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 June 30, 2022 and March 31, 2022 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 impact Bancorp's earnings in future periods. Factors that could cause future results to vary materially from current management expectations 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 (including the actions taken by the Federal Reserve to control inflation), 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; 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 We generated record net income for the second quarter of 2022 totaled $11.1 million, compared to $10.5 million in the first quarter of 2022. Diluted earnings per share were $0.69 in the second quarter of 2022, compared to $0.66 in the immediately preceding quarter. Earnings for the first six months of 2022 totaled $21.5 million, compared to $18.2 million in the same period last year. Diluted earnings per share were $1.35 and $1.37 in the first six months of 2022 and 2021, respectively. All periods of earnings presented were impacted by the costs associated with our most recent acquisition, the details of which are discussed throughout this report. In particular, diluted earnings per share for the first half of 2022 would have increased by one cent per share over 2021 without those costs. The following are highlights of our operating and financial performance for the periods presented: • Return on assets of 1.03% and return on equity of 10.74% for the three months ended June 30, 2022, would have been 1.05% and 10.95%, respectively, without one-time and conversion costs related to the 2021 merger with American River Bankshares ("ARB"). That compares to 0.98% and 9.61% (GAAP) and 1.01% and 9.96% (non-GAAP), respectively, for the three months ended March 31, 2022. As shown in the reconciliation of GAAP to non-GAAP financial measures on page 35, merger-related costs reduced net income by $219 thousand, net of taxes, or $0.02 per share in the second quarter. • The second quarter tax-equivalent net interest margin improved 9 basis points over the preceding quarter despite the 7 basis point drag of declining PPP loan fee recognition. Rising interest rates had a positive impact on the Bank's asset sensitive portfolio, as did the deployment of excess cash into securities and flat deposit costs. • Deposits increased by $22.1 million to $3.831 billion at June 30, 2022, compared to $3.809 billion at December 31, 2021. Non-interest bearing deposits made up 53% of total deposits as of June 30, 2022 versus 50% as of December 31, 2021, representing one of the strongest deposit franchises among peers. The cost of average deposits in the second quarter of 2022 was 0.06%, unchanged from the preceding quarter. The cost of average deposits in the first half of 2022 was 0.06%, a decrease from 0.07% in the first half of prior year. • Loan balances of $2.163 billion at June 30, 2022 reflected record second quarter originations of $102.2 million and first half of the year originations of $152.0 million. While our production was strong and more than double the first half of 2021, total loans decreased modestly from December 31, 2021 balances driven by payoffs including expected construction project completions, borrowers' sales of underlying real estate and business assets, PPP loan payoffs, and third-party refinancing of acquired loans outside the Bank's credit risk appetite. • Credit quality remains strong, with non-accrual loans representing 0.37% of total loans as of June 30, 2022, and December 31, 2021. There was not a significant change in classified loans. There was no provision made to the allowance for credit losses on loans or to the allowance for credit losses on unfunded loan commitments this quarter as an improvement in the California unemployment rate forecast decreased the quantitative portion of estimated credit losses while ongoing supply chain issues, inflation and recession risks increased qualitative factors. The preceding quarter's provision reversals were due primarily to the improved economic forecast at the time. Page-30 • Our declining efficiency ratios quarter-over-quarter and year-over-year are a testament to the improved operating leverage attained