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 2021 Annual Report on Form 10-K. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances. In November 2020, the SEC issued Final Rule 33-10890, Management’s Discussion and Analysis, Selected Financial Data and Supplementary Financial Information, which modernized and simplified certain disclosure requirements of Regulation S-K. The update to Item 303 of Regulation S-K related to interim period disclosures beginning with the first quarter of 2022 allows registrants to compare the results of the most recently completed quarter to the results of either the immediately preceding quarter or the corresponding quarter of the preceding year. Management believes that comparing current quarter results to those of the immediately preceding quarter is more useful in identifying current business trends and provides a more meaningful comparison. Accordingly, we have compared the results for the three months ended March 31, 2022 and December 31, 2021 throughout the Management's Discussion and Analysis sections, where applicable. 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 economic or other disruptions to financial markets caused by acts of terrorism, war or other conflicts such as Russia's military action in Ukraine, impacts from inflation, supply change disruptions, changes in interest rates, California's unemployment rate, 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; 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; and successful integration of acquisitions. Important factors that could cause results or performance to materially differ from those expressed in our prior forward-looking statements are detailed in ITEM 1A, Risk Factors section of our 2021 Form 10-K as filed with the SEC, copies of which are available from us at no charge. Forward-looking statements speak only as of the date they are made. 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-29 Critical Accounting Estimates Critical accounting estimates are those estimates made in accordance with generally accepted accounting principles that involve a significant level of estimation and uncertainty and have had or are reasonably likely to have a material impact on our financial condition and results of operations. 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. Our critical estimates include: Allowance for Credit Losses on Loans and Unfunded Commitments, Income Taxes, and Fair Value Measurements . For a detailed discussion, refer to the Critical Accounting Estimates section of our 2021 Form 10-K filed with the SEC on March 15, 2022. Executive Summary Net income for the first quarter of 2022 totaled $10.5 million, compared to $9.7 million in the fourth quarter of 2021 and $8.9 million in the first quarter of 2021. Diluted earnings per share were $0.66 in the first quarter of 2022, $0.61 in the prior quarter and $0.66 in the same quarter a year ago. First quarter 2022 and fourth quarter 2021 earnings were impacted by the costs associated with our recent acquisition. The following are highlights of our operating and financial performance for the periods presented: • Conversion of our core systems occurred in March of 2022, bringing acquired ARB accounts and key systems under the umbrella of Bank of Marin. For a smooth end-user experience in line with standards of legendary service, extra resources were deployed to assist our customers with the transition. • Merger-related one -time and conversion costs reduced net income by $385 thousand, net of taxes, or $0.02 per share in the quarter. As shown in the reconciliation of GAAP to non-GAAP financial measures on page 31, without those acquisition related components, return on average assets ("ROA") of 0.98% and return on average equity ("ROE") of 9.61% would have been 1.01% and 9.96%, respectively, compared to 0.97% and 9.19% for the quarter ended December 31, 2021. ROA and ROE were 1.21% and 10.22% for the first three months of 2021. • A good indicator of the merger's positive impact on operating earnings is the efficiency ratio, as it neither includes provisions for losses on loans and unfunded commitments, nor is it impacted by changes in share counts. As shown in the reconciliation of GAAP to non-GAAP financial measures on page 31, the efficiency ratios excluding merger-related one-time and conversion costs were 57.46% and 53.63% for the quarters ended March 31, 2022 and December 31, 2021, respectively, as