Bank of Marin Bancorp 10-Q

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Management's discussion of the financial condition and results of operations, which is unaudited, should be read in conjunction with the related consolidated financial statements in this Form 10-Q and with the audited consolidated financial statements and accompanying notes included in our 2019 Annual Report on Form 10-K. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances. Forward-Looking Statements This discussion of financial results includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, (the "1933 Act") and Section 21E of the Securities Exchange Act of 1934, as amended, (the "1934 Act"). Those sections of the 1933 Act and 1934 Act provide a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about their financial performance so long as they provide meaningful, cautionary statements identifying important factors that could cause actual results to differ significantly from projected results. Our forward-looking statements include descriptions of plans or objectives of Management for future operations, products or services, and forecasts of revenues, earnings or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include the words "believe," "expect," "intend," "estimate" or words of similar meaning, or future or conditional verbs preceded by "will," "would," "should," "could" or "may." Forward-looking statements are based on Management's current expectations regarding economic, legislative, and regulatory issues that may affect our earnings in future periods. A number of factors, many of which are beyond Management’s control, could cause future results to vary materially from current Management expectations. Such factors include, but are not limited to, natural disasters (such as wildfires and earthquakes), our borrowers’ actual payment performance as loan deferrals related to the COVID-19 pandemic expire, changes to statutes, regulations, or regulatory policies or practices as a result of, or in response to COVID-19, including the potential adverse impact of loan modifications and payment deferrals implemented consistent with recent regulatory guidance, general economic conditions, economic uncertainty in the United States and abroad, changes in interest rates, deposit flows, real estate values, costs or effects of acquisitions, competition, changes in accounting principles, policies or guidelines, legislation or regulation (including the Tax Cuts & Jobs Act of 2017 and the Coronavirus Aid, Relief and Economic Security Act of 2020, as amended), interruptions of utility service in our markets for sustained periods, and other economic, competitive, governmental, regulatory and technological factors (including external fraud and cybersecurity threats) affecting Bancorp's operations, pricing, products and services. Important factors that could cause results or performance to materially differ from those expressed in our prior forward-looking statements are detailed in the Risk Factors section of this Form 10-Q and in Item 1A . Risk Factors section of our 2019 Form 10-K as filed with the SEC, copies of which are available from us at no charge. These and other important factors are detailed in various securities law filings made periodically by Bancorp, copies of which are available from Bancorp without charge. Forward-looking statements speak only as of the date they are made. Bancorp undertakes no obligation to release publicly the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date of this Form 10-Q or to reflect the occurrence of unanticipated events. Critical Accounting Policies and Estimates Critical accounting policies are those that are both important to the portrayal of our financial condition and results of operations and require Management's most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and imprecise. There have been no material changes to our critical accounting policies, which include: Allowance for Loan Losses, Other-than-temporary Impairment of Investment Securities, Accounting for Income Taxes, and Fair Value Measurements . For a detailed discussion, refer to Note 1 to the Consolidated Financial Statements included in our 2019 Form 10-K filed with the SEC on March 13, 2020 and Note 2, Recently Adopted and Issued Accounting Standards , to the Consolidated Financial Statements in this Form 10-Q. Under the accounting relief provisions of the Coronavirus Aid, Relief and Economic Security ("CARES") Act, which was signed into law on March 27, 2020, the Bank postponed the adoption of the current expected credit losses (“CECL”) accounting standard until the earlier of the end of the national emergency or December 31, 2020 to focus on customers' needs during the COVID-19 Page-30 pandemic. Additionally, the lack of clarity around the extent and duration of the COVID-19 pandemic hindered the development of reasonable and supportable economic forecasts early in the pandemic. Executive Summary Net income for the third quarter of 2020 totaled $7.5 million, compared to $9.4 million in the third quarter of 2019. Diluted earnings per share were $0.55 in the third quarter of 2020, compared to $0.69 in the same quarter a year ago. Earnings for the first nine months of 2020 totaled $22.1 million compared to $25.2 million in the same period last year. Diluted earnings per share were $1.62 and $1.82 in the first nine months of 2020 and 2019, respectively. Our net income for the first nine months of 2020 was $3.1 million lower than 2019, primarily due to the economic impact of the pandemic, resulting in a $5.1 million year-over-year increase in the provision for loan losses and an historic low interest rate environment. Our credit quality remained strong with non-accrual loans representing only 0.07% of total loans. We continue to focus on increasing efficiencies and controlling expenses to offset the impacts of net interest margin compression. Non-interest expenses remained relatively flat during 2020 resulting in an efficiency ratio of 56.21%. The Bank has responded to the COVID-19 pandemic in a number of ways, including third quarter charitable contributions to non-profit organizations of $360 thousand to ensure equitable access to remote learning resources for underserved students in Marin, Napa and Sonoma counties and the City of Alameda. In addition, to assist our employees during the pandemic, we paid $1,200 to each employee totaling $360 thousand in the third quarter, with executive management directing their payments to non-profit organizations of their choice. Since