events, which may adversely affect our ability to process these transactions or provide services.

14

In addition, our operations rely on the secure processing, storage and transmission of confidential and other information on our computer systems and networks. Although we take protective measures to maintain the confidentiality, integrity and availability of our and our clients’ information across all geographic and product lines, and endeavor to modify these protective measures as circumstances warrant, the nature of the threats continues to evolve. As a result, our computer systems, software and networks may be vulnerable to unauthorized access, loss or destruction of data (including confidential client information), account takeovers, unavailability of service, computer viruses or other malicious code, cyber-attacks and other events that could have an adverse security impact. Despite the defensive measures we take to manage our internal technological and operational infrastructure, these threats may originate externally from third-parties such as foreign governments, organized crime and other hackers, and outsource or infrastructure-support providers and application developers, or may originate internally from within our organization. Given the increasingly high volume of our transactions, certain errors may be repeated or compounded before they can be discovered and rectified.

We also face the risk of operational disruption, failure, termination or capacity constraints of any of the third-parties that facilitate our business activities, including exchanges, clearing agents, clearing houses or other financial intermediaries. Such parties could also be the source of an attack on, or breach of, our operational systems, data or infrastructure. In addition, as interconnectivity with our clients grows, we increasingly face the risk of operational failure with respect to our clients’ systems.

Although we have not experienced a cyber-incident, if one or more of these events occurs, it could potentially jeopardize the confidential, proprietary and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our, as well as our clients’ or other third-party operations, which could result in damage to our reputation, substantial costs, regulatory penalties and/or client dissatisfaction or loss. Potential costs of a cyber-incident may include, but would not be limited to, remediation costs, increased protection costs, lost revenue from the unauthorized use of proprietary information or the loss of current and/or future customers, and litigation.

We maintain an insurance policy which we believe provides sufficient coverage at a manageable expense for an institution of our size and scope with similar technological systems. However, we cannot assure that this policy would be sufficient to cover all financial losses, damages, penalties, including lost revenues, should we experience any one or more of our or a third-party’s systems failing or experiencing attack.

Since we engage in lending secured by real estate and may be forced to foreclose on the collateral property and own the underlying real estate, we may be subject to the increased costs associated with the ownership of real property, which could result in reduced net income.

Since we originate loans secured by real estate, we may have to foreclose on the collateral property to protect our investment and may, thereafter, own and operate such property, in which case we are exposed to the risks inherent in the ownership of real estate.

The amount that we, as mortgagee, may realize after a default is dependent upon factors outside of our control, including, but not limited to general and local economic conditions, changing values of property, interest rates, unpaid real estate taxes, environmental issues, operating expenses involved with managing other real estate owned, and the supply and demand for units held for sale as well as other unforeseen cost and delays.

Certain expenditures associated with the ownership of real estate, principally real estate taxes and maintenance costs, may adversely affect the income from the real estate. Therefore, the cost of operating real property may exceed the rental income earned from such property, and we may have to advance funds in order to protect our investment or we may be required to dispose of the real property at a loss.

15

We face risks arising from acquisitions of either other financial institutions or branch locations.

From time to time, we may acquire another financial institution. We face a number of risks arising from acquisition transactions, including difficulties in integrating the acquired business into our operations, difficulties in assimilating and retaining employees and intermediaries, difficulties in retaining the existing customers of the acquired entity, unforeseen liabilities that arise in connection with the acquired business and unfavorable market conditions that could negatively impact our growth expectations for the acquired business. These risks may prevent us from realizing the expected benefits from acquisitions and could result in the impairment of goodwill and/or intangible assets recognized at the time of acquisition.

We face risk from further reductions in the size and makeup of the U.S. Army staffing at Fort Campbell, Kentucky.

The U.S. Army has provided a revised assessment of future staffing cuts that indicates that Fort Campbell may lose a small portion of its active duty military personnel by 2020. The Fort Campbell military installation in the largest employer in the region and a significant reduction in the staffing of the base would have a major negative affect on the economies of Montgomery County, Tennessee and Christian County, Kentucky. The Company has a significant portion of its loan portfolio invested in the area near Fort Campbell.

Stockholder activists could cause a disruption to our business.

Certain institutional investors have indicated that they disagree with the strategic direction of our Company. Our business, operating results or financial condition could be adversely affected by these activists. Any such disruption may result in, among other things:

Our cash availability at the holding company level may limit the Company’s ability to continue to pay a cash dividend to common shareholders and/or repurchase treasury stock.

