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Item 2. Management’s Discussion and Analysis

2022-11-03 compared with 2022-08-04 · 256 added, 294 removed, 510 unchanged (52% of the section changed)

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They include, but are not limited to:

● the risk of unfavorable economic conditions in the Company’s market areas;

● risks associated with fluctuations in interest rates;

● risks associated with the current national emergency with respect to COVID-19 and its variants, including the impact that national, state, and local responses, including limitations on business and personal activity as well as any stimulus or relief efforts have on customers’ continued ability to repay loans;

● risks associated with fluctuations in interest rates, including the impact on other comprehensive income (loss), the ability for customers to repay on floating or adjustable rates loans, and the impact on costs of funding and interest income on earning assets;

● risks associated with inflation (including efforts by the Board of Governors of the Federal Reserve to control the same);

● the risk of unfavorable economic conditions in the Company’s market areas, or the impact on the Company’s market areas of national or international economic conditions;

● liquidity risks, including the ability to effectively manage the additional liquidity from the significant increase in deposits during the COVID-19 pandemic including managing the potential loss of a portion of such deposits;

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● 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 Company’s ability to maintain a satisfactory rating under the Community Reinvestment Act;

● the outcome of any existing or future legal action for which the Company or Bank is a defendant;

● the success of acquisitions or branch expansions, closures or consolidations;

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RESULTS OF OPERATIONS SUMMARY

Second Quarter 2022 compared to Second Quarter 2021

Second quarter 2022 net income was $9.2 million, or $0.61 per diluted share, compared to $11.7 million, or $0.76 per diluted share in the second quarter of 2021.

The Company’s annualized return on average equity was 11.68% and annualized return on average assets was 1.07% for the quarter ended June 30, 2022, compared to 13.29% and 1.42%, respectively, for the same quarter in 2021.

The primary drivers behind the variance in second quarter net income are as follows:

● Net interest income decreased $0.6 million, or 2%, due primarily to a $0.4 million increase in interest expense from the issuance of subordinated debt during the third quarter of 2021 and higher cost of funds on interest-bearing liabilities due to the recent increases in the prime interest rate.

● The provision for credit losses on loans and leases was $2.5 million under the new current expected credit losses (“CECL”) methodology, as compared to a $2.1 million benefit under the incurred loss model in the same quarter of 2021, for a net increase of $4.6 million.

This is driven primarily from the replacement of allowance due to $4.1 million in net loan charge offs during the second quarter of 2022.

● Noninterest income increased $3.8 million, primarily due to a $3.2 million gain on sale of other assets, $0.4 million in life insurance proceeds, a $0.2 million recovery on an acquired loan, and a $1.0 million recovery of prior year legal expenses, partially offset by a $1.4 million negative variance in Corporate Owned Life Insurance with income linked to the Company’s nonqualified deferred compensation plan.

● Total noninterest expense increased $1.9 million, or 9%, in the second quarter of 2022 as compared to the second quarter of 2021.

Higher salaries and benefits costs accounted for $1.3 million of the increase as we added new lending teams, and $0.8 million of the increase was due to higher other expenses, mostly for the accrual of restitution payments to customers charged nonsufficient fund fees for representments in the past five years and $0.3 million in postage and mailing costs associated with new disclosure agreements which detail updated service charges on returned items and overdraft fees.

First Half 2022 compared to First Half 2021

Net income for the first half of 2022 was $16.6 million, or $1.10 per diluted share, compared to $22.8 million, or $1.48 per diluted share for the same period in 2021.

The Company’s annualized return on average equity was 10.10% and annualized return on average assets was 0.98% for the six months ended June 30, 2022, compared to a return on equity of 13.11% and return on assets of 1.41% for the six months ended June 30, 2021.

Third Quarter 2022 compared to Third Quarter 2021

Third quarter 2022 net income was $9.9 million, or $0.66 per diluted share, compared to $10.6 million, or $0.69 per diluted share in the third quarter of 2021.

The Company’s annualized return on average equity was 12.84% and annualized return on average assets was 1.13% for the quarter ended September 30, 2022, compared to 11.62% and

1.26%, respectively, for the same quarter in 2021.

The primary drivers behind the variance in third quarter net income are as follows:

● Net interest income increased $2.2 million.

