What changed in this filing

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Item 2. Management’s Discussion and Analysis

2022-11-08 compared with 2022-08-08 · 169 added, 143 removed, 379 unchanged (45% of the section changed)

5 unchanged sentences

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.

Accordingly, we have compared the results for the three months ended September 30, 2022 and June 30, 2022 throughout the Management's Discussion and Analysis sections, where applicable.

Forward-Looking Statements

24 unchanged sentences

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.

We generated record earnings of $12.2 million for the third quarter of 2022, compared to $11.1 million for the second quarter of 2022.

Diluted earnings per share were $0.76 for the third quarter, compared to $0.69 for the preceding quarter.

Earnings for the first nine months of 2022 totaled $33.7 million, compared to $23.5 million for the same period last year.

Diluted earnings per share were $2.11 and $1.69 for the first nine months of 2022 and 2021, respectively.

Certain periods of earnings presented were impacted by the costs associated with our acquisition of American River Bankshares ("AMRB"), the details of which are discussed in this report.

In particular, non-GAAP diluted earnings per share for the first nine months of 2022 would have increased by 16 cents per share over 2021 without those co sts (refer to page 34 for a discussion of this non-GAAP financial measure).

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.

• 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.

• Return on average assets ("ROA") of 1.11% and return on average equity ("ROE") of 11.65% for the three months ended September 30, 2022, increased from 1.03% and 10.74% for the three months ended June 30, 2022.

ROA of 1.04% and ROE of 10.65% for the nine months ended September 30, 2022 also compared favorably to the same period in 2021, with ROA of 0.96% and ROE of 8.40%.

• Our declining efficiency ratios quarter-over-quarter and year-over-year are a testament to the improved operating leverage of our larger post-merger organization.

The efficiency ratios of 52.24% for the third quarter of 2022 and 55.60% year-to-date 2022 compared favorably to 55.73% and 65.65% for the second quarter of 2022 and year-to-date 2021, respectively.

The improvement in both periods was pri marily due to a significant increase in net interest income and reduced merger-related expenses in 2022.

• The third quarter tax-equivalent net interest margin improved 11 basis points over the preceding quarter from 3.05% to 3.16%, as rising interest rates positively impacted the Bank's earning asset portfolio while the cost of deposits remained flat.

The tax-equivalent net interest margin for the first nine months of 2022 of 3.06% decreased 17 basis points from 3.23% for the same period in 2021.

The decrease was largely due to higher average investment securities in proportion to the larger balance sheet in 2022, as compared to 2021.

This shift was mostly the result of deposit growth in 2022 contributing to a larger investment portfolio and the assumption of AMRB's balance sheet with a lower loan-to-deposit ratio in the third quarter of 2021.

• Deposits increased by $94.2 million to $3.903 billion at September 30, 2022, compared to $3.809 billion at December 31, 2021.

Non-interest bearing deposits made up 53% of total deposits as of September 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 third quarter of 2022 was 0.06%, unchanged from the preceding quarter.

The cost of average deposits in the first nine months of 2022 was 0.06%, a decrease from 0.07% in the same period of the prior year.

• Loan balances of $2.158 billion at September 30, 2022 decreased modestly from $2.256 billion at December 31, 2021, but increased $6.3 million excluding PPP loans.

Year-to-date originations of $204.1 million in the first nine months of 2022 were double when compared to the first nine months of 2021 and included $52.2 million in the third quarter.

Year-to-date payoffs were concentrated in expected construction project completions, borrowers’ sales of underlying commercial real estate, and third-party refinancing of acquired loans outside the Bank’s credit risk appetite.

• Credit quality remains strong, with non-accrual loans representing 0.49% of total loans at September 30, 2022, compared to 0.37% at December 31, 2021.

Classified loans totaled $33.4 million at September 30, 2022, compared to $36.2 million at December 31, 2021.

Shortly after quarter end, non-accrual and classified loans decreased $7.1 million due to the resolution and payoff of a long-standing substandard credit.

• In the third quarter of 2022, there was a provision for credit losses on loans of $422 thousand and no provision for credit losses on unfunded commitments.

