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 unaudited 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 $4.6 million for the second quarter of 2023, compared to $9.4 million for the first quarter of 2023. Diluted earnings per share were $0.28 for the second quarter of 2023, compared to $0.59 for the preceding quarter. Earnings for the first six months of 2023 totaled $14.0 million, compared to $21.5 million in the same period last year. Diluted earnings per share were $0.87 and $1.35 for the first six months of 2023 and 2022, respectively. 2023 earnings presented were impacted by the increased cost of interest bearing deposits catching up to market interest rates and higher average balances on borrowings. The following are highlights of our operating and financial performance for the periods presented. Additional performance details can be found in the pages that follow. • Deposits totaled $3.325 billion as of June 30, 2023, a decrease of $248.1 million from $3.573 billion at December 31, 2022. We are closing the gap on the deposit outflows experienced in the first quarter of 2023. Our deposit franchise exhibited good growth in new and existing relationships in the second quarter of 2023 as a result of our extensive customer outreach, with the addition of over 1,400 new accounts in the quarter and over 2,400 new accounts year-to-date at average rates well below our cost of borrowing. In fact, total deposits increased by $69 million post quarter-end through July 31, 2023, following a $75 million increase in second quarter as previously reported in our earnings release, and were less than $80 million below levels immediately preceding the first quarter bank failures that resulted in industry disruption. • Non-interest bearing deposits made up 47.8% of total deposits at June 30, 2023, compared to 51.5% at December 31, 2022. We have successfully maintained high non-interest bearing deposit balances consistent with pre-pandemic levels, despite market and industry turbulence. Customer participation in the reciprocal deposit network program grew to $421.0 million, bringing estimated FDIC insured and/or collateralized deposits up to 71% of total deposits as of June 30, 2023. Our largest depositor represented 1.3% of total deposits as of June 30, 2023. • Contingent liquidity provided 209% coverage of estimated uninsured and/or uncollateralized deposits at June 30, 2023. The Bank has long followed sound liquidity management practices similar to large banks with robust liquidity requirements and regular liquidity stress testing that have been enhanced subsequent to events of the first quarter. • The credit quality of our loan portfolio remains strong with classified loans at only 1.81% of total loans and manageable delinquencies with no meaningful credit surprises during the first half of the year. Non-accrual loans were 0.10% of total loans as of June 30, 2023, compared to 0.12% at December 31, 2022. We recorded a $500 thousand provision for credit losses on loans in the second quarter, compared to a provision of $350 thousand in the previous quarter. For six months ended June 30, 2023, we recorded a provision for credit losses on loans of $850 thousand, compared to a reversal of $485 thousand for the same period in 2022. • Loan balances of $2.103 billion increased $10.3 million during the six months ended June 30, 2023. Loan originations were $67.7 million and payoffs were $46.8 million for the six months ended June 30, 2023. • The second quarter tax-equivalent net interest margin decreased 59 basis points to 2.45% from 3.04% for the previous quarter due primarily to increased deposit costs and average borrowing balances, partially offset by higher loan yields. The tax-equivalent net interest margin for the first six months of 2023 of 2.74% decreased 27 basis points from 3.01% for the same period in 2022 for the same reasons mentioned above. • Return on average assets ("ROA") was 0.44% for the second quarter of 2023, compared to 0.92% for the first quarter of 2023. Return on average equity ("ROE") was 4.25% for the second quarter of 2023, compared to 9.12% for the prior quarter. ROA was 0.68% for the six months ended June 30, 2023, compared to 1.00% in the same period of the prior year. ROE was 6.65% for the six months ended June 30, 2023, compared to 10.16% in the same period of the prior year. The efficiency ratio for the second quarter of 2023 was 76.91%, compared to 60.24% for the prior quarter. The efficiency ratio was 67.74% for the six months ended June 30, 2023, compared to 57.40% in the same period of the prior year. The sequential declines in ROA and ROE and increase in the efficiency ratio in the first six months of 2023 were due primarily to a $13.8 million increase in interest expense. Page-30 • All capital ratios were above well-capitalized regulatory requirements. The total risk-based capital ratios at June 30, 2023 for Bancorp and the Bank were 16.4% and 16.0%, respectively. Bancorp's tangible common equity to tangible assets ("TCE ratio") was 8.6% at June 30, 2023, compared to 8.2% as of December 