Item 2. Management’s Discussion and Analysis
ITEM 2
MANAGEMENT’S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This Form 10-Q includes forward-looking statements that involve inherent risks and uncertainties. Words such as “expects”, “anticipates”, “believes”, “projects”, and “estimates” or variations of such words and similar expressions are intended to identify forward-looking statements. These statements are based on certain underlying assumptions and are not guarantees of future performance, as they could be impacted by a several potential risks and developments that cannot be predicted with any degree of certainty. Therefore, actual outcomes and results may differ materially from what is expressed, forecast in, or implied by such forward-looking statements.
A variety of factors could have a material adverse impact on the Company’s financial condition or results of operations, and should be considered when evaluating the Company’s potential future financial performance. They include, but are not limited to, the risk of unfavorable economic conditions in the Company’s market areas; risks associated with the current national emergency with respect to COVID-19 including the impact that national, state, and local responses, including shelter-at-home orders and limitations on business and personal activity as well as any stimulus or relief efforts, have on customers’ ability to repay loans or to resume normal payments following the end of COVID-19 related deferrals granted by the Bank; the Company’s delayed implementation of CECL; the ability for the Company to serve its customers with modified branch operations as well as social distancing guidelines and mandates under state and local stay-at-home orders; risks associated with fluctuations in interest rates or a sustained low interest rate environment; liquidity risks; increases in nonperforming assets and credit losses that could occur, particularly in times of weak economic conditions or rising interest rates; reductions in the market value of available-for-sale securities that could result if interest rates increase substantially or an issuer has real or perceived financial difficulties; the Company’s ability to attract and retain skilled employees; the Company’s ability to successfully deploy new technology; the Company’s ability to receive regulatory approval for acquisitions or branch expansion while having a less than satisfactory rating under the Community Reinvestment Act; the success of acquisitions or branch expansion, closure or consolidation; and risks associated with the multitude of current and prospective laws and regulations to which the Company is and will be subject. Risk factors that could cause actual results to differ materially from results that might be implied by forward-looking statements include the risk factors disclosed in the Company’s Form 10-K for the fiscal year ended December 31, 2020 and in Item 1A, herein.
CRITICAL ACCOUNTING POLICIES
The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and incorporate various assumptions that are believed to be reasonable under current circumstances. Actual results may differ from those estimates under divergent conditions.
Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations. In Management’s opinion, the Company’s critical accounting policies deal with the following areas: the establishment of the allowance for loan and lease losses, as explained in detail in Note 11 to the consolidated financial statements and in the “Provision for Loan and Lease Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; the valuation of impaired loans and foreclosed assets, as discussed in Note 11 to the consolidated financial statements; income taxes and related deferred tax assets and liabilities, especially with regard to the ability of the Company to recover deferred tax assets as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; and goodwill and other intangible assets, which are evaluated annually for impairment and for which we have determined that no impairment
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exists, as discussed in the “Other Assets” section of this discussion and analysis. Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate our most recent expectations regarding those areas.
OVERVIEW OF THE RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
RESULTS OF OPERATIONS SUMMARY
First Quarter 2021 compared to First Quarter 2020
First quarter 2021 net income was $11.1 million, or $0.72 per diluted share, compared to $7.8 million, or $0.51 per diluted share in the first quarter of 2020. The Company’s annualized return on average equity was 12.94% and annualized return on average assets was 1.40% for the quarter ended March 31, 2021, compared to 9.97% and 1.23%, respectively, for the same quarter in 2020. The primary drivers behind the variance in first quarter net income are as follows:
● The $4.8 million, or 20%, increase in net interest income is due mostly to a $3.4 million increase in interest income resulting primarily from higher loan volumes as compared to March 31, 2020, accelerated fee income recognition from the forgiveness of SBA PPP loans, partially offset by lower rates. In addition, there was a $1.4 million favorable decline in interest expense due to a higher mix of noninterest bearing deposits and lower rates on the remaining deposits and borrowed funds. The provision for loan & lease losses is $1.6 million lower as a result of higher economic uncertainty as the primary driver for provision, offset by net loan recoveries and lower historical loss rates used in the calculation.
● The $0.7 million, or 12%, favorable increase in noninterest income is due to a $0.4 million favorable change in the annual fair market value adjustment of restricted equity investments, and fluctuations in income on bank- owned life insurance (BOLI) associated with deferred compensation plans. Customer service charges on deposit accounts were lower in the quarterly comparison, but were partially offset by increases in debit card interchange income.
● The efficiency ratio improved to 56.43% from 58.88%. Although there was a $2.5 million increase in noninterest expense, net interest income increased $4.8 million as described above. The largest expense item with an increase was salaries and benefits, with a $1.0 million increase due to lower deferred loan costs and higher bonus expense in the first quarter of 2021 as compared to the same period in 2020.
FINANCIAL CONDITION SUMMARY
March 31, 2021 relative to December 31, 2020
The Company’s assets totaled $3.3 billion at March 31, 2021 relative to $3.2 billion at December 31, 2020. The following provides a summary of key balance sheet changes during the first three months of 2021:
● The Company’s balance of cash and cash equivalents was up by $274.8 million, or 385% from December 31, 2020. The overall increase in cash balances was due primarily to increases in deposit accounts and decreases in loan balances during the first quarter 2021.
● Securities available-for-sale were $552.9 million at March 31, 2021, an increase of $9.0 million, or 2% from December 31, 2020. The Company purchased $45.2 million in various Government Agency sponsored mortgage-backed securities and municipal securities.
● The year-to-date 2021 loan balance decline of $175.2 million, or 7%, was highlighted by declines in outstanding balances on mortgage warehouse lines of $119.7 million, as well as a $19.3 million decline in SBA Paycheck Protection Program (PPP) loans. During the first quarter of 2021 the Bank had $33.2 million in SBA PPP loan originations, but overall SBA balances declined due to SBA forgiveness of $52.8 million in PPP loans during the same period. The remainder of the decline was primarily in real estate secured loans with an increased strategic focus of building our commercial & industrial loans, including owner-occupied CRE loans
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and small business lending. The Company’s regulatory commercial real estate concentration ratio decreased to 352% at March 31, 2021 as compared to 378% at December 31, 2020.
● Deposits increased by $229.3 million, or 9%, in the first quarter of 2021. The growth in deposits came primarily from noninterest bearing or low-cost transaction, and savings accounts, while higher-cost time deposits decreased slightly.
● Short-term borrowings decreased by $125.5 million during the first quarter of 2021 to $56.5 million at March 31, 2021. The decrease was due to a decrease in Federal Home Loan Bank (FHLB) overnight borrowings due to an increase in deposit balances.
● Total shareholders’ equity of $348.0 million at March 31, 2021 reflects an increase of $4.1 million, or 1%, relative to year-end 2020 due to capital from the $11.1 million addition of net income, a $4.1 million unfavorable swing in accumulated other comprehensive income/loss, stock options exercised, restricted stock compensation, net of $3.2 million in dividends paid.
IMPACT OF CORONAVIRUS DISEASE 2019 (COVID-19) PANDEMIC ON THE COMPANY’S OPERATIONS
Overview
On January 31, 2020, the United States Department of Health and Human Services declared a public health emergency with respect to the Coronavirus Disease 2019 (COVID-19). Subsequent to this date, federal, state, and local governmental agencies, regulatory agencies, and the Federal Reserve Board took actions impacting the Company including these more significant items:
● On March 3, 2020, the Federal Open Market Committee (FOMC) of the Federal Reserve Board lowered the federal funds rate by 50 basis points in its first emergency move since October 2008.
● On March 4, 2020, the Governor of the state of California declared a state of emergency to help make additional resources available and formalize emergency actions to address COVID-19.
● On March 6, 2020, the Federal Financial Institutions Examination Council (FFIEC) issued guidance to financial institutions reminding them to include pandemic planning in business continuity plans.
● Starting on March 9, 2020, the Board of Governors of the Federal Reserve System, Consumer Financial Protection Bureau, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency, and Conference of State Bank Supervisors began issuing various Interagency Guidance Statements to encourage financial institutions to meet the financial needs of customers affected by the Coronavirus.
● On March 11, 2020, the World Health Organization declared COVID-19 a pandemic.
● On March 15, 2020, the FOMC of the Federal Reserve Board lowered the federal funds rate by 100 basis points in its second emergency move in two weeks, this time on a Sunday. In addition, the FOMC announced that it would let banks borrow from the discount window for up to 90 days, reduced the reserve requirement ratios to zero percent, united with five other central banks to ensure dollars are available via swap lines, and increased bond holdings by at least $700 billion.
● Effective March 20, 2020, the state of California ordered the closure of all non-essential workplaces, restricting non-essential travel, and ordering a state-wide shelter-in-place order. This was followed by extensions of these orders in April and many local municipalities in which the Company operates issued orders mandating additional requirements to protect their citizens. Although many counties in California began phased reopening
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plans, due to recent increases in cases effective July 13, 2020, the Governor ordered that dine-in restaurants, wineries and tasting rooms, movie theaters, family entertainment centers, zoos and museums, and cardrooms immediately close all indoor operations. Effective August 31, 2020, a new simplified, four-tier guideline was implemented for counties to reopen. Counties must remain in a tier for at least three weeks before moving to the next tier.
● On March 22, 2020, the federal financial institution regulatory agencies (the agencies) issued guidance to financial institutions to suspend the requirements to classify certain loan modifications as troubled debt restructurings (TDRs). The guidance was subsequently modified on April 7, 2020 to conform with Section 4013 of the Coronavirus Aid, Relief and Economic Security (CARES) Act. Further interagency guidance for financial institutions was issued in June, August, and September 2020.
● On March 27, 2020, the CARES Act was enacted by Congress and signed into law by the President to address the impact of the COVID-19 on the economy. Among other things, the CARES Act provided banking institutions with the option of deferring the implementation of the Current Expected Credit Loss (“CECL”) accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-13 and related amendments, Financial Instruments – Credit Losses (Topic 326) until later in 2020; confirmed that certain loan modifications would not be treated as a TDR; authorized the Small Business Administration to create the Paycheck Protection Program (PPP) which allows banking institutions to offer a certain amount of forgivable loans to primarily assist with funding payroll for small businesses; and provides a temporary reduction to the minimum ratio under the Community Bank Leverage Ratio framework.
