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Item 7. Management’s Discussion and Analysis

2021-03-15 compared with 2020-03-13 · 389 added, 290 removed, 332 unchanged (67% of the section changed)

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Critical Accounting Policies and Estimates

Critical accounting policies are those that are both very important to the portrayal of our financial condition and results of operations and require Management's most difficult, subjective, or complex judgments, often because of the need to make estimates about the effect of matters that are inherently uncertain and imprecise.

Management has determined the following four accounting policies to be critical:

Allowance for Loan Losses :

For information regarding our ALLL methodology, the related provision for loan losses, risks related to asset quality and lending activity, including the transition from the incurred loss model to the current expected loss model under ASU No.

2016-13, Financial Instruments - Credit Losses (Topic 326):

Measurement of Credit Losses on Financial Instruments, effective January 1, 2020, see ITEM 1A - Risk Factors, the Allowance for Loan Losses section in ITEM 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, and Note 1 - Summary of Significant Accounting Policies and Note 3 - Loans and Allowance for Loan Losses in ITEM 8 - Financial Statements and Supplementary Data of this Form 10‑K.

Other-than-temporary Impairment of Investment Securities :

For information regarding our investment securities, investment activity, and related risks, see ITEM 1A - Risk Factors, Note 1 - Summary of Significant Accounting Policies and Note 2 - Investment Securities in ITEM 8 - Financial Statements and Supplementary Data of this Form 10-K.

Accounting for Income Taxes :

For information on our tax assets and liabilities, and related provision for income taxes, see Note 1 - Summary of Significant Accounting Policies and Note 11 - Income Taxes in ITEM 8 - Financial Statements and Supplementary Data of this Form 10-K.

Fair Value Measurements :

For information on our use of fair value measurements and our related valuation methodologies, see Note 1 - Summary of Significant Accounting Policies and Note 9 - Fair Value of Assets and Liabilities in ITEM 8 - Financial Statements and Supplementary Data of this Form 10-K.

The SEC requires us to disclose "critical accounting policies" defined as those that are both most important to the presentation of our financial condition and results of operations and require management's most difficult, subjective, or complex judgments, often because of the need to make estimates about the effect of matters that are inherently uncertain and imprecise.

We consider accounting estimates to be critical to our financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain, (ii) management could have applied different assumptions during the reported period, and (iii) changes in the accounting estimate are reasonably likely to occur in the future and could have a material impact on our financial statements.

Management has determined the following accounting policies to be critical:

Allowance for Credit Losses on Loans and Unfunded Commitments - For information regarding critical estimates related to our allowance methodology, the provision for credit losses, and risks to asset quality and lending activity, including the transition from the incurred loss method to the current expected credit loss ("CECL") method under ASU No.

2016-13, Financial Instruments - Credit Losses (Topic 326) and related amendments , which we adopted as of December 31, 2020, see ITEM 1A - Risk Factors, the Allowance for Credit Losses section in ITEM 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, Note 1 - Summary of Significant Accounting Policies, and Note 3 - Loans and Allowance for Credit Losses in ITEM 8 - Financial Statements and Supplementary Data of this Form 10‑K.

Allowance for Credit Losses on Investment Securities - For information regarding our investment securities and risks associated with identifying impairment and estimating the allowance for credit losses under the new CECL method, see ITEM 1A - Risk Factors, Note 1 - Summary of Significant Accounting Policies, and Note 2 - Investment Securities in ITEM 8 - Financial Statements and Supplementary Data of this Form 10‑K.

Accounting for Income Taxes - For information on our tax assets and liabilities, and related provision for income taxes, see Note 1 - Summary of Significant Accounting Policies and Note 11 - Income Taxes in ITEM 8 - Financial Statements and Supplementary Data of this Form 10-K.

Fair Value Measurements - For information on our use of fair value measurements and our related valuation methodologies, see Note 1 - Summary of Significant Accounting Policies and Note 9 - Fair Value of Assets and Liabilities in ITEM 8 - Financial Statements and Supplementary Data of this Form 10-K.

Executive Summary

Annual earnings were $30.2 million in 2020 compared to $34.2 million in 2019.

Diluted earnings were $2.48 per share for the year ended December 31, 2019 , compared to $2.33 per share in the same period of 2018 .

Diluted earnings were $2.22 per share in 2020, compared to $2.48 per share in 2019.

The following are highlights of operating and financial performance for the year ended December 31, 2020:

The Bank achieved total loan growth of $79.4 million, or 4.5% in 2019, to $1,843.3 million at December 31, 2019 , from $1,763.9 million at December 31, 2018 .

Strong credit quality remains a cornerstone of the Bank’s consistent performance.

Non-accrual loans represented 0.01% of the Bank's loan portfolio as of December 31, 2019 .

There was a $900 thousand provision for loan losses recorded in 2019, reflecting loan growth.

Deposits grew $161.7 million, or 7.4%, to $2,336.5 million at December 31, 2019 , compared to $2,174.8 million at December 31, 2018 .

Non-interest bearing deposits grew by $62.8 million in 2019 and made up 48.3% of total deposits at year-end.

For the full year of 2019, cost of total deposits remained low at 0.20%, compared to 0.10% in 2018.

• The Bank achieved total loan growth of $245.3 million, or 13% in 2020, to $2.089 billion at December 31, 2020, from $1.843 billion at December 31, 2019.

SBA PPP loans outstanding at December 31, 2020 were $291.6 million.

• Credit quality remains strong with non-accrual loans representing 0.44% of the Bank's loan portfolio as of December 31, 2020.

The adoption of CECL in the fourth quarter of 2020 resulted in an increase to the allowance for credit losses on loans of $748 thousand and a $1.1 million increase to the allowance for unfunded loan commitments.

See Note 1, Summary of Significant Accounting Policies, for additional information.

• Deposits grew $167.8 million, or 7%, to $2.504 billion at December 31, 2020, compared to $2.336 billion at December 31, 2019.

Non-interest bearing deposits grew by $225.8 million in 2020, or 20%, and made up 54% of total deposits at year-end.

Cost of deposits remained low at 0.11% in 2020, compared to 0.20% in 2019.

• Net interest income totaled $96.7 million and $95.7 million in 2020 and 2019, respectively.

The increase of $4.2 million in 2019 was primarily due to higher average loan balances and asset yields and the early redemption of a high-rate subordinated debenture in the fourth quarter of 2018.

Positive variances were partially offset by higher balances and rates on money market accounts.

The tax-equivalent net interest margin increased to 3.98% in 2019 , compared to 3.90% in 2018 for the same reasons.

The efficiency ratio was 55.3% in 2019, down from 57.3% in 2018.