31, 2022. As of June 30, 2023, Bancorp's TCE ratio, net of after tax unrealized losses on held-to-maturity securities, was 6.7%, compared to 6.2% at December 31, 2022 (ref er to page 45 for a dis cussion and reconciliation of this non-GAAP financial measure). • On July 12, 2023, the Bank completed the sale of its only other real estate owned property, which was obtained in the 2021 merger with American River Bankshares. After previously recorded write-downs totaling $385 thousand, including $40 thousand in the second quarter of 2023, the Bank realized a negligible gain after sales costs. • On July 7, 2023, the Bank entered into various interest rate swap agreements with notional values totaling $101.8 million to hedge balance sheet interest rate sensitivity and protect selected securities in its available-for-sale portfolio against changes in fair value related to changes in the benchmark interest rate. The interest rate swaps are expected to be immediately accretive to earnings. • In July 2023, the Bank sold $82.7 million of available-for-sale securities for a net loss of $2.8 million. We held the sales proceeds in cash as part of our liquidity strategy. The loss was offset by a $2.8 million gain from the July 13, 2023 sale of our remaining investment in Visa Inc. Class B restricted common stock, which had a zero carrying value. • The Board of Directors declared a cash dividend of $0.25 per share on July 21, 2023, which represents the 73 rd consecutive quarterly dividend paid by Bancorp. The dividend is payable on August 11, 2023, to shareholders of record at the close of business on August 4, 2023. • On July 21, 2023, the Board of Directors approved the adoption of Bancorp's new share repurchase program for up to $25.0 million and expiring on July 31, 2025, replacing the program that expired on July 31, 2023. Page-31 RESULTS OF OPERATIONS Highlights of the financial results are presented in the following tables: Three months ended Six months ended (dollars in thousands, except per share data) June 30, 2023 March 31, 2023 June 30, 2023 June 30, 2022 Selected operating data: Net interest income $ 24,130 $ 29,899 $ 54,029 $ 61,095 Provision for (reversal of) credit losses on loans 500 350 850 (485) Reversal of credit losses on unfunded loan commitments (168) (174) (342) (318) Non-interest income 2,739 2,935 5,674 5,595 Non-interest expense 20,665 19,780 40,445 38,281 Net income 4,551 9,440 13,991 21,531 Net income per common share: Basic $ 0.28 $ 0.59 $ 0.88 $ 1.35 Diluted $ 0.28 $ 0.59 $ 0.87 $ 1.35 Performance and other financial ratios: Return on average assets 0.44 % 0.92 % 0.68 % 1.00 % Return on average equity 4.25 % 9.12 % 6.65 % 10.16 % Tax-equivalent net interest margin 2.45 % 3.04 % 2.74 % 3.01 % Cost of deposits 0.69 % 0.20 % 0.44 % 0.06 % Efficiency ratio 76.91 % 60.24 % 67.74 % 57.40 % Net (recoveries) charge-offs $ (2) $ 3 $ 1 $ (1) Cash dividend payout ratio on common stock 1 89.29 % 42.37 % 56.82 % 35.56 % (dollars in thousands, except per share data) June 30, 2023 December 31, 2022 Selected financial condition data: Total assets $ 4,092,133 $ 4,147,464 Investment securities 1,717,750 1,774,303 Loans, net 2,078,964 2,069,563 Deposits 3,325,212 3,573,348 Short-term borrowings and other obligations 292,572 112,439 Stockholders' equity 423,941 412,092 Book value per share 26.32 25.71 Asset quality ratios: Allowance for credit losses on loans to total loans 1.13 % 1.10 % Allowance for credit losses on loans to non-performing loans 11.28x 9.45x Non-accrual loans to total loans 0.10 % 0.12 % Capital ratios: Equity to total assets ratio 10.36 % 9.94 % Tangible common equity to tangible assets 8.64 % 8.21 % Total capital (to risk-weighted assets) 16.36 % 15.90 % Tier 1 capital (to risk-weighted assets) 15.45 % 15.02 % Tier 1 capital (to average assets) 10.10 % 9.60 % Common equity Tier 1 capital (to risk weighted assets) 15.45 % 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 tables compare interest income, average interest-earning assets, interest expense, and average interest-bearing liabilities for the periods presented. The tables also presents net interest income, net interest margin and net interest rate spread for each period reported. Three months ended Three months ended June 30, 2023 March 31, 2023 Interest Interest Average Income/ Yield/ Average Income/ Yield/ (dollars in thousands) Balance Expense Rate Balance Expense Rate Assets Interest-earning deposits with banks 1 $ 3,578 $ 48 5.35 % $ 4,863 $ 56 4.58 % Investment securities 2, 3 1,819,486 10,103 2.22 % 1,851,743 10,194 2.20 % Loans 1, 3, 4 2,108,260 24,700 4.63 % 2,121,718 24,415 4.60 % Total interest-earning assets 1 3,931,324 34,851 3.51 % 3,978,324 34,665 3.49 % Cash and non-interest-bearing due from banks 38,154 39,826 Bank premises and equipment, net 8,546 8,396 Interest receivable and other assets, net 141,130 137,114 Total assets $ 4,119,154 $ 4,163,660 Liabilities and Stockholders' Equity Interest-bearing transaction accounts $ 232,090 $ 234 0.41 % $ 272,353 $ 254 0.38 % Savings accounts 285,745 146 0.20 % 329,299 170 0.21 % Money market