● On December 21, 2020, the Consolidated Appropriation Act, 2021 was enacted by Congress and signed into law by the President on December 27, 2020. Among other things, this bill provided $600 per person (subject to income limits), included $284 billion in additional forgivable loans via the PPP, extended the suspension of TDR identification, and extended the temporary delay of the implementation of CECL through January 2022.
● On March 10, 2021, the American Rescue Plan Act was enacted by Congress and signed into law by the President on March 11, 2021. Among other things, this bill provided an additional economic impact payment of $1,400 per-person (subject to income limits), and many other economic incentives and benefits to individuals, businesses, states, municipalities, and tribal governments.
● In 2021, COVID-19 vaccinations began rolling out across the country and in California. In early April 2021, with over 20 million vaccines administered in California, a Blueprint for a Safer Economy was announced to fully reopen the California economy on June 15, 2021, subject to certain health requirements, if two criteria are met regarding equitable vaccine availability and a consistently low burden of disease.
Impact of COVID-19 on the Company’s Operations
● The Company had $10.4 million in classified assets at March 31, 2021, from loans modified under the Interagency Guidance or CARES Act, as amended, that are either not expected to make all principal and interest payments in a timely manner, or will need further modifications or assistance. Starting in April 2020, the Company took actions to mitigate the impact on credit losses including permitting short-term payment deferrals to current customers, as well as providing bridge loans and SBA Paycheck Protection Program (PPP) loans. For further information on the principal and interest deferrals, please see the “Nonperforming Assets” section below.
● The uncertainty of national and local economic conditions had an impact on our provision for loan and lease losses in 2020 and continuing into 2021. The Company elected under Section 4014 of the CARES Act to defer the implementation of CECL until the earlier of when the national emergency related to the outbreak of COVID-19 ends or December 31, 2020. In December 2020, the Consolidated Appropriations Act, 2021, extended the deferral of implementation of CECL from December 31, 2020, to the earlier of the first day of the fiscal year, beginning after the national emergency terminates or January 1, 2022. Although this deferral will
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still require CECL to be implemented as of January 1, 2022, the Company believes that the deferral will provide time to better assess the impact of the COVID-19 pandemic on the expected lifetime credit losses in our loan and lease portfolio. The most significant unknown factor is how long economic activity will be impacted by COVID-19, and in turn how deeply that will impact the markets in which we operate. Therefore, more time was needed to assess the impact of this economic uncertainty and related actions taken such as the stimulus provisions of the CARES Act on the Company’s allowance for loan and lease losses under the CECL methodology.
● The Company expects that net interest income will continue to be adversely impacted over time given pressure on net interest margin as a result of the current interest rate environment. As described above, in March 2020, the FOMC cut short-term rates by 150 basis points to near zero. The uncertainty with COVID-19 and the lower targeted fed funds rates also impacted other rates including the Prime Rate and treasury yields. These lower rates impacted our net interest margin. Our net interest margin for the three months ended March 31, 2021, was 3.93%, compared to a net interest margin of 4.13% for the same period in 2020. New loans booked in 2021 have been at lower rates and although deposit costs have also declined, deposit costs were already low or at their floors.
● The COVID-19 pandemic has not adversely affected our capital or financial resources as of March 31, 2021. During the first three months of 2021, total shareholders’ equity increased by $4.1 million, or 1%, to $348.0 million. The Company earned $11.1 million in net income in the first three months of 2021, but had a $4.1 million decrease in accumulated other comprehensive income as a result of decreases in the value of our investment portfolio due to an uptick in interest rates. The Company also paid dividends of $3.2 million during the first quarter of 2021. On April 15, 2021, the Company declared a twenty-one cent per share dividend to be paid on May 12, 2021. Although presently not expected, if the Company were to incur significant credit losses as a result of COVID-19’s impact on our customers’ ability to repay loans, capital could be adversely impacted. With respect to liquidity, the Company maintains strong primary and secondary liquidity sources as further described under “Liquidity and Market Risk Management” below.
● While we do not expect COVID-19 to affect our ability to account timely for the assets on our balance sheet, this could change in future periods. Certain valuation assumptions and judgments continue to change to account for pandemic-related circumstances such as widening credit spreads. However, we do not anticipate any significant changes in methodology used to determine the fair value of assets measured in accordance with GAAP. As of March 31, 2021, our goodwill was not impaired. The Company last performed an assessment of potential impairment to its goodwill at December 31, 2020 and concluded that it was not more likely than not that a goodwill impairment exists. The Company continues to monitor its goodwill recorded on the balance sheet for potential impairment and did not believe there was any event that would trigger a potential impairment in the first quarter of 2021. In the event that we conclude that all or a portion of our goodwill is impaired, a non-cash charge for the amount of such impairment would be recorded to earnings. At March 31, 2021, we had goodwill of $27.4 million which represented 8% of total equity.
● The Company continues to serve its customers. Out of our 40 branch locations, four are open with drive-up only access, and five branches are currently closed except by appointment. Approximately 45% of our back-office and corporate employees are working remotely and it has not adversely affected our operations. In addition, none of our internal controls have changed or are expected to change as a result of the remote work arrangements other than the use of remote approvals. The Company is preparing to bring all the branch locations back to normal operating hours in the next 30 days and is analyzing the return of the corporate office staff over the next 90 days. As a result of a change in customer behaviors brought about by the COVID-19 pandemic along with an efficiency review, the Company has decided to permanently close five branch locations effective June 18, 2021. Many of our customers have found an added convenience and ease of transacting business through online and mobile banking services which precipitated our decision to close locations where in-person transaction volumes no longer warranted a traditional brick-and-mortar branch. The acceleration of leasehold improvements for these locations increased depreciation expense by $0.1 million in the first quarter of 2021 and is expected to increase depreciation expense by an additional $0.4 million in the second quarter of 2021. Further, it is anticipated that there will be additional amortization expense of $0.2 million related to the
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right of use asset from lease cancellations. It is projected that closing these five branch locations will result in annual noninterest expense savings of between $0.8 and $1.0 million.
● To date, the Company did not experience any challenges in implementing its business continuity plans. The Company’s Risk Management team began preparing in early 2020, with ordering of supplies such as hand sanitizer, masks and cleaning supplies, as well as laptops for those who did not have one. This enabled the Company to immediately communicate and implement plans to continue operations in our banking facilities while enabling those non-customer facing employees to immediately begin working remotely. The Company did not face any material resource constraints in implementing these plans.
● As a financial institution providing essential services, the Company expects continued demand for loans and deposits, albeit at a much slower pace than in 2020 for mortgage warehouse utilization and SBA PPP loan demand. In addition, it is expected that the Company’s strategic shift to focus more on loan categories other than non-owner occupied real estate will result in lower overall loan originations in 2021 than in 2020. It is further expected that certain services may see continued declines in demand for certain deposit services, such as debit and credit card interchange, given lower consumer spending.
● The Company loosened its vacation and sick-time policies to accommodate our employees who were affected by COVID-19. The Company has hired an additional 28 temporary employees throughout the pandemic related to higher demand for loan processing and forgiveness, and to provide enhanced customer service. It is expected that the number of temporary employees will begin to decline through the second and third quarters of 2021.
EARNINGS PERFORMANCE
The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on deposits and other borrowed money. The second is noninterest income, which primarily consists of customer service charges and fees but also comes from non-customer sources such as bank-owned life insurance and certain non-debt investments. The majority of the Company’s noninterest expense is comprised of operating costs that facilitate offering a broad range of banking services to our customers.
NET INTEREST INCOME AND NET INTEREST MARGIN
Net interest income increased $4.8 million to $28.6 million, for the first quarter of 2021 over the first quarter of 2020.
For the first quarter of 2021 as compared to the same quarter in 2020, average loan balances increased $658.5 million, primarily due to increases in real estate loans of $484.4 million, mortgage warehouse lines of $98.2 million and SBA PPP loans of $109.7 million contributing to the $4.3 million increase in loan interest income, however the volume increase was offset by lower yields. Overall, there was a decline of 68 bps in loan yield for the quarter ending March 31, 2021 as compared to the same period in 2020. Offsetting declines in yield on earnings assets, there was a 40 bps decrease in the cost of interest-bearing liabilities for the same period.
The level of net interest income we recognize in any given period depends on a combination of factors including the average volume and yield for interest earning assets, the average volume and cost of interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities.
The following tables show average balances for significant balance sheet categories and the amount of interest income or interest expense associated with each category for the noted periods. The tables also display calculated yields on each major component of the Company’s investment and loan portfolios, average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin for the noted periods .