Notably, 2019 non-interest expenses decreased from the prior year due to higher consulting expenses in 2018 for core processing contract renegotiations and lower FDIC Deposit Insurance Fund expenses in 2019 as discussed in Table 4 below.

The $1.0 million increase in 2020 was primarily due to SBA PPP loans and lower rates on interest-bearing deposits, largely offset by lower yields on earning-assets.

The tax-equivalent net interest margin decreased to 3.55% in 2020, compared to 3.98% in 2019.

The 43 basis point decrease was primarily due to lower yields across interest-earning asset categories, partially offset by lower rates on interest-bearing deposits.

• The efficiency ratio was 57.06% in 2020, up from 55.33% in 2019.

Contributing to this increase was the decrease in net interest margin, higher provision for credit losses on unfunded loan commitments, and lower income from s ervice charges on deposit accounts and ATM fees in 2020.

• For the year ended December 31, 2020, return on assets and return on equity were 1.04% and 8.60%, respectively, compared to 1.34% and 10.49% in the prior year.

All capital ratios exceed regulatory requirements.

• All capital ratios exceeded regulatory requirements.

The total risk-based capital ratio for Bancorp was 16.0% at December 31, 2020 up from 15.1% at December 31, 2019.

The Board of Directors declared a cash dividend of $0.23 per share on January 24, 2019, a $0.02 increase from the prior quarter.

This was the 59 th consecutive quarterly dividend paid by Bank of Marin Bancorp.

Tangible common equity to tangible assets was 11.3% at both December 31, 2020 and December 31, 2019 (See footnote 8, ITEM 6, Selected Financial Data, for the definition of this non-GAAP financial measure).

The total risk-based capital ratio for the Bank was 15.8% at December 31, 2020 and 14.6% at December 31, 2019.

• The Board of Directors declared a cash dividend of $0.23 per share on January 22, 2021.

This was the 63 rd consecutive quarterly dividend paid by Bank of Marin Bancorp.

The cash dividend was paid on February 12, 2021 to shareholders of record at the close of business on February 5, 2021.

Looking forward into the new year, with a low cost and stable deposit base, opportunities for loan growth, and our unwavering commitment to relationship banking, we believe we are well-positioned to carry our successful performance into 2020.

• Our strong capital and liquidity position afforded us the opportunity to eliminate a high cost funding source.

On March 15, 2021 we redeemed the $2.8 million subordinated debenture, which carried a rate of 5.68% in 2020.

The redemption consisted of $4.1 million principal balance, quarterly interest due, and $1.3 million in accelerated accretion of purchase discount.

The contractual interest rate on the subordinated debenture was 3-month LIBOR plus 1.40%, or 1.62% as of December 31, 2020.

COVID-19 Pandemic-Related Response Update - We have remained open and responded to customer needs throughout 2020.

We more than doubled our charitable contributions to non-profit organizations in our community to over $1.0 million in 2020.

In March 2020, we began waiving all ATM and overdraft fees and cancelling early withdrawal penalties for time certificate of deposits when allowed by law.

We accommodated loan payment relief requests for borrowers with financial hardships and lowered interest rate floors on commercial Prime Rate loans.

Under the provisions of the Coronavirus Aid, Relief and Economic Security Act ("CARES Act") of 2020, Bank of Marin originated over 1,800 PPP loans to small businesses, reaching nearly 28,000 employees in our markets.

In 2021, we are once again diligently working with our customers to accommodate requests for round two of PPP

loans under the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act ("Economic Aid Act"), which became law in December of 2020.

Paycheck Protection Program - While the PPP affords us an opportunity to assist our customers and community and requires a large of amount of human resources, the PPP loans do not pose a significant amount of risk of loss to the Bank as they are 100% guaranteed by the SBA.

As of December 31, 2020, there were 1,777 PPP loans outstanding totaling $291.6 million, net of $5.4 million in unearned fees.

During the fourth quarter Bank of Marin opened a secure PPP loan forgiveness application portal and gave all PPP borrowers access to apply.

As of December 31, 2020 we received SBA loan forgiveness payments totaling $10.9 million for 35 loans that were forgiven.

Of the total PPP loans rem aining, 74% (1,309 loans) totaling $58.7 million are less than or equal to $150 thousand and have access to streamlined forgiveness processing.

On January 19, 2021, the Bank launched the application process and began accepting loan requests for the second round of PPP, as revised by the Economic Aid Act.

As of March 11, 2021, we have received 974 loan applications totaling $131.6 million.

Payment Relief - During 2020, in accordance with section 4013 of the CARES Act, subsequently amended by the Economic Aid Act, we elected to apply the temporary accounting relief provisions for loan modifications that met certain criteria, which would otherwise be designated as TDRs under existing GAAP.

Of the 269 loans totaling $402.9 million granted payment relief since the onset of the pandemic, 222 loans or $324.2 million have resumed normal payments and 18 loans or $7.7 million paid off.

As of December 31, 2020, 21 borrowing relationships with 29 loans totaling $71.0 million had requested additional payment relief.

We know each of these clients very well and monitor their loans closely, and anticipate that the vast majority will work through current adverse conditions and resume making full payments.

The following table summarizes these loans by industry or collateral type.

Payment Relief by Type

Industry/Collateral Type Outstanding Loan Balance

(in thousands) Weighted Average LTV

Education $ 17,580 26 %

Health Clubs 16,551 38 %

Office and Mixed Use 15,883 44 %

Hospitality 12,439 49 %

Retail Related CRE 6,899 52 %

Auto Dealership 393 49 %

Non-CRE Related 121 N/A

Residential Real Estate 1,130 60 %

Payment Relief Totals $ 70,996 40 %

We have ample liquidity and capital to support organic growth and acquisitions in coming years.

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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 the interest earned on loans, investment securities and other interest-earning assets minus the interest expense incurred on deposits and other interest-bearing liabilities.

Net interest income is affected by changes in general market interest rates and by changes in the amounts and composition of interest-earning assets and interest-bearing liabilities.

