Executive Summary / Key Takeaways

• Arrow Financial Corporation operates as a community-focused regional bank in northeastern New York, leveraging a strong local brand and diversified service lines (banking, wealth management, insurance) to compete against larger regional players and emerging fintech.
• First Quarter 2025 results showed a significant 18.5% increase in net interest income year-over-year, driven by expanding asset yields and moderating funding costs, although net income decreased by 17.6% primarily due to a substantial increase in the provision for credit losses.
• A key financial event in Q1 2025 was the recognition of a $3.75 million specific reserve on a $15 million commercial real estate loan participation, highlighting isolated credit quality pressure while the broader loan portfolio quality remained relatively stable compared to peers.
• The company maintains robust capital and liquidity positions, exceeding all regulatory minimums and qualifying as well-capitalized, supported by a stable core deposit base and significant borrowing capacity, providing a buffer against potential economic volatility.
• Strategic initiatives, including the recent unification of banking subsidiaries and planned system conversion, aim to enhance operational efficiency, while the company actively manages interest rate risk and explores funding cost reduction strategies like the use of brokered CDs and interest rate swaps.

A Foundation in Community Banking: Setting the Scene for Arrow Financial

Arrow Financial Corporation, a New York-based bank holding company established in 1983, has built its identity around serving the financial needs of individuals and businesses across northeastern New York. From Albany to the Canadian border, AROW operates primarily through its unified banking subsidiary, Arrow Bank National Association, alongside complementary businesses in wealth management and insurance. This regional focus and diversified service offering form the bedrock of AROW's strategy, positioning it as a comprehensive financial partner deeply embedded within its local communities.

In a competitive landscape populated by larger regional banks like Financial Institutions, Inc. (FISI), NBT Bancorp Inc. (NBTB), and Community Bank System, Inc. (CBU), as well as increasingly agile fintech platforms and online banks, AROW differentiates itself through its established local brand and personalized service model. While competitors like FISI and NBTB have invested heavily in digital platforms offering faster processing speeds for transactions and loan applications, AROW's approach has historically leaned more on its physical branch network and relationship-based banking. This conservative stance, while fostering strong customer loyalty in its core markets, presents a vulnerability in terms of operational efficiency and the speed of digital innovation compared to peers. For instance, competitor digital platforms are noted to offer significantly faster processing speeds, potentially lowering their customer acquisition costs and enabling them to capture market share in shared segments. AROW's strategic response includes investments in technology, highlighted by the planned system conversion related to the recent unification of its banking subsidiaries, aimed at enhancing operational capabilities.

AROW's technological infrastructure, while not featuring a single, distinct "differentiated technology" in the manner of a specialized manufacturing process, is critical to its operations. The company utilizes credit evaluation software tools and an internally developed system for its CECL (Current Expected Credit Losses) modeling, supporting its risk management framework. The ongoing system conversion, slated for completion in July 2025, represents a significant operational undertaking. The stated goal of this initiative, stemming from the unification of its former subsidiary banks, is to streamline operations and presumably enhance overall efficiency, though specific quantifiable benefits or target metrics for this conversion are not detailed. The "so what" for investors is that successful execution of this conversion is crucial for AROW to improve its cost structure and potentially narrow the efficiency gap with more digitally advanced competitors, which currently exhibit lower operating costs per unit in areas like loan processing. Failure to keep pace with technological advancements in digital banking remains a key risk, potentially impacting customer acquisition and retention, particularly among younger demographics or those prioritizing convenience.

Financial Performance: Navigating Yield Expansion and Credit Costs

Arrow Financial's first quarter of 2025 results painted a picture of expanding core profitability offset by a significant credit event. Net income for the quarter stood at $6.310 million, a decrease from $7.660 million in the first quarter of 2024. This decline occurred despite a robust 18.5% increase in net interest income, which rose from $26.455 million in Q1 2024 to $31.357 million in Q1 2025.

The growth in net interest income was a direct result of continued yield expansion on earning assets, which saw average yields climb 33 basis points to 4.93% in Q1 2025 compared to 4.60% in Q1 2024. This was coupled with a moderating cost of interest-bearing liabilities, which decreased by 20 basis points to 2.42% over the same period. The net interest margin consequently expanded significantly, rising 47 basis points to 3.07% in Q1 2025 from 2.60% in Q1 2024. This trend reflects AROW's asset sensitivity over the longer term, benefiting from higher market rates, although the near-term dynamic suggests liabilities can reprice more quickly. The active management of deposit rates and the repricing of higher-cost time deposits contributed positively to this margin expansion, partially offsetting the negative impact of deposits migrating to higher-cost products.