At December 31, 2018, the Corporation has cash on hand available to pay common dividends and repurchase treasury stock. The Bank may not receive regulatory approval to pay the Corporation a dividend, which would limit the Company’s ability to repurchase treasury stock and to continue to pay a cash dividend to common shareholders.

16

Extreme weather could disrupt our operations and may negatively affect our profitability.

Some of our operations are located in areas that are susceptible to earthquakes, tornados and other forms of extreme weather. Such weather events could disrupt our operations and have a material adverse effect on our overall operating results of operations. Further, an extreme weather event in any of our market areas could make it more difficult for borrowers to make timely loan payments may reduce the value of collateral used to secured loans.

Changes in the policies of monetary authorities and other government action could adversely affect our profitability.

Our consolidated results of operations are affected by credit policies of monetary authorities, particularly the Federal Reserve. The instruments of monetary policy employed by the Federal Reserve include open market operations in U.S. government securities, changes in the discount rate or federal funds rate on bank borrowing and changes in reserve requirements against bank deposits. In view of changing conditions in the national economy and in the money markets, we are unable to predict future changes in interest rates, deposit levels, loan demand or our business and earnings. Market interest rates and the economy market be negatively influenced by terrorist attacks and political actions.

Technological changes in the banking and financial services industries may negatively impact our results of operations and our ability to compete.

The banking and financial services industries are undergoing rapid changes with frequent introductions of new technology-driven products and services. The use of technology enhances the level of service to customers and may improve the efficiencies and reduce expenses. To remain competitive, financial institutions must continuously evaluate changing consumer preferences with engage those technologies in a cost effective manner. Our future success will depend, in part, on our ability to use the correct technology that will allow the Company to meet the current and future needs of our customer base. Failure to do so may leave the Company in a competitive disadvantage and result in a loss of customer business. The Company’s competition may have greater resources to invest in technology, which may place the Company at a competitive disadvantage.

The Company’s announced merger with First Financial Corporation may not occur.

The Company has announced the execution of a definitive merger agreement with First Financial Corporation. After the announcement of the merger agreement, the Company’s stock price increased significantly. The Company’s merger into First Financial requires approval from by various regulatory agencies and by the shareholders of the Company. There is no guarantee that the merger will occur. The Company’s future business prospects may be damaged and the Company’s market capitalization may decline if the announced merger is not consummated.

There are no unresolved staff comments from the Securities and Exchange Commission.

17

The following table sets forth information regarding the Bank’s offices at December 31, 2018:

18

None

None

19

PART II

A cash dividend of $0.04 per share was declared in the first quarter of 2017. A cash dividend of $0.05 per share was declared in the second, third, four quarter of 2017 and the first quarter of 2018. A cash dividend of $0.07 per share was declared in the second, third, and fourth quarter of 2018. The high and low price range of the Company’s common stock for 2018 and 2017 is set forth below:

At February 28, 2019, the Company estimates that is has approximately 900 shareholders, with approximately 700 reported in the name of the shareholder and the remainder recorded in street name.

At December 31, 2018, the Company has 1,341,980 shares of common treasury stock and has an active repurchase plan in which we may purchase up to 296,380 shares of our common stock on the open market or in negotiated transactions. The Company did not purchase any shares during the three month period ended December 31, 2018.

The Federal Reserve Bank has issued a policy statement regarding the payment of dividends and the repurchase of common stock by commercial bank holding companies. In general, dividends should be paid out of current earnings and only if the prospective rate of earnings retention by the holding company appears consistent with the organization’s capital requirements, asset quality and overall financial condition. These regulatory policies may affect the ability of the Company to pay dividends, repurchase shares of common stock or otherwise engage in capital distributions.

Stock Performance Comparison

The following graph, which was prepared by SNL Financial LC (“SNL”), shows the cumulative total return of the Common Stock of the Company since December 31, 2013 compared with the (1) NASDAQ Composite Index, comprised of all U.S. Companies quoted on NASDAQ, (2) the SNL Midwest Thrift Index, comprised of publically traded thrifts and thrift holding companies operating in the Midwestern United States, and (3) the SNL Midwest Bank Index, comprised of publically traded commercial banks and bank holding companies operating in the Midwestern United States. Cumulative total return on the Common Stock or the index equals the total increase in the value since December 31, 2012 assuming reinvestment of all dividends paid into the Common Stock or the index, respectively. The graph was prepared assuming that $100 was invested on December 31, 2013 in the Common Stock, the securities included in the indices.

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SELECTED FINANCIAL INFORMATION AND OTHER DATA

The following summary of selected financial information and other data does not purport to be complete and is qualified in its entirety by reference to the detailed information and Consolidated Financial Statements and accompanying Notes appearing elsewhere in this Report.