the onset of the pandemic, Bank of Marin has made Small Business Administration ("SBA") Paycheck Protection Program ("PPP") loans to over 1,800 small businesses, reaching nearly 28,000 employees in our markets. We also accommodated loan payment relief requests for borrowers, lowered interest rate floors on commercial Prime Rate loans, waived ATM and overdraft fees, and cancelled early withdrawal penalties for certificates of deposit when allowed by law. The following are highlights of our operating and financial performance for the periods presented: • Loans totaled $2,108.0 million at September 30, 2020, compared to $1,843.3 million at December 31, 2019, an increase of $264.7 million, primarily due to SBA PPP loans, which totaled $301.7 million, or 14% of loan balances at September 30, 2020. During the first nine months of 2020, new non-PPP-related loan originations of $122.4 million were offset by $124.7 million in loan payoffs and a $24.5 million decrease in line utilization. • Bank of Marin is awaiting further guidance from the SBA and the Department of Treasury regarding the PPP loan forgiveness process. We are prepared to open our secure portal for customers to submit forgiveness applications online in the fourth quarter of 2020. Of the total PPP loans, 48% (870 loans) totaling $18.4 million had principal balances of less than or equal to $50,000 as of September 30, 2020. • While California’s wildfire season has once again been challenging for many communities in Northern California, fortunately, Bank of Marin and our clients have been minimally impacted. The fires had a negligible impact on our third quarter results. • Since granting $388.5 million in payment relief for 264 loans at the onset of the pandemic, 236 loans totaling $336.3 million have resumed or are scheduled to resume normal payments and eight loans totaling $5.0 million paid off. As of October 19, 2020, twenty loans totaling $47.2 million (balances as of September 30, 2020) had either requested additional payment relief or the relief period had not expired. We know each of these clients very well and presently expect the majority will navigate through the pandemic and resume normal payments. The following table summarizes these loans by industry: Page-31 Payment Relief by Type Industry Outstanding Loan Balance (in thousands) Weighted Average LTV Education $17,481 26% Hospitality 10,431 49% Retail Related CRE 6,295 48% Health Clubs 6,201 60% Office and Mixed Use 5,371 55% Non-CRE Related 1,459 N/A Payment Relief Totals $47,238 42% • Credit quality remains a cornerstone of the Bank's consistent performance. Non-accrual loans totaled $1.4 million, or 0.07% of total loans at September 30, 2020, compared to $226 thousand, or 0.01% at December 31, 2019. Despite the low non-accrual totals, we considered the potential impact of the COVID-19 pandemic on the economy in general and recorded a provision for loan losses of $5.45 million for the first nine months of 2020, compared to a $400 thousand provision for the same period in 2019. Provision for losses on off-balance sheet commitments for the first nine months of 2020 was $610 thousand compared to $129 thousand for the same period in 2019. SBA PPP loans are fully guaranteed by the SBA and did not contribute to the provisions. • Total deposits increased $232.8 million in the first nine months of 2020 to $2,569.3 million at September 30, 2020. • Non-interest bearing deposits represented 54% of total deposits as of September 30, 2020, compared to 48% at December 31, 2019. The cost of average deposits decreased 7 basis points to 0.13% during the first nine months of 2020. • Return on assets was 1.03% for the nine months ended September 30, 2020, compared to 1.33% for the first nine months of 2019. Return on equity was 8.47% for the nine months ended September 30, 2020, compared to 10.40% for the nine months ended September 30, 2019. • All capital ratios were above well capitalized regulatory requirements. The total risk-based capital ratio for the Bank was 15.5% at September 30, 2020, compared to 14.6% at December 31, 2019. • On October 23, 2020, the Board of Directors approved the reactivation of the share repurchase program that was suspended on March 20, 2020 as part of the early pandemic response, of which $23.2 million remains available for future repurchases. • The Board of Directors declared a cash dividend of $0.23 per share on October 23, 2020. This represents the 62nd consecutive quarterly dividend paid by Bank of Marin Bancorp. The dividend is payable on November 13, 2020, to shareholders of record at the close of business on November 6, 2020. Bank of Marin's strong balance sheet is built from our core values - relationship banking, disciplined fundamentals and commitment to the communities that we serve. For the remainder of 2020 and looking forward into 2021, we believe that our robust liquidity and capital positions, high credit quality loan portfolio, excellent credit metrics and low-cost deposit base should help us navigate the pandemic and low interest rate environment. Page-32 RESULTS OF OPERATIONS Highlights of the financial results are presented in the following tables: (dollars in thousands) September 30, 2020 December 31, 2019 Selected financial condition data: Total assets $ 2,975,225 $ 2,707,280 Loans, net 2,085,878 1,826,609 Deposits 2,569,289 2,336,489 Borrowings and other obligations 2,859 2,920 Stockholders' equity 357,570 336,788 Asset quality ratios: Allowance for loan losses to total loans 1.05 % 0.90 % Allowance for loan losses to total loans, excluding non-PCI and SBA PPP loans 1 1.29 % 0.96 % Allowance for loan losses to non-accrual loans 15.34x 73.86x Non-accrual loans to total loans 0.07 % 0.01 % Capital ratios: Equity to total assets ratio 12.02 % 12.44 % Tangible common equity to tangible assets 2 11.00 % 11.30 % Total capital (to risk-weighted assets) 16.05 % 15.07 % Tier 1 capital (to risk-weighted assets) 14.92 % 14.24 % Tier 1 capital (to average assets) 10.58 % 11.66 % Common equity Tier 1 capital (to risk weighted assets) 14.79 % 14.11 % Three months ended Nine months ended (dollars in thousands, except per share data) September 30, 2020 September 30, 2019 September 30, 2020 September 30, 2019 Selected operating data: Net interest income $ 24,566 $ 24,151 $ 73,060 $ 71,786 Provision for loan losses 1,250 400 5,450 400 Non-interest income 1,790 2,721 6,723 6,766 Non-interest expense 15,238 14,200 44,848 44,644 Net income 7,491 9,448 22,125 25,162 Net income per common share: Basic $ 0.55 $ 0.70 $ 1.64 $ 1.84 Diluted $ 0.55 $ 0.69 $ 1.62 $ 1.82 Performance and other financial ratios: Return on average assets 0.98 % 1.49 % 1.03 % 1.33 % Return on average equity 8.37 % 11.34 % 8.47 % 10.40 % Tax-equivalent net interest margin 3 3.44 % 4.04 % 3.61 % 4.03 % Cost of deposits 0.09 % 0.21 % 0.13 % 0.20 % Efficiency ratio 57.82 % 52.84 % 56.21 % 56.83 % Cash dividend payout ratio on common stock 4 41.82 % 30.00 % 28.05 % 32.07 % 1 The allowance for loan losses to total loans, excluding non-impaired non-PCI and guaranteed SBA PPP loans, is considered a meaningful non-GAAP financial measure, as it represents only those loans that were considered in the calculation of the allowance for loan losses. Non-PCI loans that were not impaired at September 30, 2020 and December 31, 2019 totaled $90.4 million and $106.8 million, respectively. SBA PPP loans totaled $301.7 million at September 30, 2020. There were no SBA PPP loans as of December 31, 2019. 