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Item 2. Management’s Discussion and Analysis

2023-05-09 compared with 2022-11-08 · 240 added, 314 removed, 234 unchanged (70% of the section changed)

2 unchanged sentences

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 September 30, 2022 and June 30, 2022 throughout the Management's Discussion and Analysis sections, where applicable.

Forward-Looking Statements

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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;

the impact of adverse developments at other banks, including bank failures, that impact general sentiment regarding the stability and liquidity of banks;

costs or effects of acquisitions;

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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.

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 2022 Form 10-K as filed with the SEC, and ITEM 1A Risk Factors herein, copies of which are available from us at no charge.

Forward-looking statements speak only as of the date they are made.

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Our critical estimates include:

Allowance for Credit Losses on Loans and Unfunded Commitments, Income Taxes, and Fair Value Measurements .

Allowance for Credit Losses on Loans and Unfunded Commitments, Income Taxes, Fair Value Measurements, and Business Combinations.

For a detailed discussion, refer to the Critical Accounting Estimates section of our 2022 Form 10-K filed with the SEC on March 16, 2023.

Executive Summary

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).

We generated earnings of $9.4 million for the first quarter of 2023, compared to $12.9 million for the fourth quarter of 2022 and $10.5 million in the first quarter of 2022.

Diluted earnings per share were $0.59 for the first quarter of 2023, compared to $0.81 for the preceding quarter and $0.66 in the same quarter a year ago.

Earnings declined in the first quarter of 2023, as an increase in interest expense reflected market interest rate increases on a lagged basis.

The following are highlights of our operating and financial performance for the periods presented:

• 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.

• Following recent industry events, our deposit franchise remained strong at $3.251 billion on March 31, 2023, a decrease of $322.8 million from $3.573 billion at December 31, 2022.

While there have been some outflows related to industry concerns in March and pandemic surge deposits redeploying to money market funds, the largest transactions were related to the normal operating activities of our customers.

Those activities include vendor payments, taxes, payroll and singular events such as disbursement of proceeds from the sale of a business, real property acquisitions for cash, trust distributions or estate settlements.

The cost of deposits increased 12 basis points quarter over quarter due to targeted relationship-based pricing adjustments.

Non-interest bearing deposits made up 50.3% of total deposits at March 31, 2023, compared to 51.5% at December 31, 2022, and we estimated that 67% of total deposits were fully covered by FDIC insurance as of March 31, 2023.

• Liquidity is strong, providing 181% coverage of estimated uninsured deposits.

The Bank has long followed liquidity management practices similar to larger banks with robust liquidity requirements and regular liquidity stress testing.

While the Bank has the ability to utilize the Federal Reserve Bank Term Funding Program ("BTFP") and has tested it for contingency planning purposes, there has been no need to utilize the facility at this time.

• Loan balances of $2.112 billion at March 31, 2023, increased $19.8 million from $2.093 billion at December 31, 2022 reflecting originations of $44.9 million and payoffs of $22.2 million.

Utilization of credit lines was offset by loan amortization from scheduled repayments during the quarter and unfunded commitments declined $37.4 million from December 31, 2022 to $529.5 million at March 31, 2023.

• Non-accrual loans were only 0.10% of total loans as of March 31, 2023, compared to 0.12% at December 31, 2022.

We recorded a $350 thousand provision for credit losses on loans in the first quarter, compared to no provision in the previous quarter and a $485 thousand provision reversal in the same quarter of 2022.

The provision in the first quarter of 2023 was due primarily to qualitative risk factor adjustments.

• Credit quality remains sound notwithstanding the trends in the commercial real estate market.

Our loan po rtfolio continues to perform well, with classified loans at only 1.47% of total loans and manageable delinquencies.

Non-owner occupied commercial real estate loans made up 73% of total classified loans as of March 31, 2023, compared to 76% at December 31, 2022, and all are currently paying as agreed.

We continue to maintain diversity among property types and within our geographic footprint.

In particular, our offi ce commercial real estate portfolio in the City of San Francisco represents just 3% of our total loan portfolio and 6% of our total non-owner occupied commercial real estate portfolio.

As of the last measurement period, the average loan-to-value and debt-service coverage for the entire non-owner occupied office portfolio were 55% and 1.67x, respectively.

For the eleven non-owner occupied office loans in the City of San Francisco, the average loan-to-value and debt-service coverage were 60% and 1.20x, respectively.

More details are available in the supplementary earnings presentation filed as Exhibit 99.2 to our 8-K on April 24, 2023, and also available on our website.

• The first quarter tax-equivalent net interest margin decreased 22 basis points to 3.04% from 3.26% for the previous quarter due primarily to increased deposit costs and average borrowing balances, partially offset by higher loan yields.

The margin was up from 2.96% in the same period of 2022.

• Return on average assets ("ROA") was 0.92% for the first quarter of 2023, compared to 1.21% for the fourth quarter of 2022 and 0.98% for the first quarter of 2022, and return on average equity ("ROE") was 9.12%, compared to 12.77% for the prior quarter and 9.61% for the first quarter in the prior year.

The efficiency

ratio for the first quarter of 2023 was 60.24%, compared to 50.92% for the prior quarter and 59.13% for the first q uarter of 2022.