Financial Condition and Other Data

21

Selected Quarterly Information (Unaudited)

22

Key Operating Ratios

Regulatory Capital

23

Aggregate Contractual Obligations

Deposits represent non-interest bearing, money market, savings, interest bearing checking accounts and certificates of deposits held by the Company. Amounts that have an indeterminate maturity period are included in the less than one-year category. FHLB borrowings represent the amounts that are due to Federal Home Loan Bank of Cincinnati. All amounts have fixed maturity dates. Repurchase agreements represent overnight retail repurchase accounts. Retail repurchase agreements mature daily and pay interest based on their account balances.

Subordinated debentures represent the amount borrowed in a private pool trust preferred issuance group on September 25, 2003. The Company’s rate of interest on the debentures is equal to the three-month LIBOR plus 3.10%. On January 8, 2019, the three-month LIBOR rate was 2.79% and the debenture repriced at 5.89%. The debentures re-price and pay interest quarterly and have a thirty-year final maturity. The Company may call the debentures on a quarterly basis. The interest rate of the debentures reset on the 8^th day (or the next business day) of January, April, August and November of each year.

Lease commitments represent the total minimum lease payments under non-cancelable operating leases. The most significant operating contract is for the Company’s data processing services, which re-prices monthly based on the number of accounts and other operational factors. The Company’s operating contract with the current data processing provider is currently set to expire September 30, 2019.

Off Balance Sheet Arrangements

Standby letters of credit represent commitments by the Company to repay a third-party beneficiary when a customer fails to repay a loan or debt instrument. The terms and risk of loss involved in issuing standby letters of credit are similar to those involved in issuing loan commitments and extending credit. In addition to credit risk, the Company also has liquidity risk associated with stand-by letters of credit because funding for these obligations could be required immediately. Unused lines of credit represent commercial and residential equity lines of credit with maturities ranging from one to fifteen years.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

This discussion relates to the consolidated financial condition and results of operations of the Company, which consist of the consolidation of Heritage Bank USA, Inc. (the “Bank”) and HopFed Bancorp, Inc. (the “Corporation”), JBMM LLC, Heritage USA Title LLC, and Fort Webb LLC (collectively referred to as the “Company”). The Corporation became the holding company for the Bank in February 1998. The principal business of the Bank consists of accepting deposits from the public and investing these funds primarily in loans, investment securities and mortgage-backed securities. The Bank’s loan portfolio consists primarily of loans secured by real estate and commercial business assets located in its market area.

Announced Agreement to Merge

On January 7, 2019, First Financial Corporation (NASDAQ: THFF) (“First Financial”) and the Company jointly announced the execution of a definitive merger agreement under which the Company will merge into First Financial in a cash and stock transaction. Upon completion of the merger, the Bank will merge into First Financial Bank, N.A. (“First Financial Bank”), a wholly owned subsidiary of First Financial.

Under the terms of the merger agreement, which was unanimously approved by the Boards of Directors of both the Company and First Financial, stockholders of the Company may elect to receive either (or a combination of) 0.444 shares of First Financial common stock or $21.00 in cash for each share of the Company’s common stock owned, subject to proration provisions specified in the merger agreement that provide for a targeted aggregate split of 50% of HFBC shares being exchanged for First Financial common stock and 50% for cash. Based upon the $43.01 closing price of First Financial common stock on January 4, 2019 and assuming that a shareholder received 50% stock and 50% cash, the purchase price would be worth $20.05 per share, with an aggregate transaction value of approximately $128.3 million. For more information, please review the Company’s 8-K/A filing with the Securities and Exchange Commission dated January 9, 2019.

The proposed merger is subject to regulatory approval and an affirmative vote from the Company’s shareholders. If approved, the merger is expected to close in the second quarter of 2019.

Comparison of Financial Condition at December 31, 2018 and December 31, 2017

At December 31, 2018, the Company’s total assets were $931.4 million, representing an increase of $13.9 million compared to December 31, 2017. At December 31, 2018, cash balances were $52.1 million compared to $45.1 million at December 31, 2017. At December 31, 2018, the Company’s balances of securities available for sale were $170.8 million compared to $184.8 million at December 31, 2017.

At December 31, 2018, the balance in the allowance for loan loss account was $4.5 million compared to $4.8 million at December 31, 2017. At December 31, 2018, the Company’s non-accrual loans totaled $1.4 million, or 0.22% of total loans. At December 31, 2018, the allowance for loan loss equaled 317.25% of non-accrual loans and 0.68% of total loans. At December 31, 2018, loans classified as substandard total $14.3 million, or 13.6% of risk based capital. For the year ended December 31, 2018, the Company incurred $288,000 of provision for loan loss expense and recognized net charge offs of $578,000, or 0.09% of average loans. At December 31, 2018, the Company’s continued low levels of net charge offs, non-accrual loans and loans classified as substandard are all contributing factors in the Company’s low provision for loan loss expense.