compared to 59.13% and 56.92%. The change over the prior quarter was primarily due to typical first quarter increases in salaries, related benefits and professional services expenses as discussed in the Non-Interest Expense section below. The significant improvement in operating leverage generated by the acquisition is evident in the decline in efficiency ratio from 64.60% in first quarter of 2021, which was not impacted by merger costs. • Loan balances of $2.202 billion at March 31, 2022 included an increase of $16.6 million in traditional commercial loans and a decrease of $70.6 million in PPP loans forgiven and paid off, resulting in a net decrease in loans of $53.8 million from December 31, 2021. First quarter loan originations of $49.8 million represented a six year peak for first quarter originations, and commercial line utilization increased to 38% of total commitments as of March 31, 2022, from 34% at December 31, 2021. • Credit quality remains strong, with non-accrual loans representing 0.35% of total loans as of March 31, 2022, compared to 0.37% at December 31, 2021. While classified loans did not change significantly from the prior quarter end, special mention loans decreased by $10.0 million, the majority of which was due to payoffs and upgrades to pass risk ratings. • Reversals of $485 thousand to the allowance for credit losses on loans and $318 thousand to the allowance for credit losses on unfunded loan commitments in the first quarter of 2022 resulted from improved economic forecasts. • Deposits grew by $52.8 million to $3.861 billion at March 31, 2022 compared to $3.809 billion at December 31, 2021, with most of the growth coming from non-interest bearing balances. Non-interest bearing deposits made up 51% of total deposits as of March 31, 2022 versus 50% as of December 31, 2021. The cost of average deposits was 0.06% in the first quarter, consistent with the fourth quarter of 2021 at 0.06%, compared to 0.07% in the first quarter of 2021. Additionally, as part of our liquidity management, the Bank maintained $180.0 million in deposits off-balance sheet with deposit networks at March 31, 2022. Page-30 • All capital ratios were above well-capitalized regulatory requirements. The total risk-based capital ratio for Bancorp was 14.4% at March 31, 2022, compared to 14.6% at December 31, 2021. Bancorp's tangible common equity to tangible assets was 8.0% at March 31, 2022, compared to 8.8% at December 31, 2021 (see Results of Operations for a definition of this non-GAAP financial measure). The decline in tangible equity from December 31, 2021 was primarily due to the $37.3 million other comprehensive loss, net of taxes, related to significant increases in interest rates during the quarter. The Bank's total risk-based capital ratio was 14.3% at March 31, 2022, compared to 14.4% at December 31, 2021. • The Board of Directors declared a cash dividend of $0.24 per share on April 22, 2022, which represents the 68 th consecutive quarterly dividend paid by Bank of Marin Bancorp. The dividend is payable on May 13, 2022 to shareholders of record at the close of business on May 6, 2022. Statement Regarding use of Non-GAAP Financial Measures In this Form 10-Q, Bancorp's financial results are presented in accordance with GAAP and refer to certain non-GAAP financial measures. Management believes that presentation of operating results using non-GAAP financial measures provides useful supplemental information to investors and facilitates the analysis of Bancorp's core operating results and comparison of operating results across reporting periods. Management also uses non-GAAP financial measures to establish budgets and manage Bancorp's business. A reconciliation of the GAAP financial measures to comparable non-GAAP financial measures is presented below. Reconciliation of GAAP and Non-GAAP Financial Measures Three months ended (in thousands, unaudited) March 31, 2022 December 31, 2021 March 31, 2021 Net income Net income (GAAP) $ 10,465 $ 9,714 $ 8,947 Merger-related one-time and conversion costs: Personnel and severance 335 336 — Professional services 67 — — Data processing 48 695 — Other 97 67 — Total merger costs before tax benefits 547 1,098 — Income tax benefit of merger-related expenses (162) (307) — Total merger-related one-time and conversion costs, net of tax benefits 385 791 — Comparable net income (non-GAAP) $ 10,850 $ 10,505 $ 8,947 Diluted earnings per share Weighted average