We had a 17 basis point increase in net interest margin coupled with a $119.1 million increase in average earning assets.

● Noninterest income decreased $0.9 million or 12% primarily due to a $1.1 million decrease in bank-owned life insurance linked to deferred compensation plans.

● The provision for credit losses on loans and leases was $1.2 million under the new current expected credit losses (“CECL”) methodology, as compared to a benefit of $0.6 million under the incurred loss model in the same quarter of 2021.

● Total noninterest expense increased $0.1 million, or 1%, in the third quarter of 2022 as compared to the third quarter of 2021.

Although salaries and benefits costs increased $0.9 million as we added new lending teams, other noninterest expense decreased $0.9 million mostly due to a reduction in legal expenses, telecommunications costs and a favorable variance in directors deferred compensation expense, linked to the unfavorable changes in BOLI income described above.

First Nine Months of 2022 compared to First Nine Months of 2021

Net income for the first nine months of 2022 was $26.5 million, or $1.76 per diluted share, compared to $33.4 million, or $2.17 per diluted share for the same period in 2021.

The Company’s annualized return on average equity was 10.98% and annualized return on average assets was 1.03% for the nine months ended September 30, 2022, compared to a return on equity of 12.60% and return on assets of 1.36% for the nine months ended September 30, 2021.

The primary drivers behind the variance in year-to-date net income are as follows:

● The provision for credit losses on loans and leases was $3.1 million, an increase of $5.0 million, due to a change from the incurred loss method to the current expected credit loss method, coupled with higher charge-offs in 2022 on two loan relationships.

● Net interest income decreased by $4.4 million, or 8%, due mostly to the change in mix of interest earning assets with average loan balances increasing and investments increasing.

In addition, the cost of interest-bearing liabilities was higher due to increases in index rates on certain floating rate liabilities.

● Noninterest income increased $3.1 million, or 23%, for the same reasons as noted above in the quarterly comparison, combined with a $1.0 million gain on the sale of investment securities, and a $2.6 million negative variance in BOLI income tied to our nonqualified deferred compensation plan.

● Noninterest expense increased $1.8 million, or 4% for the same reasons as outlined in the quarterly comparison above.

● Net income decreased $6.8 million, or 20%.

The most significant line-item changes was a $6.6 million increase in the provision for credit losses, under the “CECL” methodology.

There was also a decrease of $2.2 million or 3% in net interest income, due mostly to an overall 25 basis point decline in net interest margin.

The decline in margin was due primarily to lower yields and balances on loans, as well as higher overall funding costs partially offset by higher investment yields and balances.

● Noninterest income increased by $2.1 million, or 10%, due to a $1.0 million recovery of prior year legal expenses, a $1.0 million gain on the sale of investment securities, a $3.2 million gain on the sale of other assets, partially offset by negative variances in BOLI income, and the fair market value adjustment of equity securities.

● Noninterest expense increased $1.9 million, or 3% due mostly to the increases in salary expense for new loan production teams and restitution payments to customers charged nonsufficient fund fees on representments in the past five years, partially offset by lower legal costs and a positive variance in director’s deferred compensation expense which is linked to the unfavorable changes in bank-owned life insurance income described above.

FINANCIAL CONDITION SUMMARY

June 30, 2022 relative to December 31, 2021

The Company’s assets totaled $3.4 billion at June 30, 2022 unchanged from December 31, 2021.

The following provides a summary of key balance sheet changes during the first six months of 2022:

● The Company’s balance of cash and cash equivalents declined by $95.7 million, or 37% from December 31, 2021.

The overall increase in cash balances was due primarily to increases in investment securities and loans and leases during the first half 2022.

● Investment securities were $1.0 billion at June 30, 2022, an increase of $52.3 million, or 5% from December 31, 2021.

The Company purchased $158.2 million in various government agency sponsored mortgage-backed securities, agency securities, municipal securities, corporate bonds and collateralized mortgage obligations.

On April 1, 2022, the Company transferred $162.1 million of “available-for-sale” investment securities to “held-to-maturity”.

The securities were transferred at fair market value on the date of transfer.

The transfer was initiated to partially insulate other comprehensive income and equity from changes in interest rates.

This transfer had no

impact on net income, and future price changes on these securities due to changes in interest rates will not affect capital.