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Average Balances and Rates
(dollars in thousands, unaudited)
For the three months ended
For the three months ended
March 31, 2021
March 31, 2020
Assets
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Investments:
Federal funds sold/due from time
$
76,504
$
19
0.10%
$
37,124
$
140
1.52%
Taxable
317,254
1,578
2.02%
408,841
2,460
2.42%
Non-taxable
226,838
1,449
3.28%
195,440
1,339
3.48%
Total investments
620,596
3,046
2.24%
641,405
3,939
2.69%
Loans and leases: (3)
Real estate
1,879,359
21,391
4.62%
1,394,911
18,723
5.40%
Agricultural
46,153
419
3.68%
48,532
583
4.83%
Commercial
191,656
2,451
5.19%
107,696
1,096
4.10%
Consumer
5,422
196
14.66%
7,583
368
19.52%
Mortgage warehouse lines
242,865
1,928
3.22%
144,621
1,264
3.52%
Other
1,588
27
6.90%
5,242
78
5.98%
Total loans and leases
2,367,043
26,412
4.53%
1,708,585
22,112
5.21%
Total interest earning assets (4)
2,987,639
29,458
4.05%
2,349,990
26,051
4.52%
Other earning assets
13,275
12,841
Non-earning assets
201,114
196,906
Total assets
$
3,202,028
$
2,559,737
Liabilities and shareholders' equity
Interest bearing deposits:
Demand deposits
$
130,763
$
73
0.23%
$
88,731
$
62
0.28%
NOW
569,171
101
0.07%
456,586
122
0.11%
Savings accounts
391,091
53
0.05%
297,721
73
0.10%
Money market
136,422
30
0.09%
117,249
43
0.15%
Certificates of deposit, under $100,000
72,147
51
0.29%
80,852
134
0.67%
Certificates of deposit, $100,000 or more
340,269
238
0.28%
379,699
1,233
1.31%
Brokered deposits
100,000
62
0.25%
40,824
167
1.65%
Total interest bearing deposits
1,739,863
608
0.14%
1,461,662
1,834
0.50%
Borrowed funds:
Federal funds purchased
5,822
1
0.07%
4
—
—
Repurchase agreements
46,097
45
0.40%
27,482
27
0.40%
Short term borrowings
11,530
2
0.07%
5,946
9
0.61%
TRUPS
35,141
247
2.85%
34,962
394
4.53%
Total borrowed funds
98,590
295
1.21%
68,394
430
2.53%
Total interest bearing liabilities
1,838,453
903
0.20%
1,530,056
2,264
0.60%
Demand deposits - noninterest bearing
977,137
678,592
Other liabilities
39,199
36,220
Shareholders' equity
347,239
314,869
Total liabilities and shareholders' equity
$
3,202,028
$
2,559,737
Interest income/interest earning assets
4.05%
4.52%
Interest expense/interest earning assets
0.12%
0.39%
Net interest income and margin (5)
$
28,555
3.93%
$
23,787
4.13%
(1) Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.
(2) Yields and net interest margin have been computed on a tax equivalent basis utilizing a 21% effective tax rate.
(3) Loans are gross of the allowance for possible loan losses. Loan fees have been included in the calculation of interest income. Net loan fees and loan acquisition FMV amortization were $1.4 million and $(0.1) million for the quarters ended March 31, 2021 and 2020, respectively.
(4) Non-accrual loans have been included in total loans for purposes of computing total earning assets.
(5) Net interest margin represents net interest income as a percentage of average interest earning assets.
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The Volume and Rate Variances table below sets forth the dollar difference for the comparative periods in interest earned or paid for each major category of interest earning assets and interest-bearing liabilities, and the amount of such change attributable to fluctuations in average balances (volume) or differences in average interest rates. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates, and rate variances are equal to the change in rates multiplied by prior period average balances. Variances attributable to both rate and volume changes, calculated by multiplying the change in rates by the change in average balances, have been allocated to the rate variance.
Volume & Rate Variances
(dollars in thousands, unaudited)
Three months ended March 31,
2021 over 2020
Increase (decrease) due to
Assets:
Volume
Rate
Net
Investments:
Federal funds sold/due from time
$
149
$
(270)
$
(121)
Taxable
(551)
(331)
(882)
Non-taxable
215
(105)
110
Total investments
(187)
(706)
(893)
Loans and leases:
Real estate
6,502
(3,834)
2,668
Agricultural
(29)
(135)
(164)
Commercial
854
501
1,355
Consumer
(105)
(67)
(172)
Mortgage warehouse
859
(195)
664
Other
(54)
3
(51)
Total loans and leases
8,027
(3,727)
4,300
Total interest earning assets
$
7,840
$
(4,433)
$
3,407
Liabilities
Interest bearing deposits:
Demand deposits
$
29
(18)
$
11
NOW
30
(51)
(21)
Savings accounts
23
(43)
(20)
Money market
7
(20)
(13)
Certificates of deposit, under $100,000
(14)
(69)
(83)
Certificates of deposit, $100,000 or more
(128)
(867)
(995)
Brokered deposits
242
(347)
(105)
Total interest bearing deposits
189
(1,415)
(1,226)
Borrowed funds:
Repurchase agreements
18
—
18
Short term borrowings
8
(15)
(7)
TRUPS
2
(149)
(147)
Total borrowed funds
28
(163)
(135)
Total interest bearing liabilities
217
(1,578)
(1,361)
Net interest income
$
7,623
$
(2,855)
$
4,768
The volume variance calculated for the first three months of 2021 relative to the first three months of 2020 was a favorable $7.6 million due to higher average balances of interest earning assets, resulting from organic growth in commercial real estate loans, growth in commercial loans due to our participation in the SBA PPP program and higher utilization of mortgage warehouse lines. There was an unfavorable rate variance of $2.9 million for the comparative quarters since the weighted average yield on interest earning assets fell by 47 basis points and the weighted average cost of interest-bearing liabil ities decreased by 40 basis points. The rate variance was negatively impacted by the following factors: rate cuts by the FOMC in March 2020 and resulting lower rates and yields given the uncertainty of the pandemic, new loans and investments having lower yields overall, including an increase in low-yielding SBA PPP loans.
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These negative factors were partially offset by an increase in loans overall as a percent of overall earning assets, as well as lower costs of time-deposits and other interest-bearing liabilities. The average fees on the SBA PPP loans was approximately 5.5%. These fees, net of loan costs, are being accreted over the stated life of the loan (generally two years for PPP loans generated in 2020 and 5 years for PPP loans generated in 2021), net of loan costs. Our customers with an SBA PPP loan are generally eligible to apply for loan forgiveness after 24 weeks. After the 24-week covered period, PPP borrowers have ten months to apply for forgiveness. During this period, payments are not due on the loan. If a loan is forgiven, upon repayment of principal and interest by the SBA, any unaccreted fee income, net of unamortized costs, would be recognized as interest income at such time. The decrease in rate on interest earning assets was less than the net volume/rate decrease in interest bearing liabilities and resulted in a favorable $4.8 million net volume/rate difference. The Company’s net interest margin for the first three months of 2021 was 3.93%, as compared to 4.13% in the first three months of 2020.
As described above, a lower rate environment precipitated by two interest rate cuts by the Federal Open Market Committee totaling 150 bps in March 2020 and other economic uncertainty negatively impacted our yield on existing adjustable and variable rate portfolio loans and created a lower initial interest rate for new loan volumes. At March 31, 2021, approximately 10% of our total portfolio, or $226.2 million, consists of variable rate loans. Of these variable rate loans, approximately $84.1 million have floors that limited the overall reduction in rates. At March 31, 2021, our outstanding fixed rate loans represented 22% of our loan portfolio. The remaining 68% of our loan portfolio at March 31, 2021 consists of adjustable rate loans. However, the majority of these loans (approximately $1.2 billion) will not begin adjusting for at least another 3 years. Approximately $70.1 million of these adjustable rate loans will reprice in the next quarter.
Cash balances have increased on March 31, 2021 as compared to December 31, 2020 due to the increase in deposit balances and lower loan balances in the first quarter of 2021. For the quarterly comparisons, there was an unfavorable net volume rate variance since cash balances earned considerably lower yields than other earning assets.
Overall average investment securities decreased by $60.2 million for the quarter ending March 31, 2021 as compared to March 31, 2020. For the three months ending March 31, 2021 over the same period for 2020, average non-taxable securities increased $31.4 million and taxable securities decreased $91.6 million. The overall investment portfolio had a tax-equivalent yield of 2.66% at March 31, 2021, with an average life of 4.5 years.
Interest expense was $0.9 million in the first quarter of 2021, a decline of $1.4 million, or 60%, compared to the first quarter of 2020. The significant decline in interest expense for the quarterly comparisons is attributable to a favorable shift in deposit mix as average noninterest bearing demand deposits increased $298.5 million in the first quarter of 2021 as compared to the same quarter in 2020. Lower cost transaction, savings and money market accounts increased $267.2 million in the first quarter of 2021 as compared to the same quarter in 2020. The average cost of interest-bearing deposits declined by 36 basis points, or 72%, to 14 basis points for the first quarter of 2021 compared to the first quarter of 2020.
PROVISION FOR LOAN AND LEASE LOSSES
Credit risk is inherent in the business of making loans. The Company sets aside an allowance for loan and lease losses, a contra-asset account, through periodic charges to earnings which are reflected in the income statement as the provision for loan and lease losses. The Company recorded a loan loss provision of $0.3 million in the first quarter of 2021 compared to $1.8 million in the first quarter of 2020. The decrease in provision for loan and lease losses is due to a decrease in loan balances and the receipt of net loan recoveries for the first three months of 2021.
There was no provision for loan and lease losses, or related allowance for loan and leases losses, associated with the SBA PPP loans as those loans carry a full guarantee by the SBA, subject to the financial institution meetings its Bank Secrecy Act obligations and other diligence requirements in making such loans.
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Management also evaluated its qualitative risk factors under our current incurred loss model and adjusted for changes as deemed appropriate in the current environment. These qualitative risk factors accounted for the majority of the provision expense in both the first quarter of 2020 and in the first quarter of 2021.
As described above, the Company was subject to the adoption of the CECL accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-13 and related amendments, Financial Instruments – Credit Losses (Topic 326). However, the Company elected under Section 4014 of the CARES Act to defer the implementation of CECL until the earlier of when the national emergency related to the outbreak of COVID-19 ends or December 31, 2020. The Consolidated Appropriations Act, 2021 extended the deferral of implementation of CECL to the earlier of the first day of the fiscal year, beginning after the national emergency terminates or January 1, 2022. The Company has elected this deferral to provide time to better assess the impact of the COVID-19 pandemic and changing economic forecasts on the expected lifetime credit losses. It is expected that the Company’s Allowance for Credit Loss under CECL will be approximately 50% higher than the current Allowance for Loan and Lease Losses, with the initial adjustment being recorded as an adjustment to equity, as previously disclosed in the Company’s Form 10-K for the fiscal year ended December 31, 2020. If the CECL adjustment is to increase the current Allowance for Loan and Lease Losses by 50% at 1/1/2022, the adjustment to equity will also be adjusted for income taxes, causing a net decrease to equity of approximately $5.8 million to $6.5 million. This adjustment is not expected to immediately impact our regulatory capital ratios given the Interagency Guidance to phase-in the CECL adjustment as adopted in 2020. At this time, the Company is not anticipating any need to raise capital due to the CECL implementation.