diluted shares 15,946 16,027 13,469 Diluted earnings per share (GAAP) $ 0.66 $ 0.61 $ 0.66 Merger-related one-time and conversion costs, net of tax benefits 0.02 0.05 — Comparable diluted earnings per share (non-GAAP) $ 0.68 $ 0.66 $ 0.66 Return on average assets Average assets $ 4,345,258 $ 4,298,766 $ 2,966,006 Return on average assets (GAAP) 0.98 % 0.90 % 1.21 % Comparable return on average assets (non-GAAP) 1.01 % 0.97 % 1.21 % Return on average equity Average stockholders' equity $ 441,626 $ 453,468 $ 355,022 Return on average equity (GAAP) 9.61 % 8.50 % 10.22 % Comparable return on average equity (non-GAAP) 9.96 % 9.19 % 10.22 % Efficiency ratio Non-interest expense (GAAP) $ 19,375 $ 18,984 $ 15,412 Merger-related expenses (547) (1,098) — Non-interest expense (non-GAAP) $ 18,828 $ 17,886 $ 15,412 Net interest income $ 29,898 $ 30,633 $ 22,031 Non-interest income $ 2,867 $ 2,719 $ 1,826 Efficiency ratio (GAAP) 59.13 % 56.92 % 64.60 % Comparable efficiency ratio (non-GAAP) 57.46 % 53.63 % 64.60 % Page-31 RESULTS OF OPERATIONS Highlights of the financial results are presented in the following tables: Three months ended (dollars in thousands, except per share data) March 31, 2022 December 31, 2021 March 31, 2021 Selected operating data: Net interest income $ 29,898 $ 30,633 $ 22,031 (Reversal of) provision for credit losses on loans (485) 600 (2,929) (Reversal of) provision for credit losses on unfunded loan commitments (318) 210 (590) Non-interest income 2,867 2,719 1,826 Non-interest expense 19,375 18,984 15,412 Net income 10,465 9,714 8,947 Net income per common share: Basic $ 0.66 $ 0.61 $ 0.67 Diluted $ 0.66 $ 0.61 $ 0.66 Performance and other financial ratios: Return on average assets 0.98 % 0.90 % 1.21 % Return on average equity 9.61 % 8.50 % 10.22 % Tax-equivalent net interest margin 1 2.96 % 3.03 % 3.19 % Cost of deposits 0.06 % 0.06 % 0.07 % Efficiency ratio 59.13 % 56.92 % 64.60 % Cash dividend payout ratio on common stock 2 36.36 % 39.34 % 34.33 % (dollars in thousands, except per share data) March 31, 2022 December 31, 2021 Selected financial condition data: Total assets $ 4,330,424 $ 4,314,209 Loans, net 2,179,307 2,232,622 Deposits 3,861,342 3,808,550 Borrowings and other obligations 388 419 Stockholders' equity 420,408 450,368 Book value per share 26.27 28.27 Asset quality ratios: Allowance for credit losses on loans to total loans 1.02 % 1.02 % Allowance for credit losses on loans to total loans, excluding SBA PPP loans 3 1.04 % 1.07 % Allowance for credit losses on loans to non-accrual loans 2.94x 2.75x Non-accrual loans to total loans 0.35 % 0.37 % Capital ratios: Equity to total assets ratio 9.71 % 10.44 % Tangible common equity to tangible assets 4 8.03 % 8.76 % Total capital (to risk-weighted assets) 14.35 % 14.58 % Tier 1 capital (to risk-weighted assets) 13.52 % 13.70 % Tier 1 capital (to average assets) 8.90 % 8.85 % Common equity Tier 1 capital (to risk weighted assets) 13.52 % 13.70 % 1 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. 2 Calculated as dividends on common shares divided by basic net income per common share. 3 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 March 31, 2022 and December 31, 2021 totaled $40.6 million and $111.2 million, respectively. 4 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 $341 million and $371 million at March 31, 2022 and December 31, 2021, 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 $79.0 million and $79.4 million at March 31, 2022 and December 31, 2021, respectively. Page-32 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 Three months ended March 31, 2022 December 31, 2021 March 31, 2021 Interest Interest Interest Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/ (dollars in thousands) Balance Expense Rate Balance Expense Rate Balance Expense Rate Assets Interest-earning deposits with banks 1 $ 231,555 $ 106 0.18 % $ 330,894 $ 125 0.15 % $ 165,788 $ 42 0.10 % Investment securities 2, 3 1,626,537 6,871 1.69 % 1,410,383 5,801 1.65 % 540,970 3,282 2.43 % Loans 1, 3, 4 2,227,495 23,881 4.29 % 2,269,785 25,711 4.43 % 2,099,847 20,836 3.97 % Total interest-earning assets 1 4,085,587 30,858 3.02 % 4,011,062 31,637 3.09 % 2,806,605 24,160 3.44 % Cash and non-interest-bearing due from banks 69,019 85,869 50,931 Bank premises and equipment, net 7,430 7,777 4,777 Interest receivable and other assets, net 183,222 194,058 133,693 Total assets $ 4,345,258 $ 4,298,766 $ 2,996,006 Liabilities