Bank of Marin Bancorp 10-Q

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Management's discussion of the financial condition and results of operations, which is unaudited, should be read in conjunction with the related consolidated financial statements in this Form 10-Q and with the audited consolidated financial statements and accompanying notes included in our 2022 Annual Report on Form 10-K. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances. Forward-Looking Statements This discussion of financial results includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, (the "1933 Act") and Section 21E of the Securities Exchange Act of 1934, as amended, (the "1934 Act"). Those sections of the 1933 Act and 1934 Act provide a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about their financial performance so long as they provide meaningful, cautionary statements identifying important factors that could cause actual results to differ significantly from projected results. Our forward-looking statements include descriptions of plans or objectives of management for future operations, products or services, and forecasts of revenues, earnings or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include the words "believe," "expect," "intend," "estimate" or words of similar meaning, or future or conditional verbs preceded by "will," "would," "should," "could" or "may." Forward-looking statements are based on management's current expectations regarding economic, legislative, and regulatory issues that may impact Bancorp's earnings in future periods. Factors that could cause future results to vary materially from current management expectations include, but are not limited to, general economic conditions and the economic uncertainty in the United States and abroad, including economic or other disruptions to financial markets caused by acts of terrorism, war or other conflicts such as Russia's military action in Ukraine, impacts from inflation, supply change disruptions, changes in interest rates (including the actions taken by the Federal Reserve to control inflation), California's unemployment rate, deposit flows, real estate values, and expected future cash flows on loans and securities; 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; competition; changes in accounting principles, policies or guidelines; changes in legislation or regulation; natural disasters (such as wildfires and earthquakes in our area); adverse weather conditions; interruptions of utility service in our markets for sustained periods; and other economic, competitive, governmental, regulatory and technological factors (including external fraud and cybersecurity threats) affecting our operations, pricing, products and services; and successful integration of acquisitions. Important factors that could cause results or performance to materially differ from those expressed in our prior forward-looking statements are detailed in ITEM 1A, Risk Factors section of our 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. We do not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events. Critical Accounting Estimates Critical accounting estimates are those estimates made in accordance with generally accepted accounting principles that involve a significant level of estimation and uncertainty and have had or are reasonably likely to have a material impact on our financial condition and results of operations. We consider accounting estimates to be critical to our financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain, (ii) management could have applied different assumptions during the reported period, and (iii) changes in the accounting estimate are reasonably likely to occur in the future and could have a material impact on our financial statements. Our critical estimates include: Allowance for Credit Losses on Loans and Unfunded Commitments, Income Taxes, 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. Page-29 Executive Summary 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: • 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 Page-30 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 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. Page-31 RESULTS OF OPERATIONS Highlights of the financial results are presented in the following tables: Three months ended (dollars in thousands, except per share data) March 31, 2023 December 31, 2022 March 31, 2022 Selected operating data: Net interest income $ 29,899 $ 33,370 $ 29,898 Provision for (reversal of) credit losses on loans 350 — (485) Reversal of credit losses on unfunded loan commitments (174) — (318) Non-interest income 2,935 2,587 2,867 Non-interest expense 19,780 18,310 19,375 Net income 9,440 12,881 10,465 Net income per common share: Basic $ 0.59 $ 0.81 $ 0.66 Diluted $ 0.59 $ 0.81 $ 0.66 Performance and other financial ratios: Return on average assets 0.92 % 1.21 % 0.98 % Return on average equity 9.12 % 12.77 % 9.61 % Tax-equivalent net interest margin 3.04 % 3.26 % 2.96 % Cost of deposits 0.20 % 0.08 % 0.06 % Efficiency ratio 60.24 % 50.92 % 59.13 % Net (recoveries) charge-offs $ 3 $ (20) $ (9) Cash dividend payout ratio on common stock 1 42.37 % 30.86 % 36.36 % (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 Short-term borrowings and other obligations 405,802 112,439 Stockholders' equity 430,174 412,092 Book value per share 26.71 25.71 Asset quality ratios: Allowance for credit losses on loans to total loans 1.10 % 1.10 % Allowance for credit losses on loans to non-performing loans 11.52x 9.45x Non-accrual loans to total loans 0.10 % 0.12 % Capital ratios: Equity to total assets ratio 10.40 % 9.94 % Tangible common equity to tangible assets 8.69 % 8.21 % Total capital (to risk-weighted assets) 16.15 % 15.90 % Tier 1 capital (to risk-weighted assets) 15.27 % 15.02 % Tier 1 capital (to average assets) 9.94 % 9.60 % Common equity Tier 1 capital (to risk weighted assets) 15.27 % 15.02 % 1 Calculated as dividends on common shares divided by basic net income per common share. Page-32 Net Interest Income 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. Interest rate changes can create fluctuations in the net interest income and/or margin due to an imbalance in the timing of repricing and maturity of assets and liabilities. We manage interest rate risk exposure with the goal of minimizing the impact of interest rate volatility on net interest income. For more