accounts 948,670 4,292 1.81 % 952,479 1,085 0.46 % Time accounts including CDARS 174,471 946 2.18 % 126,030 223 0.72 % Short-term borrowings and other obligations 1 372,308 4,873 5.18 % 222,571 2,716 4.88 % Total interest-bearing liabilities 2,013,284 10,491 2.09 % 1,902,732 4,448 0.95 % Demand accounts 1,627,730 1,792,998 Interest payable and other liabilities 49,116 48,233 Stockholders' equity 429,024 419,697 Total liabilities & stockholders' equity $ 4,119,154 $ 4,163,660 Tax-equivalent net interest income/margin 1 $ 24,360 2.45 % $ 30,217 3.04 % Reported net interest income/margin 1 $ 24,130 2.43 % $ 29,899 3.01 % Tax-equivalent net interest rate spread 1.42 % 2.54 % Page-33 Six months ended Six months ended June 30, 2023 June 30, 2022 Interest Interest Average Income/ Yield/ Average Income/ Yield/ (in thousands) Balance Expense Rate Balance Expense Rate Assets Interest-earning deposits with banks 1 $ 4,217 $ 104 4.91 % $ 163,064 $ 286 0.35 % Investment securities 2, 3 1,835,525 20,297 2.21 % 1,717,624 15,340 1.79 % Loans 1, 3, 4 2,114,952 49,115 4.62 % 2,211,062 47,403 4.26 % Total interest-earning assets 1 3,954,694 69,516 3.50 % 4,091,750 63,029 3.06 % Cash and non-interest-bearing due from banks 38,985 62,679 Bank premises and equipment, net 8,471 7,305 Interest receivable and other assets, net 139,134 167,265 Total assets $ 4,141,284 $ 4,328,999 Liabilities and Stockholders' Equity Interest-bearing transaction accounts $ 252,110 $ 488 0.39 % $ 297,734 $ 109 0.07 % Savings accounts 307,402 316 0.21 % 343,333 61 0.04 % Money market accounts 950,564 5,377 1.14 % 1,099,439 916 0.17 % Time accounts including CDARS 150,384 1,169 1.57 % 146,061 81 0.11 % Short-term borrowings and other obligations 1 297,853 7,589 5.07 % 384 1 0.62 % Total interest-bearing liabilities 1,958,313 14,939 1.54 % 1,886,951 1,168 0.12 % Demand accounts 1,709,907 1,963,832 Interest payable and other liabilities 48,678 50,846 Stockholders' equity 424,386 427,370 Total liabilities & stockholders' equity $ 4,141,284 $ 4,328,999 Tax-equivalent net interest income/margin 1 $ 54,577 2.74 % $ 61,861 3.01 % Reported net interest income/margin 1 $ 54,029 2.72 % $ 61,095 2.97 % Tax-equivalent net interest rate spread 1.96 % 2.94 % 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 decrease in rates multiplied by prior period average balances. Mix variances are attributable to the change in yields or rates multiplied by the change in average balances, including one more day in the three months ended June 30, 2023, compared to March 31, 2023. Three Months Ended June 30, 2023 Compared to Three Months Ended March 31, 2023 Six Months Ended June 30, 2023 Compared to Six Months Ended June 30, 2022 (in thousands) Volume Yield/Rate Mix Total Volume Yield/Rate Mix Total Interest-earning deposits with banks $ (15) $ 9 $ (2) $ (8) $ (280) $ 3,735 $ (3,637) $ (182) Investment securities 1 (178) 88 (1) (91) 1,053 3,653 251 4,957 Loans 1 (155) 170 270 285 (2,061) 3,944 (171) 1,712 Total interest-earning assets (348) 267 267 186 (1,288) 11,332 (3,557) 6,487 Interest-bearing transaction accounts (38) 18 — (20) (17) 467 (71) 379 Savings accounts (22) (4) 2 (24) (6) 292 (31) 255 Money market accounts (4) 3,177 34 3,207 (124) 5,303 (718) 4,461 Time accounts, including CDARS 86 453 184 723 2 1,054 32 1,088 Short-term borrowings and other obligations 1,827 165 165 2,157 775 8 6,805 7,588 Total interest-bearing liabilities 1,849 3,809 385 6,043 630 7,124 6,017 13,771 Changes in tax-equivalent net interest income $ (2,197) $ (3,542) $ (118) $ (5,857) $ (1,918) $ 4,208 $ (9,574) $ (7,284) 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%. Page-34 Second Quarter of 2023 Compared to the First Quarter of 2023 Net interest income totaled $24.1 million in the second quarter of 2023, compared to $29.9 million in the first quarter of 2023. The $5.8 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 2.45% in the second quarter of 2023, compared to 3.04% in the first quarter of 2023. The decline from prior quarter was primarily due to higher deposit and borrowing costs slightly offset by higher yields on loans. Average interest-bearing deposit balances decreased by $39.2 million while the cost increased by 95 basis points. Average borrowing balances increased by $149.7 million and the cost of borrowings increased by 30 basis points. Average loan balances decreased by $13.5 million while the average yield increased by 3 basis points. First Six Months of 2023 Compared to the First Six Months of 2022 Net interest income totaled $54.0 million for the six months ended June 30, 2023, a decrease of $7.1 million, compared to the six months ended June 30, 2022. The decrease was primarily due to higher deposit costs resulting in an incremental $6.2 million in interest expense, and borrowing costs of $7.6 million. These decreases were partially offset by higher average balances and yields on the investment portfolio, generating incremental income of $5.1 million, and higher yields on loans, adding $1.8 million. The tax-equivalent net interest margin was 2.74% in the six months ended June 30, 2023, compared to 3.01% in the same period in the prior year. The decrease was primarily attributed to higher borrowing and deposit costs partially offset by higher yields on investments and loans. Average interest-bearing deposits balances decreased by $226.1 million while the cost increased by 77 basis points, mainly for money market and time deposit account types. Average borrowing balances increased by $297.5 million at an average cost of 4.45%. Average loan balances decreased by $96.1 million while the average yield increased by 36 basis points. 