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Table 1 Average Statements of Condition and Analysis of Net Interest Income

December 31, 2019

December 31, 2018

Year ended Year ended Year ended

December 31, 2020 December 31, 2019 December 31, 2018

Interest Interest Interest

Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/

(dollars in thousands;

Interest-bearing due from banks 1

unaudited) Balance Expense Rate Balance Expense Rate Balance Expense Rate

Interest-earning deposits with banks 1

$ 153,794 $ 461 0.29 % $ 67,192 $ 1,321 1.94 % $ 78,185 $ 1,461 1.84 %

Investment securities 2, 3

533,186 15,025 2.82 % 555,618 15,102 2.72 % 566,883 14,512 2.56 %

Loans 1, 3, 4

2,023,203 85,398 4.15 % 1,775,193 85,062 4.73 % 1,704,390 80,406 4.65 %

Total interest-earning assets 1

2,710,183 100,884 3.66 % 2,398,003 101,485 4.17 % 2,349,458 96,379 4.05 %

Cash and non-interest-bearing due from banks 49,676 35,956 41,595

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Interest receivable and other assets, net 131,780 109,837 86,709

Total assets $ 2,897,165 $ 2,550,707 $ 2,485,783

Liabilities and Stockholders' Equity

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Borrowings and other obligations 1

174 4 2.16 % 2,935 77 2.57 % 105 2 2.03 %

Subordinated debentures 1

2,741 158 5.68 % 2,673 229 8.44 % 5,025 1,339 26.29 %

Total interest-bearing liabilities 1,196,125 2,979 0.25 % 1,098,882 4,757 0.43 % 1,077,454 3,536 0.33 %

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Tax-equivalent net interest income/margin 1

$ 97,905 3.55 % $ 96,728 3.98 % $ 92,843 3.90 %

Reported net interest income/margin 1

$ 96,659 3.51 % $ 95,680 3.94 % $ 91,544 3.84 %

Tax-equivalent net interest rate spread 3.41 % 3.74 % 3.72 %

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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% in 2019 and 2018.

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.

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Mix variances are attributable to the change in yields or rates multiplied by the change in average balances.

2019 compared to 2018

(in thousands, unaudited)

Interest-bearing due from banks

2020 compared to 2019 2019 compared to 2018

(in thousands, unaudited) Volume Yield/Rate Mix Total Volume Yield/Rate Mix Total

Interest-earning deposits with banks $ 1,702 $ (1,120) $ (1,442) $ (860) $ (204) $ 75 $ (11) $ (140)

Investment securities 1

(610) 555 (22) (77) (288) 897 (19) 590

11,884 (10,337) (1,211) 336 3,340 1,263 53 4,656

Total interest-earning assets 12,976 (10,902) (2,675) (601) 2,848 2,235 23 5,106

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Total interest-bearing liabilities 344 (1,915) (207) (1,778) (557) 1,204 574 1,221

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% in 2019 and 2018.

Tax-equivalent net interest income $ 12,632 $ (8,987) $ (2,468) $ 1,177 $ 3,405 $ 1,031 $ (551) $ 3,885

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%.

2020 Compared to 2019

Net interest income totaled $96.7 million and $95.7 million in 2020 and 2019, respectively.

The $1.0 million increase in 2020 was primarily due to SBA PPP loans and lower rates on interest-bearing deposits, largely offset by lower yields on earning-assets, except for investment securities where we collected prepayment penalties on called securities in 2020.

Notable balance increases occurred in interest-earning deposits with other banks, commercial real estate loans and deposits.

The tax-equivalent net interest margin decreased 43 basis points to 3.55% in 2020, from 3.98% in 2019 for the reasons already mentioned and as shown in the above table.

Additionally, the SBA PPP loans lowered the 2020 net interest margin by 6 basis points.

On March 15, 2021, we redeemed the $2.8 million subordinated debenture.

The redemption consisted of $4.1 million principal balance, quarterly interest due, and $1.3 million in accelerated accretion of purchase discount.

The contractual interest rate on the subordinated debenture was 3-month LIBOR plus 1.40%, or 1.62% as of December 31, 2020.

2019 Compared to 2018

Net interest income totaled $95.7 million and $91.5 million in 2019 and 2018, respectively.

The increase of $4.2 million in 2019 was primarily due to higher average loan balances and assets yields across all categories and the early redemption of a high-rate subordinated debenture in the fourth quarter of 2018.

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Market interest rates are, in part, based on the target federal funds interest rate (the interest rate banks charge each other for short-term borrowings) implemented by the Federal Reserve Open Market Committee ("FOMC").

During 2018, the FOMC made four 25-basis-point increases to a range of 2.25% to 2.50% as of December 2018, where it remained during the first half of 2019.

In each of its July, September and October 2019 meetings, the FOMC lowered the federal funds target rate by 0.25% to a range of 1.50% to 1.75% at the end of 2019.

On March 3, 2020, in light of the coronavirus and its potential to disrupt the U.S.

and worldwide economies, the FOMC reduced the federal funds target rate by 50 basis points to a range of 1.0% to 1.25%.

Because the Bank is asset sensitive, upward movement in the market rates is projected to have a positive impact on net interest income.

However, as a result of the Bank's already low cost of funds, falling rates would provide minimal funding cost relief to offset downward pressure expected on asset yields which could result in lower net interest income.

In response to the evolving risks to economic activity posed by the COVID-19 pandemic, the FOMC made two emergency cuts totaling 150 basis points to the federal funds rate in March 2020.

The federal funds target rate range resided between 0.0% to 0.25% for the majority of 2020, putting downward pressure on our asset yields and net interest margin.

In each of its July, September and October 2019 meetings, the FOMC lowered the federal

funds target rate by 0.25% to a range of 1.50% to 1.75% at the end of 2019.

During 2018, the FOMC made four 25-basis-point increases to a range of 2.25% to 2.50% as of December 2018.

A low interest rate environment will continue to put downward pressure on asset yields and net interest margin to be fully seen in future periods.

Quantitative and Qualitative Disclosure about Market Risk for further information.

Impact of Acquired Loans on Net Interest Margin

Accretions and gains on payoffs of purchased loans are recorded in interest income.

As our acquired loans from prior acquisitions continue to pay off, we expect accretion income from these loans to continue to decline.

The positive affect on our net interest margin during the past two years was as follows:

Years ended December 31,

(dollars in thousands;

Dollar Amount

Basis point affect on net interest margin

Dollar Amount

Basis point affect on net interest margin

Accretion on purchased credit impaired ("PCI") loans

Accretion on non-PCI loans

Gains on payoffs of PCI loans

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.

Actual losses on loans are charged against the allowance, and the allowance is increased by loss recoveries and provisions for loan losses charged to expense.

For further discussion, see Note 1 to the Consolidated Financial Statements in ITEM 8 of this report.

We recorded a $900 thousand provision for loan losses in 2019 , compared to no provision for loan losses in 2018 .

The allowance for loan losses was 0.90% of loans at both December 31, 2019 and 2018 .

The provision for loan losses in 2019 is consistent with loan growth.

The lack of a provision for loan losses in 2018 was primarily due to a $15.3 million decrease in classified loans, resulting from two borrowing relationships whose risk grades were upgraded from substandard to special mention in the second quarter of 2018.

The allowance for loan losses excluding acquired loans was 0.96% and 0.98% of loans at December 31, 2019 and 2018 , respectively.