The provision for credit losses on loans was primarily due to an increase in qualitative factors to account for the ongoing deterioration in the economic outlook not captured in the quantitative portion of the allowance.

• 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.

The total risk-based capital ratio for Bancorp was 15.1% at September 30, 2022, compared to 14.6% at December 31, 2021.

Bancorp's tangible common equity to tangible assets was 7.5% at September 30, 2022, compared to 8.8% at December 31, 2021 (refe r to footnote 4 on page 35 f or a discussion of this non-GAAP financial measure).

The total risk-based capital ratio for the Bank was 14.7% at September 30, 2022, compared to 14.4% at December 31, 2021.

The Bank's tangible common equity to tangible assets was 7.3% at September 30, 2022, compared to 8.6% at December 31, 2021.

Declines in the Bank's and Bancorp's tangible common equity were primarily related to a $78.0 million increase in after-tax unrealized losses on available-for-sale securities associated with interest rate increases since December 31, 2021, partially offset by earnings.

• Given the strength and durability of the Bank's financial performance, the Board of Directors declared a cash dividend of $0.25 per share on October 21, 2022, which represents the 70 th consecutive quarterly dividend paid by Bancorp.

The dividend is payable on November 14, 2022, to shareholders of record at the close of business on November 7, 2022.

Statement Regarding use of Non-GAAP Financial Measures

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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

Three months ended Nine months ended

(in thousands, unaudited) September 30, 2022 June 30, 2022 September 30, 2022 September 30, 2021

Net income (GAAP) $ 12,174 $ 11,066 $ 33,705 $ 23,514

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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

Three months ended Nine months ended

(dollars in thousands, except per share data) September 30, 2022 June 30, 2022 September 30, 2022 September 30, 2021

Selected operating data:

Net interest income $ 33,027 $ 31,197 $ 94,122 $ 74,318

Reversal of credit losses on loans — (485) (485) (3,849)

Provision for (reversal of) credit losses on loans 422 — (63) (2,049)

Reversal of credit losses on unfunded loan commitments

13 unchanged sentences

Efficiency ratio 52.24 % 55.73 % 55.60 % 65.65 %

Net charge-offs (recoveries) $ 8 $ (9) $ (1) $ (75)

Net (recoveries) charge-offs $ (2) $ 8 $ (3) $ (83)

Cash dividend payout ratio on common stock 2

32.89 % 34.29 % 34.43 % 41.18 %

(dollars in thousands, except per share data) June 30, 2022 December 31, 2021

(dollars in thousands, except per share data) September 30, 2022 December 31, 2021

Selected financial condition data:

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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.

SBA PPP loans at September 30, 2022 and December 31, 2021 totaled $7.6 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 $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.

Tangible common equity of $318 million and $371 million at September 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 $78.2 million and $79.4 million at September 30, 2022 and December 31, 2021, respectively.

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 the interest earned on loans, investments 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.

11 unchanged sentences

Three months ended Three months ended

June 30, 2022 March 31, 2022

September 30, 2022 June 30, 2022

Interest Interest

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337 1 0.93 % 370 — 0.61 %

Subordinated debenture 1, 5

— — — % — — — %

Total interest-bearing liabilities 1,803,164 550 0.12 % 1,865,310 590 0.13 %

8 unchanged sentences

Tax-equivalent net interest rate spread 3.09 % 2.98 %

Six months ended Six months ended

June 30, 2022 June 30, 2021

Nine months ended Nine months ended

September 30, 2022 September 30, 2021

Interest Interest

39 unchanged sentences

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.

1 unchanged sentence

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.

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

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 September 30, 2022 compared to June 30, 2022.

Three Months Ended September 30, 2022 Compared to Three Months Ended

June 30, 2022 Nine Months Ended September 30, 2022 Compared to Nine Months Ended

September 30, 2021

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

14 unchanged sentences

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).

2 Nine months ended September 30, 2021 includes $1.3 million in accelerated discount accretion from the early redemption of our last subordinated debenture on March 15, 2021.

Third Quarter of 2022 Compared to the Second Quarter of 2022

Net interest income totaled $33.0 million in the third quarter of 2022, compared to $31.2 million in the second quarter of 2022.

The $1.8 million increase from the prior quarter was primarily attributable to higher average balances and yields on investment securities.