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 seven rate adjustments during 2022, the federal funds target rate increased to a range of 4.25% to 4.50% at year-end 2022. In 2023, on each of February 1 st , March 22 nd , May 3 rd , and July 26 th the FOMC increased the target rate by 25 basis points to a range of 5.25% to 5.50%. 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. Provision for Credit Losses on Loans Management assesses the adequacy of the allowance for credit losses on loans quarterly based on several factors including growth of the loan portfolio, past events, current conditions, and reasonable and supportable forecasts to estimate expected losses over the contractual terms of our loans. The allowance for credit losses on loans is increased by provisions charged to expense and loss recoveries and decreased by loans charged off. The following table shows the activity for the periods presented. Three months ended Six months ended (dollars in thousands) June 30, 2023 March 31, 2023 June 30, 2023 June 30, 2022 Provision for (reversal of) credit losses on loans $ 500 $ 350 $ 850 $ (485) Page-35 We recorded a $500 thousand provision for credit losses on loans in the second quarter. The provision was due primarily to increases in qualitative risk factors from continued negative trends in adversely graded loans and/or collateral values on our non-owner occupied commercial real estate office and multi-family real estate portfolios. These increases were partially offset by the impact of a decrease in loan balances. We recorded a $350 thousand provision for credit losses on loans in the first quarter. The provision was due primarily t o 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 a 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 additio n, the $19.8 million increase in loans contrib uted modestly to the provision in the first quarter. 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 at the time. The reversal of the allowance for credit losses on loans for the six months ended June 30, 2022 primarily resulted from improved unemployment rate 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 (dollars in thousands) June 30, 2023 March 31, 2023 Amount Change Percent Change Wealth Management and Trust Services $ 559 $ 511 $ 48 9.4 % Earnings on bank-owned life insurance, net 362 $ 705 (343) (48.7) % Service charges on deposit accounts 520 533 (13) (2.4) % Debit card interchange fees, net 555 447 108 24.2 % Dividends on Federal Home Loan Bank stock 290 302 (12) (4.0) % Merchant interchange fees, net 127 133 (6) (4.5) % Other income 326 304 22 7.2 % Total non-interest income $ 2,739 $ 2,935 $ (196) (6.7) % Six months ended Amount Change Percent Change (dollars in thousands) June 30, 2023 June 30, 2022 Wealth Management and Trust Services $ 1,070 $ 1,230 $ (160) (13.0) % Earnings on bank-owned life insurance, net 1,067 711 356 50.1 % Service charges on deposit accounts 1,053 953 100 10.5 % Debit card interchange fees, net 1,002 1,036 (34) (3.3) % Dividends on Federal Home Loan Bank stock 592 508 84 16.5 % Merchant interchange fees, net 260 289 (29) (10.0) % Other income 630 868 (238) (27.4) % Total non-interest income $ 5,674 $ 5,595 $ 79 1.4 % Second Quarter of 2023 Compared to the First Quarter of 2023 Non-interest income totaled $2.7 million for the second quarter of 2023, compared to $2.9 million for the prior quarter. The $196 thousand decrease from the prior quarter was primarily related to the recognition of a bank-owned life insurance benefit payment in the prior quarter, partially offset by increases in ATM and debit card interchange fees. First Six Months of 2023 Compared to the First Six Months of 2022 Non-interest income totaled $5.7 million for the six months ended June 30, 2023, compared to $5.6 million for the same period of the prior year. The $79 thousand increase from the prior year period was mostly attributable to the Page-36 higher bank-owned life insurance balances and benefit payments, partially offset by decreases in wealth management and trust services income and other income including one-way deposit and cash management fees. Non-interest Expense The following table details the components of non-interest expense. Three months ended (dollars in thousands) June 30, 2023 March 31, 2023 Amount Change Percent Change Salaries and related benefits $ 11,416 $ 10,930 $ 486 4.4 % Occupancy and equipment 1,980 2,414 (434) (18.0) % Data processing 922 1,045 (123) (11.8) % Professional services 797 1,123 (326) (29.0) % Depreciation