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 2020 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, general economic conditions and the economic uncertainty in the United States and abroad, including changes in interest rates, deposit flows, real estate values, and expected future cash flows on loans and securities; costs or effects of acquisitions; competition; changes in accounting principles, policies or guidelines; changes in legislation or regulation (including the Coronavirus Aid, Relief and Economic Security Act of 2020, as amended, and the Economic Aid to Hard-Hit Small Businesses, Nonprofits and Venues Act of 2020); our borrowers’ actual payment performance as loan deferrals related to the COVID-19 pandemic expire, including the potential adverse impact of loan modifications and payment deferrals implemented consistent with recent regulatory guidance; natural disasters (such as wildfires and earthquakes in our area); adverse weather conditions; 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 our operations, pricing, products and services. In addition, events or factors that could cause results or performance to materially differ from those expressed in the forward-looking statements concerning the AMRB acquisition include, but are not limited to: • the businesses of Bancorp and AMRB may not be integrated successfully or such integration may be more difficult, time-consuming or costly than expected; • expected cost savings from the acquisition may not be fully realized or realized within the expected time frame; • revenues following the merger may be lower than expected; • customer and employee relationships and business operations may be disrupted by the acquisition; and • the ability to obtain required regulatory and shareholder approvals, and the ability to complete the acquisition within the expected timeframe may be more difficult, time-consuming or costly than expected. 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 our 2020 Form 10-K as filed with the SEC, copies of which are available from us at no charge. We do not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events. Page-28 Critical Accounting Policies and Estimates 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. There have been no material changes to our critical accounting policies, which include: Allowance for Credit Losses on Loans and Unfunded Commitments, Allowance for Credit Losses on Investments Securities, Accounting for Income Taxes, and Fair Value Measurements . For a detailed discussion of these accounting policies, refer to Note 1 in the Consolidated Financial Statements included in our 2020 Form 10-K filed with the SEC on March 15, 2021. Executive Summary As previously reported, on April 16, 2021, Bancorp entered into a definitive agreement to acquire American River Bankshares ("AMRB"), parent company of American River Bank ("ARB"), whereby AMRB will merge with and into Bancorp and immediately thereafter ARB will merge with and into Bank of Marin (collectively, the "Merger"). We expect the transaction to be accretive to Bancorp's earnings, adding to shareholder value. AMRB shareholders will receive a fixed exchange ratio of 0.575 shares of Bancorp common stock for each share of AMRB common stock outstanding. Based on Bancorp's closing stock price of $39.06 on April 16, 2021 (date of merger agreement), the transaction was valued at $134.5 million (with approximately 3.4 million of additional shares of Bancorp common stock to be issued), or $22.46 per share of AMRB common stock, which includes the value of AMRB options being paid in cash. Such value will fluctuate with changes in Bancorp's stock price. Based on information currently available, Bank of Marin will have approximately $4.0 billion in assets and operate 31 branches in ten counties (Alameda, Amador, Contra Costa, Marin, Napa, Placer, Sacramento, San Francisco, San Mateo, and Sonoma) upon closing. The merger has been approved by the Boards of Directors of each company, all applicable regulatory agencies and shareholders of AMRB and BMRC. The Merger is expected to close on August 6, 2021. For other important factors regarding the AMRB acquisition, please see Note 10, Merger Agreement, and the Forward-Looking Statements section of this Form 10-Q. Net income for the second quarter of 2021 totaled $9.3 million, compared to $7.4 million in the second quarter of 2020. Diluted earnings per share were $0.71 in the second quarter of 2021, compared to $0.55 in the same quarter a year ago. Earnings for the first six months of 2021 totaled $18.2 million, compared to $14.6 million in the same period a year ago. Diluted earnings per share were $1.37, compared to $1.07 in the first half of 2020. Net income included the recognition of $2.6 million and $4.3 million of SBA PPP fees, net of costs in the second quarter of 2021 and first six months of 2021, respectively, compared to $1.2 million in the same periods a year ago. Additionally, reversals of the allowance for credit losses on loans totaling $920 thousand and $3.8 million in the second quarter and first half of 2021 contributed to the increase in earnings when compared to