The sequential declines in ROA and ROE and increase in the efficiency ratio were due primarily to the $3.6 million increase in interest expense.

• The Bank finalized the closure of four branch locations which were announced in January 2023.

The acquisition of American River Bank ("ARB") resulted in an overlap in the Bank’s branch network in Santa Rosa and Healdsburg, prompting branch consolidations within Northern Sonoma County.

In addition, our Tiburon and Buckhorn branches in Marin and Amador counties were in close proximity to other branches fully able to meet our customers' needs.

These closures represented the remaining expense savings anticipated from the acquisition, optimizing efficiency and our ability to fund strategic initiatives going forward.

The pre-tax savings in 2023 from the branch closures, net of accelerated costs, is expected to be approximately $470 thousand, and future annual pre-tax savings are expected to be approximately $1.4 million.

• All capital ratios were above well-capitalized regulatory requirements.

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

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 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

Merger-related one-time and conversion costs:

Personnel and severance — 58 393 2,668

Professional services — — 67 1,979

Data processing — 29 77 433

Other — 224 321 279

Total merger costs before tax benefits — 311 858 5,359

Income tax benefit of merger-related expenses — (92) (254) (1,239)

Total merger-related one-time and conversion costs, net of tax benefits — 219 604 4,120

Comparable net income (non-GAAP) $ 12,174 $ 11,285 $ 34,309 $ 27,634

Diluted earnings per share

Weighted average diluted shares 15,974 15,955 15,959 13,881

Diluted earnings per share (GAAP) $ 0.76 $ 0.69 $ 2.11 $ 1.69

Merger-related one-time and conversion costs, net of tax benefits — 0.02 0.04 0.30

Comparable diluted earnings per share (non-GAAP) $ 0.76 $ 0.71 $ 2.15 $ 1.99

Return on average assets

Average assets $ 4,334,842 $ 4,312,919 $ 4,330,968 $ 3,280,505

Return on average assets (GAAP) 1.11 % 1.03 % 1.04 % 0.96 %

Comparable return on average assets (non-GAAP) 1.11 % 1.05 % 1.06 % 1.13 %

Return on average equity

Average stockholders' equity $ 414,619 $ 413,271 $ 423,073 $ 374,445

Return on average equity (GAAP) 11.65 % 10.74 % 10.65 % 8.40 %

Comparable return on average equity (non-GAAP) 11.65 % 10.95 % 10.84 % 9.87 %

Efficiency ratio

Non-interest expense (GAAP) $ 18,678 $ 18,906 $ 56,959 $ 53,654

Merger-related expenses — (311) (858) (5,359)

Non-interest expense (non-GAAP) $ 18,678 $ 18,595 $ 56,101 $ 48,295

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

Non-interest income $ 2,723 $ 2,728 $ 8,318 $ 7,413

Efficiency ratio (GAAP) 52.24 % 55.73 % 55.60 % 65.65 %

Comparable efficiency ratio (non-GAAP) 52.24 % 54.81 % 54.76 % 59.09 %

The total risk-based capital ratios at March 31, 2023 for Bancorp and the Bank were 16.2% and 15.6%, respectively.

Bancorp's tangible common equity to tangible assets ("TCE ratio") was 8.7% at March 31, 2023, and the Bank's TCE ratio was 8.3%.

• 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 April 21, 2023, which represents the 72 nd consecutive quarterly dividend paid by Bancorp.

The dividend is payable on May 12, 2023, to shareholders of record at the close of business on May 5, 2023.

RESULTS OF OPERATIONS

Highlights of the financial results are presented in the following tables:

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

Three months ended

(dollars in thousands, except per share data) March 31, 2023 December 31, 2022 March 31, 2022

Selected operating data:

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Tax-equivalent net interest margin 3.04 % 3.26 % 2.96 %

3.16 % 3.05 % 3.06 % 3.23 %

Cost of deposits 0.20 % 0.08 % 0.06 %

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42.37 % 30.86 % 36.36 %

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

(dollars in thousands, except per share data) March 31, 2023 December 31, 2022

Selected financial condition data:

Total assets $ 4,135,279 $ 4,147,464

Investment securities 1,756,093 1,774,303

Loans, net 2,088,998 2,069,563

Deposits 3,250,574 3,573,348

Borrowings and other obligations 365 419

Short-term borrowings and other obligations 405,802 112,439

Stockholders' equity 430,174 412,092

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Allowance for credit losses on loans to total loans 1.10 % 1.10 %

Allowance for credit losses on loans to total loans, excluding SBA PPP loans 3

1.07 % 1.07 %

Allowance for credit losses on loans to non-performing loans 11.52x 9.45x

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Tangible common equity to tangible assets 8.69 % 8.21 %

7.45 % 8.76 %

Total capital (to risk-weighted assets) 16.15 % 15.90 %

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Common equity Tier 1 capital (to risk weighted assets) 15.27 % 15.02 %

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.