and amortization 400 882 (482) (54.6) % Federal Deposit Insurance Corporation insurance 666 289 377 130.4 % Information technology 357 370 (13) (3.5) % Charitable contributions 638 49 589 1,202.0 % Amortization of core deposit intangible 340 345 (5) (1.4) % Directors' expense 300 321 (21) (6.5) % Other real estate owned 44 4 40 1,000.0 % Other non-interest expense Advertising 300 278 22 7.9 % Other expense 2,505 1,730 775 44.8 % Total other non-interest expense 2,805 2,008 797 39.7 % Total non-interest expense $ 20,665 $ 19,780 $ 885 4.5 % Six months ended Amount Change Percent Change (dollars in thousands) June 30, 2023 June 30, 2022 Salaries and related benefits $ 22,346 $ 21,889 $ 457 2.1 % Occupancy and equipment 4,394 3,798 596 15.7 % Data processing 1,967 2,476 (509) (20.6) % Professional services 1,920 1,578 342 21.7 % Depreciation and amortization 1,282 845 437 51.7 % Federal Deposit Insurance Corporation insurance 955 586 369 63.0 % Information technology 727 946 (219) (23.2) % Charitable contributions 687 556 131 23.6 % Amortization of core deposit intangible 685 754 (69) (9.2) % Directors' expense 621 605 16 2.6 % Other real estate owned 48 5 43 NM Other non-interest expense Advertising 578 568 10 1.8 % Other expense 4,235 3,675 560 15.2 % Total other non-interest expense 4,813 4,243 570 13.4 % Total non-interest expense $ 40,445 $ 38,281 $ 2,164 5.7 % NM - Not Meaningful Second Quarter of 2023 Compared to the First Quarter of 2023 Non-interest expense totaled $20.7 million for the three months ended June 30, 2023, compared to $19.8 million for the prior quarter. Th e $885 thousand increase from the prior quarter included $589 thousand in charitable contributions as part of our annual grant program, $486 thousand in salaries and related benefits, which included annual merit increases, and $393 thousand in expenses and fees associated with an increase in our customers' participation in reciprocal deposit networks to bolster their FDIC insured balances. In addition, our FDIC insurance expense increased by $377 thousand as the statutory rates increased uniformly by 2 basis points for all depository institutions effective January 1, 2023 in order to strengthen the FDIC's Deposit Insurance Fund. These and other lesser increases were partially offset by a $482 thousand reduction in depreciation and amortization expense and $434 thousand decrease in occupancy and equipment expense, primarily due to the acceleration of lease-related costs for branches closed in the first quarter. These branch closures also reduced maintenance, janitorial and Page-37 utilities expenses for the quarter. In addition, professional services decreased by $326 thousand, mainly due to timing of audit work performed. First Six Months of 2023 Compared to the First Six Months of 2022 Non-interest expense totaled $40.4 million for the six months ended June 30, 2023 , compared to $38.3 million for the six months ended June 30, 2022, an increase of $2.2 million. The most significant increases over prior year came from occupancy and equipment and depreciation and amortization expenses, which rose $596 thousand and $437 thousand, respectively, from branch closures in the first quarter of 2023. In addition, expenses associated with reciprocal deposits placed into deposit networks included in other expenses increased $497 thousand due to higher average balances and fees. Salaries and related benefits increased by $457 thousand primarily due to regularly scheduled annual merit and other increases and lower deferred origination costs, which were partially offset by an adjustment to our incentive bonus accrual. The FDIC insurance assessment and professional services also increased by $369 thousand and $342 thousand, resp ectively, for the same reasons mentioned above. These increases were partially offset by a $509 thousand decrease in data processing expenses due to our core system contract renegotiation for the current period and because the prior year included data processing expenses largely eliminated after the systems conversion associated with the American River Bankshares merger. In addition, the pre-tax savings in 2023 from the branch closures, net of accelerated costs, are expected to be approximately $470 thousand, and future annual pre-tax savings are expected to be approximately $1.4 million. 