● Gross loans increased $32.9 million due predominantly to the purchase of high quality jumbo single family mortgage loan pool purchases.

This increase was offset by reductions in almost all loan categories as loan maturities and payoffs exceeded the increases in loan production for the first six months of 2022.

● Deposits increased by $69.4 million, or 2%.

The growth in deposits came primarily from noninterest-bearing or low-cost transaction and savings accounts, while higher-cost time deposits increased $5.9 million.

Total shareholders’ equity of $299.0 million at June 30, 2022 reflects a decrease of $63.4 million, or 18%, relative to year-end 2021, due to the addition of $16.6 million in net income, offset by a $61.6 million unfavorable swing in accumulated other comprehensive income/loss due principally to changes in investment securities’ fair value, a one-time adjustment from the implementation of CECL on January 1, 2022 for $7.3 million, $4.9 million in share repurchases and net of $7.0 million in dividends paid.

The remaining difference is related to stock options exercised and restricted stock compensation recognized during the quarter.

IMPACT OF CORONAVIRUS DISEASE 2019 (COVID-19) PANDEMIC ON THE COMPANY’S OPERATIONS

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 many actions impacting the Company.

These actions included, among other things, the Federal Open Market Committee (FOMC) reducing the federal funds rate;

California issuing a state-wide shelter-in-place order and various other orders at the state and local levels restricting business operations, closing schools, and thereafter prescribing requirements for reopening;

and various pieces of federal legislation were passed to attempt to address the impact of COVID-19 on the economy.

Impact of COVID-19 on the Company’s Operations

● 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.

The Company had no loans remaining on deferral, which were modified under the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act, as amended.

● The uncertainty of national and local economic conditions had an impact on our provision for credit losses in early 2022 and on our provision for loan and lease losses in 2021.

The Company implemented the Current Expected Credit Loss ("CECL") accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326) on January 1, 2022, after having elected under Section 4014 of the CARES Act and the Consolidated Appropriations Act, 2021 to defer earlier implementation.

● The Company expects that net interest income may continue to be adversely impacted given pressure on the net interest margin as a result of the current interest rate environment.

Although the FOMC has raised the fed funds rate three times in the first half of 2022;

25 basis points on March 16, 2022, 50 basis points on May 4, 2022 and 75 basis points on June 16, 2022, the overall rate environment is still relatively low.

The FOMC has indicated potential future increases to the overnight fed funds rate but uncertainty as to when and at what rate this may occur still remains.

These lower rates have impacted our net interest margin.

Our net interest margin for the six months ended June 30, 2022, was 3.31%, compared to a net interest margin of 3.76% for the same period in 2021.

Additional liquidity from significant deposit growth in 2021 and the first six months of 2022, coupled with lower loan balances has negatively impacted our net interest margin.

This additional liquidity was mostly deployed in overnight funding resulting in $170.4 million in average overnight cash during the first half of 2022.

This overnight funding earned an average rate of 43 basis points, for the first six months ending June

In addition, the Company had $1.0 billion in investment securities at average tax effective yield 207 basis points lower than that of current loan yields.

● The COVID-19 pandemic has not adversely affected our capital or financial resources as of June 30, 2022.

During the first half of 2022, total shareholders’ equity decreased by $63.4 million, or 18%, to $299.0 million.

The Company earned $16.6 million in net income in the first six months of 2022, but had a $61.6 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.

If interest rates continue to rise, this component of equity would be expected to further decline.

The Company also paid dividends of $7.0 million and repurchased shares of stock for $4.9 million during the first half of 2022.

On July 21, 2022, the Company declared a twenty-three cent per share dividend to be paid on August 15, 2022.

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.

● The Company continues to serve its customers.

Several of our branch locations were closed during the height of the pandemic, but have since re-opened.

Five branch locations were permanently closed in June 2021.

This decision to close these branches was made as a result of a change in customer behaviors brought about by the COVID-19 pandemic along with an efficiency review.

All of the five closed locations were located outside of Tulare County, the Bank’s primary market area.

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.

Overall deposits at these five closed branches increased during the period of time from announcement to closure and consolidation into a nearby branch.

● As a financial institution providing essential services, the Company expects continued demand for loans and deposits.