1 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 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 $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

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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

September 30, 2022 June 30, 2022

Interest Interest

Average Income/ Yield/ Average Income/ Yield/

(dollars in thousands) Balance Expense Rate Balance Expense Rate

Interest-earning deposits with banks 1

$ 94,963 $ 546 2.24 % $ 95,326 $ 180 0.75 %

Investment securities 2, 3

1,875,660 9,875 2.11 % 1,807,710 8,469 1.87 %

Loans 1, 3, 4

2,166,879 23,540 4.25 % 2,194,810 23,522 4.24 %

Total interest-earning assets 1

4,137,502 33,961 3.21 % 4,097,846 32,171 3.21 %

Cash and non-interest-bearing due from banks 44,597 56,408

Bank premises and equipment, net 7,052 7,182

Interest receivable and other assets, net 145,691 151,483

Total assets $ 4,334,842 $ 4,312,919

Liabilities and Stockholders' Equity

Interest-bearing transaction accounts $ 293,296 $ 121 0.16 % $ 300,258 $ 53 0.07 %

Savings accounts 341,468 32 0.04 % 343,338 32 0.04 %

Money market accounts 1,025,722 268 0.10 % 1,076,912 438 0.16 %

Time accounts including CDARS 142,341 128 0.36 % 144,432 67 0.19 %

Borrowings and other obligations 1

337 1 0.93 % 370 — 0.61 %

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

Demand accounts 2,069,476 1,984,629

Interest payable and other liabilities 47,583 49,709

Stockholders' equity 414,619 413,271

Total liabilities & stockholders' equity $ 4,334,842 $ 4,312,919

Tax-equivalent net interest income/margin 1

$ 33,411 3.16 % $ 31,581 3.05 %

Reported net interest income/margin 1

$ 33,027 3.12 % $ 31,197 3.01 %

Tax-equivalent net interest rate spread 3.09 % 2.98 %

Nine months ended Nine months ended

September 30, 2022 September 30, 2021

Interest Interest

Average Income/ Yield/ Average Income/ Yield/

(in thousands) Balance Expense Rate Balance Expense Rate

Three months ended Three months ended Three months ended

March 31, 2023 December 31, 2022 March 31, 2022

Interest Interest Interest

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

(dollars in thousands) Balance Expense Rate Balance Expense Rate Balance Expense Rate

Interest-earning deposits with banks 1

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Time accounts including CDARS 126,030 223 0.72 % 127,906 114 0.35 % 147,707 14 0.04 %

Borrowings and other obligations 1

368 2 0.71 % 1,047 8 1.10 %

Subordinated debenture 1, 5

Short-term borrowings and other obligations 1

222,571 2,716 4.88 % 8,014 89 4.34 % 399 1 0.62 %

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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.

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 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

Rate variances are equal to the increase or

decrease in rates multiplied by prior period average balances.

Mix variances are attributable to the change in yields or rates multiplied by the change in average balances, including two fewer days in the three months ended March 31, 2023 compared to December 31, 2022.

Three Months Ended March 31, 2023 Compared to Three Months Ended

December 31, 2022 Three Months Ended March 31, 2023 Compared to Three Months Ended

March 31, 2022

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

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Time accounts, including CDARS (2) 117 (6) 109 (2) 247 (36) 209

Borrowings and other obligations — — 1 1 (6) (3) 3 (6)

Subordinated debenture 2

— — — — — (1,361) — (1,361)

Short-term borrowings and other obligations 2,383 11 233 2,627 557 4 2,154 2,715

Total interest-bearing liabilities 2,335 1,163 119 3,617 478 1,418 1,974 3,870

1 unchanged sentence

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 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 3.06% 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.

First Quarter of 2023 Compared to the Fourth Quarter of 2022

Net interest income totaled $29.9 million in the first quarter of 2023, compared to $33.4 million in the fourth quarter of 2022.

The $3.5 million decrease from the prior quarter was primarily related to an increase in the cost of deposits and higher average borrowing balances.

The tax-equivalent net interest margin was 3.04% in the first quarter of 2023, compared to 3.26% in the fourth quarter of 2022.

The decline from prior quarter was primarily due to higher borrowing and deposit costs partially offset by higher interest rates on loans.

The tax-equivalent yield on interest-earning assets was 3.49% in the first quarter of 2023, an increase of 15 basis points over the fourth quarter of 2022.

For the first quarter of 2023, interest-bearing liabilities costs were 0.95%, which was a 77 basis point increase over the fourth quarter of 2022.

First Quarter of 2023 Compared to the First Quarter of 2022

Net interest income totaled $29.9 million for the first quarter of 2023, largely unchanged compared to the first quarter of 2022, as the increase in interest income on loans and investments offset the increases in interest expense on deposits and borrowings.

The tax-equivalent net interest margin was 3.04% in the first quarter of 2023, compared to 2.96% in the same period in the prior year.

The increase over the same quarter last year was primarily due to higher yields on loans and investments partially offset by higher deposit and borrowing costs.

Market Interest Rates

1 unchanged sentence

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% 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.

Our net interest margin should benefit from a rising interest rate environment.

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

The federal funds rate range remained between 0.0% to 0.25% through the beginning of 2022, putting downward pressure on our asset yields and net interest margin.

Beginning in March 2022, the FOMC began successive increases to the federal funds rate due to the evolving inflation risks, complicated by international political unrest and supply chain disruptions.