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, bank-owned life insurance ("BOLI") income, low-income housing tax credits, and stock-based compensation from the exercise of stock options, disqualifying dispositions of incentive stock options and vesting of restricted stock awards). The provision for income taxes for the second quarter of 2023 totaled $1.3 million at an effective tax rate of 22.5%, compared to $3.4 million at an effective tax rate of 26.7% in the prior quarter. The decrease in the provision for income taxes in the second quarter of 2023 reflected lower pre-tax income. The 420 basis point decrease in the effective tax rate in the second quarter of 2023 was primarily due to the larger proportional effect of permanent tax differences on lower pretax income. This decrease was partially offset by a reduction in the tax-exempt interest exclusion (due to a larger IRC Section 291(e) interest expense disallowance) and lower tax-exempt BOLI income in the second quarter, compared to the prior quarter. The provision for income taxes for the first half of 2023 totaled $4.8 million at an effective tax rate of 25.4%, compared to $7.7 million at an effective tax rate of 26.3% for the first half of 2022. The 90 basis point decrease in the effective tax rate in the first half of 2023, as compared to the same period a year ago, was primarily due the larger proportional effect of permanent tax differences on lower pretax income and higher tax-exempt BOLI income. We file a consolidated return in the U.S. Federal tax jurisdiction and a combined return in the State of California tax jurisdiction. There were no ongoing federal or state income tax examinations at the issuance of this report. At June 30, 2023, neither the Bank nor Bancorp had accruals for interest or penalties related to unrecognized tax benefits. FINANCIAL CONDITION SUMMARY Cash, Cash Equivalents and Restricted Cash Total cash, cash equivalents and restricted cash were $39.7 million at June 30, 2023, compared to $45.4 million at December 31, 2022. The $5.8 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 $1.718 billion at June 30, 2023, a decrease of $56.6 million from $1.774 billion at December 31, 2022. The decrease was primarily the result of principal repayments and maturities totaling Page-38 $58.9 million, partially offset by a $5.3 million decrease in pre-tax unrealized losses on available-for-sale investment securities, along with $2.9 million in net amortization in the first half of 2023. Both the available-for-sale and held-to maturity portfolios are eligible for pledging to either the FHLB or the Federal Reserve as collateral for borrowing. The portfolios are comprised of high credit quality investments with average effective duratio ns of 3.8 on available-for-sale securities and 5.8 on held-to-maturity securities. Both portfolios generate cash inflows monthly from interest, principal amortization and payoffs, which supports the Bank's liquidity . Those cash inflows totaled $82.9 million in the first six months of 2023. Subsequent to quarter end, the Bank sold $82.7 million of available-for-sale securities and recognized a $2.8 million net loss. We held the sales proceeds in cash as part of our liquidity strategy. The net loss was offset with the $2.8 million gain from the July 13, 2023 sale of the Bank's remaining investment in Visa Inc. Class B restricted common stock, which had a zero carrying value. See Note 4, Investment Securities, for additional information. The following table summarizes our investment in obligations of state and political subdivisions at June 30, 2023 and December 31, 2022. June 30, 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 $ 25,755 $ 21,352 14.4 % $ 25,806 $ 20,768 14.4 % Revenue bonds 3,513 2,902 2.0 3,719 2,987 2.1 Total within California 29,268 24,254 16.4 29,525 23,755 16.5 Outside California: General obligation bonds 121,232 107,777 68.0 121,908 106,375 68.0 Revenue bonds 27,808 24,130 15.6 27,922 23,752 15.5 Total outside California 149,040 131,907 83.6 149,830 130,127 83.5 Total obligations of state and political subdivisions $ 178,308 $ 156,161 100.0 % $ 179,355 $ 153,882 100.0 % Percent of investment portfolio 9.7 % 9.5 % 9.6 % 9.3 % Of the total investment in obligations of state and political subdivisions, the largest concentrations outside of California are in Texas (39.7%), 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 • 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 half of 2023, loans increased by $10.3 million and totaled $2.103 billion at June 30, 2023, compared to $2.093 billion at December 31, 2022. Loan originations wer e $67.7 million for the six months ended June 30, 2023, compared to $152.0 million for the first six months of 2022. Excluding PPP loans, payoffs were $45.0 mill ion in the six months ended June 30, 2023, compared to $159.1 million for the same period in 2022. PPP loan payoffs during the six months ended June 30, 2023 and 2022 were $1.8 million and $94.2 million, respectively. In addition, l oan amortization from scheduled repayments totaling $39.9 million was partially offset by a net increase in Page-39 utilization of credit lines of $29.7 million for the six months ended June 30, 2023. Bank of Marin has continued its usual steadfast conservative underwriting practices, and has not changed its credit standards or policies specifically in reaction to the current market conditions. The Bank continues to be focused on achieving risk-adjusted returns. The ratio of allowance for credit losses on loans to total loans was 1.13% at June 30, 2023 compared to 1.10% at December 31, 2022. Non-accrual loans decreased $320 thousand to $2.1 million, or 0.10% of the loan portfolio at June 30, 2023 from $2.4 million, or 0.12% at December 31, 2022. All of the non-accrual loans are collateralized by real