The Company has taken actions to mitigate the impact on credit losses including permitting short-term payment deferrals to current customers, as well as providing bridge loans and SBA PPP loans. As described below under Nonperforming Assets, since April 2020, the Company modified approximately $425.9 million of loans under either Section 4013 of the CARES Act or the April 7, 2020 Interagency statement that offered some practical expedients for loan modifications. These modifications generally provided for a six-month deferral of both interest and principal and the vast majority of the customers on deferral resumed making scheduled payments upon the expiration of the deferral. As of March 31, 2021, the Company had $22.4 million in remaining loan modifications; all but two small balance consumer loans are fully secured by real estate. The Company expects that all customers show an ability and willingness to pay full principal and interest upon maturity of their deferment period. These deferrals had an impact on how the Company internally grades its loans and as such had an impact on the overall provision under the incurred loss method. The performance on these loans after the end of the deferral period could impact future provision.
Specifically identifiable and quantifiable loan losses are immediately charged off against the allowance, with subsequent recoveries reflected as an increase to the allowance. The Company recorded net recoveries of $0.3 million in the first quarter of 2021 as compared to net charge-offs of $0.3 million for the comparative period of 2020.
The allowance for loan and lease losses is at a level that, in Management’s judgment, is adequate to absorb probable loan losses related to specifically identified impaired loans as well as probable incurred losses in the remaining loan portfolio.
The Company’s policies for monitoring the adequacy of the allowance, determining loan balances that should be charged off, and other detailed information with regard to changes in the allowance are discussed in Note 11 to the consolidated financial statements, and below, under “Allowance for Loan and Lease Losses.” The process utilized to establish an appropriate allowance for loan and lease losses can result in a high degree of variability in the Company’s loan loss provision, and consequently in our net earnings.
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NONINTEREST INCOME AND NONINTEREST EXPENSE
The following table provides details on the Company’s noninterest income and noninterest expense for the three periods ended March 31, 2021 and 2020:
Noninterest Income/Expense
(dollars in thousands, unaudited)
For the three months ended March 31,
Noninterest income:
2021
% of Total
2020
% of Total
Service charges on deposit accounts
$
2,767
40.51%
$
3,183
52.13%
Other service charges and fees
2,560
37.48%
2,404
39.37%
Net gains on sale of securities available-for-sale
—
—
—
—
Bank-owned life insurance
583
8.54%
38
0.62%
Other
920
13.47%
481
7.88%
Total noninterest income
$
6,830
100.00%
$
6,106
100.00%
As a % of average interest earning assets (1)
0.93%
1.05%
Noninterest expense:
Salaries and employee benefits
$
11,151
55.01%
$
10,172
57.08%
Occupancy costs
Furniture & equipment
452
2.23%
465
2.61%
Premises
2,034
10.04%
1,862
10.44%
Advertising and marketing costs
321
1.58%
601
3.37%
Data processing costs
1,426
7.03%
1,142
6.41%
Deposit services costs
2,068
10.21%
1,797
10.09%
Loan services costs
Loan processing
169
0.83%
171
0.96%
Foreclosed assets
107
0.53%
6
0.03%
Other operating costs
Telephone & data communications
380
1.87%
368
2.07%
Postage & mail
84
0.41%
68
0.38%
Other
462
2.28%
386
2.17%
Professional services costs
Legal & accounting
442
2.18%
328
1.84%
Acquisition costs
—
—
—
—
Other professional service
897
4.43%
247
1.39%
Stationery & supply costs
78
0.38%
115
0.65%
Sundry & tellers
200
0.99%
90
0.51%
Total noninterest expense
$
20,271
100.00%
$
17,818
100.00%
As a % of average interest earning assets (1)
2.75%
3.05%
Efficiency ratio (2)(3)
56.43%
58.88%
(1) Annualized
(2) Tax equivalent
(3) Noninterest expense as a percentage of the sum of net interest income and noninterest income excluding net gains (losses) from securities and bank owned life insurance income.
Noninterest Income:
Total noninterest income reflected an increase of $0.7 million, or 12%, for the quarter ended March 31, 2021 as compared to the same quarter in 2020 due mostly to higher BOLI income and an increase in the other noninterest income category.
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BOLI income increased by $0.5 million as compared to the same quarter of 2020. This BOLI variance was due mostly to fluctuations in underlying values of assets in the specific account BOLI policies that are designed to have similar assets to those in the deferred compensation plans. Thus, the higher values in BOLI policies are offset by higher deferred compensation expense reflected primarily in director fees expense. At March 31, 2021, there was $43.5 million in BOLI policies associated with the deferred compensation plans and $9.8 million in separate account BOLI policies.
Additionally, in the “other” category of noninterest income the Company reflected a $0.4 million increase in the first quarter of 2021 as compared to the first quarter of 2020 the valuation of restricted stock held by the Company as required under FASB ASU 2016-01. This stock is related to an equity investment in Pacific Coast Bankers’ Bank and is adjusted when financial information and an updated valuation report becomes available, generally in the late first quarter of each year.
Offsetting the above increases, there was a $0.4 million decrease in service charges on deposit accounts mostly from lower returned items and overdraft fees for the quarter ending March 31, 2021 over the comparable period in 2020. Customer spending behaviors have changed since the onset of the COVID-19 pandemic, reducing disbursement activity that creates overdrafts. It is unknown how long this trend will continue.
Noninterest Expense:
Total noninterest expense increased by $2.5 million, or 14%, in the first quarter of 2021 relative to the first quarter of 2020. Noninterest expense dropped to 2.8% of average earning assets in the first quarter of 2021 from 3.1% for the first quarter of 2020 and the tax-equivalent efficiency ratio improved to 56.43 % in the first quarter of 2021 as compared to 58.88% in the same quarter of 2020. The efficiency ratio represents total noninterest expense divided by the sum of fully tax-equivalent net interest and noninterest income; the provision for loan losses and investment gains/losses are excluded from the equation. The Company continues to actively consider a wide variety of operational efficiency opportunities, however with softening loan demand and reduced noninterest income further improvement of the efficiency ratio is difficult to predict.
Salaries and Benefits were $1.0 million, or 10%, higher in the first quarter of 2021 as compared to the same quarter in 2020. The reason for the increase is merit increases for employees due to annual performance evaluations for 2021 and the addition of and a focus on hiring higher-level staff and management. Salary expense deferrals related to loan originations were $0.4 million lower in the first quarter of 2021 as compared to the same quarter in 2020.
Occupancy expenses were $0.2 million higher for the first quarter of 2021 as compared to the first quarter of 2020. We experienced higher depreciation expense related to an acceleration of expense associated with the branch closures as described further below. In addition, we incurred higher janitorial costs due to intermittent COVID-19 sanitization of facilities.
Further, other noninterest expense categories were $1.3 million higher for the first quarter 2021 as compared to the first quarter in 2020. The Company experienced increases in every expense category except advertising and marketing. Advertising and marketing declined due to the COVID-19 pandemic as much of our in-person marketing efforts were temporarily suspended. The principal increases were in data processing for $0.3 million due to increased network security and additional software required for the efficient processing of SBA PPP loans, a $0.3 million increase in debit card processing costs, $0.1 million increase in foreclosed asset expenses, an increase in FDIC assessments for $0.2 million, as the first quarter of 2020 included Small Bank Assessment credits applied against the FDIC deposit insurance assessment, a $0.3 million increase in directors deferred compensation expense, which is linked to changes in BOLI income, a $0.1 million increase in debit card losses, and other costs associated with five branch closures scheduled for June 2021 as discussed in the paragraph below.
As a result of an ongoing COVID-19 pandemic, several of our branch lobbies were closed throughout the pandemic. Many of these lobbies have reopened, but a few remain closed. As a result a change in customer behaviors brought about by the COVID-19 pandemic along with an efficiency review, the Company has decided to permanently close five branch locations outside of our primary market area, effective June 18, 2021. Many of our customers have found an added convenience and ease of transacting business through online and mobile banking services which precipitated our
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decision to close locations where in-person transaction volumes no longer warranted a traditional brick-and-mortar branch. The acceleration of amortization of leasehold improvements for these locations increased depreciation expense by $0.1 million in the first quarter of 2021 and is expected to increase depreciation expense by an additional $0.4 million in the second quarter of 2021. Further, it is anticipated that there will be additional lease expense of $0.2 million related to right of use asset due to lease cancellations. It is projected that closing these five branch locations will result in annual noninterest expense savings, realized fully by the end of the fourth quarter 2021, of between $0.8 and $1.0 million.
PROVISION FOR INCOME TAXES
The Company sets aside a provision for income taxes on a monthly basis. The amount of that provision is determined by first applying the Company’s statutory income tax rates to estimated taxable income, which is pre-tax book income adjusted for permanent differences, and then subtracting available tax credits. Permanent differences include but are not limited to tax-exempt interest income, BOLI income, and certain book expenses that are not allowed as tax deductions. Our tax credits consist primarily of those generated by investments in low-income housing tax credit funds. The Company’s provision for income taxes was 25.47% of pre-tax income in the first quarter of 2021 relative to 24.02% in the first quarter of 2020. The increase in the effective tax rate for the first quarter of 2021 is due to tax credits and tax-exempt income representing a smaller percentage of total taxable income.
BALANCE SHEET ANALYSIS
EARNING ASSETS
The Company’s interest earning assets are comprised of loans and investments, including overnight investments and surplus balances held in interest earning accounts in our Federal Reserve Bank account. The composition, growth characteristics, and credit quality of both of those components are significant determinants of the Company’s financial condition. Investments are analyzed in the section immediately below, while the loan and lease portfolio and other factors affecting earning assets are discussed in the sections following investments.