As a result of five rate adjustments during 2022, the federal funds target rate increased to a range of 4.25% to 4.50% at year-end.

In 2023, on both February 1 st and March 2 nd , the FOMC increased the target rate by 25 basis points to a range of 4.75% to 5.00%.

Federal Reserve policymakers continue to monitor inflation and economic developments throughout 2023.

Quantitative and Qualitative Disclosure about Market Risk for further information.

3 unchanged sentences

The following table shows the activity for the periods presented.

Three months ended Nine months ended

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

Three months ended

(dollars in thousands) March 31, 2023 December 31, 2022 March 31, 2022

Provision for (reversal of) credit losses on loans $ 350 $ — $ (485)

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 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.

We recorded a $350 thousand provision for credit losses on loans in the first quarter.

The provision was due primarily to increases in qualitative risk factors to account for continued uncertainty about inflation and recession risks.

Management believed that these risk factors were not adequately captured in the modeled quantitative portion of the allowance and took the more prudent approach to account for loan and collateral concentration risks, mainly in our construction and commercial real estate portfolios, and the need for heightened portfolio management in light of current economic conditions.

In addition, the $19.8 million increase in loans contributed modestly to the provision.

These increases were partially offset by the quantitative impact of an improvement in Moody's Analytics' baseline California unemployment rate forecasts over the next four quarters.

There was no provision in the prior quarter and a $485 thousand provision reversal in the first quarter of 2022, due primarily to an improvement in underlying economic forecasts at the time.

For more information, refer to Note 5, Loans and Allowance for Credit Losses on Loans, to the consolidated financial statements in this Form 10-Q.

Non-interest Income

The following table details the components of non-interest income.

Three months ended Amount Change Percent Change

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

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

Debit card interchange fees, net 502 531 (29) (5.5) %

Service charges on deposit accounts 535 465 70 15.1 %

Three months ended Quarter over quarter Year over year

(dollars in thousands) March 31, 2023 December 31, 2022 March 31, 2022 Amount Change Percent Change Amount Change Percent Change

Earnings on bank-owned life insurance, net $ 705 $ 296 $ 413 $ 409 138.2 % $ 292 70.7 %

Dividends on Federal Home Loan Bank stock 251 249 2 0.8 %

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) %

NM - not meaningful

Nine months ended Amount Change Percent Change

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

Service charges on deposit accounts 533 519 488 14 2.7 % 45 9.2 %

Wealth Management and Trust Services 511 $ 490 600 21 4.3 % (89) (14.8) %

Debit card interchange fees, net 447 513 505 (66) (12.9) % (58) (11.5) %

Service charges on deposit accounts 1,488 1,062 426 40.1 %

Earnings on bank-owned life insurance, net 933 1,892 (959) (50.7) %

Dividends on Federal Home Loan Bank stock 302 297 259 5 1.7 % 43 16.6 %

Merchant interchange fees, net 133 119 140 14 11.8 % (7) (5.0) %

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

Other income 304 353 462 (49) (13.9) % (158) (34.2) %

Total non-interest income $ 2,935 $ 2,587 $ 2,867 $ 348 13.5 % $ 68 2.4 %

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.

First Quarter of 2023 Compared to the Fourth Quarter of 2022

Non-interest income totaled $2.9 million in the first quarter of 2023, compared to $2.6 million in the prior quarter.

The $348 thousand increase from the prior quarter was primarily related to the recognition of a death benefit on bank-owned life insurance, partially offset by decreases in debit card interchange fees and other income.

First Quarter of 2023 Compared to the First Quarter of 2022

Non-interest income totaled $2.9 million in the first quarter of 2023, compared to $2.9 million in the same period of the prior year.

The $68 thousand improvement from the first quarter of 2022, was primary due to the death benefit, partially offset by decreases in wealth management and trust services income and other income.

Non-interest Expense

The following table details the components of non-interest expense.

Three months ended Amount Change Percent Change

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

Three months ended Quarter over quarter Year over year

(dollars in thousands) March 31, 2023 December 31, 2022 March 31, 2022 Amount Change Percent Change Amount Change Percent Change

Salaries and related benefits $ 10,930 $ 9,600 $ 11,548 $ 1,330 13.9 % $ (618) (5.4) %

Occupancy and equipment 2,414 2,084 1,907 330 15.8 % 507 26.6 %

Data processing 1,093 1,199 (106) (8.8) %

Professional services 1,123 985 913 138 14.0 % 210 23.0 %

Information technology 573 468 105 22.4 %

Depreciation and amortization 414 393 21 5.3 %

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

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

Advertising 221 221 — — %

Other expense 1,841 2,250 (409) (18.2) %

Total other non-interest expense 2,062 2,471 (409) (16.6) %

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

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 %

Occupancy and equipment 5,739 5,373 366 6.8 %

Data processing 1,045 1,080 1,277 (35) (3.2) % (232) (18.2) %

Professional services 2,314 4,321 (2,007) (46.4) %

Information technology 1,519 1,105 414 37.5 %

Depreciation and amortization 882 581 452 301 51.8 % 430 95.1 %

Information technology 370 678 478 (308) (45.4) % (108) (22.6) %

Amortization of core deposit intangible 345 365 380 (20) (5.5) % (35) (9.2) %

Federal Deposit Insurance Corporation insurance 886 597 289 48.4 %

Directors' expense 321 269 311 52 19.3 % 10 3.2 %

Federal Deposit Insurance Corporation insurance 289 293 290 (4) (1.4) % (1) (0.3) %

Charitable contributions 49 104 45 (55) (52.9) % 4 8.9 %

Other real estate owned 355 — 355 NM

Other real estate owned 4 4 2 — — % 2 100.0 %

Other non-interest expense

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Total non-interest expense $ 19,780 $ 18,310 $ 19,375 $ 1,470 8.0 % $ 405 2.1 %

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.