Net charge-offs totaled $44 thousand in 2019 , compared to net recoveries of $54 thousand in 2018 .

See the section captioned “Allowance for Loan Losses” below for further analysis of the provision for loan losses.

Provision for Credit Losses on Loans

Management assesses the adequacy of the allowance for credit losses on loans quarterly based on several factors including growth of the loan portfolio, past events, current conditions, and reasonable and supportable forecasts to estimate expected losses over the contractual terms of our loans.

The allowance for credit losses is increased by provisions charged to expense and loss recoveries and decreased by loans charged off.

For additional information about the allowance for credit losses and transition from the incurred loss method to the CECL method in 2020, see Notes 1 and 3 to the Consolidated Financial Statements in ITEM 8 of this report.

We recorded a $4.6 million provision for credit losses in 2020, compared to a $900 thousand provision in 2019 and no provision for credit losses in 2018.

The provision for credit losses in 2020 was largely due to the impact of the COVID-19 pandemic and its effect on the local and regional economies and economic outlook.

In addition, under the CECL method, we increased our allowance for credit losses by approximately $925 thousand for previously acquired loans (i.e., non-purchased credit deteriorated or "non-PCD" loans);

whereas, under previous GAAP (incurred loss method) we did not record an allowance on our unimpaired previously acquired non-PCD loans.

Our allowance model is particularly sensitive to current and forecasted California unemployment rates, which increased from 3.7% at December 31, 2019 to 8.8% at December 31, 2020.

The pandemic also negatively affected the financial condition of many of our borrowers, which was partially alleviated by our payment relief program under the CARES Act and the SBA PPP.

Additionally, with the adoption of ASC 326 in 2020, our provision for credit losses may become more volatile in the future due to changes in macroeconomic conditions and forecasts, CECL model assumptions, and loan composition, which affect the allowance for credit losses balance.

The provision for credit losses in 2019 was consistent with loan growth.

The lack of a provision for credit losses in 2018 was primarily due to a $15.3 million decrease in classified loans, resulting from two borrowing relationships whose risk grades were upgraded from substandard to special mention in the second quarter of 2018.

Non-interest Income

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Table 3 Components of Non-Interest Income

2019 compared to 2018

2020 compared to 2019 2019 compared to 2018

Years ended December 31, Amount Increase (Decrease) Percent Increase (Decrease) Amount Increase (Decrease) Percent Increase (Decrease)

(dollars in thousands;

Increase (Decrease)

unaudited) 2020 2019 2018

Service charges on deposit accounts $ 1,314 $ 1,865 $ 1,891 $ (551) (29.5) % $ (26) (1.4) %

Wealth Management and Trust Services 1,851 1,907 1,919 (56) (2.9) % (12) (0.6) %

Debit card interchange fees, net

Merchant interchange fees, net

Debit card interchange fees 1,438 1,586 1,561 (148) (9.3) % 25 1.6 %

Earnings on bank-owned life insurance, net 973 1,196 913 (223) (18.6) % 283 23.7 %

Dividends on FHLB stock

Gains on investment securities, net 915 55 876 860 1,563.6 % (821) (1,492.7) %

Dividends on FHLB stock 654 799 959 (145) (18.1) % (160) (20.0) %

Merchant interchange fees 239 331 378 (92) (27.8) % (47) (14.2) %

Other income 1,166 1,345 1,642 (179) (13.3) % (297) (22.1) %

Total non-interest income $ 8,550 $ 9,084 $ 10,139 $ (534) (5.9) % $ (1,055) (11.6) %

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Non interest income totaled $8.6 million and $9.1 million in 2020 and 2019, respectively.

The $534 thousand decline was primarily due to $551 thousand lower service charges on deposit accounts and ATM fees, as these fees were waived during the pandemic, lower income from bank-owned life insurance (" BOLI") policies due to a $562 thousand benefit collected on BOLI policies in the third quarter of 2019 (partially offset by $283 thousand underwriting expenses for two new BOLI policies in the first quarter of 2019), $182 thousand lower fee income from

one-way deposit sales to third-party deposit networks and $145 thousand lower dividends on FHLB stock, partially offset by $860 thousand net gains on the sale of investment securities.

2019 Compared to 2018

Non-interest income totaled $9.1 million and $10.1 million in 2019 and 2018, respectively.

The decrease compared to the prior year primarily related to a $956 thousand pre-tax gain on the sale of 6,500 shares of Visa Inc.

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Table 4 Components of Non-Interest Expense

2019 compared to 2018

2020 compared to 2019 2019 compared to 2018

Years ended December 31, Amount Increase (Decrease) Percent Increase (Decrease) Amount Increase (Decrease) Percent Increase (Decrease)

(dollars in thousands;

Increase (Decrease)

Salaries and related benefits

unaudited) 2020 2019 2018

Salaries and employee benefits $ 34,393 $ 34,253 $ 33,335 $ 140 0.4 % $ 918 2.8 %

Occupancy and equipment 6,943 6,143 5,976 800 13.0 % 167 2.8 %

Depreciation and amortization

Federal Deposit Insurance Corporation insurance

Data processing 3,184 3,717 4,358 (533) (14.3) % (641) (14.7) %

Professional services 2,181 2,132 3,317 49 2.3 % (1,185) (35.7) %

Directors' expense

Depreciation and amortization 2,149 2,228 2,143 (79) (3.5) % 85 4.0 %

Provision for credit losses on unfunded loan commitments 1,570 129 — 1,441 1,117.1 % 129 100.0 %

Information technology 1,050 1,065 1,023 (15) (1.4) % 42 4.1 %

Charitable contributions 1,034 508 463 526 103.5 % 45 9.7 %

Amortization of core deposit intangible 853 887 921 (34) (3.8) % (34) (3.7) %

Provision for losses on off-balance sheet commitments

Directors' expense 713 735 700 (22) (3.0) % 35 5.0 %

Federal Deposit Insurance Corporation insurance 474 361 756 113 31.3 % (395) (52.2) %

Other non-interest expense:

Advertising 769 775 666 (6) (0.8) % 109 16.4 %

Other expense 4,715 5,037 4,608 (322) (6.4) % 429 9.3 %

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2020 Compared to 2019

Non-interest expense increased $2.1 million to $60.0 million in 2020 from $58.0 million in 2019.

The largest increases came from the provision for unfunded loan commitments, occupancy expenses (primarily due to lease renewals for our existing headquarters offices and new lease for a loan production office in San Mateo , common area maintenance and janitorial expenses), and charitable contributions due to our outreach to nonprofit organizations in our community during the pandemic.

The decrease in data processing costs was due to our digital platform conversion in 2019.