and Stockholders' Equity Interest-bearing transaction accounts $ 295,183 $ 56 0.08 % $ 290,394 $ 53 0.07 % $ 174,135 $ 39 0.09 % Savings accounts 343,327 29 0.03 % 336,715 28 0.03 % 214,049 19 0.04 % Money market accounts 1,122,215 478 0.17 % 1,102,943 505 0.18 % 703,577 286 0.16 % Time accounts including CDARS 147,707 14 0.04 % 144,993 25 0.07 % 96,349 96 0.40 % Borrowings and other obligations 1 399 1 0.62 % 430 1 0.62 % 36 — 1.99 % Subordinated debenture 1, 5 — — — % — — — % 2,164 1,361 251.54 % Total interest-bearing liabilities 1,908,831 578 0.12 % 1,875,475 612 0.13 % 1,190,310 1,801 0.61 % Demand accounts 1,942,804 1,915,309 1,406,123 Interest payable and other liabilities 51,997 54,514 44,551 Stockholders' equity 441,626 453,468 355,022 Total liabilities & stockholders' equity $ 4,345,258 $ 4,298,766 $ 2,996,006 Tax-equivalent net interest income/margin 1 $ 30,280 2.96 % $ 31,025 3.03 % $ 22,359 3.19 % Reported net interest income/margin 1 $ 29,898 2.93 % $ 30,633 2.99 % $ 22,031 3.14 % Tax-equivalent net interest rate spread 2.90 % 2.96 % 2.83 % 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 percent in 2022 and 2021. 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. Page-33 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 two more days in the three months ended March 31, 2022 compared to December 31, 2021. Three Months Ended March 31, 2022 Compared to Three Months Ended December 31, 2021 Three Months Ended March 31, 2022 Compared to Three Months Ended March 31, 2021 (in thousands) Volume Yield/Rate Mix Total Volume Yield/Rate Mix Total Interest-earning deposits with banks $ (38) $ 30 $ (11) $ (19) $ 17 $ 35 $ 12 $ 64 Investment securities 1 888 158 24 1,070 6,586 (997) (2,000) 3,589 Loans 1 (479) (835) (516) (1,830) 1,267 1,676 102 3,045 Total interest-earning assets 371 (647) (503) (779) 7,870 714 (1,886) 6,698 Interest-bearing transaction accounts 1 3 (1) 3 27 (6) (4) 17 Savings accounts 1 — — 1 11 (1) — 10 Money market accounts 9 (24) (12) (27) 170 14 8 192 Time accounts, including CDARS — (10) (1) (11) 51 (87) (46) (82) Borrowings and other obligations — — — — — — 1 1 Subordinated debenture 2 — — — — (1,361) (1,361) 1,361 (1,361) Total interest-bearing liabilities 11 (31) (14) (34) (1,102) (1,441) 1,320 (1,223) Changes in tax-equivalent net interest income $ 360 $ (616) $ (489) $ (745) $ 8,972 $ 2,155 $ (3,206) $ 7,921 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 Three months ended March 31, 2021 includes $1.3 million in accelerated discount accretion from the early redemption of our last subordinated debenture on March 15, 2021. First Quarter of 2022 Compared to the Fourth Quarter of 2021 Net interest income totaled $29.9 million in the first quarter of 2022, compared to $30.6 million in the prior quarter. The $735 thousand decrease from the prior quarter was primarily attributable to changes in amortization and accretion on acquired loans, lower loan prepayment fees, lower PPP fee recognition and fewer days in the quarter, partially offset by higher average balances and yields on investment securities. The tax-equivalent net interest margin was 2.96% in the first quarter of 2022, compared to 3.03% in the fourth quarter of 2021. The decrease from the prior quarter was primarily due to changes in amortization and accretion on acquired loans, lower loan prepayment fees, lower PPP fee recognition, and a higher proportion of investment securities from balance sheet growth. Average yields on the non-PPP portion of the loan portfolio and the investment portfolio are beginning to reflect recent increases in interest rates, particularly commercial loans. First Quarter of 2022 Compared to the First Quarter of 2021 Net interest income totaled $29.9 million in the first quarter of 2022, compared to $22.0 million in the first quarter of 2021. The $7.9 million increase from the comparative quarter a year ago was reflective of the ARB merger, a larger allocation of the loan portfolio to higher rate loans, deployment of cash into investment securities, and costs associated with the early redemption of subordinated debt in the first quarter of 2021. Increases were partially offset by a lower average yield on the investment portfolio. The tax-equivalent net interest margin was 2.96% in the first quarter of 2022 compared to 3.19% in the same quarter last year. The decrease in tax-equivalent net interest margin from the same period a year ago was primarily attributed to a higher proportion of investment securities in the larger balance sheet associated with ARB's lower loan-to-deposit ratio and other deposit growth with average yields 74 basis points lower. 