2 Tangible common equity to tangible assets is considered to be a meaningful non-GAAP financial measure of capital adequacy and is useful for investors to assess Bancorp's ability to absorb potential losses. Tangible common equity of $323 million and $302 million at September 30, 2020 and December 31, 2019, respectively, includes common stock, retained earnings and unrealized gains (losses) on available-for sale securities, net of tax, less goodwill and intangible assets. Tangible assets exclude goodwill and intangible assets of $34.2 million and $34.8 million at September 30, 2020 and December 31, 2019, respectively. 3 Tax-equivalent net interest margin is computed by dividing taxable equivalent net interest income, which is adjusted for taxable equivalent income on tax-exempt loans and securities based on Federal statutory rate of 21 percent, by total average interest-earning assets. 4 Calculated as dividends on common shares divided by basic net income per common share. Page-33 Net Interest Income Net interest income is the difference between the interest earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and other interest-bearing liabilities. Net interest income is impacted by changes in general market interest rates and by changes in the composition of interest-earning assets and interest-bearing liabilities. Interest rate changes can create fluctuations in the net interest income and/or margin due to an imbalance in the timing of repricing and maturity of assets and liabilities. We manage interest rate risk exposure with the goal of minimizing the impact of interest rate volatility on net interest income. For more information, refer to Item 3. Quantitative and Qualitative Disclosure about Market Risk in this Form 10-Q. Net interest margin is expressed as net interest income divided by average interest-earning assets. Net interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate incurred on total interest-bearing liabilities. Both of these measures are reported on a taxable-equivalent basis. Net interest margin is the higher of the two because it reflects interest income earned on assets funded with non-interest-bearing sources of funds, which include demand deposits and stockholders’ equity. Average Statements of Condition and Analysis of Net Interest Income The following table compares interest income, average interest-earning assets, interest expense, and average interest-bearing liabilities for the periods presented. The table also presents net interest income, net interest margin and net interest rate spread for each period reported. Three months ended Three months ended September 30, 2020 September 30, 2019 Interest Interest Average Income/ Yield/ Average Income/ Yield/ (dollars in thousands) Balance Expense Rate Balance Expense Rate Assets Interest-earning deposits with banks 1 $ 184,883 $ 50 0.11 % $ 77,467 $ 425 2.15 % Investment securities 2, 3 527,077 3,481 2.64 % 506,023 3,443 2.72 % Loans 1, 3, 4 2,117,679 21,957 4.06 % 1,780,325 21,719 4.77 % Total interest-earning assets 1 2,829,639 25,488 3.52 % 2,363,815 25,587 4.24 % Cash and non-interest-bearing due from banks 55,353 38,434 Bank premises and equipment, net 5,412 6,713 Interest receivable and other assets, net 138,938 114,537 Total assets $ 3,029,342 $ 2,523,499 Liabilities and Stockholders' Equity Interest-bearing transaction accounts $ 153,089 $ 41 0.11 % $ 137,861 $ 101 0.29 % Savings accounts 191,915 17 0.04 % 170,166 17 0.04 % Money market accounts 802,585 377 0.19 % 661,131 855 0.51 % Time accounts including CDARS 97,465 133 0.54 % 101,404 147 0.57 % Borrowings and other obligations 1 113 — 2.51 % 599 4 2.69 % Subordinated debenture 1 2,751 35 4.97 % 2,682 57 8.27 % Total interest-bearing liabilities 1,247,918 603 0.19 % 1,073,843 1,181 0.44 % Demand accounts 1,380,708 1,088,903 Interest payable and other liabilities 44,486 30,268 Stockholders' equity 356,230 330,485 Total liabilities & stockholders' equity $ 3,029,342 $ 2,523,499 Tax-equivalent net interest income/margin 1 $ 24,885 3.44 % $ 24,406 4.04 % Reported net interest income/margin 1 $ 24,566 3.40 % $ 24,151 4.00 % Tax-equivalent net interest rate spread 3.33 % 3.80 % Page-34 Nine months ended Nine months ended September 30, 2020 September 30, 2019 Interest Interest Average Income/ Yield/ Average Income/ Yield/ (in thousands; unaudited) Balance Expense Rate Balance Expense Rate Assets Interest-earning deposits with banks 1 $ 152,587 $ 421 0.36 % $ 43,896 $ 754 2.27 % Investment securities 2, 3 544,754 11,632 2.85 % 564,050 11,477 2.71 % Loans 1, 3, 4 1,998,456 64,423 4.24 % 1,765,260 63,786 4.76 % Total interest-earning assets 1 2,695,797 76,476 3.73 % 2,373,206 76,017 4.22 % Cash and non-interest-bearing due from banks 44,665 34,634 Bank premises and equipment, net 5,631 7,108 Interest receivable and other assets, net 130,525 108,806 Total assets $ 2,876,618 $ 2,523,754 Liabilities and Stockholders' Equity Interest-bearing transaction accounts $ 144,784 $ 146 0.13 % $ 130,109 $ 269 0.28 % Savings accounts 179,288 50 0.04 % 174,837 52 0.04 % Money market accounts 786,012 1,731 0.29 % 665,167 2,406 0.48 % Time accounts including CDARS 96,237 436 0.61 % 109,978 441 0.54 % Borrowings and other obligations 1 208 3 2.14 % 3,848 75 2.57 % Subordinated debenture 1 2,733 124 5.96 % 2,664 175 8.66 % Total interest-bearing liabilities 1,209,262 2,490 0.27 % 1,086,603 3,418 0.42 % Demand accounts 1,278,265 1,083,260 Interest payable and other liabilities 40,279 30,344 Stockholders' equity 348,812 323,547 Total liabilities & stockholders' equity $ 2,876,618 $ 2,523,754 Tax-equivalent net interest income/margin 1 $ 73,986 3.61 % $ 72,599 4.03 % Reported net interest income/margin 1 $ 73,060 3.56 % $ 71,786 3.99 % Tax-equivalent net interest rate spread 3.45 % 3.80 % 1 Interest income/expense is divided by actual number of days in the period times 360 days to correspond to stated interest rate terms, where applicable. 