provisions of $2.0 million and $4.2 million in the comparative periods a year ago. Increases to income in the first half of 2021 were partially offset by the early redemption of our last subordinated debenture, generating $1.3 million accelerated discount accretion in interest expense in the first quarter of 2021. The following are highlights of our operating and financial performance for the periods presented: • Loans totaled $2.003 billion at June 30, 2021, compared to $2.089 billion at December 31, 2020, a decrease of $85.8 million, or 4.1%. The first half of 2021 included a $43.3 million net decrease in PPP loans. Non-PPP-related loan originations of $69.1 million were more than offset by loan payoffs of $95.4 million and a $34.8 million decrease in line utilization. • Credit quality remained strong, with non-accrual loans representing $9.2 million at June 30, 2021 and December 31, 2020, or 0.46% and 0.44% of total loans, respectively. The ratio of allowance for credit losses on loans to total loans was 0.95% at June 30, 2021 and 1.10% at December 31, 2020. Excluding acquired and SBA PPP loans, the allowance for credit losses on loans represented 1.09% of total loans as of June 30, 2021, compared to 1.27% as of December 31, 2020 (see Results of Operations for a definition of this non-GAAP financial measure). Page-29 • Return on average assets ("ROA") and return on average equity ("ROE") were 1.20% and 10.72% in the second quarter of 2021, compared to 1.21% and 10.47% in the first half of 2021, respectively. ROA and ROE were 1.01% and 8.52% in the second quarter of 2020, compared to 1.05% and 8.53% in the first half of 2020. • The tax-equivalent net interest margin was 3.37% and 3.53% in the second quarters of 2021 and 2020, respectively. The decrease from the same quarter a year ago was primarily attributed to the low interest rate environment. SBA PPP loans contributed 12 basis points to the second quarter's net interest margin due to PPP loans forgiven and paid off by the SBA. The tax-equivalent net interest margin was 3.28% in the first six months of 2021 compared to 3.70% in the first six months a year ago. The decrease from the same period a year ago was primarily attributed to the lower interest rate environment. SBA PPP loans added 5 basis points to the first six months' net interest margin as compared to a 2 basis points reduction to the same period a year ago. The early redemption of our last subordinated debenture reduced first quarter 2021 tax-equivalent net interest margin by approximately 18 basis points. • The efficiency ratio was 58.58% for the three months ended June 30, 2021, up from 53.01% in the comparative period a year ago, mainly due to a $1.7 million increase in non-interest expense mostly attributable to fewer salary-related deferred SBA PPP loan origination costs and ARB acquisition-related expenses. The efficiency ratio for the first half of 2021 was 61.43%, compared to 54.74% the same period a year ago. The increase was primarily due to a $1.9 million decrease in net interest income and $1.1 million decrease in non-interest income. Additionally, non-interest expenses increased by $1.7 million. • Total deposits increased $179.3 million to $2.684 billion at June 30, 2021 from $2.504 billion at December 31, 2020. The increase was primarily due to customers depositing PPP funds into their accounts and new account openings in the second quarter of 2021. Non-interest bearing deposits represented 54% of total deposits as of June 30, 2021 and December 31, 2020. The cost of average deposits was 0.07% in the second quarter and first half of 2021, a decrease of 2 basis points and 8 basis points from the equivalent periods a year ago. • All capital ratios were above well capitalized regulatory requirements. The total risk-based capital ratio for Bancorp was 15.5% at June 30, 2021, compared to 16.0% at December 31, 2020. Tangible common equity to tangible assets was 10.4% at June 30, 2021, compared to 11.3% at December 31, 2020 (see Results of Operations for a definition of this non-GAAP financial measure). The total risk-based capital ratio for the Bank was 15.3% at June 30, 2021, compared to 15.8% at December 31, 2020. • The Board of Directors declared a cash dividend of $0.24 per share on July 16, 2021, a $0.01 increase from the prior quarter. This represents the 65th consecutive quarterly dividend paid by Bank of Marin Bancorp. The dividend is payable on August 6, 2021, to shareholders of record at the close of business on July 30, 2021. • Given our strong capital and liquidity, the Board of Directors approved a new share repurchase program on July 16, 2021 under which Bancorp may repurchase up to $25.0 million of its outstanding common stock through July 31, 2023. The share repurchase program became effective July 22, 2021. • As announced in May 2021, Tim Myers, Chief Operating Officer, was promoted from Executive Vice President to President. Tim is now responsible for the management of Centralized Operations and Technology in addition to Commercial Banking, Retail Banking, Wealth Management & Trust, and Marketing. 