INVESTMENTS
The Company’s investments may at any given time consist of debt securities and marketable equity securities (together, the “investment portfolio”), investments in the time deposits of other banks, surplus interest earning balances in our Federal Reserve Bank account, and overnight fed funds sold. The Company’s investments can serve several purposes, including the following: 1) they can provide liquidity for potential funding needs; 2) they provide a source of pledged assets for securing public deposits, bankruptcy deposits and certain borrowed funds which require collateral; 3) they constitute a large base of assets with structural characteristics that can be changed more readily than loan or deposit portfolios, as might be required for interest rate risk management purposes; 4) they are another interest earning option for the placement of surplus funds when loan demand is light; and 5) they can provide partially tax exempt income.
The investment portfolio is reflected on the balance sheet as investment securities and totaled $552.9 million, or 17% of total assets at March 31, 2021, and $544.0 million, or 17% of total assets at December 31, 2020. In addition, within the Cash and Due from Banks account on the balance sheet was $268.4 million of surplus interest earning balances in our Federal Reserve Bank account at March 31, 2021, as compared to $3.5 million at December 31, 2020. Surplus balances in our Federal Reserve Bank account and fed funds sold to correspondent banks typically represent the temporary investment of excess liquidity.
The Company carries investments at their fair market values. We currently have the intent and ability to hold our investment securities to maturity, but the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management. The expected average life for bonds in
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our investment portfolio was 4.5 years and their average effective duration was 3.0 years at March 31, 2021, up from an expected average life of 4.2 years and an average effective duration of 2.4 years at year-end 2020.
The following table sets forth the amortized cost and fair market value of Company’s investment portfolio by investment type as of the dates noted:
Investment Portfolio
(dollars in thousands, unaudited)
March 31, 2021
December 31, 2020
Amortized
Fair Market
Amortized
Fair Market
Cost
Value
Cost
Value
Available for Sale
U.S. government agencies
$
1,724
$
1,780
$
1,725
$
1,800
Mortgage-backed securities
307,973
316,833
304,108
314,435
State and political subdivisions
222,863
234,318
212,011
227,739
Total securities
$
532,560
$
552,931
$
517,844
$
543,974
The net unrealized gain on our investment portfolio, or the amount by which aggregate fair market values exceeded amortized cost, was $20.4 million at March 31, 2021, a $5.7 million decrease relative to the net unrealized gain of $26.1 million at December 31, 2020. The change was caused by increased long-term market interest rates on fixed-rate bond values. Municipal bond balances comprise 42% of our total securities portfolio at March 31, 2021, as compared to 42% at December 31, 2020. Municipal bonds purchased have strong underlying ratings, and we review all municipal bonds in our portfolio every quarter for potential impairment.
Investment securities that were pledged as collateral for borrowings and/or potential borrowings from the Federal Home Loan Bank and the Federal Reserve Bank, customer repurchase agreements, and other purposes as required or permitted by law totaled $246.7 million at March 31, 2021 and $232.0 million at December 31, 2020, leaving $306.3 million in unpledged debt securities at March 31, 2021 and $312.0 million at December 31, 2020. Securities that were pledged in excess of actual pledging needs and were thus available for liquidity purposes, if needed, totaled $53.8 million at March 31, 2021 and $52.9 million at December 31, 2020.
LOAN AND LEASE PORTFOLIO
A distribution of the Company’s loans showing the balance and percentage of loans by type is presented for the noted periods in the table below. The balances in the table are before deferred or unamortized loan origination, extension, or commitment fees, and deferred origination costs. While not reflected in the loan totals and not currently comprising a material segment of our lending activities, the Company also occasionally originates and sells, or participates out portions of, loans to non-affiliated investors.
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Loan and Lease Distribution
(dollars in thousands, unaudited)
March 31, 2021
December 31, 2020
Real estate:
1-4 family residential construction
$
36,818
$
48,565
Other construction/land
50,433
71,980
1-4 family - closed-end
126,949
139,836
Equity lines
36,276
38,075
Multi-family residential
58,324
61,865
Commercial real estate - owner occupied
359,777
343,199
Commercial real estate - non-owner occupied
1,071,532
1,062,498
Farmland
126,157
129,905
Total real estate
1,866,266
1,895,923
Agricultural
45,476
44,872
Commercial and industrial
183,762
209,048
Mortgage warehouse lines
187,940
307,679
Consumer loans
5,024
5,589
Total loans and leases
$
2,288,468
$
2,463,111
Percentage of Total Loans and Leases
Real estate:
1-4 family residential construction
1.61%
1.97%
Other construction/land
2.20%
2.92%
1-4 family - closed-end
5.55%
5.68%
Equity lines
1.59%
1.55%
Multi-family residential
2.55%
2.51%
Commercial real estate - owner occupied
15.72%
13.93%
Commercial real estate - non-owner occupied
46.82%
43.14%
Farmland
5.51%
5.27%
Total real estate
81.55%
76.97%
Agricultural
1.99%
1.82%
Commercial and industrial
8.03%
8.49%
Mortgage warehouse lines
8.21%
12.49%
Consumer loans
0.22%
0.23%
Total loans and leases
100.00%
100.00%
Gross loans and leases at $2.3 billion, reflected a decrease of $174.6 million, or 7%, at March 31, 2021 from $2.5 billion at December 31, 2020 due mostly to declines in outstanding balances on mortgage warehouse lines, as well as the forgiveness of PPP loans.
Balances on mortgage warehouse lines were down $119.7 million or 39% during the first quarter of 2021, due to seasonal fluctuations and a decline in mortgage refinancing activity. Mortgage warehouse utilization was 51% at March 31, 2021, as compared to 71% at December 31, 2020. Utilization of mortgage warehouse lines in the future could be impacted by fluctuations in interest rates and from economic uncertainty including the impact of the COVID-19 pandemic.
Non-agricultural real estate loan balances decreased due to a deliberate decision to supplement the Company’s core commercial real estate franchise with an increased strategic focus of building our commercial and industrial lending, including loans for owner-occupied commercial real estate and small business.
At March 31, 2021 the Bank’s regulatory credit concentration of commercial real estate loans (CRE), as defined in the Interagency Guidance dated, December 12, 2006, was 352%, down from 378% at December 31, 2020. Management employs heightened risk management practices with respect to CRE lending, including board and management oversight, strategic planning, development and underwriting standards, risk assessment and monitoring through market
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analysis, and stress testing. At March 31, 2021 we have concluded that we have an acceptable and well-managed concentration in CRE lending under the foregoing standards, however, given the current level of CRE, and potential increased regulatory scrutiny it could bring, we are actively monitoring this segment of the loan portfolio.
The 12% decrease in Commercial and Industrial loans from $209.0 million at December 31, 2020 to $183.8 million was primarily driven by loan forgiveness precipitated by the Company’s participation in the Small Business Administration’s PPP as authorized by the CARES Act. The Company began accepting and funding loans under this program in April 2020. There were 1,070 loans for $97.3 million outstanding at March 31, 2021, compared to 1,274 loans for $117.2 million at December 31, 2020. During the first quarter of 2021, the Bank originated, and the SBA approved, funding for $33.2 million in PPP loans while the SBA forgave $52.8 million of PPP loans.
NONPERFORMING ASSETS
Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, in addition to foreclosed assets which is primarily OREO, but can included other foreclosed assets.
If the Company grants a concession to a borrower in financial difficulty, the loan falls into the category of a TDR, unless the modification was granted under section 4016 of the CARES Act or the April 7, 2020 Interagency Statement. TDRs may be classified as either nonperforming or performing loans depending on their underlying characteristics and circumstances. The following table presents comparative data for the Company’s nonperforming assets and performing TDRs as of the dates noted:
Nonperforming assets and performing troubled debt restructurings
(dollars in thousands, unaudited)
March 31, 2021
December 31, 2020
March 31, 2020
NON-ACCRUAL LOANS:
Real estate:
Other construction/land
$
—
$
—
$
10
1-4 family - closed-end
1,530
1,193
866
Equity lines
2,176
2,403
535
Commercial real estate - owner occupied
1,574
1,678
1,941
Commercial real estate - non-owner occupied
563
582
2,608
Farmland
434
442
257
TOTAL REAL ESTATE
6,277
6,298
6,217
Agriculture
466
250
—
Commercial and industrial
1,835
1,026
1,116
Consumer loans
21
24
18
TOTAL NONPERFORMING LOANS
8,599
7,598
7,351
Foreclosed assets
945
971
766
Total nonperforming assets
$
9,544
$
8,569
$
8,117
Performing TDRs (1)
$
10,596
$
11,382
$
8,188
Nonperforming loans as a % of total gross loans and leases
0.38%
0.31%
0.41%
Nonperforming assets as a % of total gross loans and leases and foreclosed assets
0.42%
0.35%
0.45%
(1) Performing TDRs are not included in nonperforming loans above, nor are they included in the numerators used to calculate the ratios disclosed in this table.
Total nonperforming assets increased by $1.0 million, or 11%, during the first three months of 2021. The increase resulted from two loans to one borrower. None of these increases were due to COVID-19. As a result of the decrease in the gross loan portfolio, the Company’s ratio of nonperforming assets to loans increased to 0.42% at March 31, 2021, from 0.35% at December 31, 2020. All of the Company’s impaired assets are periodically reviewed and are either well-
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reserved based on current loss expectations, or are carried at the fair value of the underlying collateral net of expected disposition costs.
As shown in the table, we also had $10.6 million in loans classified as performing TDRs on which we were still accruing interest as of March 31, 2021, a decrease of $0.8 million, or 7%, relative to December 31, 2020.
Foreclosed assets had a carrying value of $0.9 million at March 31, 2021 comprised of 7 properties classified as OREO as compared to 7 properties for $1.0 million at December 31, 2020. All foreclosed assets are periodically evaluated and written down to their fair value less expected disposition costs, if lower than the then-current carrying value.
An action plan is in place for each of our non-accruing loans and foreclosed assets and they are all being actively managed. Collection efforts are continuously pursued for all nonperforming loans, but we cannot provide assurance that they will be resolved in a timely manner or that nonperforming balances will not increase.