2 Yields on available-for-sale securities are calculated based on amortized cost balances rather than fair value, as changes in fair value are reflected as a component of stockholders' equity. Investment security interest is earned on 30/360 day basis monthly. 3 Yields and interest income on tax-exempt securities and loans are presented on a taxable-equivalent basis using the Federal statutory rate of 21%. 4 Average balances on loans outstanding include non-performing loans. The amortized portion of net loan origination fees is included in interest income on loans, representing an adjustment to the yield. Analysis of Changes in Tax-Equivalent Net Interest Income The following table presents the effects of changes in average balances (volume) or changes in average rates on tax-equivalent net interest income for the years indicated. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates. Rate variances are equal to the increase or decrease in rates multiplied by prior period average balances. Mix variances are attributable to the change in yields or rates multiplied by the change in average balances, including one more day in the nine months ended September 30, 2020. Page-35 Three Months Ended September 30, 2020 Compared to Three Months Ended September 30, 2019 Nine Months Ended September 30, 2020 Compared to Nine Months Ended September 30, 2019 (in thousands) Volume Yield/Rate Mix Total Volume Yield/Rate Mix Total Interest-earning deposits with banks $ 589 $ (404) $ (560) $ (375) $ 1,867 $ (633) $ (1,567) $ (333) Investment securities 1 143 (101) (4) 38 (393) 567 (19) 155 Loans 1 4,116 (3,260) (618) 238 8,426 (7,088) (701) 637 Total interest-earning assets 4,848 (3,765) (1,182) (99) 9,900 (7,154) (2,287) 459 Interest-bearing transaction accounts 11 (64) (7) (60) 30 (138) (15) (123) Savings accounts 1 (1) — — 1 (3) — (2) Money market accounts 183 (544) (117) (478) 437 (946) (166) (675) Time accounts, including CDARS (6) (8) — (14) (55) 56 (6) (5) Borrowings and other obligations (3) (6) 5 (4) (71) (13) 12 (72) Subordinated debenture 1 (23) — (22) 5 (55) (1) (51) Total interest-bearing liabilities 187 (646) (119) (578) 347 (1,099) (176) (928) Changes in tax-equivalent net interest income $ 4,661 $ (3,119) $ (1,063) $ 479 $ 9,553 $ (6,055) $ (2,111) $ 1,387 1 Yields and interest income on tax-exempt securities and loans are presented on a taxable-equivalent basis using the federal statutory rate of 21%. Third Quarter of 2020 Compared to Third Quarter of 2019 Net interest income totaled $24.6 million in the third quarter of 2020, compared to $24.2 million in the same quarter a year ago. The $415 thousand increase from the comparative quarter a year ago was primarily attributed to $2.4 million from SBA PPP loans, higher non-PPP loan balances and lower interest expense on deposits. These positive variances were partially offset by the impact of lower interest rates on non-PPP loans, cash and investments. The tax-equivalent net interest margin was 3.44% in the third quarter of 2020 compared to 4.04% in the same quarter of the previous year. The decrease in tax-equivalent net interest margin was attributable to both the lower interest rate environment and SBA PPP loans. SBA PPP loans lowered the third quarter 2020 net interest margin by 4 basis points. In October 2020, due to the continued delay in the PPP forgiveness process, the Bank extended the payment deferral period from six to sixteen months for PPP loans that originated prior to June 5, 2020 in accordance with the PPP Flexibility Act. The extension of the first payment due date decreased the effective rate used to accrete net loan origination fees and costs, which will affect the timing of when the accretion of PPP net loan origination fees will be recognized. We estimate this change will decrease fourth quarter 2020 net interest income by approximately $850 thousand. The decrease may be partially or fully offset by the accelerated fee accretion related to loans that are forgiven and paid off during the fourth quarter, which cannot be estimated at this time. First Nine Months of 2020 Compared to First Nine Months of 2019 Net interest income totaled $73.1 million in the nine months ended September, 30 2020, compared to $71.8 million in the same period a year ago. The $1.3 million increase was primarily due to SBA PPP loan income, higher commercial loan balances, higher yields on investments and lower rates on deposits partially offset by lower yields on loans. The tax-equivalent net interest margin was 3.61% in the nine months ended September 30, 2020, compared to 4.03% in the same period a year ago. The decrease in tax-equivalent net interest margin was attributable to both the lower interest rate environment and SBA PPP loans. SBA PPP loans lowered the 2020 net interest margin by 3 basis points. To offset the impacts of margin compression, we continue to focus on increasing efficiencies and controlling expenses including evaluating the cost of our facilities. Market Interest Rates In response to the evolving risks to economic activity posed by the COVID-19 pandemic, the Federal Reserve Open Market Committee ("FOMC") made two emergency cuts totaling 150 basis points to the federal funds rate in March 2020. This will continue to put downward pressure on our asset yields and net interest margin. See ITEM 3. Quantitative and Qualitative Disclosure about Market Risk for further information. Page-36 Provision for Loan Losses Management assesses the adequacy of the allowance for loan losses quarterly based on several factors including growth of the loan portfolio, analysis of probable losses in the portfolio, historical loss experience and the current economic climate, including the economic uncertainties of the COVID-19 pandemic. While loss recoveries and provisions for loan losses charged to expense increase the allowance, actual losses on loans reduce the allowance. Impaired loans totaled $13.8 million at September 30, 2020 and $11.5 million at December 31, 2019, with specific valuation allowances of $1,106 thousand and $397 thousand at the same respective dates. Loans graded special mention totaled $87.7 million at September 30, 2020 and $73.4 million at December 31, 2019. While special mention graded loans are not