In addition, higher interest rates increased income from other interest-earning assets while the cost of interest-bearing liabilities went down slightly.

The tax-equivalent net interest margin was 3.16% in the third quarter of 2022, compared to 3.05% in the second quarter of 2022.

The increase from the prior quarter was primarily due to continued deployment of cash into higher yielding investment securities and higher yields on loans and Federal Reserve balances, partially offset by lower interest and fee income on PPP loans and lower construction loan balances.

The average yield on the investment portfolio increased 24 basis points in the third quarter.

First Nine Months of 2022 Compared to the First Nine Months of 2021

Net interest income totaled $94.1 million for the nine months ended September 30, 2022, compared to $74.3 million for the same period in the prior year.

The $19.8 million increase from the prior year was primarily due to the larger balance sheet resulting from the AMRB acquisition and deposit growth.

The Bank also benefited from its asset sensitivity in the rising interest rate environment.

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.

The tax-equivalent net interest margin was 3.06% in the nine months ended September 30, 2022, compared to 3.23% in the same period in the prior year.

The decrease resulted from a higher proportion of investment securities in the larger balance sheet associated with the acquisition and AMRB's lower loan-to-deposit ratio.

Additionally, other deposit growth over the period contributed to the larger investment portfolio.

Reductions were partially offset by the shift to a higher percentage of non-PPP loans within the loan portfolio and the absence of a subordinated debenture that was redeemed in 2021.

Market Interest Rates

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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

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% .

The federal funds target rate range resided between 0.0% and 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.

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.

Continued evolving economic risks exacerbated by global economic contraction and international political unrest have resulted in oil shortages and other supply chain disruptions, and elevated inflation.

In response, the FOMC increased the federal funds rate by 75 basis

points four additional times this year effective June 16, 2022, July 28, 2022, September 21, 2022, and November 2, 2022 to a range of 3.75% - 4.00%.

It is widely anticipated that additional increases in the target range will occur in 2022.

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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)

Three months ended Nine months ended

(dollars in thousands) September 30, 2022 June 30, 2022 September 30, 2022 September 30, 2021

Provision for (reversal of) credit losses on loans $ 422 $ — $ (63) $ (2,049)

We recorded a $422 thousand provision for credit losses on loans in the third quarter.

The provision was due primarily to an increase in qualitative factors to account for the ongoing deterioration in the economic outlook not captured in the quantitative portion of the allowance.

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.

The net provision reversal for the first nine months in 2022 resulted from a provision reversal in the first quarter due to improvements in the economic forecasts, partially offset by the provision in the third quarter as discussed above.

The provision reversal for the first nine months in 2021 was primarily due to continued improvements in the forecasted California unemployment rates at the time, partially offset by a provision in the third quarter related to the purchased AMRB loans without credit deterioration.

Loans designated special mention, which are not considered adversely classified, decreased year-to-date by $9.1 million to $64.2 million at September 30, 2022 from $73.3 million at December 31, 2021.

The decrease was largely due to $30.1 million in upgrades to pass risk ratings because of the borrowers' improved financial condition, which was partially offset by $26.1 million in downgrades from pass to special mention.

Additionally, there were $3.6 million in downgrades from special mention to substandard and $2.1 million in paydowns and payoffs.

Classified assets (loans with risk ratings of substandard or doubtful) totaled $33.3 million at September 30, 2022, compared to $36.1 million at December 31, 2021.

The $2.8 million decrease was primarily due to $5.2 million in upgrades to pass risk rating and $3.2 million in paydowns and payoffs.

These decreases were partially offset by $1.4 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, net of $2.3 million in paydowns 2022) and the downgrade of two well-secured owner occupied commercial real estate loans totaling $2.3 million.

Classified loans also included one $101 thousand loan acquired from AMRB with a doubtful risk rating as of September 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 1.06% and 1.02% at September 30, 2022 and December 31, 2021, respectively.

Non-accrual loans increased $2.2 million to $10.6 million, or 0.49% of total loans at September 30, 2022 from $8.4 million, or 0.37% of total loans at December 31, 2021.