The Company had $4.2 million in loans past due 30-59 days at March 31, 2021. This is an increase of $2.1 million over the balance at December 31, 2020. All of these past due loans are under management supervision and every effort is being taken to assist the borrowers and manage credit risk in this regard.
As described above, the Company is providing loan modifications to certain customers and taking advantage of either Section 4013 of the CARES Act or the April 7, 2020 Interagency Statement, which provides that such modifications do not result in treatment of such loan as a TDR. Since April 2020, the Company modified approximately $426 million of its loans under this guidance. For the Company, these modifications typically provided a deferral of both principal and interest for 180 days. Interest continues to accrue during the deferral period. At the end of the deferral period, for term loans, payments will be applied to accrued interest first and after the accrued interest is paid in full, the loan will be re-amortized with the maturity extended. For lines of credit, the borrower must repay the accrued interest at the end of the deferral period or take out a second credit facility to repay the accrued interest. As of March 31, 2021, the Company had $22.4 million remaining in loan modification under Section 4013 of the CARES Act. All but one small consumer relationship are fully secured by real estate collateral. We expect all customers to show an ability and willingness to pay full principal and interest upon maturity of their deferment periods. We monitor these loans during the deferral period and if circumstances change, we may downgrade the loan to a criticized asset. An additional modification, if necessary, could also result in the loan being treated as a TDR or classified asset. If some portion of the customers are not able to resume payments after the deferral period, it likely could result in higher classified and/or nonperforming assets, reversals of interest income, and/or higher charge-offs. At March 31, 2020, approximately $10.4 million of the $22.4 million in outstanding modification already are internally graded as a classified asset.
ALLOWANCE FOR LOAN AND LEASE LOSSES
The allowance for loan and lease losses, a contra-asset, is established through periodic provisions for loan and lease losses. It is maintained at a level that is considered adequate to absorb probable losses on specifically identified impaired loans, as well as probable incurred losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when sufficient cash payments are received subsequent to the charge off.
As described above, the Company elected under Section 4014 of the CARES Act to defer the implementation of CECL until January 1, 2022. The Company made this election as it believed that the deferral provided additional time to better assess the impact of the COVID-19 pandemic and related stimulus and relief efforts on the expected lifetime credit losses.
The Company’s allowance for loan and lease losses was $18.3 million at March 31,2021, an increase of $0.6 million, or 3%, relative to December 31, 2020 resulting from a $0.3 million loan loss provision recorded during the first three months of 2021, plus a $0.3 million in net recoveries during the same period. The loan loss provision in the first three months of 2021 was precipitated primarily by the decrease in loan balances as well as the impact of loan recoveries.
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No allowance for loan and lease losses was considered necessary for the SBA PPP loans as those loans carry a 100 percent guarantee under the “Paycheck Protection Program”, subject to certain diligence requirements by the issuing financial institution. For further information regarding the Company's decision to defer the implementation of CECL under Section 4014 of the CARES Act, as well as further detail on the increase in provision during the first quarter of 2021, please see the discussion above under Provision for Loan and Lease Losses.
The allowance for loan and lease losses was 0.80% of total loans at March 31, 2021, 0.72% at December 31, 2020 and 0.64% at March 31, 2020. The ratio of the allowance for loan and lease losses to nonperforming loans was 213.0% at March 31, 2021, relative to 233.5% at December 31, 2020 and 155.8% for March 31, 2020. Management's detailed analysis indicates that the Company's allowance for loan and lease losses should be sufficient to cover credit losses inherent in loan and lease balances outstanding as of March 31, 2021, but no assurance can be given that the Company will not experience substantial future losses relative to the size of the allowance.
A separate allowance of $0.3 million for potential losses inherent in unused commitments is included in other liabilities at March 31, 2021.
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The following table summarizes activity in the allowance for loan and lease losses for the noted periods:
Allowance for Loan and Lease Losses
(dollars in thousands, unaudited)
For the three
months ended
For the three
months ended
For the year ended
March 31,
March 31,
December 31,
Balances:
2021
2020
2020
Average gross loans and leases outstanding during period (1)
$
2,367,043
$
1,708,585
$
2,068,690
Gross loans and leases outstanding at end of period
$
2,288,468
$
1,798,025
$
2,463,111
Allowance for loan and lease losses:
Balance at beginning of period
$
17,738
$
9,923
$
9,923
Provision charged to expense
250
1,800
8,550
Charge-offs
Real estate
1-4 family residential construction
—
—
—
Other construction/land
—
—
—
1-4 family - closed-end
—
—
—
Equity lines
—
—
—
Multi-family residential
—
—
—
Commercial real estate- owner occupied
233
—
—
Commercial real estate- non-owner occupied
—
—
—
Farmland
—
—
—
Total real estate
233
—
—
Agricultural
—
—
436
Commercial and industrial
52
25
—
Consumer loans
163
617
1,397
Total
$
448
$
642
$
1,833
Recoveries
Real estate
1-4 family residential construction
—
—
—
Other construction/land
218
34
40
1-4 family - closed-end
3
4
13
Equity lines
—
34
34
Multi-family residential
—
—
—
Commercial real estate- owner occupied
233
—
—
Commercial real estate- non-owner occupied
—
—
—
Farmland
—
—
—
Total real estate
454
72
87
Agricultural
—
—
—
Commercial and industrial
110
28
129
Consumer loans
215
272
882
Total
$
779
$
372
$
1,098
Net loan (recoveries) charge offs
$
(331)
$
270
$
735
Balance at end of period
$
18,319
$
11,453
$
17,738
RATIOS
Net (recoveries) charge-offs to average loans and leases (annualized)
(0.06)%
0.06%
0.04%
Allowance for loan losses to gross loans and leases at end of period
0.80%
0.64%
0.72%
Allowance for loan losses to nonperforming loans
213.04%
155.80%
233.46%
Net loan (recoveries) charge-offs to allowance for loan losses at end of period
(1.81)%
2.36%
4.14%
Net loan (recoveries) charge-offs to provision for loan losses
(132.40)%
15.00%
8.60%
(1) Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.
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The Company’s allowance for loan and lease losses at March 31, 2021 represents Management’s best estimate of probable losses in the loan portfolio as of that date, but no assurance can be given that the Company will not experience substantial losses relative to the size of the allowance. Furthermore, fluctuations in credit quality, changes in economic conditions, updated accounting or regulatory requirements, and/or other factors could induce us to augment or reduce the allowance.
OFF-BALANCE SHEET ARRANGEMENTS
The Company maintains commitments to extend credit in the normal course of business, as long as there are no violations of conditions established in the outstanding contractual arrangements. It is unlikely that all unused commitments will ultimately be drawn down. Unused commitments to extend credit, which included standby letters of credit, totaled $485.3 million at March 31, 2021 and $449.9 million at December 31, 2020, representing approximately 21% of gross loans outstanding at March 31, 2021 and 18% at December 31, 2020. The increase in unused commitments is due in large part to the increase in unfunded commitments on mortgage warehouse lines. The Company also had undrawn letters of credit issued to customers totaling $8.4 million at March 31, 2021 and $8.1 million at December 31, 2020. The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of commitments to provide credit cannot be reasonably predicted because there is no guarantee that the lines of credit will ever be used. However, the “Liquidity” section in this Form 10-Q outlines resources available to draw upon should we be required to fund a significant portion of unused commitments.
In addition to unused commitments to provide credit, the Company is utilizing a $100 million letter of credit issued by the Federal Home Loan Bank on the Company’s behalf as security for certain local agency deposits. That letter of credit is backed by loans that are pledged to the FHLB by the Company. For more information on the Company’s off-balance sheet arrangements, see Note 7 to the consolidated financial statements located elsewhere herein.
OTHER ASSETS
Interest earning cash balances were discussed above in the “Investments” section, but the Company also maintains a certain level of cash on hand in the normal course of business as well as non-earning deposits at other financial institutions. Our balance of cash and due from banks depends on the timing of collection of outstanding cash items (checks), the amount of cash held at our branches, and our reserve requirement among other things, and it is subject to significant fluctuations in the normal course of business. While cash flows are normally predictable within limits, those limits are fairly broad and the Company manages its short-term cash position through the utilization of overnight loans to, and borrowings from, correspondent banks, including the Federal Reserve Bank and the Federal Home Loan Bank. Should a large “short” overnight position persist for any length of time, the Company typically raises money through focused retail deposit gathering efforts or by adding brokered time deposits. If a “long” position is prevalent, we could let brokered deposits or other wholesale borrowings roll off as they mature, or we might invest excess liquidity into longer-term, higher-yielding bonds. The Company’s balance of non-earning cash and due from banks was $77.8 million at March 31, 2021 relative to $67.9 million at December 31, 2020. The increase is primarily due to maintaining higher amounts of cash on hand due to the COVID-19 pandemic specifically government stimulus payments and customer needs for higher amounts of cash.
Foreclosed assets are discussed above in the section titled “Nonperforming Assets.” Net premises and equipment decreased by $0.7 million during the first three months of 2021, to $26.8 million. Goodwill was $27 million at March 31, 2021, unchanged during the first three months of 2021. As mentioned above, the Company performed a qualitative assessment of goodwill impairment during the fourth quarter 2020 and determined that a quantitative analysis was not required. There have been no triggering events in the first quarter of 2021 that would require The Company to perform a Goodwill impairment test, however the Company will continue to monitor its Goodwill for potential impairment given the COVID-19 pandemic. Bank-owned life insurance, with a balance of $53.3 million at March 31, 2021, is discussed in detail above in the “Noninterest Income and Noninterest Expense” section.
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DEPOSITS AND INTEREST BEARING LIABILITIES
DEPOSITS
Deposits represent another key balance sheet category impacting the Company’s net interest income and profitability metrics. Deposits provide liquidity to fund growth in earning assets, and the Company’s net interest margin is improved to the extent that growth in deposits is concentrated in less volatile and typically less costly non-maturity accounts such as demand deposit accounts, NOW accounts, savings accounts, and money market demand accounts. Information concerning average balances and rates paid by deposit type is included in the Average Balances and Rates tables appearing above, in the section titled “Net Interest Income and Net Interest Margin.” A distribution of the Company’s deposits by type, showing the period-end balance and percentage of total deposits, is presented as of the dates indicated in the following table.