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. We believe that our robust liquidity and capital positions, high credit quality loan portfolio, excellent credit metrics, and low-cost deposit base, as well as our acquisition of AMRB will reinforce the long-term success of the bank and position us well for the remainder of 2021. Page-30 RESULTS OF OPERATIONS Highlights of the financial results are presented in the following tables: (dollars in thousands) June 30, 2021 December 31, 2020 Selected financial condition data: Total assets $ 3,073,818 $ 2,911,926 Loans, net 1,983,667 2,065,682 Deposits 2,683,575 2,504,249 Borrowings and other obligations 438 58 Subordinated debenture — 2,777 Stockholders' equity 348,649 358,253 Asset quality ratios: Allowance for credit losses on loans to total loans 0.95 % 1.10 % Allowance for credit losses on loans to total loans, excluding SBA PPP loans 1 1.09 % 1.27 % Allowance for credit losses on loans to non-accrual loans 2.08x 2.48x Non-accrual loans to total loans 0.46 % 0.44 % Capital ratios: Equity to total assets ratio 11.34 % 12.30 % Tangible common equity to tangible assets 2 10.36 % 11.27 % Total capital (to risk-weighted assets) 15.53 % 16.03 % Tier 1 capital (to risk-weighted assets) 14.54 % 14.82 % Tier 1 capital (to average assets) 10.04 % 10.80 % Common equity Tier 1 capital (to risk weighted assets) 14.54 % 14.69 % Three months ended Six months ended (dollars in thousands, except per share data) June 30, 2021 June 30, 2020 June 30, 2021 June 30, 2020 Selected operating data: Net interest income $ 24,534 $ 24,375 $ 46,565 $ 48,494 (Reversal of) provision for credit losses on loans (920) 2,000 (3,849) 4,200 Non-interest income 2,022 1,813 3,848 4,933 Non-interest expense 15,556 13,881 30,968 29,248 Net income 9,285 7,406 18,232 14,634 Net income per common share: Basic $ 0.71 $ 0.55 $ 1.38 $ 1.08 Diluted $ 0.71 $ 0.55 $ 1.37 $ 1.07 Performance and other financial ratios: Return on average assets 1.20 % 1.01 % 1.21 % 1.05 % Return on average equity 10.72 % 8.52 % 10.47 % 8.53 % Tax-equivalent net interest margin 3 3.37 % 3.53 % 3.28 % 3.70 % Cost of deposits 0.07 % 0.09 % 0.07 % 0.15 % Efficiency ratio 58.58 % 53.01 % 61.43 % 54.74 % Cash dividend payout ratio on common stock 4 32.39 % 41.82 % 33.33 % 42.59 % 1 The allowance for credit losses on loans to total loans, excluding SBA-guaranteed 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 credit losses on loans. SBA PPP loans at June 30, 2021 and December 31, 2020 totaled $248.3 million and $291.6 million, respectively. 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 $315 million and $324 million at June 30, 2021 and December 31, 2020, 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 $33.6 million and $34.0 million at June 30, 2021 and December 31, 2020, 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-31 Net Interest Income Net interest income is the interest earned on loans, investment and other interest-earning assets minus 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 June 30, 2021 June 30, 2020 Interest Interest Average Income/ Yield/ Average Income/ Yield/ (dollars in thousands) Balance Expense Rate Balance Expense Rate Assets Interest-earning deposits with banks 1 $ 193,749 $ 54 0.11 % $ 173,161 $ 39 0.09 % Investment securities 2, 3 661,361 3,666 2.22 % 550,483 3,886 2.82 % Loans 1, 3, 4 2,062,497 21,601 4.14 % 2,043,197 21,399 4.14 % Total interest-earning assets 1 2,917,607 25,321 3.43 % 2,766,841 25,324 3.62 % Cash and non-interest-bearing due from banks 39,252 37,680 Bank premises and equipment, net 4,795 5,543 Interest receivable and other assets, net 131,667 133,639 Total assets $ 3,093,321 $ 2,943,703 Liabilities and Stockholders' Equity Interest-bearing transaction accounts $ 167,787 $ 39 0.09 % $ 142,778 $ 39 0.11 % Savings accounts 227,767 21 0.04 % 182,371 17 0.04 % Money market accounts 735,784 312 0.17 % 794,654 383 0.19 % Time accounts including CDARS 95,354 81 0.34 % 95,076 142 0.60 % Borrowings and other obligations 1 61 — 1.15 % 156 1 2.62 % Subordinated debenture 1, 5 — — — % 2,733 40 5.73 % Total interest-bearing liabilities 1,226,753 453 0.15 % 1,217,768 622 0.21 % Demand accounts 1,478,119 1,332,986 Interest payable and other liabilities 40,976 43,255 Stockholders' equity 347,473 349,694 Total liabilities & stockholders' equity $ 3,093,321 $ 2,943,703 Tax-equivalent net interest income/margin 1 $ 24,868 3.37 % $ 24,702 3.53 % Reported net interest income/margin 1 $ 24,534 3.33 % $ 24,375 3.49 % Tax-equivalent net interest rate spread 3.28 % 3.41 % Page-32 Six months ended Six months ended June 30, 2021 June 30, 2020 Interest Interest Average Income/ Yield/ Average Income/ Yield/ (in thousands) Balance Expense Rate Balance Expense Rate Assets Interest-earning deposits with banks 1 $ 179,846 $ 96 0.11 % $ 136,261 $ 371 0.54 % Investment securities 2, 3 601,498 6,948 2.31 % 553,690 8,151 2.94 % Loans 1, 3, 4 2,081,069 42,437 4.06 % 1,938,189 42,465 4.33 % Total interest-earning assets 1 2,862,413 49,481 3.44 % 2,628,140 50,987 3.84 % Cash and non-interest-bearing due from banks 45,059 39,262 Bank premises and equipment, net 4,786 5,741 Interest receivable and other assets, net 132,675 