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In each of the last three years, loan growth has driven improved profitability levels. At December 31, 2018, total net loans were $658.8 million compared to $637.1 million at December 31, 2017. Total net loans were $672.3 million at June 30, 2018 before declining in both the third and fourth quarter of 2018. The decline in net loans in the second half of 2018 was the result of significant customer payoffs, declining loan originations and the loss of loan participations repurchased from other financial institutions. The Company’s net loan growth in each of the last three years is as follows:

At December 31, 2018, December 31, 2017 and December 31, 2016, the Company’s loan production offices (“Tennessee LPO’s”) experienced loan growth of $23.3 million, $26.1 million and $27.1 million, respectively. The highly desirable demographics and growth characteristics of the Nashville market continue to provide the most significant opportunities for loan growth.

At December 31, 2018, the Company’s non-interest checking account balances were $129.5 million compared to $136.2 million at December 31, 2017. The decline in checking account balances occurred largely due to rising interest rates, providing customers with the incentive to transfer funds into interest earning deposit accounts. At December 31, 2018, the Company’s interest bearing checking were $197.0 million, representing a decline of $11.5 million compared to December 31, 2017. The decline is the result of a few municipal customers changing institutions for higher rates. The Company’s time deposit balances increased from $305.0 million at December 31, 2017 to $316.2 million at December 31, 2018. The increase in time deposit balances for the year ended December 31, 2018 included a $5.7 million increase in brokered deposits. The Company’s Federal Home Loan Bank (“FHLB”) borrowings increased from $23.0 million at December 31, 2017 to $33.0 million at December 31, 2018.

Comparison of Financial Condition at December 31, 2017 and December 31, 2016

At December 31, 2017, the Company’s total assets were $917.5 million, representing an increase of $26.0 million compared to December 31, 2016. At December 31, 2017, cash balances were $45.1 million compared to $25.7 million at December 31, 2016. At December 31, 2017, the Company’s balances of securities available for sale were $184.8 million compared to $209.5 million at December 31, 2016. In 2017, the Company foreclosed on a significant substandard loan relationship and recognized a $2.6 million charge off. At December 31, 2017, the balance in the allowance for loan loss account declined to $4.8 million compared to $6.1 million at December 31, 2016.

At December 31, 2017, net loans outstanding were $637.1 million compared to $604.3 million at December 31, 2016. In each of the last two years, a significant portion of the Company’s loan growth has occurred in two key markets. At December 31, 2017, the Company’s non-interest checking account balances were $136.2 million compared to $131.1 million at December 31, 2016. The growth in checking account balances occurred despite changes to retail deposit offerings that reduced the amount of checking accounts not being assessed a monthly fee. The Company’s time deposit balances increased from $293.1 million at December 31, 2016 to $305.0 million at December 31, 2017 and our Federal Home Loan Bank (“FHLB”) borrowings increased from $11.0 million at December 31, 2016 to $23.0 million at December 31, 2017.

26

Comparison of Operating Results for the Years Ended December 31, 2018 and 2017

The Company’s net income for the years ended December 31, 2018 and December 31, 2017 was $5.7 million and $3.3 million, respectively. For the year ended December 31, 2018, the Company’s return on average assets and return on average equity were 0.62% and 6.52%, respectively, compared to 0.36% and 3.78%, respectively, for the year ended December 31, 2017. The improvement in net income was largely the result of modest loan growth coupled with an increase in yields, slightly lower levels of non-interest expenses and a lower federal income tax rate.

For the year ended December 31, 2018, total interest and dividend income increased $3.0 million compared to December 31, 2017 due to the higher market interest rates and a $35.8 million increase in the average balance of net loans. In 2018, the Company continued to use our investment portfolio’s cash flow to fund loan growth in an effort to enhance our net interest margin and profitability.

For the year ended December 31, 2018, interest expense was $8.2 million compared to $6.0 million for the year ended December 31, 2017. The increase in interest expense was largely the result of higher short term interest rates as the Federal Reserve Open Market Committee (“FED”) continued to increase its overnight borrowing rate to 2.50% by the end of 2018. The average cost of all deposits was 0.85% for the year ended December 31, 2018 compared to 0.64% for the year ended December 31, 2017. Over the same period, the average balance of total deposits declined by $11.2 million. For the year ended December 31, 2018, the Company’s cost of all interest bearing liabilities was 1.19% compared to 0.87% for the year ended December 31, 2017.