through the ARB acquisition. The efficiency ratios of 55.73% for the second quarter and 57.40% year-to-date compare to 59.13% and 61.43% for the first quarter of 2022 and year to date 2021, respectively. Changes from the prior quarter were primarily visible in salaries, benefits and professional services expenses. • All capital ratios were above well-capitalized regulatory requirements. The total risk-based capital ratio for Bancorp was 14.7% at June 30, 2022, compared to 14.6% at December 31, 2021. Bancorp's tangible common equity to tangible assets was 7.8% at June 30, 2022, compared to 8.8% at December 31, 2021 (refer to footnot e 4 on page 36 for a discussion of this non-GAAP financial measure). The total risk-based capital ratio for the Bank was 14.2% at June 30, 2022, compared to 14.4% at December 31, 2021. The Bank's tangible common equity to tangible assets was 7.5% at June 30, 2022, compared to 8.6% at December 31, 2021. Declines in the Bank's and Bancorp's tangible common equity and book value per share were primarily related to an increase in after-tax unrealized losses on available-for-sale securities associated with interest rate increases during 2022. • Given the strength and durability of the Bank's financial performance, the Board of Directors declared a cash dividend of $0.25 per share, an increase from $0.24 per share in the prior quarter, on July 22, 2022, which represents the 69 th consecutive quarterly dividend paid by Bancorp. The dividend is payable on August 12, 2022, to shareholders of record at the close of business on August 5, 2022. Page-31 Statement Regarding use of Non-GAAP Financial Measures In this Form 10-Q, Bancorp's financial results are presented in accordance with GAAP and with reference 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 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 Six months ended (in thousands, unaudited) June 30, 2022 March 31, 2022 June 30, 2022 June 30, 2021 Net income Net income (GAAP) $ 11,066 $ 10,465 $ 21,531 $ 18,232 Merger-related one-time and conversion costs: Personnel and severance 58 335 393 — Professional services — 67 67 201 Data processing 29 48 77 — Other 224 97 321 16 Total merger costs before tax benefits 311 547 858 217 Income tax benefit of merger-related expenses (92) (162) (254) (17) Total merger-related one-time and conversion costs, net of tax benefits 219 385 604 200 Comparable net income (non-GAAP) $ 11,285 $ 10,850 $ 22,135 $ 18,432 Diluted earnings per share Weighted average diluted shares 15,955 15,946 15,950 13,316 Diluted earnings per share (GAAP) $ 0.69 $ 0.66 $ 1.35 $ 1.37 Merger-related one-time and conversion costs, net of tax benefits 0.02 0.02 0.04 0.01 Comparable diluted earnings per share (non-GAAP) $ 0.71 $ 0.68 $ 1.39 $ 1.38 Return on average assets Average assets $ 4,312,919 $ 4,345,258 $ 4,328,999 $ 3,044,933 Return on average assets (GAAP) 1.03 % 0.98 % 1.00 % 1.21 % Comparable return on average assets (non-GAAP) 1.05 % 1.01 % 1.03 % 1.22 % Return on average equity Average stockholders' equity $ 413,271 $ 441,626 $ 427,370 $ 351,227 Return on average equity (GAAP) 10.74 % 9.61 % 10.16 % 10.47 % Comparable return on average equity (non-GAAP) 10.95 % 9.96 % 10.44 % 10.58 % Efficiency ratio Non-interest expense (GAAP) $ 18,906 $ 19,375 $ 38,281 $ 30,968 Merger-related expenses (311) (547) (858) (217) Non-interest expense (non-GAAP) $ 18,595 $ 18,828 $ 37,423 $ 30,751 Net interest income $ 31,197 $ 29,898 $ 61,095 $ 46,565 Non-interest income $ 2,728 $ 2,867 $ 5,595 $ 3,848 Efficiency ratio (GAAP) 55.73 % 59.13 % 57.40 % 61.43 % Comparable efficiency ratio (non-GAAP) 54.81 % 57.46 % 56.11 % 61.00 % Page-32 RESULTS OF OPERATIONS Highlights of the financial results are presented in the following tables: Three months ended Six months ended (dollars in thousands, except per share data) June 30, 2022 March 31, 2022 June 30, 2022 June 30, 2021 Selected operating data: Net interest income $ 31,197 $ 29,898 $ 61,095 $ 46,565 Reversal of credit losses on loans — (485) (485) (3,849) Reversal of credit losses on unfunded loan commitments — (318) (318) (1,202) Non-interest income 2,728 2,867 5,595 3,848 Non-interest expense 18,906 19,375 38,281 30,968 Net income 11,066 