126,274 Total assets $ 3,044,933 $ 2,799,417 Liabilities and Stockholders' Equity Interest-bearing transaction accounts $ 170,943 $ 78 0.09 % $ 140,587 $ 105 0.15 % Savings accounts 220,946 40 0.04 % 172,905 33 0.04 % Money market accounts 719,769 598 0.17 % 777,635 1,354 0.35 % Time accounts including CDARS 95,849 177 0.37 % 95,616 303 0.64 % Borrowings and other obligations 1 50 — 1.46 % 257 3 2.06 % Subordinated debenture 1, 5 1,076 1,361 251.54 % 2,724 89 6.46 % Total interest-bearing liabilities 1,208,633 2,254 0.38 % 1,189,724 1,887 0.32 % Demand accounts 1,442,320 1,226,481 Interest payable and other liabilities 42,753 38,150 Stockholders' equity 351,227 345,062 Total liabilities & stockholders' equity $ 3,044,933 $ 2,799,417 Tax-equivalent net interest income/margin 1 $ 47,227 3.28 % $ 49,100 3.70 % Reported net interest income/margin 1 $ 46,565 3.24 % $ 48,494 3.65 % Tax-equivalent net interest rate spread 3.06 % 3.52 % 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. 5 2021 interest on subordinated debenture included $1.3 million in accelerated discount accretion from the early redemption of our last subordinated debenture on March 15, 2021. Analysis of Changes in 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 periods 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 six months ended June 30, 2020. Page-33 Three Months Ended June 30, 2021 Compared to Three Months Ended June 30, 2020 Six Months Ended June 30, 2021 Compared to Six Months Ended June 30, 2020 (in thousands) Volume Yield/Rate Mix Total Volume Yield/Rate Mix Total Interest-earning deposits with banks $ 5 $ 9 $ 1 $ 15 $ 119 $ (298) $ (96) $ (275) Investment securities 1 783 (835) (168) (220) 704 (1,755) (152) (1,203) Loans 1 202 — — 202 3,130 (2,723) (435) (28) Total interest-earning assets 990 (826) (167) (3) 3,953 (4,776) (683) (1,506) Interest-bearing transaction accounts 7 (6) (1) — 23 (40) (10) (27) Savings accounts 4 — — 4 9 — (2) 7 Money market accounts (28) (46) 3 (71) (101) (704) 49 (756) Time accounts, including CDARS — (61) — (61) 1 (125) (2) (126) Borrowings and other obligations (1) — — (1) (2) (1) — (3) Subordinated debenture 2 (40) — — (40) (54) 1,326 — 1,272 Total interest-bearing liabilities (58) (113) 2 (169) (124) 456 35 367 Changes in tax-equivalent net interest income $ 1,048 $ (713) $ (169) $ 166 $ 4,077 $ (5,232) $ (718) $ (1,873) 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%. 2 Six months ended June 30, 2021 includes $1.3 million in accelerated discount accretion from the early redemption of our last subordinated debenture on March 15, 2021. Second Quarter of 2021 Compared to Second Quarter of 2020 Net interest income totaled $24.5 million in the second quarter of 2021, compared to $24.4 million in the same quarter a year ago. The $159 thousand increase was primarily due to higher income from SBA PPP loans, higher average investment securities and commercial real estate loan balances, and lower rates on interest-bearing liabilities. Increases were mostly offset by lower yields on investment securities, and lower average commercial, home equity, and other residential loan balances. The tax-equivalent net interest margin was 3.37% in the second quarter of 2021 compared to 3.53% in the same quarter of the previous year. The decrease in tax-equivalent net interest margin was primarily attributed to the lower interest rate environment. SBA PPP loans added 12 basis points to the second quarter 2021's net interest margin as compared to 3 basis points reduction for the same quarter a year ago due to higher fee income accretion in the second quarter of 2021 as more PPP loans were forgiven and paid off by the SBA. First Six Months of 2021 Compared to First Six Months of 2020 Net interest income totaled $46.6 million in the six months ended June 30, 2021, compared to $48.5 million in the same period a year ago. The decrease was primarily attributed to $1.3 million in accelerated discount accretion from the early redemption of a subordinated debenture in the first quarter of 2021, lower yielding interest-earning assets, lower average balances of commercial and consumer loans, and one less day in the period. Decreases were partially offset by higher income from SBA PPP loans and higher investment securities, commercial real estate, and construction loan balances, and lower rates on interest-bearing liabilities. We recognized $4.3 million in SBA PPP fees, net of cost in the first six months of 2021, compared to $1.2 million in the first six months a year ago. As of June 30, 2021 $6.5 million PPP fees, net of deferred costs remain outstanding and will be recognized into income in future periods. The tax-equivalent net interest margin was 3.28% in the six months ended June 30, 2021, compared to 3.70% in the same period a year ago. The decrease from the first six months of 2020 was primarily attributed to the lower interest rate environment. SBA PPP loans added 5 basis points to the first six months' net interest margin as compared to a 2 basis points reduction to the same period a year ago. Market Interest Rates 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"). Page-34 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 has resided between 0.0% and 0.25% since March 15, 2020, putting downward pressure on our asset yields and net interest margin. A low interest rate environment 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. 