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"). 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 Page-34 range resided between 0.0% a nd 0.25% after March 15, 2020 through the beginning of 2022, putting downward pressure on our asset yields and net interest margin. In its March 16, 2022 meeting, the FOMC raised the target federal funds by 25 basis points followed by a 50 basis point increase on May 4, 2022 to a range of 75% - 1.00% and anticipates that ongoing increases in the target range will be appropriate in 2022. Our net interest margin should benefit from a rising interest rate environment. 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 (dollars in thousands) March 31, 2022 December 31, 2021 March 31, 2021 (Reversal of) provision for credit losses on loans $ (485) $ 600 $ (2,929) The reversals of the allowance for credit losses on loans in the quarters ended March 31, 2022 and 2021 primarily resulted from improved economic conditions. The $600 thousand provision for credit losses on loans in the fourth quarter of 2021 resulted from increases to qualitative risk factors primarily impacted by changes in executive leadership, senior lending positions, and integration of the ARB lending staff and loan portfolio as well as further refinements to the discounted cash flow assumptions applied to acquired loans within the allowance model. These increases were partially offset by reductions in qualitative risk factors due to a decline in the volume of loans downgraded to substandard classification, fewer delinquencies, and the elimination of an allowance related to a commercial real estate loan that had been individually analyzed for potential credit losses in the previous periods and paid off in the fourth quarter. Additionally, there was an overall improvement in the underlying economic forecasts. Loans designated special mention, which are not considered adversely classified, decreased year-to-date by $10.0 million to $63.3 million at March 31, 2022 from $73.3 million at December 31, 2021. The decrease was largely due to $15.0 million in upgrades to pass risk ratings because of the borrowers' improved financial condition, $3.6 million in downgrades from special mention to substandard, and $706 thousand in paydowns and payoffs. These decreases were partially offset by $8.7 million in downgrades from pass to special mention. Classified assets (loans with risk ratings of substandard or doubtful) totaled $36.6 million at March 31, 2022, compared to $36.2 million at December 31, 2021. The $224 thousand increase was primarily related to $6.8 million in commercial loans to one borrowing relationship that were downgraded from special mention to substandard (comprised of $3.6 million as of December 31, 2021 and $3.2 million in additional advances in 2022). The increase was largely offset by $5.2 million in upgrades to pass and $684 thousand in paydowns and payoffs. Classified loans also included one $110 thousand loan acquired from ARB with a doubtful risk rating as of March 31, 2022 and December 31, 2021, which is well-secured by real estate collateral. The ratio of allowance for credit losses on loans to total loans was 1.02% at March 31, 2022 and December 31, 2021. Non-accrual loans decreased $698 thousand to $7.7 million, or 0.35% of total loans at March 31, 2022 from $8.4 million, or 0.37% of total loans at December 31, 2021. 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 Quarter over quarter Year over year (dollars in thousands) March 31, 2022 December 31, 2021 March 31, 2021 Amount Change Percent Change Amount Change Percent Change Wealth Management and Trust Services $ 600 $ 607 $ 488 $ (7) (1.2) % $ 112 23.0 % Debit card interchange fees, net 505 544 366 (39) (7.2) % 139 38.0 % Service charges on deposit accounts 488 531 281 (43) (8.1) % 207 73.7 % Earnings on bank-owned life insurance, net 413 302 257 111 36.8 % 156 60.7 % Dividends on Federal Home Loan Bank stock 259 255 149 4 1.6 % 110 73.8 % Merchant interchange fees, net 140 175 57 (35) (20.0) % 83 145.6 % Losses on sale of investment securities, net — (17) — 17 NM — NM Other income 462 322 228 140 43.5 % 234 102.6 % Total non-interest income $ 2,867 $ 2,719 $ 1,826 $ 148 5.4 % $ 1,041 57.0 % NM - not meaningful