Deposit Distribution
(dollars in thousands, unaudited)
March 31, 2021
December 31, 2020
Noninterest bearing demand deposits
$
1,020,350
$
943,664
Interest bearing demand deposits
163,618
109,938
NOW
606,653
558,407
Savings
415,230
368,420
Money market
136,653
131,232
Time, under $250,000
184,235
73,046
Time, $250,000 or more
227,153
339,899
Brokered deposits
100,000
100,000
Total deposits
$
2,853,892
$
2,624,606
Percentage of Total Deposits
Noninterest bearing demand deposits
35.75%
35.95%
Interest bearing demand deposits
5.73%
4.19%
NOW
21.26%
21.28%
Savings
14.55%
14.04%
Money market
4.79%
5.00%
Time, under $250,000
6.46%
2.78%
Time, $250,000 or more
7.96%
12.95%
Brokered deposits
3.50%
3.81%
Total
100.00%
100.00%
Deposit balances reflect net growth of $229.3 million, or 9%, during the first three months of 2021. Time deposits were $511.4 million at March 31, 2021 as compared to $512.9 million at December 31, 2020. Brokered deposits were flat for the same period. Non-maturity deposit growth of $230.8 million for the first three months of 2021was primarily the result of increases in balances of existing customers as the total number of customers increased by less than 1%.
Management is of the opinion that a relatively high level of core customer deposits is one of the Company’s key strengths, and we continue to strive for core deposit retention and growth. In particular, the Company’s ratio of noninterest-bearing deposits to total deposits was 35.8% at March 31, 2021 as compared to 36.0% at December 31, 2020.
OTHER INTEREST-BEARING LIABILITIES
The Company’s non-deposit borrowings may, at any given time, include fed funds purchased from correspondent banks, borrowings from the Federal Home Loan Bank, advances from the Federal Reserve Bank, securities sold under agreements to repurchase, and/or junior subordinated debentures. The Company uses short-term FHLB advances and fed funds purchased on uncommitted lines to support liquidity needs created by seasonal deposit flows, to temporarily satisfy funding needs from increased loan demand, and for other short-term purposes. The FHLB line is committed, but the amount of available credit depends on the level of pledged collateral.
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Total non-deposit interest-bearing liabilities decreased by $125.5 million, or 58%, during the first three months of 2021 primarily due to a decrease in federal funds purchased and borrowings from the FHLB, due to the increase in deposits. Repurchase agreements totaled $51.5 million at March 31, 2021 relative to a balance of $39.1 million at year-end 2020. Repurchase agreements represent “sweep accounts”, where commercial deposit balances above a specified threshold are transferred at the close of each business day into non-deposit accounts secured by investment securities. The Company had junior subordinated debentures totaling $35.2 million and $35.1 million at March 31, 2021 and December 31, 2020, respectively, in the form of long-term borrowings from trust subsidiaries formed specifically to issue trust preferred securities.
OTHER NONINTEREST BEARING LIABILITIES
Other liabilities are principally comprised of operating lease right-of-use liabilities, accrued interest payable, other accrued but unpaid expenses, and certain clearing amounts. The Company’s balance of other liabilities was $32.5 million at March 31, 2021 as compared to $35.1 million at December 31, 2020.
LIQUIDITY AND MARKET RISK MANAGEMENT
LIQUIDITY
Liquidity management refers to the Company’s ability to maintain cash flows that are adequate to fund operations and meet other obligations and commitments in a timely and cost-effective manner. Detailed cash flow projections are reviewed by Management on a monthly basis, with various stress scenarios applied to assess our ability to meet liquidity needs under unusual or adverse conditions. Liquidity ratios are also calculated and reviewed on a regular basis. While those ratios are merely indicators and are not measures of actual liquidity, they are closely monitored, and we are committed to maintaining adequate liquidity resources to draw upon should unexpected needs arise.
The Company, on occasion, experiences cash needs as the result of loan growth, deposit outflows, asset purchases or liability repayments. To meet these short-term needs, we can borrow overnight funds from other financial institutions, draw advances via Federal Home Loan Bank lines of credit, or solicit brokered deposits if customer deposits are not immediately obtainable from local sources.
At March 31, 2021 and December 31, 2020, the Company had the following sources of primary and secondary liquidity ($ in thousands):
Primary and Secondary Liquidity Sources
March 31, 2021
December 31, 2020
Cash and Cash Equivalents
$
346,211
$
71,417
Unpledged Investment Securities
306,256
311,983
Excess Pledged Securities
53,840
52,892
FHLB Borrowing Availability
665,756
535,404
Unsecured Lines of Credit
305,000
230,000
Funds Available through Fed Discount Window
59,643
58,127
Totals
$
1,736,706
$
1,259,823
In addition to the above sources, the Company could obtain brokered deposits, obtain deposits via deposit listing services, or offer higher rate time deposits within our market. At March 31, 2021, the Company had previously applied for and received approval to borrow $99.8 million from the Federal Reserve Bank for a Paycheck Protection Program Lending Facility (PPPLF) through June 30, 2021. The PPPLF provides the Company with the ability to pledge any PPP loan to the Federal Reserve Bank and obtain funding at 35 basis points. Further, any loans pledged to the PPPLF will be excluded from the regulatory leverage capital ratio. Due to the Company’s liquidity throughout the first three months of 2021 it elected not to utilize the PPPLF during the quarter. The Company will continue to evaluate whether it should utilize the PPPLF in the second quarter 2021.
The Company performs regular stress tests on its liquidity and at this time, believes that we have sufficient primary and secondary liquidity sources for operations.
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The Company has a higher level of actual balance sheet liquidity than might otherwise be the case, since we utilize a letter of credit from the FHLB rather than investment securities for certain pledging requirements. That letter of credit, which is backed by loans pledged to the FHLB by the Company, totaled $100 million at March 31, 2021 and December 31, 2020. Other sources of liquidity included the brokered deposit market, deposit listing services, and the ability to offer local time-deposit campaigns. Management is of the opinion that available investments and other potentially liquid assets, along with standby funding sources it has arranged, are more than sufficient to meet the Company’s current and anticipated short-term liquidity needs and that its liquidity has not been adversely impacted by COVID-19.
The Company’s net loans to assets and available investments to assets ratios were 68.7% and 18.9%, respectively, at March 31, 2021, as compared to internal policy guidelines of “less than 78%” and “greater than 3%.” Other liquidity ratios reviewed periodically by Management and the Board include net loans to total deposits and wholesale funding to total assets, including ratios and sub-limits for the various components comprising wholesale funding, which were all well within policy guidelines at March 31, 2021. The Company has been able to maintain a robust liquidity position in recent periods, but no assurance can be provided that our liquidity position will continue at current strong levels.
The holding company’s primary uses of funds include operating expenses incurred in the normal course of business, interest on trust preferred securities, shareholder dividends, and stock repurchases. Its primary source of funds is dividends from the Bank, since the holding company does not conduct regular banking operations. As of March 31, 2021, the holding company maintained a cash balance of $12.4 million. Management anticipates that with the available cash and the continued ability for the Bank to provide dividends to the holding company, that the holding company has sufficient liquidity to meet its funding requirements for the foreseeable future. Both the holding company and the Bank are subject to legal and regulatory limitations on dividend payments, as outlined in Item 5(c) Dividends in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020 which was filed with the SEC.
INTEREST RATE RISK MANAGEMENT
Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company does not engage in the trading of financial instruments, nor does it have exposure to currency exchange rates. Our market risk exposure is primarily that of interest rate risk, and we have established policies and procedures to monitor and limit our earnings and balance sheet exposure to changes in interest rates. The principal objective of interest rate risk management is to manage the financial components of the Company’s balance sheet in a manner that will optimize the risk/reward equation for earnings and capital under a variety of interest rate scenarios.
To identify areas of potential exposure to interest rate changes, we utilize commercially available modeling software to perform monthly earnings simulations and calculate the Company’s market value of portfolio equity under varying interest rate scenarios. The model imports relevant information for the Company’s financial instruments and incorporates Management’s assumptions on pricing, duration, and optionality for anticipated new volumes. Various rate scenarios consisting of key rate and yield curve projections are then applied in order to calculate the expected effect of a given interest rate change on interest income, interest expense, and the value of the Company’s financial instruments. The rate projections can be shocked (an immediate and parallel change in all base rates, up or down), ramped (an incremental increase or decrease in rates over a specified time period), economic (based on current trends and econometric models) or stable (unchanged from current actual levels).
In addition to a stable rate scenario, which presumes that there are no changes in interest rates, we typically use at least six other interest rate scenarios in conducting our rolling 12-month net interest income simulations: upward shocks of 100, 200, and 300 basis points, and downward shocks of 100, 200, and 300 basis points. Those scenarios may be supplemented, reduced in number, or otherwise adjusted as determined by Management to provide the most meaningful simulations considering economic conditions and expectations at the time. Given the current near zero interest rate environment it is unlikely that rates could decline much further beyond the downward shock of 100 basis points, therefore the downward shock scenarios of 200 and 300 basis points are temporarily being suspended after concurrence by the Company’s Board of Directors. We currently utilize an additional upward rate shock scenario of 400 basis points. Pursuant to policy guidelines, we generally attempt to limit the projected decline in net interest income relative to the
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stable rate scenario to no more than 5% for a 100 basis point (bp) interest rate shock, 10% for a 200 bp shock, 15% for a 300 bp shock, and 20% for a 400 bp shock.