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 on loans is increased by provisions charged to expense and loss recoveries and decreased by loans charged off. The following table shows the provision for credit losses activity for the periods presented. Three months ended Six months ended (dollars in thousands) June 30, 2021 June 30, 2020 June 30, 2021 June 30, 2020 (Reversal of) provision for credit losses on loans $ (920) $ 2,000 $ (3,849) $ 4,200 The provision reversals in 2021 were primarily due to continued improvements in the forecasted California unemployment rates over the next four quarters and a $42.5 million year-to-date decrease in non-PPP loan balances. Our allowance model is particularly sensitive to current and forecasted California unemployment rates, which decreased to 8.0% at June 30, 2021 from 9.1% at December 31, 2020. The provision for credit losses in 2020 calculated under the incurred loss method (prior to the adoption of the excepted credit loss method on December 31, 2020) was largely due to the uncertainty about the impact of the COVID-19 pandemic on the local and regional economies and our customers at that time. Loans designated special mention, which are not considered adversely classified, decreased by $37.9 million to $49.0 million at June 30, 2021 from $86.9 million at December 31, 2020. The decrease was largely due to the upgrading of several borrowing relationships totaling approximately $25.5 million because of their improved financial condition, loan reductions and payoffs totaling approximately $16.4 million, and the downgrade from special mention to substandard of one well-secured commercial real estate loan totaling $4.6 million. These decreases were partially offset by two well-secured commercial real estate loans totaling $8.8 million that were downgraded from pass to special mention risk rating. Classified assets (loans with risk ratings of substandard or doubtful) totaled $30.8 million at June 30, 2021, compared to $25.8 million at December 31, 2020. The $5.0 million increase was primarily due to the downgrade of a $4.6 million commercial real estate loan mentioned above. There were no loans considered doubtful at June 30, 2021 or December 31, 2020. The ratio of allowance for credit losses on loans to total loans was 0.95% at June 30, 2021, compared to 1.10% at December 31, 2020. Excluding SBA-guaranteed PPP loans, the ratio of the allowance for credit losses on loans to total loans was 1.09% and 1.27% at June 30, 2021 and December 31, 2020, respectively (Refer to footnote 1 on page 31 for a definition and reconciliation of this non-GAAP financial measure). Non-accrual loans totaled $9.2 million, or 0.46% of total loans at June 30, 2021, and remained largely unchanged from $9.2 million, or 0.44% of total loans at December 31, 2020. For more information, refer to Note 5 to the consolidated financial statements in this Form 10-Q. Page-35 Non-interest Income The following table details the components of non-interest income. Three months ended Amount Percent (dollars in thousands) June 30, 2021 June 30, 2020 Increase (Decrease) Increase (Decrease) Wealth Management and Trust Services $ 530 $ 421 $ 109 25.9 % Debit card interchange fees 419 308 111 36.0 % Service charges on deposit accounts 317 293 24 8.2 % Earnings on bank-owned life insurance, net 233 234 (1) (0.4) % Dividends on FHLB stock 177 146 31 21.2 % Merchant interchange fees 61 47 14 29.8 % Gains on sale of investment securities, net — 115 (115) (100.0) % Other income 285 249 36 14.5 % Total non-interest income $ 2,022 $ 1,813 $ 209 11.5 % Six months ended Amount Percent (dollars in thousands) June 30, 2021 June 30, 2020 Increase (Decrease) Increase (Decrease) Wealth Management and Trust Services $ 1,018 $ 925 $ 93 10.1 % Debit card interchange fees 785 668 117 17.5 % Service charges on deposit accounts 598 744 (146) (19.6) % Earnings on bank-owned life insurance, net 490 509 (19) (3.7) % Dividends on FHLB stock 326 354 (28) (7.9) % Merchant interchange fees 118 120 (2) (1.7) % Gains on sale of investment securities, net — 915 (915) (100.0) % Other income 513 698 (185) (26.5) % Total non-interest income $ 3,848 $ 4,933 $ (1,085) (22.0) % Second Quarter of 2021 Compared to Second Quarter of 2020 Non-interest income increased by $209 thousand in the second quarter of 2021 to $2.0 million, compared to $1.8 million in the same quarter a year ago. The increase was mostly attributed to debit card interchange fees from increased levels of activity and volume, and higher wealth management and trust services income generated from new accounts and favorable market performance. Increases relative to the prior year quarter were partially offset by the absence of gains on investment security sales in the second quarter of 2021. First Six Months of 2021 Compared to First Six Months of 2020 Non-interest income decreased by $1.1 million in the first six