First Quarter of 2022 Compared to Fourth Quarter of 2021 Non-interest income increased by $148 thousand in the first quarter of 2022 to $2.9 million, compared to $2.7 million in the prior quarter. The increase from the prior quarter was primarily due to a payment on bank-owned life insurance. First Quarter of 2022 Compared to the First Quarter of 2021 Non-interest income increased by $1.0 million in the first quarter of 2022 to $2.9 million, compared to $1.8 million in the same quarter a year ago. The increase from the first quarter of 2021 was mostly attributable to increased activity associated with the ARB acquisition in the first quarter of 2022. Non-interest Expense The following table details the components of non-interest expense. Three months ended Quarter over quarter Year over year (dollars in thousands) March 31, 2022 December 31, 2021 March 31, 2021 Amount Change Percent Change Amount Change Percent Change Salaries and related benefits $ 11,548 $ 10,716 $ 9,208 $ 832 7.8 % $ 2,340 25.4 % Occupancy and equipment 1,909 1,929 1,751 (20) (1.0) % 158 9.0 % Data processing 1,277 1,887 819 (610) (32.3) % 458 55.9 % Professional services 913 653 863 260 39.8 % 50 5.8 % Information technology 478 445 313 33 7.4 % 165 52.7 % Depreciation and amortization 452 461 459 (9) (2.0) % (7) (1.5) % Amortization of core deposit intangible 380 393 204 (13) (3.3) % 176 86.3 % Directors' expense 311 297 175 14 4.7 % 136 77.7 % Federal Deposit Insurance Corporation insurance 290 292 179 (2) (0.7) % 111 62.0 % Charitable contributions 45 90 31 (45) (50.0) % 14 45.2 % Other non-interest expense Advertising 347 305 239 42 13.8 % 108 45.2 % Other expense 1,425 1,516 1,171 (91) (6.0) % 254 21.7 % Total other non-interest expense 1,772 1,821 1,410 (49) (2.7) % 362 25.7 % Total non-interest expense $ 19,375 $ 18,984 $ 15,412 $ 391 2.1 % $ 3,963 25.7 % First Quarter of 2022 Compared to Fourth Quarter of 2021 Non-interest expense increased by $391 thousand to $19.4 million in the first quarter of 2022, compared to $19.0 million in the prior quarter. The increase from the prior quarter is primarily due to seasonal increases related to annual incentives, share-based compensation and 401(k) contributions included in salaries and related benefits. Page-36 Additionally, the cost of professional services increased due to audit work performed in the first quarter related to both the year-end financial statement audit and the ARB acquisition. Increases were partially offset by a decrease in acquisition-related one-time data processing expenses. First Quarter of 2022 Compared to the First Quarter of 2021 Non-interest expense increased by $4.0 million to $19.4 million in the first quarter of 2022, compared to $15.4 million in the same period a year ago. The largest increases over prior year first quarter expense came from salaries and related benefits, which rose $2.3 million due to increased numbers of employees in acquired branch and loan offices, regularly scheduled annual merit and related increases, and lower deferred loan origination costs. Higher expenses across most other categories reflect the ARB acquisition, including one-time and conversion costs of $547 thousand and additional amortization associated with the ARB core deposit intangible asset in the first quarter of 2022. 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 first quarter of 2022 totaled $3.7 million at an effective tax rate of 26.3%, compared to $3.8 million at an effective tax rate of 28.4% in the prior quarter and $3.0 million at an effective tax rate of 25.2% in the same quarter last year. Although pretax income was higher in the first quarter of 2022 compared to the prior quarter, the higher provision in the prior quarter reflects non-deductible merger expenses and executive compensation, which also accounted for the higher effective tax rate. The increase in the provision in the first quarter of 2022 reflected higher pre-tax income as compared to the same quarter a year ago. The 110 basis point increase in the effective tax rate in the first quarter of 2022 as compared to the same quarter a year ago was primarily due to a higher level of tax benefits in 2021 from the disqualifying dispositions of incentive stock options. 