The increase was mainly due to the $3.0 million in non-accrual loans designated during 2022, partially offset by the removal of a $695 thousand commercial real estate loan from non-accrual status and paydowns of $88 thousand.

Over 90% of the non-accrual loans as of September 30, 2022 were well secured by commercial real estate.

In addition, s ubsequent to quarter end, $7.1 million of the substandard non-accrual loans paid off.

For more information, refer to Note 5 to the consolidated financial statements in this Form 10-Q.

2 unchanged sentences

Three months ended Amount Change Percent Change

(dollars in thousands) June 30, 2022 March 31, 2022

(dollars in thousands) September 30, 2022 June 30, 2022

Wealth Management and Trust Services $ 507 $ 630 $ (123) (19.5) %

4 unchanged sentences

Merchant interchange fees, net 141 149 (8) (5.4) %

Losses on sale of investment securities, net (63) — (63) NM

Other income 628 406 222 54.7 %

Total non-interest income $ 2,723 $ 2,728 $ (5) (0.2) %

Six months ended Amount Change Percent Change

(dollars in thousands) June 30, 2022 June 30, 2021

NM - not meaningful

Nine months ended Amount Change Percent Change

(dollars in thousands) September 30, 2022 September 30, 2021

Wealth Management and Trust Services $ 1,737 $ 1,615 $ 122 7.6 %

4 unchanged sentences

Merchant interchange fees, net 430 247 183 74.1 %

(Losses) gains on sale of investment securities, net (63) 1 (64) NM

Other income 1,496 823 673 81.8 %

Total non-interest income $ 8,318 $ 7,413 $ 905 12.2 %

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.

NM - not meaningful

Third Quarter of 2022 Compared to the Second Quarter of 2022

Non-interest income totaled $2.7 million in the third quarter of 2022, substantially unchanged from the preceding quarter.

The reduction in Wealth Management and Trust Services income related to stock market volatility and losses on investment securities sold were generally offset by increased fees for off-balance sheet deposits within other income.

The $63 thousand loss on sale of investment securities was related to the sale of short-term municipal bonds.

The sales proceeds were reinvested into higher yielding securities with an expected loss earnback period of less than four months.

First Nine Months of 2022 Compared to the First Nine Months of 2021

Non-interest income totaled $8.3 million in the nine months ended September 30, 2022, compared to $7.4 million in the same period of the prior year.

The $905 thousand improvement from the prior year period was mostly attributable to higher activity associated with the AMRB acquisition and higher fees on deposit balances held off balance sheet with deposit networks, partially offset by a decrease in benefits year-over-year associated with bank-owned life insurance payments.

Non-interest Expense

1 unchanged sentence

Three months ended Amount Change Percent Change

(dollars in thousands) June 30, 2022 March 31, 2022

(dollars in thousands) September 30, 2022 June 30, 2022

Salaries and related benefits $ 10,557 $ 10,341 $ 216 2.1 %

5 unchanged sentences

Amortization of core deposit intangible 370 374 (4) (1.1) %

Directors' expense 294 311 (17) (5.5) %

Federal Deposit Insurance Corporation insurance 300 296 4 1.4 %

Directors' expense 233 294 (61) (20.7) %

Charitable contributions 49 511 (462) (90.4) %

Other real estate owned 350 3 347 NM

Other non-interest expense

3 unchanged sentences

Total non-interest expense $ 18,678 $ 18,906 $ (228) (1.2) %

Six months ended Amount Change Percent Change

(dollars in thousands) June 30, 2022 June 30, 2021

NM - Not Meaningful

Nine months ended Amount Change Percent Change

(dollars in thousands) September 30, 2022 September 30, 2021

Salaries and related benefits $ 32,446 $ 31,223 $ 1,223 3.9 %

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Amortization of core deposit intangible 1,124 742 382 51.5 %

Directors' expense 605 405 200 49.4 %

Federal Deposit Insurance Corporation insurance 886 597 289 48.4 %

Directors' expense 838 660 178 27.0 %

Charitable contributions 605 497 108 21.7 %

Other real estate owned 355 — 355 NM

Other non-interest expense

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Total non-interest expense $ 56,959 $ 53,654 $ 3,305 6.2 %

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.