considered adversely classified, the $14.4 million increase was largely due to a small number of commercial real estate borrowers who, after further analysis, were granted additional payment relief beyond the initial relief period and a few commercial real estate loans that were considered temporarily affected by the pandemic. All of these loans have low loan-to-value ratios and will be monitored at least quarterly as part of the Bank's credit management process. Classified assets (loans with substandard or doubtful risk grades) totaled $11.0 million at September 30, 2020, compared to $9.9 million at December 31, 2019. There were no loans with doubtful risk grades at September 30, 2020 or December 31, 2019. In accordance with the accounting relief provisions of the CARES Act, the Bank has postponed the adoption of the CECL accounting standard to focus on our customers' needs during the COVID-19 pandemic and due to the lack of clarity around the extent and duration of the COVID-19 pandemic, which hindered development of reasonable and supportable forecasts in the early days of the pandemic. Under the existing incurred loss model we adjusted certain qualitative factors, primarily to account for the significant increase in the unemployment rate and recorded a $5.45 million loan loss provision for the nine months ended September 30, 2020, compared to $400 thousand for the same period in the prior year. Net charge-offs were $14 thousand for the nine months ended September 30, 2020, compared to net recoveries of $19 thousand same period in the prior year. The ratio of allowance for loan losses to total loans, including acquired loans and SBA-guaranteed PPP loans, was 1.05% at September 30, 2020, compared to 0.90% at December 31, 2019. Excluding guaranteed SBA PPP loans and non-PCI acquired loans, the ratio of the allowance for loan losses to total loans would have been 1.29% and 0.96% at September 30, 2020 and December 31, 2019, respectively (Refer to footnote 1 on page 33 for a definition and reconciliation of this non-GAAP financial measure). Non-accrual loans totaled $1.4 million, or 0.07% of total loans at September 30, 2020, compared to $226 thousand, or 0.01% of total loans at December 31, 2019. The $1.4 million increase in non-accrual loans was primarily attributable to one loan secured by a triplex property with a low loan-to-value ratio as well as one home equity loan. For more information, refer to Note 5 to the Consolidated Financial Statements in this Form 10-Q. Non-interest Income The following tables detail the components of non-interest income. Three months ended Amount Percent (dollars in thousands) September 30, 2020 September 30, 2019 Increase (Decrease) Increase (Decrease) Service charges on deposit accounts $ 284 $ 439 $ (155) (35.3) % Wealth Management and Trust Services 450 495 (45) (9.1) % Debit card interchange fees, net 383 406 (23) (5.7) % Merchant interchange fees, net 63 79 (16) (20.3) % Earnings on bank-owned life insurance 232 795 (563) (70.8) % Dividends on FHLB stock 149 202 (53) (26.2) % Gains on sale of investment securities, net — — — N/A Other income 229 305 (76) (24.9) % Total non-interest income $ 1,790 $ 2,721 $ (931) (34.2) % Page-37 Nine months ended Amount Percent (dollars in thousands) September 30, 2020 September 30, 2019 Increase (Decrease) Increase (Decrease) Service charges on deposit accounts $ 1,028 $ 1,403 $ (375) (26.7) % Wealth Management and Trust Services 1,375 1,406 (31) (2.2) % Debit card interchange fees, net 1,051 1,200 (149) (12.4) % Merchant interchange fees, net 183 253 (70) (27.7) % Earnings on bank-owned life insurance, net 741 970 (229) (23.6) % Dividends on FHLB stock 503 591 (88) (14.9) % Gains on sale of investment securities, net 915 55 860 1,563.6 % Other income 927 888 39 4.4 % Total non-interest income $ 6,723 $ 6,766 $ (43) (0.6) % Third Quarter of 2020 Compared to Third Quarter of 2019 Non-interest income decreased by $931 thousand in the third quarter of 2020 to $1.8 million, compared to $2.7 million in the same quarter a year ago. The decrease was primarily due to a $562 thousand benefit collected on BOLI policies in the third quarter of 2019. Additionally fewer ATM fees and service charges on deposit accounts, lower dividends on FHLB stock, and lower fee income from one-way deposit sales to third-party deposit networks in the third quarter of 2020 all contributed to the decrease. First Nine Months of 2020 Compared to First Nine Months of 2019 Non-interest income decreased by $43 thousand in the first nine months of 2020 to $6.7 million, compared to $6.8 million in the same period a year ago. The small decline was driven by decreases across most non-interest income categories, partially offset by higher gains on sales of investment securities in the first nine months of 2020. Non-interest Expense The following tables detail the components of non-interest expense. Three months ended Amount Percent (dollars in thousands) September 30, 2020 September 30, 2019 Increase (Decrease) Increase (Decrease) Salaries and related benefits $ 8,638 $ 8,412 $ 226 2.7 % Occupancy and equipment 1,776 1,507 269 17.9 % Depreciation and amortization 539 573 (34) (5.9) % Federal Deposit Insurance Corporation insurance 181 1 180 18,000.0 % Data processing 822 923 (101) (10.9) % Professional services 655 580 75 12.9 % Directors' expense 184 189 (5) (2.6) % Information technology 256 279 (23) (8.2) % Amortization of core deposit intangible 213 222 (9) (4.1) % Provision for losses on off-balance sheet commitments 248 — 248 100.0 % Charitable contributions 481 111 370 333.3 % Other non-interest expense Advertising 163 183 (20) (10.9) % Other expense 1,082 1,220 (138) (11.3) % Total other non-interest expense 1,245 1,403 (158) (11.3) % Total non-interest expense $ 15,238 $ 14,200 $ 1,038 7.3 % Page-38 Nine months ended Amount Percent (dollars in thousands) September 30, 2020 September 30, 2019 Increase (Decrease) Increase (Decrease) Salaries and related benefits $ 25,979 $ 26,426 $ (447) (1.7) % Occupancy and equipment 5,100 4,616 484 10.5 % Depreciation and amortization 1,591 1,701 (110) (6.5) % Federal Deposit Insurance Corporation insurance 299 354 (55) (15.5) % Data processing 2,437 2,942 (505) (17.2) % Professional services 1,749 1,701 48 2.8 % Directors' expense 533 555 (22) (4.0) % Information technology 758 822 (64) (7.8) % Amortization of core deposit intangible 639 665 (26) (3.9) % Provision for losses on off-balance sheet commitments 610 129 481 372.9 % Charitable contributions 921 377 544 144.3 % Other non-interest