While salaries and related benefits were relatively unchanged year-over-year, annual merit and related increases were mostly offset by $915 thousand in SBA PPP-related deferred loan origination costs.

The increase in the provision for credit losses on unfunded loan commitments was mainly attributed to a $75.3 million increase in unfunded loan commitments, an increase in expected loss rates due to the COVID-19 pandemic, and changes in certain allowance model assumptions in the transition from the incurred loss method to the CECL method in 2020 (refer to Note 1, Summary of Significant Accounting Policies, for additional information).

2019 Compared to 2018

In 2019, non-interest expense decreased by $296 thousand to $58.0 million.

The decrease was primarily due to $1.0 million in consulting expenses related to core processing contract negotiations in 2018, lower data processing expenses in 2019 as a result of the contract renegotiation, and lower Federal Deposit Insurance Corporation ("FDIC") deposit insurance expenses due to the FDIC Deposit Insurance Fund reserve exceeding its billing threshold in 2019.

The decrease was primarily due to $1.0 million in consulting expenses related to core processing contract negotiations in 2018, lower data processing expenses in 2019 as a result of the renegotiation of the Bank's core systems contract, and lower Federal Deposit Insurance Corporation ("FDIC") deposit insurance expenses due to the FDIC Deposit Insurance Fund reserve exceeding its billing threshold in 2019.

The decreases in non-interest expense were partially offset by $918 thousand higher salaries and related benefits as a result of annual merit increases, three additional full-time equivalent employees (on average), and personnel severance, as well as higher recruiting fees recorded in other expenses.

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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 totaled $11.7 million at an effective tax rate of 25.4% in 2019 , compared to $10.8 million at an effective tax rate of 24.9% in 2018 .

The increase in the provision from the prior year reflected a higher level of pre-tax income and lower tax-exempt interest income.

The increase in the effective tax rate was also due to a higher level of tax benefits in 2018 from the exercise of non-qualified stock options and disqualifying dispositions of incentive stock options by former employees of Bank of Napa post-acquisition.

The tax benefits from stock-based compensation reduced the effective tax rate approximately 59 basis points in 2018 versus 10 basis points in 2019.

Additional fluctuations in the effective tax rate from period to period were due to the relationship of other net permanent differences to income before tax.

The provision for income taxes totaled $10.3 million at an effective tax rate of 25.5% in 2020, compared to $11.7 million at an effective tax rate of 25.4% in 2019 and $10.8 million at an effective tax rate of 24.9% in 2018.

The decrease in the provision in 2020 compared to 2019 reflected lower pre-tax income and higher tax-exempt interest income on municipal securities.

The slight increase in the effective tax rate in 2020 as compared to 2019 was due to a favorable deferred tax liability true-up recognized in 2019 and a lower tax benefit from BOLI income in 2020.

The increase in the effective tax rate in 2019 compared to 2018 was due to a higher level of tax benefits in 2018 from the exercise of non-qualified stock options and disqualifying dispositions of incentive stock options by former employees of Bank of Napa post-acquisition.

We file a consolidated return in the U.S.

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FINANCIAL CONDITION

Our assets increased $186.4 million from December 31, 2018 to December 31, 2019 .

Cash increased $149.2 million, mainly due to an increase in deposits of $161.7 million.

Additionally, loan growth for 2019 was $79.4 million.

Our assets increased $204.6 million from December 31, 2019 to December 31, 2020, mainly due to loan growth of $245.3 million, primarily driven by PPP loan originations, which were offset by a $68.3 million decrease in investment security balances.

Investment Securities

We maintain an investment securities portfolio to provide liquidity and to generate earnings on funds that have not been loaned to customers.

Management determines the maturities and types of securities to be purchased based on liquidity, the interest rate risk position, and the desire to attain a reasonable investment yield balanced with risk exposure.

Management determines the maturities and types of securities to be purchased based on liquidity and interest rate risk position, and the desire to attain a reasonable investment yield balanced with risk exposure.

Table 5 shows the composition of the debt securities portfolio by expected maturity at December 31, 2020 and 2019.

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We estimate and update expected maturity dates regularly based on current and historical prepayment speeds.

The weighted average life of the investment portfolio at December 31, 2019 and 2018 was approximately six and five years, respectively.

The weighted average life of the investment portfolio at December 31, 2020 and 2019 was approximately five and six years, respectively.

Table 5 Investment Securities

December 31, 2019

Within 1 Year

After 10 Years

December 31, 2020 Within 1 Year 1-5 Years 5-10 Years After 10 Years Total

(dollars in thousands;

AmortizedCost 1

unaudited) AmortizedCost 1

Average Yield 2

6 unchanged sentences

AmortizedCost 1

Average Yield 2

Fair Value Average Yield 2

Held-to-maturity:

2 unchanged sentences

SBA-backed securities — — — — 6,547 3.17 — — 6,547 6,947 3.17

State and municipal 3

Obligations of state and political subdivisionsl 3

1,461 5.46 206 4.58 — — 1,667 1,688 5.35

Total held-to-maturity $ 1,461 5.46 $ 76,584 1.89 $ 30,991 2.65 $ — — $ 109,036 $ 115,185 2.16

3 unchanged sentences

SBA-backed securities — — 16,994 2.40 13,947 3.43 — — 30,941 32,862 2.86

State and municipal 3

Obligations of state and political subdivisions 3

3,653 2.68 18,616 3.01 82,618 2.73 — — 104,887 110,652 2.78

Debentures of government sponsored agencies 9,993 2.18 5,984 2.62 1,976 1.42 1,991 1.39 19,944 20,186 2.16

Corporate bonds

Total available-for-sale $ 18,411 2.13 $ 136,438 2.46 $ 216,198 2.76 $ 1,991 1.39 $ 373,038 $ 392,351 2.61

December 31, 2018

Within 1 Year

After 10 Years

Total $ 19,872 2.37 % $ 213,022 2.26 % $ 247,189 2.74 % $ 1,991 1.39 % $ 482,074 $ 507,536 2.51 %

December 31, 2019 Within 1 Year 1-5 Years 5-10 Years After 10 Years Total

(dollars in thousands;

AmortizedCost 1

unaudited) AmortizedCost 1

Average Yield 2

6 unchanged sentences

AmortizedCost 1

Average Yield 2

Fair Value Average Yield 2

Held-to-maturity:

2 unchanged sentences

SBA-backed securities — — — — 7,999 3.19 — — 7,999 8,264 3.19

State and municipal 3

Obligations of state and political subdivisions 3

1,807 4.45 1,706 5.36 — — — — 3,513 3,588 4.89

Total held-to-maturity $ 5,570 3.11 $ 74,567 2.19 $ 57,276 2.63 $ — — $ 137,413 $ 139,642 2.41