NM - Not Meaningful

Third Quarter of 2022 Compared to the Second Quarter of 2022

Non-interest expense totaled $18.7 million in the third quarter of 2022, compared to $18.9 million in the prior quarter.

The decrease from the prior quarter was primarily from $462 thousand less in charitable contributions due to the annual distribution of grant funding related to the Bank's corporate giving program primarily occurring in the second quarter.

In addition, the third quarter included a partial reversal of a vendor contract termination fee accrual originally recorded in the second quarter, for a net quarter-over-quarter effect of $200 thousand.

These decreases were partially offset by a $345 thousand valuation adjustment to other real estate owned.

First Nine Months of 2022 Compared to the First Nine Months of 2021

Almost all expense categories increased over 2021 due primarily to a full nine months of operating expenses attributable to the 2021 AMRB acquisition.

In addition, salaries and benefits reflected annual merit and other incentive increases, data processing and information technology expenses were elevated due to the systems conversions associated with the merger and systems upgrades in 2022, and other expense reflected higher

recruiting fees.

These increases were partially offset by a $2.0 million decrease in professional services expense, as 2021 included merger-related legal and other professional fees.

Provision for Income Taxes

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Provisions also reflect permanent differences between income for tax and financial reporting purposes (such as earnings on tax exempt loans and municipal securities, BOLI, low-income housing tax credits, and stock-based compensation from the exercise of stock options, disqualifying dispositions of incentive stock options and vesting of restricted stock awards).

The provision for income taxes 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.

The provision for income taxes for the third quarter of 2022 totaled $4.5 million at an effective tax rate of 26.9%, compared to $4.0 million at an effective tax rate of 26.3% in the prior quarter.

The provision for income taxes for the first nine months of 2022 totaled $12.2 million at an effective tax rate of 26.5%, compared to $7.8 million at an effective tax rate of 24.9% for the first nine months of 2021.

The increase in the provision in the third quarter of 2022 reflected higher pre-tax income as compared to the prior quarter.

The 160 basis point increase in the effective tax rate in the first nine months of 2022 as compared to the same period in 2021 was primarily due to lower BOLI income in 2022 and a higher level of tax benefits in 2021 from the disqualifying dispositions of incentive stock options, partially offset by the non-deductible merger expenses incurred in 2021.

We file a consolidated return in the U.S.

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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.

At September 30, 2022, neither the Bank nor Bancorp had accruals for interest nor penalties related to unrecognized tax benefits.

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.

Total cash, cash equivalents and restricted cash were $185.6 million at September 30, 2022, compared to $347.6 million at December 31, 2021.

The $162.0 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.

Cash and cash equivalents do not include $11.3 million and $173.1 million in one-way sale transfers of deposits to third-party deposit networks as part of our liquidity management at September 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.

The investment securities portfolio totaled $1.772 billion at September 30, 2022, an increase of $262.6 million from December 31, 2021.

The increase was primarily due to purchases of $537.2 million to deploy excess cash into interest earning assets in a more favorable interest rate environment in 2022, partially offset by paydowns, sales, maturities and calls of $156.7 million.

Additionally, the unrealized losses on available-for-sale securities increased $97.0 million as a result of higher interest rates in the first nine 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

The following table summarizes our investment in obligations of state and political subdivisions at September 30, 2022 and December 31, 2021.

September 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

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• Credit ratings by major credit rating agencies

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.

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.

During the first nine months of 2022, loans decreased by $97.3 million and totaled $2.158 billion at September 30, 2022, primarily due to $103.6 million in PPP loans forgiven and paid off.

New non-PPP related loan originations totaled $204.1 million in the first nine months of 2022.

Non-PPP loan payoffs were $204.2 million in the first nine months of 2022.

These payoffs reflected construction project completions, 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 September 30, 2022, there were 42 PPP loans outstanding totaling $7.6 million (net of $161 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 nine months of 2022, Bank of Marin recognized $2.3 million in PPP fees, net of costs, compared to $6.6 million in the same period of 2021.

As of the date of this report, there were no loans benefiting from payment relief under the provisions of the 2020 CARES Act.

During the onset of the pandemic, Bank of Marin granted payment relief for 269 loans totaling $402.9 million.