10,465 21,531 18,232 Net income per common share: Basic $ 0.70 $ 0.66 $ 1.35 $ 1.38 Diluted $ 0.69 $ 0.66 $ 1.35 $ 1.37 Performance and other financial ratios: Return on average assets 1.03 % 0.98 % 1.00 % 1.21 % Return on average equity 10.74 % 9.61 % 10.16 % 10.47 % Tax-equivalent net interest margin 1 3.05 % 2.96 % 3.01 % 3.28 % Cost of deposits 0.06 % 0.06 % 0.06 % 0.07 % Efficiency ratio 55.73 % 59.13 % 57.40 % 61.43 % Net charge-offs (recoveries) $ 8 $ (9) $ (1) $ (75) Cash dividend payout ratio on common stock 2 34.29 % 36.36 % 35.56 % 33.33 % (dollars in thousands, except per share data) June 30, 2022 December 31, 2021 Selected financial condition data: Total assets $ 4,326,904 $ 4,314,209 Loans, net 2,140,093 2,232,622 Deposits 3,830,670 3,808,550 Borrowings and other obligations 356 419 Stockholders' equity 409,573 450,368 Book value per share 25.58 28.27 Asset quality ratios: Allowance for credit losses on loans to total loans 1.04 % 1.02 % Allowance for credit losses on loans to total loans, excluding SBA PPP loans 3 1.05 % 1.07 % Allowance for credit losses on loans to non-performing loans 2.81x 2.75x Non-accrual loans to total loans 0.37 % 0.37 % Capital ratios: Equity to total assets ratio 9.47 % 10.44 % Tangible common equity to tangible assets 4 7.79 % 8.76 % Total capital (to risk-weighted assets) 14.67 % 14.58 % Tier 1 capital (to risk-weighted assets) 13.84 % 13.70 % Tier 1 capital (to average assets) 9.07 % 8.85 % Common equity Tier 1 capital (to risk weighted assets) 13.84 % 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 June 30, 2022 and December 31, 2021 totaled $17.0 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 $331 million and $371 million at June 30, 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 $78.6 million and $79.4 million at June 30, 2022 and December 31, 2021, respectively. Page-33 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, 2022 March 31, 2022 Interest Interest Average Income/ Yield/ Average Income/ Yield/ (dollars in thousands) Balance Expense Rate Balance Expense Rate Assets Interest-earning deposits with banks 1 $ 95,326 $ 180 0.75 % $ 231,555 $ 106 0.18 % Investment securities 2, 3 1,807,710 8,469 1.87 % 1,626,537 6,871 1.69 % Loans 1, 3, 4 2,194,810 23,522 4.24 % 2,227,495 23,881 4.29 % Total interest-earning assets 1 4,097,846 32,171 3.11 % 4,085,587 30,858 3.09 % Cash and non-interest-bearing due from banks 56,408 69,019 Bank premises and equipment, net 7,182 7,430 Interest receivable and other assets, net 151,483 183,222 Total assets $ 4,312,919 $ 4,345,258 Liabilities and Stockholders' Equity Interest-bearing transaction accounts $ 300,258 $ 53 0.07 % $ 295,183 $ 56 0.08 % Savings accounts 343,338 32 0.04 % 343,327 29 0.03 % Money market accounts 1,076,912 438 0.16 % 1,122,215 478 0.17 % Time accounts including CDARS 144,432 67 0.19 % 147,707 14 0.04 % Borrowings and other obligations 1 370 — 0.61 % 399 1 0.62 % Subordinated debenture 1, 5 — — — % — — — % Total interest-bearing liabilities 1,865,310 590 0.13 % 1,908,831 578 0.12 % Demand accounts 1,984,629 1,942,804 Interest payable and other liabilities 49,709 51,997 Stockholders' equity 413,271 441,626 Total liabilities & stockholders' equity $ 4,312,919 $ 4,345,258 Tax-equivalent net interest income/margin 1 $ 31,581 3.05 % $ 30,280 2.96 % Reported net interest income/margin 1 $ 31,197 3.01 % $ 29,898 2.93 % Tax-equivalent net interest rate spread 2.98 % 2.90 % Page-34 Six months ended Six months ended June 30, 2022 June 30, 2021 Interest Interest Average Income/ Yield/ Average Income/ Yield/ (in thousands) Balance Expense Rate Balance Expense Rate Assets Interest-earning deposits with banks 1 $ 163,064 $ 286 0.35 % $ 179,846 $ 96 0.11 % Investment securities 2, 3 1,717,624 15,340 1.79 % 601,498 6,948 2.31 % Loans 1, 3, 4 2,211,062 47,403 4.26 % 2,081,069 42,437 4.06 % Total interest-earning assets 1 4,091,750 63,029 3.06 % 2,862,413 49,481 3.44 % Cash and non-interest-bearing due from banks 62,679 45,059 Bank premises and equipment, net 7,305 4,786 Interest receivable and other assets, net 167,265 132,675 Total assets $ 4,328,999 $ 3,044,933 Liabilities and Stockholders' Equity Interest-bearing transaction accounts $ 297,734 $ 109 0.07 % $ 170,943 $ 78 0.09 % Savings accounts 343,333 61 0.04 % 220,946 40 0.04 % Money market accounts 1,099,439 916 0.17 % 719,769 598 0.17 % Time accounts including CDARS 146,061 81 0.11 % 95,849 177 0.37 % Borrowings and other obligations 1 384 1 0.62 % 50 — 1.46 % Subordinated debenture 1, 5 — — — % 1,076 1,361 251.54 % Total interest-bearing liabilities 1,886,951 1,168 0.12 % 1,208,633 2,254 0.38 % Demand accounts 1,963,832 1,442,320 Interest payable and other liabilities 50,846 42,753 Stockholders' equity 427,370 351,227 Total liabilities & stockholders' equity $ 4,328,999 $ 3,044,933 Tax-equivalent net interest income/margin 1 $ 61,861 3.01 % $ 47,227 3.28 % Reported net interest income/margin 1 $ 61,095 2.97 % $ 46,565 3.24 % Tax-equivalent net interest rate spread 2.94 % 3.06 % 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. 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 three months ended June 30, 2022 compared to March 31, 2022. Page-35 Three Months Ended June 30, 2022 Compared to Three Months Ended March 31, 2022 Six Months Ended June 30, 2022 Compared to Six Months Ended June 30, 2021 (in thousands) Volume Yield/Rate Mix Total Volume Yield/Rate Mix Total Interest-earning deposits with banks $ (63) $ 325 $ (188) $ 74 $ (9) $ 221 $ (22) $ 190 Investment securities 1 765 749 84 1,598 12,893 (1,576) (2,925) 8,392 Loans 1 (350) (271) 262 (359) 2,651 2,179 136 4,966 Total interest-earning assets 352 803 158 1,313 15,535 824 (2,811) 13,548 Interest-bearing transaction accounts 1 (4) — (3) 58 (15) (12) 31 Savings accounts — 3 — 3 22 (1) — 21 Money market accounts (19) (27) 6 (40) 315 2 1 318 Time accounts, including CDARS — 54 (1) 53 93 (124) (65) (96) Borrowings and other obligations — — (1) (1) — — 1 1 Subordinated debenture 2 — — — — — (1,361) — (1,361) Total interest-bearing liabilities (18) 26 4 12 488 (1,499) (75) (1,086) Changes in tax-equivalent net interest income $ 370 $ 777 $ 154 $ 1,301 $ 15,047 $ 2,323 $ (2,736) $ 14,634 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 2022 Compared to the First Quarter of 2022 Net interest income totaled $31.2 million in the second quarter of 2022, compared to $29.9 million in the first quarter of 2022. The $1.3 million increase from the prior quarter was primarily attributable to higher average balances and yields on investment securities driving an increase of $1.6 million, quarter-over-quarter in investment interest income. The tax-equivalent net interest margin was 3.05% in the second quarter of 2022, compared to 2.96% in the first quarter of 2022. The increase from the prior quarter was primarily due to continued deployment of cash into higher yielding investment securities and higher interest rates on non-PPP loans, partially offset by lower interest and fee income on PPP loans. Average yields on the investment portfolio increased from 1.69% in the first quarter of 2022 to 1.87% in the second quarter reflecting recent increases in market interest rates, and the average rate on gross loans increased 10 basis points, which excludes the impact of loan origination fees/costs and purchase discounts/premiums. First Six Months of 2022 Compared to the First Six Months of 2021 Net interest income totaled $61.1 million for the six months ended June 30, 2022, compared to $46.6 million for the same period in the prior year. The $14.5 million increase from the prior year was primarily due to the larger investment portfolio generating an incremental $8.3 million, and $4.9 million related to higher balances and yields on the loan portfolio (net of a $3.7 million decrease in interest and fees on PPP loans). Additionally, 2021 included a $1.3 million accelerated discount from the early redemption of a subordinated debenture. The tax-equivalent net interest margin was 3.01% in the six months ended June 30, 2022, compared to 3.28% in the same period in the prior year. The decrease 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 over the period. The decrease was partially offset by a shift to a higher percentage of non-PPP loans within the loan portfolio and the absence of trust preferred securities redemption that occurred in 2021. 