For the year ended December 31, 2018, total non-interest income was $7.8 million compared to $8.0 million for the year ended December 31, 2017. For the year ended December 31, 2018, the decline in non-interest income was largely the result of a $286,000 decline in service charge income and a $443,000 decline in other income. The decline in service charge income was the result of a decline in the usage of the Company’s overdraft checking account product. The decline of other income was partially the result of a $225,000 one-time payment received from a vendor in 2017. For the year ended December 31, 2018, gains on the sales of securities were $553,000, an increase of $384,000 compared to the year ended December 31, 2017 largely due to the call of a trust preferred security that previously incurred a $400,000 impairment charge.

Total non-interest expenses for the years ended December 31, 2018 and December 31, 2017 was $29.4 and $29.9 million, respectively. For the year ended December 31, 2018, the Company’s professional services expenses declined by $605,000 compared to the year ended December 31, 2017 due to the resolution of a shareholder lawsuit. For the year ended December 31, 2018, data processing expenses increased by $284,000 compared to the year ended December 31, 2017 due to a $225,000 refund from a vendor in 2017.

For the twelve month period ended December 31, 2018, total federal income tax expense was $1.1 million compared to $2.1 million for the twelve month period ended December 31, 2017. The passage of the Tax Cut and Jobs Act of 2017 resulted in a $980,000 increase in federal income tax expense in 2017 while reducing the Company’s stated federal tax rate from 34% to 21% beginning January 1, 2018. The effective tax rates for the years ended December 31, 2018 and December 31, 2017 were 15.8% and 39.4%, respectively.

Comparison of Operating Results for the Years Ended December 31, 2017 and 2016

The Company’s net income for the year ended December 31, 2017 and December 31, 2016 was $3.3 million and $2.9 million, respectively. The modest improvement in net income was largely the result of loan growth and lower levels of provision for loan loss expenses. The passage of the Tax Cut and Jobs Act of 2017 reduced the Company’s future corporate tax rate but required a $980,000 after-tax expense to reduce the value of the Company’s deferred tax assets. Improvements in net income were further limited by more than $1.1 million in legal expenses that resulted from a shareholder lawsuit and shareholder demand letter.

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For the year ended December 31, 2017, total interest income on loans increased $2.4 million compared to December 31, 2016 due to the Company’s $56.1 million increase in the average balance of net loans. For the year ended December 31, 2017, the Company’s interest income on investments declined by $411,000 due to lower average balances of securities.

For the year ended December 31, 2017, interest expense was $6.0 million compared to $5.3 million for the year ended December 31, 2016. The increase in interest expense was largely the result of higher short term interest rates as the FED increased its overnight borrowing rate to 1.50% by the end of 2017. The average cost of deposits was 0.64% for the year ended December 31, 2017 compared to 0.59% of average deposits for the year ended December 31, 2016. Over the same period, the average balance of deposits increased from $721.8 million for the year ended December 31, 2016 to $747.8 million for the year ended December 31, 2017.

The Company determined that an additional $477,000 and $1.2 million in provision for loan loss expense was required for the years ended December 31, 2017 and December 31, 2016, respectively. We reduced our provision expense in 2017 due to lower levels of non-accrual and substandard loans. The Company’s ratio of allowance for loan losses to non-performing loans at December 31, 2017 and December 31, 2016 was 351.49% and 67.36%, respectively.

For the year ended December 31, 2017, total non-interest income was $8.0 million, an increase of $95,000 compared to December 31, 2016. For the year ended December 31, 2017, the slight increase in non-interest income was accomplished despite a $443,000 decline in gains on the sale of securities and a $264,000 decline in mortgage origination income. The decline of income in both gains on the sale of securities and mortgage origination income is partially attributable to rising interest rates as well as increased competition for mortgage originators in the Company’s higher growth markets.

For the year ended December 31, 2017, the Company’s service charge income was $3.2 million, representing an increase of $436,000 compared to the year ended December 31, 2016. The increase in service charge income is the result of changes made by management to the Company’s retail deposit account offerings that increased the number of checking accounts paying a monthly fee. For the year ended December 31, 2017, other non-interest income increased by $306,000 as compared to the year ended December 31, 2016. The increase in other income was largely the result of a $225,000 one-time payment collected from a vendor.