3 unchanged sentences

SBA-backed securities — — 5,280 2.54 30,394 2.88 — — 35,674 36,286 2.83

State and municipal 3

Obligations of state and political subdivisionsl 3

2,082 2.67 16,619 2.82 47,341 3.03 — — 66,042 67,282 2.96

Debentures of government sponsored agencies 498 2.05 16,040 2.92 21,881 2.75 9,970 2.91 48,389 49,046 2.83

Privately issued CMOs

Corporate bonds 1,497 3.54 — — — — — — 1,497 1,502 3.54

Total available-for-sale $ 8,234 2.44 $ 164,641 2.70 $ 241,078 2.97 $ 9,970 2.91 $ 423,923 $ 432,260 2.85

Total $ 13,804 2.71 % $ 239,208 2.54 % $ 298,354 2.91 % $ 9,970 2.91 % $ 561,336 $ 571,902 2.75 %

1 Book value reflects cost, adjusted for accumulated amortization and accretion.

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The amortized cost of our investment securities portfolio decreased $79.3 million or 14% during 2020.

We purchased $114.4 million in securities in 2019 , including $3.5 million designated as held-to-maturity and $110.9 million designated as available-for-sale to provide flexibility for liquidity and interest rate risk management.

We purchased $97.5 million in securities in 2020 designated as available-for-sale to provide flexibility for liquidity and interest rate risk management.

These purchases were offset by $143.1 million of paydowns, calls and maturities, and $32.8 million of sales during 2020.

During 2019 , we purchased $17.0 million in collateralized mortgage obligations ("CMOs"), $42.2 million in mortgage pass-through securities, $25.3 million in debentures of government sponsored agencies, and $29.9 million in obligations of state and political subdivisions.

We consider agency debentures, mortgage-backed securities, and CMOs issued by U.S.

During 2020, we purchased $57.6 million in obligations of state and political subdivisions, $31.0 million in collateralized mortgage obligations ("CMOs") and $9.0 million in debentures of government sponsored agencies.

We consider agency debentures and CMOs issued by U.S.

government sponsored entities to have low credit risk as they carry the credit support of the U.S.

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At December 31, 2020, distribution of our investment in obligations of state and political subdivisions was as follows:

December 31, 2019

December 31, 2018

December 31, 2020 December 31, 2019

(dollars in thousands;

Amortized Cost

state and municipal securities

Amortized Cost

unaudited) Amortized Cost Fair Value Percent of

State and Municipal Securities Amortized Cost Fair Value Percent of

State and Municipal Securities

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The portion of the portfolio outside the state of California is distributed among 10 states.

The largest concentrations outside California are in Texas (28.7%), Florida (7.8%), and Maryland (9.8%).

Revenue bonds, both within and outside California, primarily consisted of bonds issued for essential services (such as transportation, infrastructure, public services, education and utilities).

The largest concentrations outside California are in Texas (55.3%), Washington (9.3%), and Maryland (6.4%).

During March 2020, we strategically increased our credit exposure to obligations issued by high credit quality 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 believe the healthy level of reserves and excess guarantee capacity at the PSF sufficiently mitigates any potential credit issues posed by the issuers' exposure to the oil and gas industry, as well as the negative effects of the recent winter storms in Texas.

In addition, 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.

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• Credit ratings by major credit rating agencies

Table 6 Loans Outstanding by Type at December 31

Table 6 Loans Outstanding by Class at December 31

(in thousands;

Commercial loans

unaudited) 2020 2019 2018 2017 2016

Commercial and industrial loans $ 498,408 $ 246,687 $ 230,739 $ 235,835 $ 218,615

Commercial owner-occupied 304,963 308,824 313,277 300,963 247,713

Commercial investor

Commercial investor-owned 961,208 946,317 873,410 822,984 724,228

Construction 73,046 61,095 76,423 63,828 74,809

Home equity 104,813 116,024 124,696 132,467 117,207

Other residential 123,395 136,657 117,847 95,526 78,549

Installment and other consumer loans 22,723 27,682 27,472 27,410 25,495

Allowance for loan losses

Total net loans

Total loans increased by $79.4 million to $1,843.3 million from $1,763.9 million in 2018.

Loan originations totaled $259.6 million in 2019, compared to $239.4 million in 2018.

Loan originations were partially offset by payoffs totaling $145.7 million in 2019 and $157.3 million in 2018.

Payoffs to total loans were 7.9%, 8.9% and 7.9% in 2019, 2018 and 2017, respectively.

Approximately 88% of our outstanding loans were secured by real estate at December 31, 2019 and 2018.

Also, see ITEM 1A, Risk Factors, regarding our loan concentration risk.

The following table summarizes our commercial real estate loan portfolio by the geographic location in which the property is located as of December 31, 2019 and 2018 .

Table 7 Commercial Real Estate Loans Outstanding by Geographic Location

December 31, 2019

December 31, 2018

Total loans, at amortized cost 2,088,556 1,843,286 1,763,864 1,679,013 1,486,616

Allowance for credit losses on loans (22,874) (16,677) (15,821) (15,767) (15,442)

Total loans, net of allowance for credit losses $ 2,065,682 $ 1,826,609 $ 1,748,043 $ 1,663,246 $ 1,471,174

Loans increased $245.3 million in 2020, or 13%, to $2.089 billion at December 31, 2020, from $1.843 billion at December 31, 2019.

SBA PPP loans outstanding at December 31, 2020 totaled $291.6 million and were included in commercial and industrial loans.

For the year ended December 31, 2020, new non-PPP-related loan originations were $165.5 million, compared to $259.6 million in 2019.

The decrease in non-PPP loan originations was largely due a decrease in conventional loan demand as a result of the pandemic and shelter-at-home orders.

New loan originations were more than offset by payoffs of $180.1 million and reduction in line usage.

Loan payoffs were concentrated in consumer and retail loans (mostly tenant in common and HELOC) and commercial loans on which underlying assets were sold, loans refinanced with other banks, or loans that were paid off with cash.

Payoffs as a percentage of beginning of the year loan balances were 9.8%, 8.3% and 9.4% in 2020, 2019 and 2018, respectively.

Approximate ly 77% and 88%, of total loans were secured by real estate at December 31, 2020 and 2019, respectively.

The decrease in the percentage in 2020 was due to PPP loans, which are not secured by real estate.

For additional information on loan concentration risk, see ITEM 1A, Risk Factors.

The following table summarizes our commercial real estate loan portfolio by the county in which the property was located as of December 31, 2020 and 2019.