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 economic risks posed by the COVID-19 pandemic, the FOMC made two emergency cuts totaling 150 basis points to the federal funds rate in March 2020. The federal funds target rate range resided between 0.0% a nd 0.25% after March 15, 2020 through the beginning of 2022, putting downward pressure on our asset yields and net interest margin through early 2022. I n 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. C ontinued evolving economic risks exacerbated by global economic contraction and international political unrest, have resulted in shortages of oil, other supply Page-36 chain disruptions, and elevated inflation. In response, the FOMC increased the federal funds rate by 75 basis points twice effective June 16, 2022 and July 28, 2022 to a range of 2.25% - 2.50% . It is widely anticipated that additional increases in the target range will occur 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 activity for the periods presented. Three months ended Six months ended (dollars in thousands) June 30, 2022 March 31, 2022 June 30, 2022 June 30, 2021 Reversal of credit losses on loans $ — $ (485) $ (485) $ (3,849) There was no provision made to the allowance for credit losses on loans in the second quarter. An improvement in the California unemployment rate forecast decreased the quantitative portion of estimated credit losses while ongoing supply chain issues, inflation and recession risks increased qualitative factors. The reversal of the allowance for credit losses on loans in the prior quarter primarily resulted from improved forecasted economic conditions at the time. The provision reversals in the six months ended June 30, 2021 were primarily due to improvements in the forecasted California unemployment rates at the time and decrease in non-PPP loan balances. Loans designated special mention, which are not considered adversely classified, decreased year-to-date by $14.7 million to $58.6 million at June 30, 2022 from $73.3 million at December 31, 2021. The decrease was largely due to $22.3 million in upgrades to pass risk ratings because of the borrowers' improved financial condition, which was offset by $11.5 million in downgrades from pass to special mention. Additionally, there were $3.6 million in downgrades from special mention to substandard, and $908 thousand in paydowns and payoffs. Classified assets (loans with risk ratings of substandard or doubtful) totaled $36.9 million at June 30, 2022, compared to $36.2 million at December 31, 2021. The $815 thousand increase was primarily related to $5.1 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 $1.5 million in additional advances in 2022) and the downgrade of two well-secured owner occupied commercial real estate loans totaling $2.3 million and two home equity loans totaling $128 thousand. Additionally, there were $5.2 million in upgrades to pass and $832 thousand in paydowns and payoffs. Classified loans also included one $106 thousand loan acquired from ARB with a doubtful risk rating as of June 30, 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 1.04% and 1.02% at June 30, 2022 and December 31, 2021, respectively. Non-accrual loans decreased $358 thousand to $8.0 million, or 0.37% of total loans at June 30, 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-37 Non-interest Income The following table details the components of non-interest income. Three months ended Amount Change Percent Change (dollars in thousands) June 30, 2022 March 31, 2022 Wealth Management and Trust Services $ 630 $ 600 $ 30 5.0 % Debit card interchange fees, net 531 505 26 5.1 % Service charges on deposit accounts 465 488 (23) (4.7) % Earnings on bank-owned life insurance, net 298 413 (115) (27.8) % Dividends on Federal Home Loan Bank stock 249 259 (10) (3.9) % Merchant interchange fees, net 149 140 9 6.4 % Other income 406 462 (56) (12.1) % Total non-interest income $ 2,728 $ 2,867 $ (139) (4.8) % Six months ended Amount Change Percent Change (dollars in thousands) June 30, 2022 June 30, 2021 Wealth Management and Trust Services $ 1,230 $ 1,018 $ 212 20.8 % Debit card interchange fees, net 1,036 785 251 32.0 % Service charges on deposit accounts 953 598 355 59.4 % Earnings on bank-owned life insurance, net 711 490 221 45.1 % Dividends on Federal Home Loan Bank stock 508 326 182 55.8 % Merchant interchange fees, net 289 118 171 144.9 % Other income 868 513 355 69.2 % Total non-interest income $ 5,595 $ 3,848 $ 1,747 45.4 % Second Quarter of 2022 Compared to First Quarter of 2022 Non-interest income totaled $2.7 million in the second quarter of 2022, compared to $2.9 million in the preceding quarter. The $139.0 thousand decrease was primarily related to payments on bank-owned life insurance in the prior quarter. First Six Months of 2022 Compared to the First Six Months of 2021 Non-interest income totaled $5.6 million in the six months ended June 30, 2022, compared to $3.8 million in the same period of the prior year. The $1.7 million improvement from the prior year period was evident in all categories and mostly attributable to increased activity associated with the ARB acquisition and higher Wealth Management and Trust Services income. Non-interest Expense The following table details the components of non-interest expense. Three months ended Amount Change Percent Change (dollars in thousands) June 30, 2022 March 31, 2022 Salaries and related benefits $ 10,341 $ 11,548 $ (1,207) (10.5) % Occupancy and equipment 1,894 1,909 (15) (0.8) % Data processing 1,199 1,277 (78) (6.1) % Professional services 665 913 (248) (27.2) % Information technology 468 478 (10) (2.1) % Depreciation and amortization 393 452 (59) (13.1) % Amortization of core deposit intangible 374 380 (6) (1.6) % Directors' expense 294 311 (17) (5.5) % Federal Deposit Insurance Corporation insurance 296 290 6 2.1 % Charitable contributions 511 45 466 1,035.6 % Other non-interest expense Advertising 221 347 (126) (36.3) % Other expense 2,250 1,425 825 57.9 % Total other non-interest expense 2,471 1,772 699 39.4 % Total non-interest expense $ 18,906 $ 19,375 $ (469) (2.4) % Page-38 Six months ended Amount Change Percent Change (dollars in thousands) June 30, 2022 June 30, 2021 Salaries and related benefits $ 21,889 $ 18,096 $ 3,793 21.0 % Occupancy and equipment 3,803 3,502 301 8.6 % Data processing 2,476 1,639 837 51.1 % Professional services 1,578 1,849 (271) (14.7) % Information technology 946 609 337 55.3 % Depreciation and amortization 845 848 (3) (0.4) % Amortization of core deposit intangible 754 408 346 84.8 % Directors' expense 605 405 200 49.4 % Federal Deposit Insurance Corporation insurance 586 361 225 62.3 % Charitable contributions 556 493 63 12.8 % Other non-interest expense Advertising 568 414 154 37.2 % Other expense 3,675 2,344 1,331 56.8 % Total other non-interest expense 4,243 2,758 1,485 53.8 % Total non-interest expense $ 38,281 $ 30,968 $ 7,313 23.6 % Second Quarter of 2022 Compared to First Quarter of 2022 Non-interest expense totaled $18.9 million in the second quarter of 2022, compared to $19.4 million in the prior quarter. The decrease from the prior quarter was primarily due to a $1.2 million reduction in salaries and benefits after the completion of the acquisition-related conversion in March 2022 and 22 fewer full-time equivalent employees. Decreases were partially offset by a $466 thousand increase in charitable contributions in the quarter due to the annual distribution of grant funding related to the Bank's corporate giving program. First Six Months of 2022 Compared to the First Six Months of 2021 Non-interest expense totaled $38.3 million in the six months ended June 30, 2022, compared to $31.0 million in the same period of prior year. The largest increases over prior year expenses came from salaries and related benefits, which rose $3.8 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 (the first six months of 2021 included PPP round two origination activity). Higher expenses across most other categories reflect the acquisition, including one-time and conversion costs of $858 thousand, an increase in other data processing of $762 thousand, and an additional $346 thousand in amortization associated with the ARB core deposit intangible asset in the first half 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 second quarter of 2022 totaled $4.0 million at an effective tax rate of 26.3%, compared to $3.7 million at an effective tax rate of 26.3% in the prior quarter. The provision for income