Of the three loans outstanding for $23.6 million as of June 30, 2022, one resumed payments and was removed from payment relief prior to September 30, 2022, and the others paid off in early October.

During the first nine months of 2022, total liabilities increased by $88.2 million to $3.952 billion.

Deposits increased $94.2 million in the first nine months of 2022 to $3.903 billion.

Non-interest bearing deposits increased $141.7 million while money market deposits decreased $41.7 million in the first nine months of 2022.

The decrease in m oney market deposits was primarily due to seasonal fluctuations in some of our large clients' business accounts.

The net increase in total deposits was primarily due to the replacement of expected deposit outflows with deposits held off balance sheet.

Additionally, as part of our liquidity management, the Bank maintained $11.3 million in deposits off-balance sheet with d eposit networks at September 30, 2022, compared to $173.1 million at December 31, 2021.

Non-interest bearing deposits represented 52.6% of total deposits at September 30, 2022, compared to 50.2% at December 31, 2021.

The average cost of deposits was 0.06% in the first nine months of 2022 compared to 0.07% in the same period of 2021.

Capital Adequacy

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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.

In addition, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action as of September 30, 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 June 30, 2022 and December 31, 2021 are presented in the following tables.

Tangible common equity to tangible assets was 7.5% at September 30, 2022, compared to 8.8% at December 31, 2021 for Bancorp and 7.3% at September 30, 2022, compared to 8.6% at December 31, 2021 for the Bank (refer to footnote 4 on page 35 for a discussion of this non-GAAP financial measure).

Declines in the Bank's and Bancorp's tangible common equity ratios were primarily related to a $78.0 million increase in after-tax unrealized losses on available-for-sale securities associated with interest rate increases since December 31, 2021, partially offset by earnings.

As mentioned above, our substantial liquidity position enabled us to transfer $357.5 million of securities at fair value from available-for-sale to held-to-maturity in March 2022, to reduce the effect of future rate increases on other comprehensive income and equity.

The Bancorp’s and Bank’s capital adequacy ratios as of September 30, 2022 and December 31, 2021 are presented in the following tables.

Capital Ratios for Bancorp

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Actual Ratio Adequately Capitalized Threshold Ratio to be a Well Capitalized Bank Holding Company

June 30, 2022 Amount Ratio Amount Ratio Amount Ratio

September 30, 2022 Amount Ratio Amount Ratio Amount Ratio

Total Capital (to risk-weighted assets) $ 422,110 15.06 % $ 294,306 ≥ 10.50 % $ 280,292 ≥ 10.00 %

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Actual Ratio Adequately Capitalized Threshold Ratio to be Well Capitalized under Prompt Corrective Action Provisions

June 30, 2022 Amount Ratio Amount Ratio Amount Ratio

September 30, 2022 Amount Ratio Amount Ratio Amount Ratio

Total Capital (to risk-weighted assets) $ 413,236 14.74 % $ 294,282 ≥ 10.50 % $ 280,269 ≥ 10.00 %

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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 maintained $11.3 million in one-way-sale deposits off-balance sheet with deposit networks at September 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.

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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.

Our cash and cash equivalents decreased $162.0 million in the first nine months of 2022.

Significant uses of liquidity during 2022 were $537.2 million in investment securities purchased, $11.7 million in cash dividends paid on common stock to our shareholders, and $1.2 million in common stock repurchases.

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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.

The most significant source of liquidity during the first nine months of 2022 was proceeds from principal paydowns, maturities, sales and calls of investment securities of $156.7 million, loans collected (net of loan originations) of $97.9 million, a net increase in deposits of $94.2 million (primarily related to $162 million of one-way sell deposits brought back on the balance sheet that were previously placed in third-party deposit networks), and $39.0 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 $561.7 million at September 30, 2022.

We expect to fund these commitments to the extent utilized primarily through the repayment of existing loans, deposit growth and liquid assets.

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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.

While we had no borrowings under our credit facilities at September 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 $97.5 million from December 31, 2021 to September 30, 2022, primarily because the rising market interest rates in the first nine months 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.

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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.

Bancorp held $8.8 million in cash at September 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.

Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-Q

Item 2. Management’s Discussion and Analysis