Fitch Ratings has affirmed the Long- and Short-Term Issuer Default Ratings (IDRs) for Community Bank System Inc (CBU) and its bank main subsidiary Community Bank, N.A. at 'A-' and 'F2', respectively.

The Rating Outlook has been revised to Negative from Stable.

Key Rating Drivers

The affirmation of CBU's ratings reflect its diversified business model for a bank its size, stable asset quality and solid deposit franchise that offers ample low-cost core deposits that support earnings. The revision of the rating Outlook to Negative reflects downward adjustments to CBU's Capitalization and Leverage, and Risk Profile factor scores related to its longer duration investment portfolio that has been more sensitive in the recent rising rate environment, negatively impacting tangible capital levels.

Differentiated Business Model: CBU's ratings are supported by its business model which is somewhat unique for a bank its size, with considerable revenue diversity derived from its non-banking businesses that help it achieve a proportion of noninterest income near 40%. These fee businesses also tend to be stable over time and also give the bank reach outside of its branch footprint. Fitch views this diversity in CBU's business as a key point of differentiation.

Risk Profile Revised: CBU has historically been judicious in pursuing growth, supplementing modest organic growth with a regular cadence of acquisitions. Fitch views CBU ability to effectively integrate banks both into its systems and culture, as a core competency of the bank. The robust 15% organic loan growth achieved in 2022 is notably higher than more typical low single digits, which Fitch views cautiously, as sustained growth at these higher levels could signal a higher risk appetite. This growth, combined with the interest rate risk of its longer duration investment portfolio, drove the revision of CBU's Risk Profile factor score from 'a-' to 'bbb+'.

Asset Quality Stable: Asset quality metrics remain stable and in line with historical metrics, with the bank's ratio of impaired loans of 0.40% in 2022, below its four-year average of 0.64%. Likewise, net charge-offs of 0.08% remained below their four-year average of 0.10%, supported by a stable regional economy. The loan portfolio is granular and diversified, and largely sourced in-footprint from markets that the bank knows well. CBU also holds a high-quality investment portfolio, which as of 4Q22, was 81% comprised of U.S. government and agency securities.

Profitability Better Than Peers: CBU's risk-adjusted profitability continues to be among the strongest of its peers with its ratio of operating profit to risk-weighted assets of 2.73% and 3.06% both for 2022 and on a four-year average basis, the second highest of Fitch's mid-tier regional bank peers. The bank enjoys greater revenue diversity, with its proportion of noninterest income to total revenue of 38% in 2022, significantly better than the peer median of 24%. 2023 profitability will be dampened by the $53 million loss on the sale of lower yielding securities, executed in 1Q23, but remain within the parameters of its current earnings and profitability factor score. The sale was executed as part of balance sheet restructuring, and will likely also have a positive effect on the bank's net interest margin in subsequent quarters.

Tangible Capital Drops: While CBU's regulatory capital levels remain relatively high, with a common equity Tier 1 ratio of 15.7%, more notably, unrealized losses from CBU's longer duration securities portfolio had a large impact on the bank's tangible common equity ratio (TCE), which experienced the largest YoY decline in 2022 of any bank in its peer group, dropping 408 bps compared to a median decline of 161 bps. Fitch's Negative Outlook reflects CBU's markedly lower TCE ratio. Fitch acknowledges CBU's balance sheet restructuring which has somewhat shortened the duration of its investment portfolio, contributing to the improvement of the ratio in 1Q23 to 5.41%. However, we expect that CBU's tangible capital levels will remain more sensitive than peers.

Solid Deposit Franchise: CBU continues to benefit from strong market share within the rural markets that it operates in, with a market share over 25% in 52% of these markets. With more limited competition, it was able achieve the lowest cost of deposits among its peers in 2022, with noninterest bearing deposits constituting approximately 30% of total deposits. The bank should continue to outperform peers, with management anticipating a low deposit beta of around 20%. Additionally, while the majority of peers saw their loan-to-deposit ratio decline as a result of the rising tightening monetary environment, CBU experienced 0.8% increase in deposits, compared to a median decline of 0.2%.

Rating Sensitivities

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

Fitch sees CBU's capital adequacy as an important supporting factor for its rating. Thus, Fitch would be sensitive to a TCE ratio that is sustained below the peer median. Ratings would be sensitive to additional realized losses from the sale of securities that cause earnings and profitability to fall below benchmark levels.

Fitch recognizes acquisitions are an important component of CBU's strategy and believes its success has been driven by its conservative and disciplined approach. However, Fitch would be sensitive to any large acquisition that fundamentally changes the risk appetite/profile of the company, or depress tangible capital levels.

Fitch views CBU's fee businesses, particularly the BPAS unit, as a key point of differentiation and supportive of its rating. These fees provide the company with a source of dependable noninterest income and growth outside its core footprint. Fitch would thus be sensitive to any strategic or structural changes that would materially diminish BPAS' contribution to earnings.

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade

Fitch continues to view CBU's rating as well situated at its current level. Fitch believes CBU's concentration in rural markets in upstate and central New York, northeast Pennsylvania, and Vermont, as a limiting factor for upwards ratings movement. Any longer-term movement would likely require an enhanced business profile and operating income base more consistent with higher rated banks. This would need to be achieved without major shifts in risk appetite.

OTHER DEBT AND ISSUER RATINGS: KEY RATING DRIVERS

HOLDING COMPANY

The IDR and Viability Rating (VR) of CBU are equalized with its operating company Community Bank, N.A., reflecting its role as the bank holding company, which is mandated in the U.S. to act as a source of strength for its bank subsidiaries. The ratings are also equalized to reflect the very close correlation between holding company and subsidiary failure and default probabilities.

LONG- AND SHORT-TERM DEPOSIT RATINGS

CBU's uninsured deposit ratings at the subsidiary bank are rated one notch higher than the company's IDR and senior unsecured debt because U.S. uninsured deposits benefit from depositor preference. U.S. depositor preference gives deposit liabilities superior recovery prospects in the event of default.

Government Support Rating

CBU has a Government Support Rating (GSR) of 'ns'. In Fitch's view, the probability of support is unlikely. IDRs and VRs do not incorporate any support.

OTHER DEBT AND ISSUER RATINGS: RATING SENSITIVITIES

HOLDING COMPANY

Should CBU begin to exhibit signs of weakness, demonstrate trouble accessing the capital markets, or have inadequate cash flow coverage to meet near-term obligations, Fitch could notch down the holding company IDR and VR from the ratings of the operating companies.

LONG- AND SHORT-TERM DEPOSIT RATINGS

The Long- and Short-Term deposit ratings are sensitive to any changes to CBU's Long- and Short-Term IDRs.

Government Support Rating

CBU's GSR is rated 'ns' and there is limited likelihood that these ratings will change over the foreseeable future.

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VR ADJUSTMENTS

The Business Profile score of 'a-' has been assigned above its implied 'bbb' category score due to the following adjustment reason: Business Model (positive);

The Asset Quality score of 'a-' has been assigned below its implied 'aa' category score due to the following adjustment reason: Concentrations (negative);

The Funding and liquidity score of 'a-' has been assigned below its implied 'aa' category score due to the following adjustment reason: Future and Historical Metrics (negative).

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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