months of 2021 to $3.8 million, from $4.9 million in the first half of 2020. The decrease was primarily attributed to the absence of gains on investment security sales in the first six months of 2021, versus $915 thousand realized in the same period a year ago, lower service charges on deposit accounts, and lower fee income from one-way deposit sales to third-party deposit networks in the first quarter of 2021. On March 30, 2020, we implemented temporary waivers for all ATM fees, overdraft fees and early withdrawal penalties for time deposits to help ease the financial burden customers began experiencing due to the pandemic. After honoring the fee waivers for one year, we provided our customers a 30-day notice and reinstituted the fees as of May 3, 2021. Page-36 Non-interest Expense The following table details the components of non-interest expense. Three months ended Amount Percent (dollars in thousands) June 30, 2021 June 30, 2020 Increase (Decrease) Increase (Decrease) Salaries and related benefits $ 8,888 $ 7,864 $ 1,024 13.0 % Occupancy and equipment 1,751 1,661 90 5.4 % Professional services 986 550 436 79.3 % Data processing 820 829 (9) (1.1) % Charitable contributions 462 273 189 69.2 % Depreciation and amortization 389 526 (137) (26.0) % Information technology 296 252 44 17.5 % Directors' expense 230 175 55 31.4 % Amortization of core deposit intangible 204 213 (9) (4.2) % Federal Deposit Insurance Corporation insurance 182 116 66 56.9 % Other non-interest expense Advertising 175 158 17 10.8 % Other expense 1,173 1,264 (91) (7.2) % Total other non-interest expense 1,348 1,422 (74) (5.2) % Total non-interest expense $ 15,556 $ 13,881 $ 1,675 12.1 % Six months ended Amount Percent (dollars in thousands) June 30, 2021 June 30, 2020 Increase (Decrease) Increase (Decrease) Salaries and related benefits $ 18,096 $ 17,341 $ 755 4.4 % Occupancy and equipment 3,502 3,324 178 5.4 % Professional services 1,849 1,094 755 69.0 % Data processing 1,639 1,615 24 1.5 % Depreciation and amortization 848 1,052 (204) (19.4) % Information technology 609 502 107 21.3 % Charitable contributions 493 440 53 12.0 % Amortization of core deposit intangible 408 426 (18) (4.2) % Directors' expense 405 349 56 16.0 % Federal Deposit Insurance Corporation insurance 361 118 243 205.9 % Other non-interest expense Advertising 414 409 5 1.2 % Other expense 2,343 2,578 (235) (9.1) % Total other non-interest expense 2,758 2,987 (229) (7.7) % Total non-interest expense $ 30,968 $ 29,248 $ 1,720 5.9 % Second Quarter of 2021 Compared to Second Quarter of 2020 Non-interest expense increased by $1.7 million to $15.6 million in the second quarter of 2021, compared to $13.9 million in the same period a year ago. The increase was primarily attributed to $1.0 million in higher salaries and related benefits (mostly attributable to fewer deferred SBA PPP loan origination costs), $351 thousand increase in ARB acquisition-related expenses (mostly related to professional services), and $189 thousand increase in charitable contributions. We expect higher ARB acquisition related expenses in the next two quarters. The majority of our expected 2021 charitable contributions were disbursed in the second quarter. First Six Months of 2021 Compared to First Six Months of 2020 Non-interest expense increased by $1.7 million to $31.0 million in the first half of 2021, compared to $29.2 million in the first half of 2020. The increase was driven by higher salaries and related benefits of $755 thousand, most of which was attributed to fewer deferred SBA PPP loan origination costs. Professional services increased by $755 thousand due to some pandemic-related delays in 2020 activities and ARB acquisition-related activities. In addition, Page-37 FDIC deposit insurance expenses increased by $243 thousand relative to the first six months of 2020 due to the absence of assessment credits, which were fully utilized as of June 30, 2020. The (reversal of) or provision for credit losses on unfunded commitments was reclassified out of non-interest expense and included as a separate line item under net interest income in the consolidated statements of comprehensive income for all periods presented. Efficiency ratios for all periods reported have been updated to reflect the reclassification. Reclassification conforms to Call Report instructions. 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 second quarter of 2021 totaled $3.2 million at an effective tax rate of 25.9%, compared to $2.6 million at an effective tax rate of 26.3% in the same quarter last year. The provision for income taxes for the first half of 2021 totaled $6.3 million at an effective tax rate of 25.6%, compared to $5.0 million at an effective tax rate of 25.4% for the first half of 2020. The increase in the provision reflected higher pre-tax income for both the second quarter and first half of 2021 compared to the same periods a year ago. The 40 basis point decrease in the effective tax rate in the second quarter of 2021 as compared to the same quarter a year ago was primarily due to the true-up of low-income tax credits. 