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 March 31, 2022, neither the Bank nor Bancorp had accruals for interest nor penalties related to unrecognized tax benefits. FINANCIAL CONDITION SUMMARY At March 31, 2022, assets totaled $4.330 billion, an increase of $16.2 million, from $4.314 billion at December 31, 2021, mainly due to organic growth. Cash, Cash Equivalents and Restricted Cash Total cash, cash equivalents and restricted cash were $170.9 million at March 31, 2022, compared to $347.6 million at December 31, 2021. The $176.7 million decrease was primarily due to the deployment of funds into investment securities, as noted below. Cash and cash equivalents do not include $180.0 million and $173.1 million in temporary one-way sale transfers of deposits to third-party deposit networks as part of our liquidity management at March 31, 2022 and December 31, 2021, respectively. Investment Securities The investment securities portfolio totaled $1.746 billion at March 31, 2022, an increase of $235.9 million from December 31, 2021. The increase was primarily due to purchases of $339.4 million to deploy excess cash into interest earning assets in a more favorable interest rate environment in 2022, partially offset by paydowns, calls and maturities of $48.0 million. Additionally, the fair value of available-for-sale securities decreased $53.0 million as a result of higher interest rates in the first three months of 2022. As part of our ongoing review of the investment securities portfolio and because of our strong liquidity position, we reassessed the classification of certain securities issued by government sponsored agencies in the context of recent changes in market expectations for future interest rates. In March 2022, we transferred $357.5 million securities at fair value from available-for-sale to held-to- Page-37 maturity to reduce the effect of future rate increases on the available-for-sale portfolio mark-to-market, other comprehensive income and equity. See Note 4, Investment Securities, for additional information. The following table summarizes our investment in obligations of state and political subdivisions at March 31, 2022 and December 31, 2021. March 31, 2022 December 31, 2021 (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 $ 26,023 $ 23,757 14.4 % $ 25,036 $ 25,020 14.2 % Revenue bonds 5,245 4,911 2.9 5,249 5,185 3.0 Tax allocation bonds 502 505 0.3 503 510 0.3 Total within California 31,770 29,173 17.6 30,788 30,715 17.5 Outside California: General obligation bonds 120,546 114,862 66.8 117,278 121,303 66.5 Revenue bonds 28,091 26,689 15.6 28,146 29,272 16.0 Total outside California 148,637 141,551 82.4 145,424 150,575 82.5 Total obligations of state and political subdivisions $ 180,407 $ 170,724 100.0 % $ 176,212 $ 181,290 100.0 % Percent of investment portfolio 10.1 % 10.0 % 11.7 % 12.0 % Of the total investment in obligations of state and political subdivisions, the largest concentrations outside of California are in Texas (37.4%), Washington (16.0%) and Wisconsin (6.6%). 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 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 three months of 2022, loans decreased by $53.8 million and totaled $2.202 billion at March 31, 2022, primarily due to $70.6 million in PPP loans being forgiven and paid off. New non-PPP related loan originations totaled $49.8 million in the first three months of 2022, representing a six year peak for first quarter originations. Non-PPP loan payoffs were $49.3 million in the first quarter 2022, which were largely driven by borrower sales of real estate assets and cash payoffs due to excess liquidity, as well as investor commercial real estate loans with structures outside the Bank’s risk appetite or in locations beyond our market area. Offsetting the decreases are increases in credit line utilization, net of normal loan amortization, of $16.3 million. As of March 31, 2022, there were 191 PPP loans outstanding totaling $40.6 million (net of $993 thousand in unrecognized fees and costs) compared to 368 loans outstanding December 31, 2021 for a total of $111.2 million (net of $2.5 million in unrecognized fees and costs). In the first quarter of 2022, Bank of Marin recognized $1.5 million in PPP fees, net of costs, compared to $1.8 million in the prior quarter and $1.7 million in the same quarter of 2021. Page-38 As of March 31, 2022, two borrowing relationships w ith three loans totaling $23.6 million we re continuing to benefit from payment relief under the provisions of the 2020 CARES Act. We will continue to work closely with both of these clients and monitor their performance. Liabilities During the first three months of 2022, total liabilities increased by $46.2 million to $3.910 billion. Deposits increased $52.8 million in the first three months of 2022, which is consistent with activity experienced throughout 2021 from larger business clients. Non-interest bearing deposits increased $50.4 million in the first three months of 2022 to $1.961 billion, and represented 50.8% of total deposits at March 31, 2022, compared to 50.2% at December 31, 2021. The average cost of deposits remained consistent in the first quarter at 0.06%. 