estate with no expected credit loss as of June 30, 2023. Accruing loans past due 30 to 89 days totaled $1.0 million at June 30, 2023, compared to $664 thousand at December 31, 2022. Classified loans with risk ratings of substandard or doubtful totaled $38.1 million at June 30, 2023, compared to $28.1 million at December 31, 2022. Increases in 2023 were primarily due to a $5.8 million increase in the usage of a revolving line of credit that was previously downgraded and the addition of eight loans to seven borrowers totaling $7.4 million. Approximately 90% of the additions were comprised of one commercial loan and two non-owner occupied commercial real estate loans. Partially offsetting the additions were $2.3 million in payoffs and paydowns and $939 thousand in upgrades to pass risk rating. Loans designated special mention, which are not considered adversely classified, increased by $26.3 million to $86.5 million at June 30, 2023 from $60.2 million at December 31, 2022. The increase was largely due to $35.9 million in downgrades from pass risk ratings and balance increases of $548 thousand, which were partially offset by $5.9 million in downgrades from special mention to substandard and $4.2 million in paydowns and payoffs. With the heightened market concern about non-owner occupied commercial real estate, and in particular the office portfolios, we are providing the following additional information. Non-owner occupied commercial real estate loans made up 64% of total classified loans as of June 30, 2023, compared to 88% at December 31, 2022 and all are currently paying in accordance with loan terms. We continue to maintain diversity among property types and within our geographic footprint. Specifically, our office 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 annual review period (generally December 2022), 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 totaling $71.4 with an average loan balance of $6.5 million, the average loan-to-value and debt-service coverage ratios were 63% and 1.20x, respectively. 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 six months of 2023, total liabilities decreased by $67.2 million to $3.668 billion. Deposits totaled $3.325 billion at June 30, 2023, a decrease of $248.1 million compared to $3.573 billion at December 31, 2022. Federal Home Loan Bank borrowings increased $180.2 million to $292.2 million at June 30, 2023 from $112.0 million at December 31, 2022. Post quarter end, we reduced borrowings by another $92 million through July 31, 2023 and maintained excess cash, mostly from the sale of available-for-sale securities mentioned above, that is available for further reductions. Non-interest bearing deposits decreased $250.4 million, while money market deposits increased $39.7 million and time deposits increased $84.4 million in the first six months of 2023. There was a small shift in deposit composition in the first half of 2023, droppin g non-interest bearing deposits from 51.5% of total deposits to 47.8%, and raising money markets from 27.7% to 30.9% and time deposits from 3.3% to 6.1%. While there was some runoff in the first quarter attributed to industry disruptions and bank deposits moving to money market funds, the Bank experienced a modest recovery and gained deposit growth momentum in the second quarter. Additionally, the Bank's competitive and balanced approach to relationship management and focused outreach supported the growth adding over 1,400 new accounts during the second quarter, bringing the total to over 2,400 new accounts in 2023 (excluding new reciprocal accounts). Of those, approximately 40% were new relationships to the Bank. The average cost of deposits was 0.44% in the first half of 2023, compared to 0.06% in the same period of 2022. Page-40 At June 30, 2023, the Bank had $292.2 million outstanding in overnight borrowings from the Federal Home Loan Bank at a rate of 5.28%, an increase of $180.2 million, 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 $1.992 billion, or 60% of total deposits a nd 209% of estimated uninsured and/or uncollateralized deposits as of June 30, 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 June 30, 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 TCE ratio was 8.6% at June 30, 2023, compared to 8.2% at December 31, 2022. Bancorp's TCE ratio, net of after tax unrealized losses on held-to-maturity securities, was 6.7%, compared to 6.2% at December 31, 2022. Management believes this non-GAAP measure is important because it reflects the level of capital available to withstand drastic changes in market conditions (ref er to page 45 for a dis cussion and reconciliation of this non-GAAP financial measure). The Bancorp’s and Bank’s capital adequacy ratios as of June 30, 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 June 30, 2023 Amount Ratio Amount Ratio Amount Ratio Total Capital (to risk-weighted assets) $ 440,340 16.36 % $ 282,667 10.50 % $ 269,207 10.00 % Tier 1 Capital (to risk-weighted assets) $ 415,943 15.45 % $ 228,826 8.50 % $ 215,365 8.00 % Tier 1 Leverage Capital (to average assets) $ 