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 June 30, 2021, neither the Bank nor Bancorp had accruals for interest nor penalties related to unrecognized tax benefits. FINANCIAL CONDITION SUMMARY At June 30, 2021, assets totaled $3.074 billion, an increase of $161.9 million, from $2.912 billion at December 31, 2020, mainly due to increases in investment securities as we redeploy our excess liquidity from deposit inflows as discussed below. Cash, Cash Equivalents and Restricted Cash Total cash, cash equivalents and restricted cash were $257.5 million at June 30, 2021, compared to $200.3 million at December 31, 2020. The increase was mainly due to SBA PPP loan forgiveness and an increase in deposits. Cash and cash equivalents do not include $174.0 million and $173.4 million in temporary one-way sale transfers of deposits to third-party deposit networks as part of our liquidity management at June 30, 2021 and December 31, 2020, respectively. Investment Securities The investment securities portfolio totaled $687.0 million at June 30, 2021, an increase of $185.6 million from December 31, 2020. The increase was primarily due to purchases of $244.7 million to deploy excess cash into interest earning assets in a more favorable interest rate environment in 2021, partially offset by paydowns, calls and maturities of $51.3 million. Additionally, the fair value of available-for-sale securities decreased $6.3 million as a result of the higher interest rate environment in the first six months of 2021. There were no security sales in the first six months of 2021. See Note 4, Investment Securities, for additional information. The following table summarizes our investment in obligations of state and political subdivisions at June 30, 2021 and December 31, 2020. Page-38 June 30, 2021 December 31, 2020 (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 $ 3,315 $ 3,532 2.8 % $ 3,327 $ 3,565 3.1 % Revenue bonds 2,044 2,113 1.7 2,352 2,448 2.2 Tax allocation bonds 1,746 1,767 1.5 2,832 2,876 2.7 Total within California 7,105 7,412 6.0 8,511 8,889 8.0 Outside California: General obligation bonds 91,366 95,434 77.3 78,299 82,100 73.5 Revenue bonds 19,704 20,966 16.7 19,744 21,351 18.5 Total outside California 111,070 116,400 94.0 98,043 103,451 92.0 Total obligations of state and political subdivisions $ 118,175 $ 123,812 100.0 % $ 106,554 $ 112,340 100.0 % 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 (51.0%), Washington (16.0%) and Maryland (5.7%). Our investment in obligations issued by municipal issuers in Texas 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 six months of 2021, loans decreased by $85.8 million and totaled $2.003 billion at June 30, 2021, primarily due to SBA PPP loans which totaled $248.3 million at June 30 2021, compared to $291.6 million at December 31, 2020. New non-PPP related loan originations totaled $69.1 million in the first six months of 2021. Payoffs totaled $95.4 million and credit line utilization decreased $34.8 million during the first six months of 2021. Loan payoffs in the first half of 2021 consisted largely of loans on which underlying assets were sold or paid off with cash (including completed construction projects). Residential real estate and consumer loan payoffs as well as loans refinanced with other banks contributed to the decline. As of June 30, 2021, there were 1,532 PPP loans outstanding totaling $248.3 million (net of $6.5 million in unrecognized fees and costs). Of the total 2,876 PPP loans granted amounting to $444.1 million, we funded 1,813 loans totaling $307.9 million in the first round and 1,063 loans totaling $136.2 million in the second round. As of June 30, 2021, PPP loans forgiven and paid off were 1,344 totaling $189.3 million. Forgiveness of PPP loans continues with an additional 126 loans totaling $24.1 million approved between June 30, 2021 and July 31, 2021. Of the number of PPP loans remaining as of July 31, 2021, 71% (1,002 loans) totaling $43.0 million were less than or equal to $150 thousand and had access to streamlined forgiveness processing. Page-39 As of July 31, 2021, 6 borrowing relationships with 9 loans totaling $43.4 million were benefiting from payment relief. We monitor the financial situation of these clients closely and expect the majority to resume payments as the economy continues to reopen. Liabilities During the first six months of 2021, total liabilities increased by $171.5 million to $2.725 billion. Deposits increased $179.3 million in the first six months of 2021, primarily driven by a combination of PPP loan proceeds and normal fluctuations in some of our larger commercial accounts. Non-interest bearing deposits increased $105.4 million in the first six months of 2021 to $1.460 billion, and represented 54.4% of total deposits at June 30, 2021, compared to 54.1% at December 31, 2020. The cost of average deposits was 0.07% in the second quarter and first half of 2021, a decrease of 2 basis points and 8 basis points from the equivalent periods a year ago. 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 June 30, 2021. There are no conditions or events since that 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 December 31, 2020. 