The primary factor driving the year-over-year decrease in net income was a substantial increase in the provision for credit losses, which surged from $0.617 million in Q1 2024 to $5.019 million in Q1 2025. This significant increase was predominantly due to the recognition of a $3.75 million specific reserve on a $15 million commercial real estate (CRE) loan participation. This reserve was deemed necessary following the initiation of foreclosure proceedings and an updated appraisal that indicated a significant decline in the collateral's expected recovery value. While this specific situation highlights an isolated credit quality pressure point, the company noted that the underlying properties remained largely tenant-occupied and continued to generate positive net operating income as of quarter-end. Other factors contributing to the higher provision included net charge-offs of $0.846 million (up from $0.321 million in Q1 2024), overall loan growth, and adjustments based on economic forecast factors within the CECL model.

Non-interest income remained relatively stable year-over-year, totaling $7.839 million in Q1 2025 compared to $7.858 million in Q1 2024. Growth in insurance commissions (up 8.6%), partly attributable to the AB Acquisition in Q3 2024, and a significant net gain on securities (primarily from equity securities) were offset by a decrease in other operating income. Non-interest expense increased by 8.5% to $26.045 million in Q1 2025 from $24.012 million in Q1 2024, reflecting higher salaries and employee benefits (up 5.1%), occupancy costs (up 14.2%), and technology expenses (up 5.5%). This increase also included approximately $600 thousand in expenses related to the banking subsidiary unification and planned system conversion. The efficiency ratio, a measure of expense control, improved slightly to 66.52% in Q1 2025 from 69.54% in Q1 2024, indicating better operational leverage despite the absolute increase in expenses.

Looking at the balance sheet, total assets grew to $4.45 billion at March 31, 2025, up 3.3% from $4.31 billion at December 31, 2024. This growth was primarily driven by an increase in cash balances and expansion in the loan portfolio. Total loans reached $3.42 billion, a modest 0.7% increase from year-end 2024, led by growth in residential real estate loans (up 1.5%). Consumer loans saw a slight decrease, while commercial and commercial real estate loans experienced minor growth. Deposit balances also increased, rising 3.7% to $3.97 billion, influenced by seasonal municipal deposits and the strategic addition of $125 million in brokered CDs as part of a funding cost reduction strategy utilizing interest rate swaps.

AROW maintains a strong capital position, comfortably exceeding all regulatory minimums and qualifying as well-capitalized at both the holding company and bank levels. Stockholders' equity increased by 0.9% to $404.409 million in Q1 2025, benefiting from net income and other comprehensive gain, partially offset by cash dividends ($0.28 per share paid) and stock repurchases ($3.5 million under the $5 million authorization, with an additional $5 million authorized post-quarter). The tangible book value per share, a key metric for bank valuation, increased to $22.72 at March 31, 2025.

Outlook and Risk Considerations

The outlook for Arrow Financial is shaped by the prevailing interest rate environment, loan demand, deposit dynamics, and the successful execution of its strategic initiatives. Analyst estimates point to current quarter earnings around $0.62 per share and full-year 2025 earnings around $2.69 per share, suggesting an expectation of improved performance following the Q1 credit provision impact. The possibility of future rate decreases, as implied by the Federal Funds rate trend, could influence both asset yields and funding costs, impacting the net interest margin.

Loan growth is expected to remain solid, though a potential deterioration of economic conditions could temper production. The company's decision to resume selling residential real estate loans into the secondary market provides flexibility for balance sheet and interest rate risk management, with future sales volume dependent on market conditions and strategic needs. The strategic use of brokered CDs and interest rate swaps is intended to stabilize and potentially reduce funding costs, a critical factor in the current rate environment.

Key risks for AROW include the inherent uncertainty in the allowance for credit losses, which remains sensitive to economic conditions and specific loan performance, as demonstrated by the Q1 CRE reserve. While the company's loan quality indicators are monitored closely, unexpected changes in the economic forecast or specific borrower distress could necessitate further provisions. Interest rate risk continues to be a primary market risk, with potential volatility impacting net interest income, although simulation modeling suggests the company's profile is relatively neutral with long-term asset sensitivity. Operational risks, particularly related to the significant system conversion planned for July 2025, could potentially disrupt services or incur unexpected costs if not managed effectively. Competition from both traditional banks and digital-first players poses a continuous challenge, requiring AROW to balance its community-focused model with necessary technological investments to remain competitive in efficiency and service delivery.

Conclusion

Arrow Financial Corporation stands as a deeply rooted regional bank navigating a dynamic financial landscape. The first quarter of 2025 highlighted the core strength of its net interest income generation, benefiting from favorable interest rate dynamics, even as an isolated credit event impacted bottom-line profitability. AROW's strategic focus on community banking, complemented by wealth management and insurance services, leverages its strong local presence and customer relationships. While facing competitive pressures, particularly in digital capabilities compared to larger peers, the company is undertaking initiatives like the banking subsidiary unification and system conversion to enhance operational efficiency. With robust capital and liquidity positions providing a solid foundation, the investment thesis for AROW hinges on its ability to maintain asset quality, effectively manage funding costs in a potentially changing rate environment, and successfully execute its strategic operational improvements to compete effectively in its regional market. Investors should closely monitor trends in loan performance, deposit costs, and the progress of the system conversion as key indicators of future financial health and competitive positioning.