415,943 10.10 % $ 164,763 4.00 % $ 205,954 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 415,943 15.45 % $ 188,445 7.00 % $ 174,984 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 % Page-41 Bank Capital Ratios (dollars in thousands) Actual Adequately Capitalized Threshold 1 Threshold to be Well Capitalized under Prompt Corrective Action Provisions June 30, 2023 Amount Ratio Amount Ratio Amount Ratio Total Capital (to risk-weighted assets) $ 430,491 15.99 % $ 282,659 10.50 % $ 269,199 10.00 % Tier 1 Capital (to risk-weighted assets) $ 406,094 15.09 % $ 228,819 8.50 % $ 215,359 8.00 % Tier 1 Leverage Capital (to average assets) $ 406,094 9.86 % $ 164,759 4.00 % $ 205,949 5.00 % Common Equity Tier 1 (to risk-weighted assets) $ 406,094 15.09 % $ 188,439 7.00 % $ 174,979 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 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 off-balance sheet one-way deposit sales with our deposit networks at both June 30, 2023 and December 31, 2022. Net available contingent funding sources, including unrestricted cash, unencumbered available-for-sale securities and total available borrowing capacity was $1.992 billion, or 209% of estimated uninsured and/or uncollateralized deposits as of June 30, 2023. The Federal Reserve's new BTFP facility offers borrowing capacity based on par values of securities pledged making it less sensitive to changes in market rates. The following table details the components of our contingent liquidity sources as of June 30, 2023. (in thousands) Total Available Amount Used Net Availability Internal Sources Unrestricted cash 1 $ 16,705 N/A $ 16,705 Unencumbered securities at market value 761,472 N/A 761,472 External Sources FHLB line of credit 1,033,792 $ (292,200) 741,592 FRB line of credit and BTFP facility 337,047 — 337,047 Lines of credit at correspondent banks 135,000 — 135,000 Total Liquidity $ 2,284,016 $ (292,200) $ 1,991,816 1 Excludes cash items in transit. Note: Brokered deposits available through third party networks are 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, dividends to common stockholders, and operating expenses. Page-42 Customer deposits are a significant component of our daily liquidity position. The attraction and retention of new deposits depend 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 $5.8 million in the first half of 2023. Significant uses of liquidity during 2023 were $248.1 million in withdrawals of deposits, $9.3 million in loan originations and advances, net of principal collected, and $8.0 million in cash dividends paid on common stock to our shareholders. The most significant sources of liquidity during the first half of 2023 were increased Federal Home Loan Bank borrowings of $180.2 million, proceeds from principal paydowns and maturities of investment securities of $59.0 million, and $21.5 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 this report, and contingent funding sources outlined in the table above are adequate to support our operational needs. Unfunded loan commitments, as discussed in Note 8 to the Consolidated Financial Statements in this Form 10-Q, totaled $489.6 million at June 30, 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, $179.4 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 $292.2 million at June 30, 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 $9.7 million in cash at June 30, 2023 and 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 half of 2022 was impacted by costs associated with our 2021 acquisition of American River Bankshares, which we considered immaterial to discuss in this report. For additional information regarding the impact of non-GAAP adjustments to our first half of 2022 performance measures, refer to Form 10-Q filed on August 8, 2022. In this report, 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 held-to-maturity 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. Page-43 Reconciliation of GAAP and Non-GAAP Financial Measures (in thousands, unaudited) June 30, 2023 December 31, 2022 Tangible Common Equity - Bancorp Total stockholders' equity $ 423,941 412,092 Goodwill and core deposit intangible (77,185) (77,870) Total TCE a 346,756 334,222 Unrealized losses on HTM securities, net of tax 1 (85,046) (89,432) TCE, net of unrealized losses on HTM securities (non-GAAP) b $ 261,710 244,790 Total assets $ 4,092,133 4,147,464 Goodwill and core deposit intangible (77,185) (77,870) Total tangible assets d 4,014,948 4,069,594 Unrealized losses on HTM securities, net of tax 1 (85,046) (89,432) Total tangible assets, net of unrealized losses on HTM securities (non-GAAP) e $ 3,929,902 3,980,162 Bancorp TCE ratio a / d 8.6 % 8.2 % Bancorp TCE ratio, net of unrealized losses on HTM securities (non-GAAP) b / e 6.7 % 6.2 % 1 Net unrealized losses on held-to-maturity securities as of June 30, 2023 and December 31, 2022 of $120.7 million and $127.0, respectively, as shown in Note 4, net of an estimated $35.7 million and $37.5, respectively, in deferred tax benefits based on a blended state and federal statutory tax rate of 29.56%.