Total non-interest expense for each of the years ended December 31, 2017 and December 31, 2016 was $29.9 million. For the year ended December 31, 2017, the Company’s salaries and benefits expense increased by $649,000 compared to the year ended December 31, 2016. The increase in salary and benefit expenses in 2017 compared to 2016 was the result of a $300,000 increase in health insurance benefits and a $349,000 increase in compensation. For the year ended December 31, 2017, professional services expenses were $2.3 million compared to $1.4 million for the year ended December 31, 2016 largely due to legal expenses of approximately $1.1 million incurred as a result of a shareholder lawsuit and shareholder demand letter.

For the year ended December 31, 2017, foreclosure expenses net of gains and losses on the sale of foreclosed assets were $9,000 compared to $448,000 for the year ended December 31, 2016. The decline in net foreclosure expenses for the year ended December 31, 2017 was the result of a reduction in both the number and complexity of foreclosures and higher realized values on properties sold. For the year ended December 31, 2017, other operating expenses were $3.6 million compared to $4.2 million for the year ended December 31, 2016.

Income Taxes. The effective tax rates for the years ended December 31, 2017 and December 31, 2016, was 39.4% and 11.1%, respectively. For the year ended December 31, 2017, the Company’s effective tax rate was largely influenced by the $980,000 reduction in the Company’s deferred tax asset. For the year ended December 31, 2017, higher tax rates were the result of higher levels of taxable income and reduced balances of municipal bonds.

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Lending Activities

The total gross loans, net of deferred loan fees of $419,000 and allowance for loan loss of $4.5 million, totaled $658.8 million at December 31, 2018, representing 70.7% of total assets at that date. Set forth below is selected data relating to the composition of the loan portfolio by type of loan at the dates indicated. At December 31, 2018, there were no concentrations of loans exceeding 10% of total loans other than as disclosed below:

Loan Maturity Schedule. The following table sets forth certain information at December 31, 2018 regarding the dollar amount of loans maturing in the portfolio based on their contractual maturity dates. Demand loans, loans having no stated schedule of repayments, loans having no stated maturity, and overdrafts are due in one year or less.

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The following table sets forth at December 31, 2018 the dollar amount of all loans due after December 31, 2019 which had predetermined interest rates and had floating or adjustable interest rates.

Scheduled contractual principal repayments of loans do not reflect the actual life of such assets. The average life of loans is substantially less than their contractual terms because of prepayments. In addition, due-on-sale clauses on loans generally give the lender the right to declare a loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan market rates are substantially higher than rates on existing mortgage loans and, conversely, decrease when current mortgage loan market rates are substantially lower than rates on existing mortgage loans.

Management measures commercial real estate (CRE) concentrations as discussed in Concentrations of Commercial Real Estate Lending, Sound Risk Management Practices issued on December 12, 2006 jointly by the Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (Federal Reserve) and the Federal Deposit Insurance Corporation (FDIC). In this guidance, the agencies make a significant distinction between owner-occupied CRE and non-owner occupied CRE. The agencies have a heightened level of concern with those loans with risk profiles sensitive to the condition of the CRE market.

CRE loans secured by non-farm, non-residential CRE where the primary source of repayment is the cash flow from the ongoing operations and activities conducted by the owner of the property are excluded from the guidance. The Company has determined that $222.7 million of our loan portfolio, or 212.0% of the Company’s risk based capital, consists of properties classified as non-owner occupied commercial real estate. Non-owner occupied commercial real estate loans (“NOOCRE”) include all loans secured by multi-family properties, all construction and land development loans and certain other commercial real estate loans identified by regulations as non-owner occupied. At December 31, 2018 and December 31, 2017, the Company’s NOOCRE portfolio consisted of the following:

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Loan Underwriting Policies. Lending activities are subject to written, non-discriminatory underwriting standards and to loan origination procedures prescribed by the Board of Directors and its management. Detailed loan applications are obtained to determine the ability of borrowers to repay, and the more significant items on these applications are verified through the use of credit reports, financial statements and confirmations. Loan requests exceeding loan officer limits must be approved by the Chief Credit Officer, Chief Executive Officer, Executive Loan Committee of the Board of Directors or the entire Board of Directors.

The Bank offers a residential fixed rate loan program with maturities of 15, 20, and 30 years. The majority of our fixed rate single-family loans are underwritten and closed in accordance with secondary market standards. The Bank originates these loans with intent to sell on the secondary market. However, the Bank may choose to maintain a certain percentage of these loans in our portfolio. The Bank offers both servicing retained and servicing released products in an attempt to meet the needs of our customers. Due to the increasing level of regulatory burden imposed on companies that provide servicing for single family home loans, our pricing strategy provides incentives for the vast majority of our customers to select a servicing released loan product. At December 31, 2018, the Company’s 1 – 4 family servicing portfolio totals $14.3 million. The Company does not recognize a serving asset on its financial statements.