Table 7 Commercial Real Estate Loans Outstanding by County

(dollars in thousands;

% of Commercial real estate loans

unaudited) December 31, 2020 December 31, 2019

County Amount Percent of Commercial Real Estate Loans Amount Percent of Commercial Real Estate Loans

Marin $ 348,106 27.5 % $ 339,917 27.1 %

Sonoma 208,745 16.5 199,717 15.9

Napa 181,054 14.3 175,170 14.0

San Francisco 169,902 13.4 165,205 13.2

Commercial real estate loans increased $68.5 million in 2019 and $62.7 million in 2018.

The increases in 2019 and 2018 were primarily in Sonoma, Napa, Alameda and San Francisco counties.

Of the commercial real estate loans at December 31, 2019, 75% were non-owner occupied and 25% were owner occupied.

Almost the entire commercial real estate loan portfolio is comprised of term loans for which the primary source of repayment is the operating cash flow from the leasing activities of the real estate collateral.

We believe we applied conservative underwriting standards to our originated loans and both the acquired and originated loans are actively managed.

Alameda 164,921 13.0 175,664 14.0

Contra Costa 49,155 3.9 46,933 3.7

San Mateo 26,306 2.1 22,278 1.8

Solano 21,380 1.7 23,710 1.9

Other 96,602 7.6 106,547 8.4

Total $ 1,266,171 100.0 % $ 1,255,141 100.0 %

Commercial real estate loans increased $11.0 million in 2020, compared to a $68.5 million increase in 2019.

Of the commercial real estate loans at December 31, 2020, 76% were investor-owned and 24% were owner-occupied.

Almost the entire commercial real estate loan portfolio is comprised of term loans for which the primary source of repayment is either the cash flow from the leasing activities of the real estate collateral or the operating cash flow of the owner occupant.

We occasionally provide interest-only term loans to borrowers who exhibit strong financial capacity and/or for commercial real estate loans during the occupancy stabilization period.

These interest-only term loans must meet our stringent underwriting standards.

After the initial interest-only payment period, these loans will usually require principal and interest payments.

After the initial inte rest-only payment period, these loans will normally require principal and interest payments.

In addition, we may make interest-only concessions in a modified troubled debt restructuring ("TDR").

At December 31, 2019 and 2018, approximately 3.7% and 2.9%, respectively, of our commercial real estate

loans contained an interest-only feature as part of the loan terms.

At December 31, 2020 and 2019, approximately 3.4% and 3.7%, respectively, of our commercial real estate loans contained an interest-only feature as part of the loan terms.

All of these loans were current with their payments as of December 31, 2020.

Except for two TDR loans to one borrowing relationship totaling $7.1 million as of December 31, 2020, all were considered to have low credit risk (graded "Pass").

The following table shows an analysis of construction loans by type and location as of December 31, 2019 and 2018 .

Table 8 Construction Loans Outstanding by Type and Geographic Location

The following table shows an analysis of construction loans by type and county as of December 31, 2020 and 2019.

Table 8 Construction Loans Outstanding by Type and County

(dollars in thousands;

December 31, 2019

December 31, 2018

Construction loans by type

% of Construction Loans

unaudited) December 31, 2020 December 31, 2019

Loan Type Amount Percent of Construction Loans Amount Percent of Construction Loans

Commercial real estate $ 29,788 40.8 % $ 29,568 48.4 %

3 unchanged sentences

Land - unimproved 1,248 1.6 1,293 2.1

Total $ 73,046 100.0 % $ 61,095 100.0 %

(dollars in thousands;

December 31, 2019

December 31, 2018

Construction loans by geographic location

% of Construction Loans

unaudited) December 31, 2020 December 31, 2019

County Amount Percent of Construction Loans Amount Percent of Construction Loans

San Francisco $ 41,707 57.1 % $ 19,374 31.7 %

Construction loans decreased by $15.3 million in 2019 and increased by $12.6 million in 2018.

The $14.8 million decrease in Sonoma and Alameda construction loans primarily resulted from one loan that converted to a commercial real estate loan and one payoff from a completed apartment building construction project.

The increase in 2018 was primarily due to new construction projects, partially offset by payoffs related to completed construction projects.

The improving economy resulted in a number of new financing opportunities for existing and new customers who had successfully completed construction projects in the past.

Sonoma 10,058 13.8 8,808 14.4

Solano 9,020 12.3 1,952 3.2

Marin 8,858 12.1 18,600 30.5

Alameda 1,862 2.5 2,092 3.4

San Mateo — — 5,323 8.7

Napa — — 4,284 7.0

Other 1,541 2.2 662 1.1

Total $ 73,046 100.0 % $ 61,095 100.0 %

Construction loans increased by $12.0 million in 2020, compared to a $15.3 million decrease in 2019.

The increase in 2020 primarily resulted from additional borrowings under existing construction loans as well as advances on six new construction loans to well-known, experienced builders.

The increase was partially offset by the successful completion of projects, one of which converted to a permanent commercial real estate loan.

The decrease in 2019 was primarily due to a $14.8 million loan that converted to a commercial real estate loan and one payoff from a completed apartment building construction project.

The following table presents the maturity distribution of our commercial and construction loans as of December 31, 2020 based on their contractual maturity dates and does not include scheduled payments or potential prepayments.

Table 9A Commercial and Construction Loan Maturity Distribution

Due after 1 but

Table 9A Commercial and Industrial and Construction Loan Maturity Distribution

Due within Due after 1 but Due after

(in thousands;

within 5 years

Maturity distribution:

unaudited) 1 year within 5 years 5 years Total

Commercial and industrial 1

$ 77,534 $ 373,463 $ 47,411 $ 498,408

Construction 2

28,454 21,862 22,730 73,046

Total $ 105,988 $ 395,325 $ 70,141 $ 571,454

1 Commercial and industrial due after 1 but within 5 years includes SBA PPP loans totaling $291.6 million, the majority of which are expected to be forgiven by the SBA in 2021.

2 Construction loans that mature after 5 years are structured to convert to permanent financing after the initial construction period.

1 unchanged sentence

The large majority of the variable-rate loans are tied to independent indices (such as the Prime Rate or a Treasury Constant Maturity Rate).

Most loans with original terms of more than five years have provisions for the fixed rates to

reset, or convert to variable rates, after three, five or seven years.

Most loans with original terms of more than five years have provisions for the fixed rates to reset, or convert to variable rates, after three, five or seven years.

These loans are included in variable-rate balances below.

Table 9B Commercial and Construction Loan Interest Rate Sensitivity

Table 9B Commercial and industrial and Construction Loan Interest Rate Sensitivity

(in thousands;

Allowance for Loan Losses

Credit risk is inherent in the business of lending.