information, refer to Item 3. Quantitative and Qualitative Disclosure about Market Risk in this Form 10-Q. Net interest margin is expressed as net interest income divided by average interest-earning assets. Net interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate incurred on total interest-bearing liabilities. Both of these measures are reported on a taxable-equivalent basis. Net interest margin is the higher of the two because it reflects interest income earned on assets funded with non-interest-bearing sources of funds, which include demand deposits and stockholders’ equity. Average Statements of Condition and Analysis of Net Interest Income The following table compares interest income, average interest-earning assets, interest expense, and average interest-bearing liabilities for the periods presented. The table also presents net interest income, net interest margin and net interest rate spread for each period reported. Three months ended Three months ended Three months ended March 31, 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 Assets Interest-earning deposits with banks 1 $ 4,863 $ 56 4.58 % $ 61,878 $ 575 3.64 % $ 231,555 $ 106 0.18 % Investment securities 2, 3 1,851,743 10,194 2.20 % 1,873,028 10,319 2.20 % 1,626,537 6,871 1.69 % Loans 1, 3, 4 2,121,718 24,415 4.60 % 2,113,201 23,670 4.38 % 2,227,495 23,881 4.29 % Total interest-earning assets 1 3,978,324 34,665 3.49 % 4,048,107 34,564 3.34 % 4,085,587 30,858 3.02 % Cash and non-interest-bearing due from banks 39,826 44,480 69,019 Bank premises and equipment, net 8,396 7,933 7,430 Interest receivable and other assets, net 137,114 125,483 183,222 Total assets $ 4,163,660 $ 4,226,003 $ 4,345,258 Liabilities and Stockholders' Equity Interest-bearing transaction accounts $ 272,353 $ 254 0.38 % $ 290,064 $ 191 0.26 % $ 295,183 $ 56 0.08 % Savings accounts 329,299 170 0.21 % 338,760 32 0.04 % 343,327 29 0.03 % Money market accounts 952,479 1,085 0.46 % 1,036,932 405 0.15 % 1,122,215 478 0.17 % Time accounts including CDARS 126,030 223 0.72 % 127,906 114 0.35 % 147,707 14 0.04 % Short-term borrowings and other obligations 1 222,571 2,716 4.88 % 8,014 89 4.34 % 399 1 0.62 % Total interest-bearing liabilities 1,902,732 4,448 0.95 % 1,801,676 831 0.18 % 1,908,831 578 0.12 % Demand accounts 1,792,998 1,975,390 1,942,804 Interest payable and other liabilities 48,233 48,592 51,997 Stockholders' equity 419,697 400,345 441,626 Total liabilities & stockholders' equity $ 4,163,660 $ 4,226,003 $ 4,345,258 Tax-equivalent net interest income/margin 1 $ 30,217 3.04 % $ 33,733 3.26 % $ 30,280 2.96 % Reported net interest income/margin 1 $ 29,899 3.01 % $ 33,370 3.23 % $ 29,898 2.93 % Tax-equivalent net interest rate spread 2.54 % 3.16 % 2.90 % 1 Interest income/expense is divided by actual number of days in the period times 360 days to correspond to stated interest rate terms, where applicable. 2 Yields on available-for-sale securities are calculated based on amortized cost balances rather than fair value, as changes in fair value are reflected as a component of stockholders' equity. Investment security interest is earned on 30/360 day basis monthly. 3 Yields and interest income on tax-exempt securities and loans are presented on a taxable-equivalent basis using the Federal statutory rate of 21 percent in 2023 and 2022. 4 Average balances on loans outstanding include non-performing loans. The amortized portion of net loan origination fees is included in interest income on loans, representing an adjustment to the yield. 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 Page-33 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 Interest-earning deposits with banks $ (530) $ 153 $ (142) $ (519) $ (105) $ 2,559 $ (2,504) $ (50) Investment securities 1 (117) (8) — (125) 951 2,083 289 3,323 Loans 1 95 1,187 (537) 745 (1,134) 1,751 (83) 534 Total interest-earning assets (552) 1,332 (679) 101 (288) 6,393 (2,298) 3,807 Interest-bearing transaction accounts (12) 86 (11) 63 (4) 219 (17) 198 Savings accounts (1) 147 (8) 138 (1) 148 (6) 141 Money market accounts (33) 802 (89) 680 (72) 800 (121) 607 Time accounts, including CDARS (2) 117 (6) 109 (2) 247 (36) 209 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 Changes in tax-equivalent net interest income $ (2,887) $ 169 $ (798) $ (3,516) $ (766) $ 4,975 $ (4,272) $ (63) 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%. 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 Market interest rates are, in part, based on the target federal funds interest rate (the interest rate banks charge each other for short-term borrowings) implemented by the Federal Reserve Open Market Committee ("FOMC"). In response to the evolving risks to economic activity 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. See ITEM 3. Quantitative and Qualitative Disclosure about Market Risk for further information. Page-34 Provision for Credit Losses on Loans Management assesses the adequacy of the allowance for credit losses on loans quarterly based on several factors including growth of the loan portfolio, past events, current conditions, and reasonable and supportable forecasts to estimate expected losses over the contractual terms of our loans. The allowance for credit losses on loans is increased by provisions charged to expense and loss recoveries and decreased by loans charged off. The following table shows the activity for the periods presented. Three months ended (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 $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 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 % 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) % 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) % 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 % 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. Page-35 Non-interest Expense The following table details the components of non-interest expense. Three months ended Quarter over quarter Year over year (dollars in thousands) March 31, 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 % Professional services 1,123 985 913 138 14.0 % 210 23.0 % Data processing 1,045 1,080 1,277 (35) (3.2) % (232) (18.2) % 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) % 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 4 4 2 — — % 2 100.0 % Other non-interest expense Advertising 278 281 347 (3) (1.1) % (69) (19.9) % Other expense 1,730 1,986 1,425 (256) (12.9) % 305 21.4 % Total other non-interest expense 2,008 2,267 1,772 (259) (11.4) % 236 13.3 % Total non-interest expense $ 19,780 $ 18,310 $ 19,375 $ 1,470 8.0 % $ 405 2.1 % 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 Income tax provisions reflect accruals for taxes at the applicable rates for federal income tax and California franchise tax based upon reported pre-tax income. Provisions also reflect permanent differences between income for tax and financial reporting purposes (such as earnings on tax exempt loans and municipal securities, BOLI, low-income housing tax credits, and stock-based compensation from the exercise of stock options, disqualifying dispositions of incentive stock options and vesting of restricted stock awards). The provision for income taxes for the first quarter of 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 Page-36 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. Federal tax jurisdiction and a combined return in the State of California tax jurisdiction. There were no ongoing federal or state income tax examinations at the issuance of this report. At March 31, 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 $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 $1.756 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 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 Within California: General obligation bonds $ 25,780 $ 21,491 14.4 % $ 25,806 $ 20,768 14.4 % Revenue bonds 3,716 3,085 2.1 3,719 2,987 2.1 Total within California 29,496 24,576 16.5 29,525 23,755 16.5 Outside California: General obligation bonds 121,571 109,632 67.9 121,908 106,375 68.0 Revenue bonds 27,865 24,608 15.6 27,922 23,752 15.5 Total outside California 149,436 134,240 83.5 149,830 130,127 83.5 Total obligations of state and political subdivisions $ 178,932 $ 158,816 100.0 % $ 179,355 $ 153,882 100.0 % Percent of investment portfolio 9.8 % 9.6 % 9.6 % 9.3 % Of the total investment in obligations of state and political subdivisions, the largest concentrations outside of California are in Texas (39.6%), Washington (14.3%) and Wisconsin (8.9%). 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). Investments in states, municipalities and political subdivisions are subject to an initial pre-purchase credit assessment and ongoing monitoring. Key considerations include: • The soundness of a municipality’s budgetary position and stability of its tax revenues • Debt profile and level of unfunded liabilities, diversity of revenue sources, taxing authority of the issuer • Local demographics/economics including unemployment data, largest taxpayers and local employers, income indices and home values Page-37 • For revenue bonds, the source and strength of revenue for municipal authorities including the obligor’s financial condition and reserve levels, annual debt service and debt coverage ratio, and credit enhancement (such as insurer’s strength and collateral in escrow accounts) • Credit ratings by major credit rating agencies Loans 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 Page-38 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 We are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements as set forth in the following tables can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on our consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and the Bank’s prompt corrective action classification are also subject to qualitative judgments by the regulators about components of capital, risk weightings and other factors. Management reviews capital ratios on a regular basis and produces a five-year capital plan semi-annually to ensure that capital exceeds the prescribed regulatory minimums and is adequate to meet our anticipated future needs. Stress tests are performed on capital ratios and include scenarios such as additional unrealized losses on the investment portfolio, additional deposit growth and potential share repurchases. For all periods presented, the Bank’s ratios exceed the regulatory definition of “well capitalized” under the regulatory framework for prompt corrective action and Bancorp’s ratios exceed the required minimum ratios to be considered a well-capitalized bank holding company. In addition, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action as of 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. 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. Page-39 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 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 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 % December 31, 2022 Total Capital (to risk-weighted assets) $ 431,667 15.90 % $ 285,079 10.50 % $ 271,504 10.00 % Tier 1 Capital (to risk-weighted assets) $ 407,912 15.02 % $ 230,778 8.50 % $ 217,203 8.00 % 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 % Bank Capital Ratios (dollars in thousands) 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 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 % December 31, 2022 Total Capital (to risk-weighted assets) $ 427,108 15.73 % $ 285,052 10.50 % $ 271,478 10.00 % Tier 1 Capital (to risk-weighted assets) $ 403,352 14.86 % $ 230,757 8.50 % $ 217,183 8.00 % 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 seen in the table below and 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. 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 $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 Page-40 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 Note: 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. 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 $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 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 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. Under the California Financial Code, payment of a dividend from the Bank to Bancorp without advance regulatory approval is restricted to the lesser of the Bank’s retained earnings or the amount of the Bank’s net profits from the previous three fiscal years less the amount of dividends paid during that period. The primary uses of funds for Bancorp are shareholder dividends and ordinary operating expenses. Bancorp held $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. Page-41 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 (76,378) 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 (76,378) 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%.