taxes for the first half of 2022 totaled $7.7 million at an effective tax rate of 26.3%, compared to $6.3 million at an effective tax rate of 25.6% for the first half of 2021. The increase in the provision in the second quarter of 2022 reflected higher pre-tax income as compared to the prior quarter. The 70 basis point increase in the effective tax rate in the first half of 2022 as compared to the first half of 2021 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 June 30, 2022, neither the Bank nor Bancorp had accruals for interest nor penalties related to unrecognized tax benefits. Page-39 FINANCIAL CONDITION SUMMARY Cash, Cash Equivalents and Restricted Cash Total cash, cash equivalents and restricted cash were $115.9 million at June 30, 2022, compared to $347.6 million at December 31, 2021. The $231.7 million decrease was primarily due to the deployment of funds into investment securities, as noted below. Cash and cash equivalents do not include $152.4 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 June 30, 2022 and December 31, 2021, respectively. Investment Securities The investment securities portfolio totaled $1.825 billion at June 30, 2022, an increase of $314.9 million from December 31, 2021. The increase was primarily due to purchases of $492.5 million to deploy excess cash into interest earning assets in a more favorable interest rate environment in 2022, partially offset by paydowns, maturities and calls of $93.1 million. Additionally, the unrealized losses on available-for-sale securities increased $80.1 million as a result of higher interest rates in the first six months of 2022. In March 2022, we transferred $357.5 million securities at fair value from available-for-sale to held-to-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 June 30, 2022 and December 31, 2021. June 30, 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 $ 25,997 $ 22,042 13.6 % $ 25,036 $ 25,020 14.2 % Revenue bonds 5,055 4,496 2.6 5,249 5,185 3.0 Tax allocation bonds 501 501 0.3 503 510 0.3 Total within California 31,553 27,039 16.5 30,788 30,715 17.5 Outside California: General obligation bonds 131,479 118,110 68.8 117,278 121,303 66.5 Revenue bonds 28,035 23,659 14.7 28,146 29,272 16.0 Total outside California 159,514 141,769 83.5 145,424 150,575 82.5 Total obligations of state and political subdivisions $ 191,067 $ 168,808 100.0 % $ 176,212 $ 181,290 100.0 % Percent of investment portfolio 10.2 % 9.8 % 11.7 % 12.0 % Of the total investment in obligations of state and political subdivisions, the largest concentrations outside of California are in Texas (38.2%), Washington (15.0%) and Wisconsin (9.7%). 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. 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 Page-40 Loans During the first six months of 2022, loans decreased by $93.0 million and totaled $2.163 billion at June 30, 2022, primarily due to $94.2 million in PPP loans being forgiven and paid off. New non-PPP related loan originations totaled $152.0 million in the first six months of 2022. Non-PPP loan payoffs were $159.1 million in the first six months of 2022, including construction project completions of $34.6 million. These payoffs also reflected borrowers' sales of underlying real estate and business assets and third-party refinancing of acquired loans outside the Bank's credit risk appetite. As of June 30, 2022, there were 112 PPP loans outstanding totaling $17.0 million (net of $420 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 half of 2022, Bank of Marin recognized $2.1 million in PPP fees, net of costs, compared to $4.3 million in the same period of 2021. As of June 30, 2022, two borrowing relationships with three loans totaling $23.6 million were 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 six months of 2022, total liabilities increased by $53.5 million to $3.917 billion. Deposits increased $22.1 million in the first six months of 2022 to $3.831 billion. Non-interest bearing deposits increased $124.5 million while money market deposits decreased $103.5 million in the first six months of 2022, and was partially related to a large transfer to non-interest bearing deposits by a significant customer in preparation for withdrawals in early July consistent with that customer's normal business activity. Non-interest bearing deposits represented 53.1% of total deposits at June 30, 2022, compared to 50.2% at December 31, 2021. The average cost of deposits was 0.06% in the first half of 2022 compared to 0.07% in the same period of 2021. Additionally, as part of our liquidity management, the Bank maintained $152.4 million in deposits off-balance sheet with deposit networks at June 30, 2022, compared to $173.1 million at December 31, 2021. 