First Quarter of 2023 Compared to the Fourth Quarter of 2022

Non-interest expense totaled $19.8 million in the first quarter of 2023, compared to $18.3 million in the prior quarter.

The $1.5 million increase from the prior quarter included $417 thousand in adjustments to estimated incentive and supplemental executive retirement plan accruals, and $432 thousand from accelerated amortization and lease costs associated with branch closures.

Other increases to salaries and related benefits included $389 thousand in 401(k) matching contributions, which is typically higher in the first quarter, and $383 thousand of additional salaries, insurance and payroll taxes.

Meaningful decreases in expenses included $343 thousand in information technology and data processing costs due largely to timing of purchases and the renegotiation of our data processing contract.

First Quarter of 2023 Compared to the First Quarter of 2022

Non-interest expense totaled $19.8 million in the first quarter of 2023, compared to $19.4 million in the first quarter of 2022.

The $405 thousand increase from the first quarter of 2022 was primarily related to $646 thousand in accelerated amortization and lease costs for branches closed and a $210 thousand increase in professional services fees from the completion of multiple internal audit and consulting engagements.

These increases were partially offset by $466 thousand in net changes to estimated incentive, vacation and retirement plan accruals included within salaries and related benefits expense and acquisition costs included within data processing expense.

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 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.

The provision for income taxes for the first quarter of 2023 totaled $3.4 million at an effective tax rate of 26.7%, compared to $4.8 million at an effective tax rate of 27.0% in the prior quarter and $3.7 million at an effective tax rate of 26.3% in the same quarter last year.

The decrease in the provision in the first quarter of 2023 reflected lower pre-tax income as compared to the prior quarter and the same quarter a year ago.

The 30 basis point decrease in the effective tax rate in the first quarter of 2023 as compared to the prior quarter was primarily due to higher nontaxable BOLI income in 2023.

The 40 basis point increase in the effective tax rate in the first quarter of 2023 as compared to the same quarter a year ago was primarily due to lower income from tax exempt loans and municipal securities

and a higher level of tax benefits in 2022 from the exercise of stock options and disqualifying dispositions of incentive stock options.

We file a consolidated return in the U.S.

1 unchanged sentence

There were no ongoing federal or state income tax examinations at the issuance of this report.

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

At March 31, 2023, 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 $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 $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.

Total cash, cash equivalents and restricted cash were $38.0 million at March 31, 2023, compared to $45.4 million at December 31, 2022.

The $7.4 million decrease was due primarily to increases in loans and decreases in deposits partially offset by cash flows from investment securities and increased borrowings.

Investment Securities

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.

The investment securities portfolio totaled $1.756 billion at March 31, 2023, a decrease of $18.2 million from December 31, 2022.

The decrease was primarily the result of principal repayments totaling $32.9 million, partially offset by a $16.2 million reduction in pre-tax unrealized losses on available-for-sale investment securities.

The portfolio is comprised of high credit quality investments with average effective durations of approximately 3.8 on available-for-sale securities and 5.9 on held-to-maturity securities.

Both portfolios generate cash flow monthly from interest, principal amortization and payoffs, which supports the Bank's liquidity.

In the first quarter investment cash flows totaled $46.2 million.

See Note 4, Investment Securities, for additional information.

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

The following table summarizes our investment in obligations of state and political subdivisions at March 31, 2023 and December 31, 2022.

March 31, 2023 December 31, 2022

(dollars in thousands) Amortized Cost Fair Value % of Total State and Political Subdivisions Amortized Cost Fair Value % of Total State and Political Subdivisions

2 unchanged sentences

Revenue bonds 3,716 3,085 2.1 3,719 2,987 2.1

Tax allocation bonds — — — 503 510 0.3

Total within California 29,496 24,576 16.5 29,525 23,755 16.5

7 unchanged sentences

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.

5 unchanged sentences

• Credit ratings by major credit rating agencies

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.

Loans and Credit Quality

During the first three months of 2023, loans increased by $19.8 million and totaled $2.112 billion at March 31, 2023, compared to $2.093 billion at December 31, 2023.

Loan originations for the first quarter of 2023 were $44.9 million, compared to $36.1 million for the fourth quarter of 2022 and $49.8 million for the first quarter of 2022.

Loan payoffs were $22.2 million for the first quarter, compared to $55.3 million for the fourth quarter of 2022 and $119.7 million for the first quarter of 2022, which included $70.4 million in PPP loan payoffs.