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. The Bancorp’s and Bank’s capital adequacy ratios as of June 30, 2021 and December 31, 2020 are presented in the following tables. As of December 31, 2020, Bancorp's Tier 1 capital included a subordinated debenture, which was not included at the Bank level. On March 15, 2021, Bancorp redeemed in full our last subordinated debenture due to NorCal Community Bancorp Trust II. The redemption reduced Bancorp's total risk-based capital ratio by approximately 18 basis points. Page-40 Capital Ratios for Bancorp (dollars in thousands) Actual Ratio Adequately Capitalized Threshold Ratio to be a Well Capitalized Bank Holding Company June 30, 2021 Amount Ratio Amount Ratio Amount Ratio Total Capital (to risk-weighted assets) $ 326,698 15.53 % ≥ $ 220,955 ≥ 10.50 % ≥ $ 210,433 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 306,021 14.54 % ≥ $ 178,868 ≥ 8.50 % ≥ $ 168,346 ≥ 8.00 % Tier 1 Capital (to average assets) $ 306,021 10.04 % ≥ $ 121,892 ≥ 4.00 % ≥ $ 152,365 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 306,021 14.54 % ≥ $ 147,303 ≥ 7.00 % ≥ $ 136,781 ≥ 6.50 % December 31, 2020 Total Capital (to risk-weighted assets) $ 339,544 16.03 % ≥ $ 222,393 ≥ 10.50 % ≥ $ 211,802 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 313,891 14.82 % ≥ $ 180,032 ≥ 8.50 % ≥ $ 169,442 ≥ 8.00 % Tier 1 Capital (to average assets) $ 313,891 10.80 % ≥ $ 116,224 ≥ 4.00 % ≥ $ 145,280 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 311,114 14.69 % ≥ $ 148,262 ≥ 7.00 % ≥ $ 137,672 ≥ 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 June 30, 2021 Amount Ratio Amount Ratio Amount Ratio Total Capital (to risk-weighted assets) $ 321,837 15.30 % ≥ $ 220,905 ≥ 10.50 % ≥ $ 210,386 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 301,160 14.31 % ≥ $ 178,828 ≥ 8.50 % ≥ $ 168,309 ≥ 8.00 % Tier 1 Capital (to average assets) $ 301,160 9.88 % ≥ $ 121,877 ≥ 4.00 % ≥ $ 152,346 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 301,160 14.31 % ≥ $ 147,270 ≥ 7.00 % ≥ $ 136,751 ≥ 6.50 % December 31, 2020 Total Capital (to risk-weighted assets) $ 334,686 15.80 % ≥ $ 222,391 ≥ 10.50 % ≥ $ 211,801 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 309,033 14.59 % ≥ $ 180,031 ≥ 8.50 % ≥ $ 169,441 ≥ 8.00 % Tier 1 Capital (to average assets) $ 309,033 10.64 % ≥ $ 116,224 ≥ 4.00 % ≥ $ 145,280 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 309,033 14.59 % ≥ $ 148,261 ≥ 7.00 % ≥ $ 137,671 ≥ 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 Bank's 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. We obtain funds from the repayment and maturity of loans, deposit inflows, investment security maturities and paydowns, 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 component of our daily liquidity position is customer deposits. The attraction and retention of new deposits depends upon the variety and effectiveness of our customer account products, service and convenience, rates paid to customers, and our financial strength. The cash cycles and unique business activities of some of our large commercial depositors may cause short-term fluctuations in their deposit balances held with us. Since 2020, the banking industry experienced abundant liquidity driven by pandemic-related government programs such as PPP and stimulus checks as well as an elevated savings rate system-wide. Page-41 The most significant source of liquidity during 2021 was an increase in deposits of $179.3 million. The increase was primarily due to increases in PPP borrower-related accounts and normal fluctuations in some of our large business accounts. Proceeds from loans collected net of loan origination was $84.3 million. Proceeds from principal paydowns and maturities of securities totaled $51.3 million, and $19.8 million in net cash was provided by operating activities. Significant uses of liquidity during 2021 were $244.7 million in investment securities purchased, $19.7 million in common stock repurchases, $6.1 million in cash dividends paid on common stock to our shareholders, and $4.1 million in repayment of a subordinated debenture. 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 are adequate to fund our operations. Undrawn credit commitments, as discussed in Note 8 to the Consolidated Financial Statements in this Form 10-Q, totaled $571.7 million at June 30, 2021. We expect to fund these commitments to the extent utilized primarily through the repayment of existing loans, deposit growth and liquid assets. Over the next twelve months, $69.0 million of time deposits will mature. We expect to replace these funds with new deposits. Our emphasis on local deposits, combined with our liquid investment portfolio, provides a very stable 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 $4.6 million of cash at June 30, 2021. Combined with $34.0 million of dividend from the Bank to the Bancorp in July 2021, there is sufficient cash to cover Bancorp's operational needs, share repurchases, and cash dividends to shareholders through 2022. Management anticipates that there will be sufficient earnings at the Bank to provide dividends to Bancorp to meet its funding requirements for the foreseeable future.