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 and produces a five-year capital plan semi-annually to ensure that capital exceeds the prescribed regulatory minimums and is adequate to meet our anticipated future needs. Stress tests are performed on capital ratios and include scenarios such as additional unrealized losses on the investment portfolio, additional deposit growth and potential share repurchases. 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, 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. Page-41 The Bancorp’s and Bank’s capital adequacy ratios as of June 30, 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 June 30, 2022 Amount Ratio Amount Ratio Amount Ratio Total Capital (to risk-weighted assets) $ 412,325 14.67 % $ 295,112 ≥ 10.50 % $ 281,059 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 389,091 13.84 % $ 238,900 ≥ 8.50 % $ 224,847 ≥ 8.00 % Tier 1 Capital (to average assets) $ 389,091 9.07 % $ 171,628 ≥ 4.00 % $ 214,535 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 389,091 13.84 % $ 196,741 ≥ 7.00 % $ 182,689 ≥ 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 % 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, 2022 Amount Ratio Amount Ratio Amount Ratio Total Capital (to risk-weighted assets) $ 399,228 14.21 % $ 295,078 ≥ 10.50 % $ 281,027 ≥ 10.00 % Tier 1 Capital (to risk-weighted assets) $ 375,994 13.38 % $ 238,873 ≥ 8.50 % $ 224,822 ≥ 8.00 % Tier 1 Capital (to average assets) $ 375,994 8.76 % $ 171,618 ≥ 4.00 % $ 214,523 ≥ 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 375,994 13.38 % $ 196,719 ≥ 7.00 % $ 182,667 ≥ 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 $152.4 million in one-way-sale deposits off-balance sheet with deposit networks at June 30, 2022, compared to $173.1 million at December 31, 2021. 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 Page-42 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. Our cash and cash equivalents decreased $231.7 million in the first six months of 2022. Significant uses of liquidity during 2022 were $452.2 million in investment securities purchased, $7.7 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 the first six months of 2022 was proceeds from loans collected (net of loan originations) of $93.9 million, principal paydowns, maturities and calls of investment securities of $93.1 million, a net increase in deposits of $22.1 million (primarily related to $25 million of one-way sell deposits that was previously placed in third-party deposit networks being brought back on balance sheet), and $19.6 million in net cash provided by operating activities. Undrawn credit commitments, as discussed in Note 8 to the Consolidated Financial Statements in this Form 10-Q, totaled $592.5 million at June 30, 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, $107.5 million of time deposits will mature. We expect to replace these funds with new deposits or excess liquidity. Our emphasis on local deposits, combined with our liquid investment portfolio, provides a very stable funding base. While we had no borrowings under our credit facilities at June 30, 2022 or December 31, 2021, as discussed in Note 6 to the Consolidated Financial Statements in ITEM 1 of this report, the available credit lines with FHLB and FRB SF have declined by $71.4 million from December 30, 2021 to June 30, 2022, primarily because the rising market interest rates in the first half of 2022 have unfavorably affected the market value of the loans collateralizing these lines. 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 $13.0 million in cash at June 30, 2022, which is expected to be sufficient 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.