expense Advertising 572 588 (16) (2.7) % Other expense 3,660 3,768 (108) (2.9) % Total other non-interest expense 4,232 4,356 (124) (2.8) % Total non-interest expense $ 44,848 $ 44,644 $ 204 0.5 % Third Quarter of 2020 Compared to Third Quarter of 2019 Non-interest expense increased by $1.0 million to $15.2 million, compared to $14.2 million in the same period a year ago. The increase was primarily due to $370 thousand more in charitable contributions to non-profit organizations, $248 thousand provision for losses on off-balance sheet commitments, and higher salaries and benefits driven by annual merit increases. Additionally, the third quarter of 2020 included higher FDIC insurance expense due to fewer FDIC assessment credits, and higher occupancy expense associated with the renewal of leases for our existing headquarters offices and a new lease for a loan production office in San Mateo. First Nine Months of 2020 Compared to First Nine Months of 2019 Non-interest expense increased by $204 thousand to $44.8 million in the first nine months of 2020, compared to $44.6 million in the same period a year ago. The increase was primarily due to $544 thousand higher charitable contributions to non-profit organizations, $484 thousand higher occupancy expense associated with new and renewed leases mentioned above, and $481 thousand higher provision for losses on off-balance sheet commitments. These increases were partially offset by decreases in salaries and related benefits primarily due to $915 thousand SBA PPP-related deferred loan origination costs and fewer data processing costs from our digital platform conversion. Provision for Income Taxes Income tax provisions reflect accruals for taxes at the applicable rates for federal income tax and California franchise tax based upon reported pre-tax income. Provisions also reflect permanent differences between income for tax and financial reporting purposes (such as earnings on tax exempt loans and municipal securities, BOLI, low-income housing tax credits, and stock-based compensation from the exercise of stock options, disqualifying dispositions of incentive stock options and vesting of restricted stock awards). The provision for income taxes for the third quarter of 2020 totaled $2.4 million at an effective tax rate of 24.1%, compared to $2.8 million at an effective tax rate of 23.0% in the same quarter last year. The decrease in the provision reflected a lower level of pre-tax income in 2020, partially offset by a favorable deferred tax liability true-up adjustment recognized in the third quarter of 2019. The increase in the effective tax rate was primarily due to the true-up adjustment recognized in third quarter of 2019. The provision for income taxes for the first nine months of 2020 totaled $7.4 million at an effective tax rate of 25.0%, compared to $8.3 million at an effective tax rate of 24.9% for the first nine months of 2019. The decrease in the provision reflected a lower level of pre-tax income and higher tax exempt earnings on investment securities in 2020. The slight increase in the effective tax rate was primarily due to the 2019 favorable deferred tax liability true-up Page-39 adjustment as described above and a lower tax benefit from BOLI income in 2020. These increases were substantially offset by a higher level of discrete tax benefits in 2020 from the exercise of non-qualified stock options and disqualifying dispositions of incentive stock options compared to 2019. We file a consolidated return in the U.S. Federal tax jurisdiction and a combined return in the State of California tax jurisdiction. There were no ongoing federal or state income tax examinations at the issuance of this report. At September 30, 2020, neither the Bank nor Bancorp had accruals for interest nor penalties related to unrecognized tax benefits. FINANCIAL CONDITION SUMMARY At September 30, 2020, assets totaled $2,975.2 million, an increase of $267.9 million, from $2,707.3 million at December 31, 2019, mainly due to an increase in cash and loans related to our participation in the PPP in response to the COVID-19 pandemic as explained below, partially offset by a $38.9 million decrease in investment securities. Cash, Cash Equivalents and Restricted Cash Total cash, cash equivalents and restricted cash were $213.6 million at September 30, 2020, compared to $183.4 million at December 31, 2019. The $30.2 million increase was largely due to temporary increases in SBA PPP borrowers' deposit accounts. Cash and cash equivalents as of September 30, 2020 do not include $146.6 million in temporary one-way sale transfers of deposits to third-party deposit networks as part of our liquidity management. Effective March 26, 2020, the Federal Reserve reduced the reserve requirement ratios to zero percent in response to the COVID-19 pandemic resulting in no restricted cash requirements as of September 30, 2020. Restricted cash held at the Federal Reserve as of December 31, 2019 totaled $4.8 million. Investment Securities The investment securities portfolio totaled $530.8 million at September 30, 2020, a decrease of $38.9 million from December 31, 2019. The decrease reflects paydowns, calls and maturities totaling $88.0 million and sales totaling $32.8 million during the first nine months of 2020, partially offset by purchases of $71.7 million high credit quality longer duration securities and increase in the fair value of available-for-sale securities in 2020. During the first and second quarters of 2020, respectively, we sold $26.6 million of short duration agency residential mortgage-backed securities subject to increasing prepayment speeds and $6.2 million of obligations of state and political subdivisions that were sensitive to the credit exposure posed by the COVID-19 pandemic. There were no security sales in the third quarter. The following table summarizes our investment in obligations of state and political subdivisions at September 30, 2020 and December 31, 2019. September 30, 2020 December 31, 2019 (dollars in thousands) Amortized Cost Fair Value % of Total State and Political Subdivisions Amortized Cost Fair Value % of Total State and Political Subdivisions Within California: General obligation bonds $ 3,333 $ 3,570 3.6 % $ 4,597 $ 4,813 6.6 % Revenue bonds 2,569 2,675 2.8 2,928 2,977 4.2 Tax allocation bonds 3,343 3,416 3.7 3,376 3,456 4.9 Total within California 9,245 9,661 10.1 10,901 11,246 15.7 Outside California: General obligation bonds 62,182 64,836 68.2 45,974 46,976 66.1 Revenue bonds 19,763 20,966 21.7 12,680 12,648 18.2 Total outside