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 March 31, 2022. 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. The Bancorp’s and Bank’s capital adequacy ratios as of March 31, 2022 and December 31, 2021 are presented in the following tables. Capital Ratios for Bancorp (dollars in thousands) Actual Ratio Adequately Capitalized Threshold Ratio to be a Well Capitalized Bank Holding Company March 31, 2022 Amount Ratio Amount Ratio Amount Ratio Total Capital (to risk-weighted assets) $ 404,039 14.35 % ≥ $ 295,720 ≥ 10.50 % ≥ $ 281,638 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 380,876 13.52 % ≥ $ 239,392 ≥ 8.50 % ≥ $ 225,310 ≥ 8.00 % Tier 1 Capital (to average assets) $ 380,876 8.90 % ≥ $ 171,200 ≥ 4.00 % ≥ $ 214,000 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 380,876 13.52 % ≥ $ 197,147 ≥ 7.00 % ≥ $ 183,065 ≥ 6.50 % December 31, 2021 Total Capital (to risk-weighted assets) $ 397,101 14.58 % ≥ $ 286,035 ≥ 10.50 % ≥ $ 272,414 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 373,286 13.70 % ≥ $ 231,552 ≥ 8.50 % ≥ $ 217,931 ≥ 8.00 % Tier 1 Capital (to average assets) $ 373,286 8.85 % ≥ $ 168,750 ≥ 4.00 % ≥ $ 210,937 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 373,286 13.70 % ≥ $ 190,690 ≥ 7.00 % ≥ $ 177,069 ≥ 6.50 % Page-39 Capital Ratios for the Bank (dollars in thousands) Actual Ratio Adequately Capitalized Threshold Ratio to be Well Capitalized under Prompt Corrective Action Provisions March 31, 2022 Amount Ratio Amount Ratio Amount Ratio Total Capital (to risk-weighted assets) $ 402,918 14.31 % ≥ $ 295,688 ≥ 10.50 % ≥ $ 281,607 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 379,755 13.49 % ≥ $ 239,366 ≥ 8.50 % ≥ $ 225,286 ≥ 8.00 % Tier 1 Capital (to average assets) $ 379,755 8.87 % ≥ $ 171,192 ≥ 4.00 % ≥ $ 213,989 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 379,755 13.49 % ≥ $ 197,125 ≥ 7.00 % ≥ $ 183,045 ≥ 6.50 % December 31, 2021 Total Capital (to risk-weighted assets) $ 390,924 14.35 % ≥ $ 286,009 ≥ 10.50 % ≥ $ 272,390 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 367,109 13.48 % ≥ $ 231,531 ≥ 8.50 % ≥ $ 217,912 ≥ 8.00 % Tier 1 Capital (to average assets) $ 367,109 8.70 % ≥ $ 168,724 ≥ 4.00 % ≥ $ 210,905 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 367,109 13.48 % ≥ $ 190,673 ≥ 7.00 % ≥ $ 177,053 ≥ 6.50 % Liquidity and Capital Resources 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, which are subject to projection and stress testing over a two-year horizon. 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 maintained $180.0 million in one-way-sale deposits off-balance sheet with deposit networks at March 31, 2022. 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. Our cash and cash equivalents decreased $176.7 million in the first three months of 2022. Significant uses of liquidity during 2022 were $339.4 million in investment securities purchased, $3.8 million in cash dividends paid on common stock to our shareholders, and $1.2 million in common stock repurchases. 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. The most significant source of liquidity during 2022 was proceeds from loans collected net of loan originations of $54.5 million, and a net increase in deposits totaling $52.8 million. Proceeds from principal paydowns and maturities of securities totaled $48.0 million, and $11.5 million in net cash was provided by operating activities. Undrawn credit commitments, as discussed in Note 8 to the Consolidated Financial Statements in this Form 10-Q, totaled $581.4 million at March 31, 2022. 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, $106.5 Page-40 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 $1.1 million of cash at March 31, 2022, and is in the process of obtaining regulatory approval to distribute a dividend from the Bank to the Bancorp to cover Bancorp's operational needs 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.