The Company had the following estimated net interest income sensitivity profiles over one-year, without factoring in any potential negative impact on spreads resulting from competitive pressures or credit quality deterioration:
March 31, 2021
March 31, 2020
Immediate change in Interest Rates (basis points)
% Change in Net Interest Income
$ Change in Net Interest Income
% Change in Net Interest Income
$ Change in Net Interest Income
+400
7.2%
$
7,726
5.0%
$
4,952
+300
5.7%
$
6,137
4.7%
$
4,603
+200
4.4%
$
4,741
3.7%
$
3,591
+100
2.8%
$
2,991
2.4%
$
2,404
Base
-100
(7.6)%
$
(8,181)
(7.4)%
$
(7,233)
For the periods ended March 31, 2021 and 2020, the Company was asset sensitive, with net income increasing in a rising rate environment in all scenarios but declining considerably in the down shocks.
The simulation for the period ending March 31, 2020 indicates that the Company’s net interest income will increase over the next 12 months in a rising rate environment in all scenarios, but a continued drop in interest rates could have a substantial negative impact. However the rate of increase is not as pronounced as in the March 31, 2021 scenario due to considerably less cash on hand and the impact of interest rate reductions and balance sheet changes including an increase in loans with variable rate characteristics (mortgage warehouse loans), the runoff of loans which had rates fixed for periods in excess of a year, and a projected slight shift in our deposit mix toward time deposits over time. In the up 400 basis point shock scenario, expected net interest income over the next twelve months increases $7.7 million, or 7%, to $115.7 million at March 31, 2021 compared to a 5% increase or $5.0 million for the same period in 2020. The primary reason for the increase in expected net interest income despite a lower rate environment, was the increase in surplus interest-bearing cash in other banks. In an instantaneous parallel rate shock the entire balance of surplus cash would reprice immediately. Over the next twelve months, surplus cash is projected to remain at higher levels than prior years as the Company shifts from non-owner occupied commercial real estate to other types of lending. Although the cost of interest-bearing liabilities will also increase, the deposit betas utilized in the model mitigate the magnitude of a deposit rate increase.
The change in net interest income is similar for the up 100, 200, and 300 basis point scenarios. If there were an immediate and sustained upward adjustment of 100 basis points in interest rates, all else being equal, net interest income over the next 12 months is projected to improve by $2.4 million, or 2.40%, relative to a stable interest rate scenario, with the favorable variance increasing marginally as interest rates rise higher.
If there was an immediate downward adjustment of 100 basis points in interest rates, net interest income would drop $8.2 million or a negative variance of 8%. Since many of deposit products are at their natural floors as reflected in our current cost of deposits of.14% for the first quarter of 2021, the unfavorable variances increase as interest rates decline because non-floored variable-rate loans continue to drop. This effect is further exacerbated by accelerated prepayments on fixed-rate loans and mortgage- backed securities when rates decline. While we view material interest rate reductions as unlikely in the near term, the potential percentage drop in net interest income in the “down 100 basis points” interest rate scenario exceeds our internal policy guidelines and we will continue to monitor our interest rate risk profile and implement remedial changes as deemed appropriate.
In addition to the net interest income simulations shown above, we run stress scenarios for the unconsolidated Bank modeling the possibility of no balance sheet growth, the potential runoff of “surge” core deposits which flowed into the Bank in the most recent economic cycle, and unfavorable movement in deposit rates relative to yields on earning assets (i.e., higher deposit betas). When a static balance sheet and a stable interest rate environment are assumed, projected annual net interest income is more than $3 million lower than in our standard simulation.
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The economic value (or “fair value”) of financial instruments on the Company’s balance sheet will also vary under the interest rate scenarios previously discussed. The difference between the projected fair value of the Company’s financial assets and the fair value of its financial liabilities is referred to as the economic value of equity (“EVE”), and changes in EVE under different interest rate scenarios are effectively a gauge of the Company’s longer-term exposure to interest rate fluctuations. Fair values for financial instruments are estimated by discounting projected cash flows (principal and interest) at anticipated replacement interest rates for each account type, while the fair value of non-financial accounts is assumed to equal their book value for all rate scenarios. An economic value simulation is a static measure utilizing balance sheet accounts at a given point in time, and the measurement can change substantially over time, as is evident in the tables below for the periods ending March 31, 2021 and 2020, respectively, as the Company’s balance sheet evolves and interest rate and yield curve assumptions are updated.
The change in economic value under different interest rate scenarios depends on the characteristics of each class of financial instrument, including stated interest rates or spreads relative to current or projected market-level interest rates or spreads, the likelihood of principal prepayments, whether contractual interest rates are fixed or floating, and the average remaining time to maturity. As a general rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the greater the impact a rate change will have on its value. In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based on historical patterns and Management’s best estimates.
Our EVE increased in the past twelve months due to asset growth, but that trend slowed in the first quarter of 2021 as loan growth decelerated. The tables below show estimated changes in the Company’s EVE, under different interest rate scenarios relative to a base case of current interest rates:
March 31, 2021
March 31, 2020
Immediate change in Interest Rates (basis points)
% Change in Fair Value of Equity
$ Change in Fair Value of Equity
% Change in Fair Value of Equity
$ Change in Fair Value of Equity
+400
31.5%
$
174,274
30.4%
$
152,966
+300
28.0%
$
155,182
27.1%
$
136,480
+200
22.8%
$
126,402
21.5%
$
108,427
+100
13.7%
$
76,032
12.5%
$
63,135
Base
-100
(20.1)%
$
(111,586)
(10.4)%
$
(52,569)
The table shows that our EVE will deteriorate in moderate declining rate scenarios but should benefit from a parallel shift upward in the yield curve. The rate of increase in EVE accelerates the higher interest rates rise. This increase in sensitivity is caused by the increase in gross deposits, namely, an increase in noninterest bearing deposits. We also run stress scenarios for the unconsolidated Bank’s EVE to simulate the possibility of adverse movement in loan prepayment rates, unfavorable changes in deposit rates, and higher deposit decay rates. Model results are highly sensitive to changes in assumed decay rates for non-maturity deposits, in particular, with material unfavorable variances occurring relative to the standard simulations shown above as decay rates are increased. Furthermore, while not as extreme as the variances produced by increasing non-maturity deposit decay rates, EVE also displays a relatively high level of sensitivity to unfavorable changes in deposit rate betas in rising interest rate scenarios.
CAPITAL RESOURCES
The Company had total shareholders’ equity of $348.0 million at March 31, 2021, comprised of $113.5 million in common stock, $4.0 million in additional paid-in capital, $216.2 million in retained earnings, and accumulated other comprehensive income of $14.3 million. At the end of 2020, total shareholders’ equity was $343.9 million. The increase during the first three months of 2021 is due to the addition of capital from net income, stock options exercised and restricted stock accrued. These positive changes were partially offset by a $4.1 million unfavorable swing in accumulated other comprehensive income, net and the impact of cash dividends paid. The Company has 268,301 shares authorized to repurchase under the current repurchase program. The Company suspended its stock repurchase program on March 16, 2020 and continues to evaluate when or if we will restart repurchasing shares.
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The Company uses a variety of measures to evaluate its capital adequacy, including the leverage ratio which is calculated separately for the Company and the Bank. Management reviews these capital measurements on a quarterly basis and takes appropriate action to help ensure that they meet or surpass established internal and external guidelines. As permitted by the regulators for financial institutions that are not deemed to be “advanced approaches” institutions, the Company has elected to opt out of the Basel III requirement to include accumulated other comprehensive income in risk-based capital. The following table sets forth the Bank’s regulatory capital ratios as of the dates indicated.
Regulatory Capital Ratios
Minimum
Minimum
Requirement
Required
March 31,
December 31,
to be
Community Bank
2021
2020
Well Capitalized (3)
Leverage Ratio (2) (4)
Bank of the Sierra
Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio")
10.36
%
10.12
%
5.00
%
8.50
%
(1) Current data is not applicable as the Bank adopted the Community Bank Leverage Ratio Framework as of the first quarter of 2020.
(2) The minimum required Community Bank Leverage Ratio is 9.00%, but the CARES Act temporarily lowers this to 8.5% as described below.
(3) The Company was subject to these minimum requirements under the regulatory framework for Prompt Corrective Action at December 31, 2019.
(4) If the subsidiary bank’s Leverage Ratio exceeds the minimum ratio under the Community Bank Leverage Ratio Framework, it is deemed to be “well capitalized” under all other regulatory capital requirements. The Company may revert back to the regulatory framework for Prompt Corrective Action if the subsidiary bank’s Leverage Ratio falls below the minimum under the Community Bank Leverage Ratio Framework.
The federal banking agencies published a final rule on November 13, 2019, that provided a simplified measure of capital adequacy for qualifying community banking organizations. A qualifying community banking organization that opts into the community bank leverage ratio framework and maintains a leverage ratio greater than 9 percent will be considered to have met the minimum capital requirements, the capital ratio requirements for the well capitalized category under the Prompt Corrective Action framework, and any other capital or leverage requirements to which the qualifying banking organization is subject. A qualifying community banking organization with a leverage ratio of greater than 9 percent may opt into the community bank leverage ratio framework if has average consolidated total assets of less than $10 billion, has off-balance-sheet exposures of 25% or less of total consolidated assets, and has total trading assets and trading liabilities of 5 percent or less of total consolidated assets. Further, the bank must not be an advance approaches banking organization.
The final rule became effective January 1, 2020 and banks that meet the qualifying criteria can elect to use the community bank leverage framework starting with the quarter ended March 31, 2020. The CARES Act reduced the required community bank leverage ratio to 8% until the earlier of December 31, 2020, or the national emergency is declared over. Beginning in 2021 the CBLR was increased to 8.5% for the calendar year with the CBLR increasing to 9% on January 31, 2022. The federal bank regulatory agencies adopted an interim final rule to implement this change from the CARES Act. At March 31, 2021, the Company and the Bank met the criteria outlined in the final rule and the interim final rule and elected to measure capital adequacy under the CBLR framework.
PART I – FINANCIAL INFORMATION
ITEM 3
QUALITATIVE & QUANTITATIVE DISCLOSURES
ABOUT MARKET RISK
The information concerning quantitative and qualitative disclosures about market risk is included in Part I, Item 2 above. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Market Risk Management.”
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PART I – FINANCIAL INFORMATION
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.