The Bank may lend up to 100% of the appraised value of the residential real property securing a mortgage loan. Under its lending policies, the Bank may originate a one-to-four family residential mortgage loan for owner-occupied property with a loan-to-value ratio of up to 95%. In most cases, the Bank requires private mortgage insurance for loan-to-value ratios exceeding 85%. For residential properties that are not owner-occupied, the Bank generally does not lend more than 80% of the appraised value. For all residential mortgage loans, the Bank may increase its lending level on a case-by-case basis.

At December 31, 2018 and December 31, 2017, the Bank’s loan portfolio included loan balances totaling $1.4 million and $2.0 million, respectively that are secured by 1–4 family residential mortgages with a loan to value ratio exceeding 90% without private mortgage insurance. At December 31, 2018 and December 31, 2017, no loans with a loan to value exceeding 90% without private mortgage insurance were past due 30 days or more or in non-accrual status.

Under applicable law, with certain limited exceptions, loans and extensions of credit outstanding by a commercial bank to a person at one time shall not exceed 15% of the institution’s unimpaired capital and surplus. Loans and extensions of credit fully secured by readily marketable collateral may comprise an additional 10% of unimpaired capital and surplus. Under these limits, the Bank’s loans to one borrower were limited to approximately $15.0 million at December 31, 2018. At that date, the Bank had no lending relationships in excess of the loans-to-one-borrower limit.

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Non-accrual Loans and Other Problem Assets

The Company’s non-accrual loan to total loan ratio at December 31, 2018 was 0.22%. Loans are classified as non-accrual when the loan is past due in excess of 90 days or the collection of principal and interest is doubtful. At December 31, 2018, the Company had no loans past due more than 90 days and accruing interest. At December 31, 2017, the Company had $88,000 in loans secured by a single family residence that was past due more than 90 days and still accruing interest. The following table sets forth information with respect to the Company’s non-performing loans at the dates indicated.

Federal regulations require commercial banks to classify their assets based on credit quality. In determining the classification of an asset, the Company utilizes a Classified Asset Committee consisting of members of senior management, credit analysis, loan review and collections. The committee attempts to determine the value of assets that are potentially impaired as well as the accurate reporting of Troubled Debt Restructuring (TDR) assets as defined later in this report. The committee’s function is an important step in management’s determination as to the necessary level of funding required in the Company’s allowance for loan loss account.

An asset is classified as substandard if it is determined to be inadequately protected by the current retained earnings and paying capacity of the obligor or of the collateral pledged, if any and may or may not be paying as agreed. An asset is classified as doubtful if full collection is highly questionable or improbable. An asset is classified as loss if it is considered uncollectible, even if a partial recovery could be expected in the future. The regulations also provide for a special mention designation, described as assets which do not currently expose a savings institution to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving management’s close attention. Such assets designated as special mention may include non-performing loans consistent with the above definition.

Assets classified as substandard or doubtful with aggregate balances exceeding $250,000 require the Company to conduct an impairment test to determine if the establishment of a specific reserve against the allowance for loan loss account is necessary. Typically, the basis for a loan impairment test is the current market value of the collateral, discounted to allow for selling and carrying cost. Typically, the Company obtains a new appraisal for all impairment testing of collateral when the loan balance exceeds $250,000. If the Company determines that a loan relationship is collateral dependent, it will charge off the portion of that loan that is deemed to be impaired. The Company defines collateral dependent as any loan in that the customer will be unable to reduce the principal balance of the loan without the complete or partial sale of the collateral.

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State and federal examiners may disagree with management’s classifications. If management does not agree with an examiner’s classification of an asset, it may appeal this determination to the appropriate supervisory examiner with the Kentucky Department of Financial Institutions (“KDFI”) and the FDIC. Management regularly reviews its assets to determine whether any assets require classification or re-classification. At December 31, 2018, the Bank had $14.3 million in loans classified as substandard and no loans classified as doubtful. Loans classified as substandard or doubtful by the Bank meet our classification of impaired loans, as defined by ASC 942-310-45-1. At December 31, 2018 and including our most recent examination, there were no material disagreements between examiners and management regarding risk grading or the funding of the allowance for loan loss account.