First quarter 2023 loan payoffs were the lowest first quarter payoffs since 2017 and consisted mainly of a large construction project completed.

The ratio of allowance for credit losses on loans to total loans remained at 1.10% at March 31, 2023 and December 31, 2022.

Net charge-offs for the first quarter of 2023 totaled $3 thousand, compared to net recoveries of $20 thousand for the fourth quarter of 2022 and net recoveries of $9 thousand for the first quarter of 2022.

Non-accrual loans decreased $406 thousand to $2.0 million, or 0.10% of the loan portfolio at March 31, 2023 from $2.4 million, or 0.12% at December 31, 2022.

Non-accrual loans at March 31, 2023 included the addition of six loans totaling $1.4 million in the first quarter, 68% of which were well-secured by commercial real estate, offset by decreases due to payoffs of $1.4 million, upgrades of $413 thousand, and paydowns of $27 thousand.

Over 99% of the non-accrual loans were collateralized by real estate with no expected credit loss as of March 31, 2023.

Accruing loans past due 30 to 89 days totaled $1.2 million at March 31, 2023, compared to $664 thousand at December 31, 2022.

Classified loans with risk ratings of substandard or doubtful totaled $31.0 million at March 31, 2023, compared to $28.1 million at December 31, 2022, increasing primarily due to higher usage of a revolving line of credit already graded substandard.

Other increases included $1.4 million in downgrades, partially offset by $1.7 million in payoffs and paydowns and $314 thousand in upgrades to pass risk rating.

All of the downgrades in the first quarter were for loans that are secured by real estate collateral.

Loans designated special mention, which are not considered adversely classified, increased year-to-date by $2.9 million to $63.1 million at March 31, 2023 from $60.2 million at December 31, 2022.

The increase was largely due to $3.0 million in downgrades from pass risk ratings and balance increases of $550 thousand, which were partially offset by $630 thousand in paydowns and payoffs.

For more information, refer to Note 5, Loans and Allowance for Credit Losses on Loans, to the consolidated financial statements in this Form 10-Q.

Liabilities - Deposits and Borrowings

During the first three months of 2023, total liabilities decreased by $30.3 million to $3.705 billion.

Deposits totaled $3.251 billion at March 31, 2023, a decrease of $322.8 million, compared to $3.573 billion at December 31, 2022.

Federal Home Loan Bank borrowings increased $293.4 million to $405.4 million in the first quarter of 2023.

Up until the regulatory closures of Silicon Valley Bank on March 10, 2023 and Signature Bank on March 12, 2023, deposit fluctuations were fairly consistent with prior years' first quarter customer activity with some additional outflows to alternative investments observed.

In 2022, the Bank maintained excess liquidity in anticipation of planned customer activities and expected outflows from pandemic surge deposits received in 2020 and 2021.

As outflows materialized, our low cost of funds relative to the industry provided an opportunity to balance deposit levels against costs.

Early in the first quarter of 2023, our bankers engaged in discussions with clients about account structure and pricing, which positioned the Bank well to navigate uncertainty in the marketplace later in the quarter.

The Bank experien ced a $203.6 million decline in dep osits between March 10 th and March 31 st .

Of the 100 relationships with the largest net outflows totaling approximat ely $206.4 million, 83% was attributed to normal business activities including vendor payments, taxes, payroll and singular events such as estate settlements and sales of businesses, 14% moved to outside brokerage firms or other financial institutions, and the remaining 3% move d to assets under management of our Wealth Management and Trust Service s department.

From March 31 st

through May 5 th deposits have been relatively stable.

Daily balances have not fluctuated up or down more than 0.70% when compared to total deposits as of March 31 st .

We believe that our customer outreach has been effective, and it has resulted in a 48 basis point increase in the cost of our deposits to 56 basis points in the month of April from 8 basis points in the month of December, as we balanced the level of deposits against cost.

Additionally, we opened over 1,000 accounts in the first quarter with $60 million in new deposits.

Non-interest bearing deposits decreased $202.5 million, money market deposits decreased $78.2 million while time deposits increased $25.0 million in the first three months of 2023.

Non-interest bearing deposits represented 50.3% of total deposits at March 31, 2023, compared to 51.5% at December 31, 2022.

The average cost of deposits was 0.20% in the first quarter of 2023 compared to 0.06% in the same period of 2022.

At March 31, 2023, the Bank had $155.4 million outstanding in overnight borrowings and $250.0 million outstanding in short-term borrowings from the Federal Home Loan Bank at rates of 5.11% and 5.21%, respectively.

This compared to $112.0 million i n overnight borrowings at December 31, 2022 at a rate of 4.65%.

The Bank is actively evaluating strategies for reducing borrowings in the current environment and as market conditions change.

Total immediate contingent funding sources, including unrestricted cash, unencumbered available-for-sale securities, and remaining borrowing capacity was $1.932 billion, or 59% of total deposits a nd 181% of estimated uninsured deposits as of March 31, 2023.

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 September 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 March 31, 2023.

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.

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

Bancorp's tangible common equity to tangible assets was 8.7% at March 31, 2023, compared to 8.2% at December 31, 2022.

The Bank's tangible common equity to tangible assets was 8.3% at March 31, 2023, compared to 8.1% at December 31, 2022 for the Bank.