As a result, we maintain an allowance for loan losses to absorb probable losses in our loan portfolio through a provision for loan losses charged against earnings.

unaudited) Fixed Variable Total

Commercial and industrial 1

$ 395,619 $ 102,789 $ 498,408

Construction 43,851 29,195 73,046

Total $ 439,470 $ 131,984 $ 571,454

1 Commercial and industrial includes SBA PPP 1% fixed rate loans totaling $291.6 million, the majority of which are expected to be forgiven by the SBA in 2021.

Allowance for Credit Losses on Loans

As of December 31, 2020, we calculated the allowance for credit losses using the current expected loss methodology, or CECL, which required us to estimate credit losses over the expected life of a loan and consider future changes in macroeconomic conditions.

All specifically identifiable and quantifiable losses are charged off against the allowance.

The balance of our allowance for loan losses is Management's best estimate of the remaining probable losses in the portfolio.

The ultimate adequacy of the allowance is dependent upon a variety of factors beyond our control, including the real estate market, changes in interest rates and economic and political environments.

Based on the current conditions of the loan portfolio, Management believes that the $16.7 million allowance for loan losses at December 31, 2019 is adequate to absorb losses in our loan portfolio under accounting standards in effect at December 31, 2019, but provides no assurance that adverse economic conditions or other circumstances over the life of the loans will not result in increased losses in the portfolio.

For information on the adoption of FASB ASU No.

Based on the current conditions of the loan portfolio and reasonable and supportable forecasts, management believes that the $22.9 million allowance for credit losses at December 31, 2020 is adequate to absorb expected credit losses in our loan portfolio, but provides no assurance that adverse changes in economic conditions or other circumstances over the remaining terms of our loans will not result in increased losses in the portfolio.

For information on our allowance for credit losses methodology and adoption of FASB ASU No.

2016-13, Financial Instruments - Credit Losses (Topic 326):

Measurement of Credit Losses on Financial Instruments , effective January 1, 2020, and potential impact on the Allowance for Loan losses, refer to Note 1 to the Consolidated Financial Statements in ITEM 8, under "Accounting Standards Not Yet Effective."

The Components of the Allowance for Loan Losses

As stated in Note 1 to the Consolidated Financial Statements in ITEM 8 of this report, the overall allowance consists of 1) specific allowances for individually identified impaired loans ("ASC 310-10") and 2) general allowances for pools of loans ("ASC 450-20"), which incorporate quantitative (e.g., historical loan loss rates) and qualitative risk factors (e.g., portfolio growth and trends, credit concentrations, economic and regulatory factors, etc.).

The first component, specific allowances, results from the analysis of identified problem credits and the evaluation of sources of repayment including collateral, as applicable.

Management evaluates these loans individually for impairment.

Management considers an originated loan to be impaired when it is probable we will be unable to collect all amounts due according to the contractual terms of the loan agreement.

For PCI loans, specific allowances are established to account for credit deterioration subsequent to acquisition if we have probable decreases in cash flows expected to be collected.

For loans determined to be impaired, the extent of the impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate at origination (for originated loans), based on the loan's observable market price, or based on the fair value of the collateral if the loan is collateral dependent or if foreclosure is imminent.

Generally, for problem credits that are collateral dependent, we obtain appraisals of the collateral at least annually.

We may obtain appraisals more frequently if we believe the collateral is subject to market volatility, if a specific event has occurred to the collateral, or if we believe foreclosure is imminent.

Impaired loan balances decreased to $11.5 million at December 31, 2019 from $15.0 million at December 31, 2018.

The specific allowance for impaired loans decreased to $397 thousand at December 31, 2019 from $778 thousand at December 31, 2018 .

The decrease in impaired loan balances primarily related to the payoff of a land development loan with recorded investment of $2.7 million at December 31, 2018 and paydowns on other TDR loans.

The decrease in reserves for impaired loans was primarily due to two unsecured commercial loans that paid down outstanding balances during 2019 and exhibited improved expected cash flows.

The second component is an estimate of the probable inherent losses in each loan pool with similar risk characteristics.

This analysis encompasses the entire loan portfolio, excluding individually identified impaired loans and acquired loans whose purchase discount has not been fully accreted.

Under our allowance model, loans are evaluated on a pool basis by federal regulatory reporting codes ("CALL codes" or "segments"), which are further delineated by assigned credit risk ratings, as described in Note 3 to the Consolidated Financial Statements in ITEM 8 of this report.

At December 31, 2019 and 2018, the allowance allocated for the second component totaled $16.3 million and $15.0 million, respectively.

The increase in the general allowance was almost entirely attributed to growth in loans subject

to general allowance reserves (i.e., second component).

Loans classified substandard decreased by $2.7 million during 2019 primarily due to the payoff of the land development loan mentioned previously.

Loans designated special mention increased by $56.1 million during 2019 due primarily to new commercial loan originations to three borrowing relationships totaling $17.7 million that were experiencing perceived temporary financial conditions that warranted the initial designation, and downgrades of existing commercial real estate loans to two borrowing relationships totaling $26.7 million.

These loans are either well-secured or have strong sponsorship and are not indicative of deteriorating credit quality in the loan portfolio.

Table 10 shows the allocation of the allowance by loan type as well as the percentage of total loans in each of the same loan types.

Table 10 Allocation of Allowance for Loan Losses

December 31, 2019

December 31, 2018

December 31, 2017

December 31, 2016

December 31, 2015

Measurement of Credit Losses on Financial Instruments , effective December 31, 2020, refer to Notes 1 and 3 to the Consolidated Financial Statements in ITEM 8 of this report.

The allowance for credit losses to loans was 1.10% at December 31, 2020 and 0.90% at both December 31, 2019 and 2018.

The allowance for credit losses to loans, excluding SBA PPP loans and previously acquired loans was 1.27%, 0.96% and 0.98% at year-end 2020, 2019, and 2018, respectively (for a discussion of this non-GAAP financial measure, refer to ITEM 6, Selected Financial Data of this report).

As stated in the Provision for Credit Losses section above, the increase in allowance for credit losses in 2020 was almost entirely due to the impact of the COVID-19 pandemic and its effect on the local and regional economies and economic outlook coupled with the transition to the CECL method.

Due to the high credit quality of our loan portfolio, net charge-offs have been minimal for the past several years.

Net charge-offs totaled $1 thousand in 2020 and $44 thousand in 2019, compared to net recoveries of $54 thousand in 2018.

Table 10 shows the allocation of the allowance by loan class as well as the per centage of total loans in each of the same loan classes.

Table 10 Allocation of Allowance for Credit Losses

December 31, 2020 December 31, 2019 December 31, 2018 December 31, 2017 December 31, 2016

(dollars in thousands;

Allowance balance allocation