The tables below provide a summary of loans classified by the Bank as special mention and substandard by loan type for the years ended December 31, 2018 and December 31, 2017. The table also identifies the amount of the Bank’s allowance for loan loss account specifically allocated to individual loans for the specific periods below:

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Troubled Debt Restructuring

A loan customer may experience financial hardship and make request that the Company modify the original terms of their loan agreement. The Company analyzes each request separately and grants loan modifications based on the customer’s ability to eventually repay the loan and return to the original loan terms, the customer’s current loan status and the current and projected future value of the Company’s collateral. Loans that are modified as a result of a customer’s financial distress are classified as TDRs. The classification of a loan as a TDR is important in that it indicates that a particular customer may not be past due but represents a credit weakness due to the Company’s willingness to modify loan terms based on the financial weakness of the borrower. The table below provides a summary of the activity of loans classified as TDR for the year ended December 31, 2018:

The table below provides a summary of the activity of loans classified as TDR for the year ended December 31, 2017:

Foreclosed Assets

Real estate acquired by the Company as a result of foreclosure is classified as foreclosed assets until such time as it is sold. When such property is acquired, it is recorded at its fair value less estimated costs of sale. At the time of foreclosure, the collateral is reduced in value to its fair market value less holding and selling expenses and the remaining balance is charged against the allowance for loan losses. The value of foreclosed assets is periodically evaluated to ascertain its current market value. Additional reductions in market value are recognized as an expense through a charge to losses on foreclosures. At December 31, 2018, the Company’s total non-performing asset to total asset ratio was 0.54%. The following table sets forth information with respect to the Bank’s foreclosed assets at December 31, 2018, December 31, 2017, and December 31, 2016:

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Allowance for Loan Losses

In originating loans, the Company recognizes that credit losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. It is management’s policy to maintain an adequate allowance for loan losses based on, among other things, the Company’s and the industry’s historical loan loss experience, evaluation of economic conditions, regular reviews of delinquencies and loan portfolio quality and evolving standards imposed by federal bank examiners and other regulatory agencies. The Company increases its allowance for loan losses by charging provisions for loan losses against the Company’s income.

Management will continue to actively monitor the Company’s asset quality and allowance for loan losses. Management will charge off loans and properties acquired in settlement of loans against the allowances for loan losses on such loans and such properties when appropriate and will provide specific loss allowances when necessary. Although management believes it uses the best information available to make determinations with respect to the allowances for loan losses and believes such allowances are adequate, future adjustments may be necessary if economic conditions differ substantially from the economic conditions in the assumptions used in making the initial determinations.

The Company’s methodology for establishing the allowance for loan losses takes into consideration probable losses that have been identified in connection with specific assets as well as losses that have not been identified but have occurred in the last twelve quarters. Management conducts regular reviews of the Company’s assets and evaluates the need to establish allowances on the basis of this review. Allowances are established by the Board of Directors on a quarterly basis based on an assessment of risk in the Company’s assets taking into consideration the composition and quality of the portfolio, delinquency trends, current charge-off and loss experience, loan concentrations, the state of the real estate market, regulatory reviews conducted in the regulatory examination process and economic conditions generally.

Specific reserves will be provided for individual assets, or portions of assets, when ultimate collection is considered improbable by management based on the current payment status of the assets and the fair value of the security. At the date of foreclosure or other repossession, the Company would transfer the property to foreclosed assets at the lower of cost or estimated fair value and subsequently at the lower of book value or fair value less estimated selling costs. Any portion of the outstanding loan balance in excess of fair value less estimated selling costs would be charged off against the allowance for loan losses. If, upon ultimate disposition of the property, net sales proceeds exceed the net carrying value of the property, a gain on sale of other real estate would be recorded.

Financial institutions must provide adequate disclosure of the methodology used regarding maintenance of an adequate allowance for loan and lease losses and an effective loan review system. The Company utilizes a combination of its twelve quarter loan loss history and the sum of all impairment testing completed on individually classified loans deemed collateral dependent. The charge off history is weighted using the sum of the year’s digits. This method provides a 15.4% weight to the most recent quarterly losses, then 14.1% for the prior quarter’s losses, 12.8% for the 2^nd prior quarter’s losses and 11.5% for the prior quarter’s losses and continuing for twelve quarters.

Using this method, the Company trends for increasing or decreasing levels of charge offs may materially impact the funding level of the allowance for loan loss account. Additionally, the Company reserves the loss amount of any loans deemed to be impaired. The Company also applies certain qualitative factors in reviewing its allowance funding, including local and national delinquency and loss trends, noted concentrations or risk and recent additions to regulatory guidance. Financial institutions regulated by the KDFI and FDIC may require institutions to immediately charge off any portion of a collateral dependent loan that is deemed to be impaired.

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The following table sets forth an analysis of the Bank’s allowance for loan losses for the years indicated.