The pro forma TCE ratio if held-to-maturity securities were treated the same as available-for-sale securities at March 31, 2023 would have been 6.9% (refer to page 41 for a discussion and reconciliation of this non-GAAP financial measure).

Management believes this non-GAAP measure is important because it reflects the level of capital available to withstand drastic changes in market conditions.

Contingent funding sources, such as the Federal Home Loan Bank and the Federal Reserve BTFP facility, ensure that banks have immediate access to liquidity and alleviate the need to sell securities in an unrealized loss position.

The Bancorp’s and Bank’s capital adequacy ratios as of March 31, 2023 and December 31, 2022 are presented in the following tables.

Bancorp Capital Ratios

(dollars in thousands)

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

September 30, 2022 Amount Ratio Amount Ratio Amount Ratio

Actual Adequately Capitalized Threshold 1

Threshold to be a Well Capitalized Bank Holding Company

March 31, 2023 Amount Ratio Amount Ratio Amount Ratio

Total Capital (to risk-weighted assets) $ 438,510 16.15 % $ 285,095 10.50 % $ 271,519 10.00 %

Tier 1 Capital (to risk-weighted assets) $ 414,524 15.27 % $ 230,791 8.50 % $ 217,215 8.00 %

Tier 1 Capital (to average assets) $ 398,412 9.21 % $ 172,967 ≥ 4.00 % $ 216,209 ≥ 5.00 %

Tier 1 Leverage Capital (to average assets) $ 414,524 9.94 % $ 166,844 4.00 % $ 208,555 5.00 %

Common Equity Tier 1 (to risk-weighted assets) $ 414,524 15.27 % $ 190,063 7.00 % $ 176,487 6.50 %

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Tier 1 Capital (to risk-weighted assets) $ 407,912 15.02 % $ 230,778 8.50 % $ 217,203 8.00 %

Tier 1 Capital (to average assets) $ 373,286 8.85 % ≥ $ 168,750 ≥ 4.00 % ≥ $ 210,937 ≥ 5.00 %

Tier 1 Leverage Capital (to average assets) $ 407,912 9.60 % $ 169,948 4.00 % $ 212,435 5.00 %

Common Equity Tier 1 (to risk-weighted assets) $ 407,912 15.02 % $ 190,053 7.00 % $ 176,478 6.50 %

Capital Ratios for the Bank

Bank Capital Ratios

(dollars in thousands)

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

September 30, 2022 Amount Ratio Amount Ratio Amount Ratio

Actual Adequately Capitalized Threshold 1

Threshold to be Well Capitalized under Prompt Corrective Action Provisions

March 31, 2023 Amount Ratio Amount Ratio Amount Ratio

Total Capital (to risk-weighted assets) $ 424,276 15.63 % $ 285,083 10.50 % $ 271,508 10.00 %

Tier 1 Capital (to risk-weighted assets) $ 400,290 14.74 % $ 230,782 8.50 % $ 217,206 8.00 %

Tier 1 Capital (to average assets) $ 389,538 9.01 % $ 172,957 ≥ 4.00 % $ 216,197 ≥ 5.00 %

Tier 1 Leverage Capital (to average assets) $ 400,290 9.60 % $ 166,837 4.00 % $ 208,546 5.00 %

Common Equity Tier 1 (to risk-weighted assets) $ 400,290 14.74 % $ 190,056 7.00 % $ 176,480 6.50 %

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Tier 1 Capital (to risk-weighted assets) $ 403,352 14.86 % $ 230,757 8.50 % $ 217,183 8.00 %

Tier 1 Capital (to average assets) $ 367,109 8.70 % ≥ $ 168,724 ≥ 4.00 % ≥ $ 210,905 ≥ 5.00 %

Tier 1 Leverage Capital (to average assets) $ 403,352 9.49 % $ 169,940 4.00 % $ 212,425 5.00 %

Common Equity Tier 1 (to risk-weighted assets) $ 403,352 14.86 % $ 190,035 7.00 % $ 176,461 6.50 %

1 Except for Tier 1 Leverage Capital, the adequately capitalized thresholds reflect the regulatory minimum plus a 2.5% capital conservation buffer as required under the Basel III Capital Standards in order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses.

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.

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 seen in the table below and discussed in Note 6 to the Consolidated Financial Statements in ITEM 1 of this report.

The Bank has long-established minimum liquidity and diversification requirements using tools similar to larger banks such as the Liquidity Coverage Ratio and multi-scenario, long-horizon stress testing.

Our c on tingency funding plan provides for 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 $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 maintained $2.2 million in one-way-sale deposits off-balance sheet with deposit networks at March 31, 2023 and December 31, 2022.

In February 2023, we enhanced our borrowing capacity at the FHLB by pledging certain held-to-maturity securities to the Securities-Backed Credit Program.

In addition, under the Federal Reserve’s new BTFP facility, we added $283.6 million to our borrowing capacity.

Net available contingent funding sources, including unrestricted cash, unencumbered available-for-sale securities and total available borrowing capacity was $1.932 billion, or 181% of estimated uninsured deposits as of March 31, 2023.