California 81,945 85,802 89.9 58,654 59,624 84.3 Total obligations of state and political subdivisions $ 91,190 $ 95,463 100.0 % $ 69,555 $ 70,870 100.0 % The portion of the portfolio outside the state of California is distributed among eleven states. Of the total investment in obligations of state and political subdivisions, the largest concentrations outside of California are in Texas (47.6%), Washington (9.7%) and Maryland (7.5%). During March 2020, we strategically increased our credit Page-40 exposure to obligations issued by high credit quality municipal issuers in Texas that are either guaranteed by the AAA-rated Texas Permanent School Fund ("PSF") or backed by revenue sources from essential services (such as utilities and transportation). We have $6.0 million in obligations of Texas school district issuers having high concentrations in oil and gas industry taxpayers and all of them have credit guarantees from PSF. We have little or no exposure to municipal sectors such as higher education or health care that are most vulnerable to credit risks posed by the COVID-19 pandemic. Investments in states, municipalities and political subdivisions are subject to an initial pre-purchase credit assessment and ongoing monitoring. Key considerations include: • The soundness of a municipality’s budgetary position and stability of its tax revenues • Debt profile and level of unfunded liabilities, diversity of revenue sources, taxing authority of the issuer • Local demographics/economics including unemployment data, largest taxpayers and local employers, income indices and home values • For revenue bonds, the source and strength of revenue for municipal authorities including the obligor’s financial condition and reserve levels, annual debt service and debt coverage ratio, and credit enhancement (such as insurer’s strength and collateral in escrow accounts) • Credit ratings by major credit rating agencies Loans During the first nine months of 2020, loans increased by $264.7 million and totaled $2,108.0 million at September 30, 2020, primarily due to SBA PPP loans which totaled $308.2 million. We ended the origination of new PPP loans on June 30, 2020 to focus our efforts on helping our customers through the loan forgiveness process. New non-PPP related loan originations totaled $122.4 million in the first nine months of 2020. Payoffs totaled $124.7 million and line utilization decreased $24.5 million during the first nine months of 2020. While we have had success originating new loans this year, we have found that the pandemic has extended traditional timelines as loans move through the origination process. During these unprecedented times, we are focused on maintaining relationships with our customers and bringing in new client relationships where prudent and possible. Liabilities During the first nine months of 2020, total liabilities increased by $247.2 million to $2,617.7 million. Deposits increased $232.8 million in the first nine months of 2020, primarily driven by a combination of PPP loan proceeds and increased liquidity throughout the banking system as a result of depositors' higher level of savings during these uncertain economic times. Non-interest bearing deposits increased $254.9 million in the first nine months of 2020 to $1,383.7 million, and represented 53.9% of total deposits at September 30, 2020, compared to 48.3% at December 31, 2019. Liabilities as of September 30, 2020 included operating lease liabilities totaling $27.5 million, which increased $14.9 million in the first nine months of 2020 due to the extension of lease terms for our existing headquarters office and seven retail branches and a new lease agreement for one of our retail branches. Capital Adequacy We are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements as set forth in the following tables can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on our consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and the Bank’s prompt corrective action classification are also subject to qualitative judgments by the regulators about components of capital, risk weightings and other factors. Management reviews capital ratios on a regular basis to ensure that capital exceeds the prescribed regulatory minimums and is adequate to meet our anticipated future needs. For all periods presented, the Bank’s ratios exceed the regulatory definition of “well capitalized” under the regulatory framework for prompt corrective action and Bancorp’s ratios exceed the required minimum ratios to be considered a well-capitalized bank holding company. In addition, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action as of September 30, 2020. There are no conditions or events since that Page-41 notification that Management believes have changed the Bank’s categories and we expect the Bank to remain well capitalized for prompt corrective action purposes. In August 2018, the Board of Governors of the Federal Reserve System changed the definition of a "Small Bank Holding Company" by increasing the asset threshold from $1.0 billion to $3.0 billion. As a result, Bancorp was not subject to separate minimum capital requirements as of September 30, 2020 and December 31, 2019. However, we disclosed comparative capital ratios for Bancorp, which would have exceeded well-capitalized levels had Bancorp been subject to the same minimum capital requirements in 2020 and 2019. The Bancorp’s and Bank’s capital adequacy ratios as of September 30, 2020 and December 31, 2019 are presented in the following tables. Bancorp's Tier 1 capital includes the subordinated debenture, which are not included at the Bank level. Capital Ratios for Bancorp (dollars in thousands) Actual Ratio Adequately Capitalized Threshold Ratio to be a Well Capitalized Bank Holding Company September 30, 2020 Amount Ratio Amount Ratio Amount Ratio Total Capital (to risk-weighted assets) $ 338,841 16.05 % ≥ $ 221,701 ≥ 10.50 % ≥ $ 211,144 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 315,031 14.92 % ≥ $ 179,472 ≥ 8.50 % ≥ $ 168,915 ≥ 8.00 % Tier 1 Capital (to average assets) $ 315,031 10.58 % ≥ $ 119,063 ≥ 4.00 % ≥ $ 148,829 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 312,271 14.79 % ≥ $ 147,801 ≥ 7.00 % ≥ $ 137,243 ≥ 6.50 % December 31, 2019 Total Capital (to risk-weighted assets) $ 319,317 15.07 % ≥ $ 222,430 ≥ 10.50 % ≥ $ 211,838 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 301,553 14.24 % ≥ $ 180,063 ≥ 8.50 % ≥ $ 169,471 ≥ 8.00 % Tier 1 Capital (to average assets) $ 301,553 11.66 % ≥ $ 103,489 ≥ 4.00 % ≥ $ 129,361 