The Federal Reserve BTFP facility offers borrowing capacity

based on par values of securities pledged and attractive borrowing rates.

While the Bank has pledged securities and tested the facility, there has been no need to use it.

The following table details the components of liquidity as of March 31, 2023.

(in thousands) Total Available Amount Used Net Availability

Internal Sources

Unrestricted cash $ 37,993 N/A $ 37,993

Unencumbered securities at market value 767,724 N/A 767,724

External Sources

FHLB line of credit 1,037,158 $ (405,400) 631,758

FRB line of credit and BTFP facility

344,181 — 344,181

Lines of credit at correspondent banks 150,000 — 150,000

Total Liquidity $ 2,337,056 $ (405,400) $ 1,931,656

Access to brokered deposit purchases through networks such as Intrafi and Reich & Tang and brokered CD sales is not included above.

We obtain funds from the repayment and maturity of loans, deposit inflows, investment security maturities and paydowns, federal funds purchases, FHLB advances, other borrowings, and cash flow from operations.

Our primary uses of funds are the origination of loans, the purchase of investment securities, withdrawals of deposits, maturity of certificates of deposit, repayment of borrowings, and dividends to common stockholders.

T he most significant component of our daily liquidity position is customer deposits.

The attraction and retention of new deposits depends upon the variety and effectiveness of our customer account products, service and

convenience, rates paid to customers, and our financial strength.

Customer deposits are a significant component of our daily liquidity position.

The attraction and retention of new deposits depends upon the variety and effectiveness of our customer account products, service and convenience, rates paid to customers, and our financial strength.

The cash cycles and unique business activities of some of our large commercial depositors may cause short-term fluctuations in their deposit balances held with us.

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.

Our cash and cash equivalents decreased $7.4 million in the first three months of 2023.

Significant uses of liquidity during 2023 were $322.8 million in withdrawals of deposits, $19.1 million in loan originations and advances, net of principal collected, and $4.0 million in cash dividends paid on common stock to our shareholders.

The most significant sources of liquidity during the first three months of 2023 were increased Federal Home Loan Bank borrowings of $293.4 million, proceeds from principal paydowns of investment securities of $32.9 million, and $13.4 million in net cash provided by operating activities.

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 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.

Management anticipates that our current strong liquidity position as detailed in the table above is adequate to fund our operations.

Undrawn credit commitments, as discussed in Note 8 to the Consolidated Financial Statements in this Form 10-Q, totaled $529.5 million at March 31, 2023.

We expect to fund these commitments to the extent utilized primarily through the repayment of existing loans, principal paydowns of investment securities, and liquid assets.

Over the next twelve months, $112.0 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 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.

Our emphasis on local deposits, combined with our immediately available funding sources, provides a very stable base for our liquidity needs.

We had borrowings under our credit facilities of $405.4 million at March 31, 2023, and $112.0 million at December 31, 2022, as discussed in Note 6 to the Consolidated Financial Statements in ITEM 1 of this report.

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 $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.

Bancorp held $14.1 million in cash at March 31, 2023, which is expected to be sufficient to cover Bancorp's operational needs and cash dividends to shareholders through 2023.

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.

Statement Regarding use of Non-GAAP Financial Measures

Our first quarter 2022 was impacted by costs associated with our acquisition of American River Bank ("ARB"), which we considered immaterial to discuss in this release.

For additional information regarding the impact of non-GAAP adjustments to our first quarter 2022 performance measures, refer to Form 10-Q filed on May 9, 2022.

In this Form 10-Q, financial results are presented in accordance with GAAP and with reference to certain non-GAAP financial measures.

Management believes that, given recent industry turmoil, the presentation of Bancorp's non-GAAP TCE ratio reflecting the after tax impact of unrealized losses on HTM securities provides useful supplemental information to investors because it reflects the level of capital available to withstand drastic changes in market conditions.

Because there are limits to the usefulness of this measure to investors, Bancorp encourages readers to consider its annual and quarterly consolidated financial statements and notes related thereto in their entirety, as filed with the Securities and Exchange Commission, and not to rely on any single financial measure.

A reconciliation of the non-GAAP TCE ratio is presented below.

Reconciliation of GAAP and Non-GAAP Financial Measures

(in thousands, unaudited) March 31, 2023

Tangible Common Equity - Bancorp

Total stockholders' equity $ 430,174

Goodwill and core deposit intangible (77,525)

Total TCE a 352,649

Unrealized losses on HTM securities, net of tax 1

TCE, net of unrealized losses on HTM securities (non-GAAP) b $ 276,271

Total assets $ 4,135,279

Goodwill and core deposit intangible (77,525)

Total tangible assets d 4,057,754

Unrealized losses on HTM securities, net of tax 1

Total tangible assets, net of unrealized losses on HTM securities (non-GAAP) e $ 3,981,376

Bancorp TCE ratio a / d 8.7 %

Bancorp TCE ratio, net of unrealized losses on HTM securities (non-GAAP) b / e 6.9 %

1 Net unrealized losses on held-to-maturity securities as of March 31, 2023 of $108.4 million, as shown in Note 4, net of an estimated $32.0 million in deferred tax benefits based on a blended state and federal statutory tax rate of 29.56%.

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