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 298,845 14.11 % ≥ $ 148,287 ≥ 7.00 % ≥ $ 137,695 ≥ 6.50 % Capital Ratios for the Bank (dollars in thousands) Actual Ratio Adequately Capitalized Threshold Ratio to be Well Capitalized under Prompt Corrective Action Provisions September 30, 2020 Amount Ratio Amount Ratio Amount Ratio Total Capital (to risk-weighted assets) $ 326,658 15.47 % ≥ $ 221,693 ≥ 10.50 % ≥ $ 211,136 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 302,848 14.34 % ≥ $ 179,466 ≥ 8.50 % ≥ $ 168,909 ≥ 8.00 % Tier 1 Capital (to average assets) $ 302,848 10.17 % ≥ $ 119,062 ≥ 4.00 % ≥ $ 148,827 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 302,848 14.34 % ≥ $ 147,795 ≥ 7.00 % ≥ $ 137,239 ≥ 6.50 % December 31, 2019 Total Capital (to risk-weighted assets) $ 309,875 14.63 % ≥ $ 222,437 ≥ 10.50 % ≥ $ 211,844 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 292,111 13.79 % ≥ $ 180,068 ≥ 8.50 % ≥ $ 169,476 ≥ 8.00 % Tier 1 Capital (to average assets) $ 292,111 11.29 % ≥ $ 103,488 ≥ 4.00 % ≥ $ 129,360 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 292,111 13.79 % ≥ $ 148,291 ≥ 7.00 % ≥ $ 137,699 ≥ 6.50 % Liquidity The goal of liquidity management is to provide adequate funds to meet loan demand and to fund operating activities and deposit withdrawals. We accomplish this goal by maintaining an appropriate level of liquid assets and formal lines of credit with the FHLB, FRBSF and correspondent banks that enable us to borrow funds as discussed in Note 6 to the Consolidated Financial Statements in ITEM 1 of this report. Our Asset Liability Management Committee ("ALCO"), which is comprised of independent Bank directors and the President and Chief Executive Officer, is responsible for approving and monitoring our liquidity targets and strategies. ALCO has adopted a contingency funding plan that provides early detection of potential liquidity issues in the market or the Bank and institutes prompt responses that may prevent or alleviate a potential liquidity crisis. Management monitors liquidity daily and regularly adjusts our position based on current and future liquidity needs. We also have relationships with third party deposit networks and can adjust the placement of our deposits via reciprocal or one-way sales, as part of our cash management strategy. Page-42 We obtain funds from the collection of loan payments, deposit inflows, investment security maturities, paydowns and sales, federal funds purchases, FHLB advances, other borrowings, and cash flow from operations. Our primary uses of funds are the origination of loans, the purchase of investment securities, withdrawals of deposits, maturity of certificates of deposit, repayment of borrowings and dividends to common stockholders. T he most significant factor in our daily liquidity position has been the level of customer deposits. The attraction and retention of new deposits depends upon the variety and effectiveness of our customer account products, service and convenience, and rates paid to customers, as well as our financial strength. Deposit balances increased by $232.8 million in the first nine months of 2020 due to the increased level of liquidity in the financial markets. In addition, there has been an influx of deposits throughout the banking system as a result of depositors' higher level of savings during the uncertain economic times. Since March 2020, we have granted $388.5 in payment relief for 264 loans by allowing certain borrowers with hardship requests either full payment deferrals or interest-only payments. As of October 19, 2020, 236 loans totaling $336.3 million have resumed or are scheduled to resume normal payments and eight loans totaling $5.0 million have paid off. The Bank has substantial contingent and on-balance-sheet liquidity to support the loan payment relief programs, including unencumbered available-for-sale securities and cash. At September 30, 2020, our cash and cash equivalents increased $30.2 million from December 31, 2019, primarily due to an increase in deposits of $232.8 million, as explained above. Other significant sources of liquidity during the first nine months of 2020 included $121.7 million in paydowns, maturities and sales of investment securities and $31.3 million net cash provided by operating activities (including $10.7 million in processing fees received from the SBA for the origination of PPP loans as of September 30, 2020). Uses of liquidity during the first nine months of 2020 included $269.4 million in loan originations, net of principal collected, $71.7 million in investment securities purchases, and $9.4 million in cash dividends paid on common stock to our shareholders. Refer to the Consolidated Statement of Cash Flows in this Form 10-Q for additional information on our sources and uses of liquidity. Management anticipates that our current strong liquidity position and core deposit base will provide adequate liquidity to fund our operations. Undrawn credit commitments, as discussed in Note 8 to the Consolidated Financial Statements in this Form 10-Q, totaled $567.5 million at September 30, 2020. These commitments, to the extent used, are expected to be funded primarily through the repayment of existing loans, deposit growth and liquid assets. Over the next twelve months, $70.7 million of time deposits will mature. In addition, we waived the early withdrawal penalties for certificates of deposit when allowed by law in response to the pandemic, which might cause more depositors to withdraw time deposits during the uncertain economic environment. Our emphasis on local deposits combined with our equity position is expected to provide a strong funding base. Since Bancorp is a holding company and does not conduct regular banking operations, its primary sources of liquidity are dividends from the Bank. Under the California Financial Code, payment of a dividend from the Bank to Bancorp without advance regulatory approval is restricted to the lesser of the Bank’s retained earnings or the amount of the Bank’s net profits from the previous three fiscal years less the amount of dividends paid during that period. The primary uses of funds for Bancorp are shareholder dividends and ordinary operating expenses. Bancorp held $12.2 million of cash at September 30, 2020. The cash level at Bancorp is deemed sufficient to cover Bancorp's operational needs and cash dividends to shareholders through mid-2021. Management anticipates that the Bank will continue to have sufficient earnings to provide dividends to Bancorp to meet its funding requirements going forward.