In addition, strong mortgage warehouse utilization that resulted from the low rate refinance environment of 2020 and 2021 is not expected to return in 2022 and hence our loans outstanding in this sector remain at lower levels.

Further, it is expected that SBA PPP loans will continue to be forgiven, with the remainder expected to be forgiven in 2022.

September 30, 2022 relative to December 31, 2021

The Company’s assets totaled $3.5 billion at September 30, 2022, an increase of $161.3 million, or 5%from December 31, 2021.

The following provides a summary of key balance sheet changes during the first nine months of 2022:

● Cash and due from banks decreased $170.8 million, to $86.7 million during the first nine months of the year due mostly to increases in other earning assets.

● Investment securities increased by $252.3 million, or 26%, to $1.2 billion primarily due to strategic purchases of $181 million of collateralized loan obligations, as well as other investment securities.

● Gross loans increased $30.6 million, or 2% due predominantly to the purchase of $173.1 million in high quality jumbo single family mortgage loan pools earlier in the year.

These mortgage loan pool purchases were offset by $267.7 million in loan maturities, charge-offs and payoffs.

Organic loan production for the first nine months of 2022 was $225.1 million, as compared to $93.0 million for the comparative period in 2021.

impacting loan growth was a $45.2 million decline in credit line utilization and a $54.6 million decline in mortgage warehouse line utilization.

PPP loan forgiveness during the first nine months was $27.6 million.

● Deposits totaled $2.9 billion at September 30, 2022, representing a year-to-date increase of $103.9 million, or 4%.

The growth in deposits came from a $45.5 million increase in core transaction and savings accounts, coupled with a $58.4 million increase in time and wholesale brokered deposits.

● Short-term debt totaled $215.1 million due to increases of $103.1 million in overnight FHLB borrowings and $5.1 million in customer repurchase agreements.

Total capital of $295.1 million at September 30, 2022 reflects a decrease of $67.4 million, or 19%, relative to year-end 2021.

The decrease in equity during the first nine months of 2022 was due to the addition of $26.5 million in net income, offset by a $72.2 million unfavorable swing in accumulated other comprehensive income/loss, due principally to changes in investment securities’ fair value, a one-time adjustment from the implementation of CECL on January 1, 2022 for $7.3 million, $4.9 million in share repurchases, net of $10.4 million in dividends paid.

The remaining difference is related to stock options exercised and restricted stock granted during the first nine months.

EARNINGS PERFORMANCE

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NET INTEREST INCOME AND NET INTEREST MARGIN

Net interest income decreased $0.6 million to $26.6 million, for the second quarter of 2022 over the second quarter of 2021 and decreased $4.4 million, or 8% to $51.3 million for the first six months of 2022 relative to the same period in 2021.

For the second quarter of 2022 as compared to the same quarter in 2021, average loan balances decreased $173.0 million, or 8%, primarily due to decreases in commercial loans of $86.0 million, or 52%, a $13.5 million, or 31% decrease in agricultural production loans, and a $92.5 million, or 65%, decrease in the utilization of mortgage warehouse lines.

These decreases were partially offset by an $18.8 million, or 1% increase in real estate loans.

The yield on the loan and lease portfolio was 26 basis points lower in the second quarter of 2022 as compared to the same period in 2021.

Average investment balances also increased $290.6 million with a 79 basis point increase in yield, mostly due to a $388.9 million increase in average collateralized loan obligation balances which have variable rates, which helped

alleviate some of the negative pressure on our net interest margin.

Adding to the pressure on our net interest margin, was a 13 basis points unfavorable increase in the cost of interest-bearing liabilities in the second quarter of 2022 as compared to the second quarter of 2021.

For the first half of 2022 as compared to the same period in 2021, average loan balances decreased $293.5 million or 13%.

All categories of loans decreased with the primary decrease in commercial loans for $90.3 million and a $136.8 million decline in mortgage warehouse line utilization.

There was a 24 basis points decrease in loan yield for the first half of 2022 as compared to the same period in 2021.

Average investment balances increased $451.0 million yielding 28 basis points higher for the same period, which helped offset the negative loan yield variances.

Adding to the unfavorable decrease in yield was an 11 basis point decrease in the yield on interest bearing liabilities, driven by the recent increases in the prime interest rate.

Net interest income was $28.9 million, for the third quarter of 2022, a $2.2 million increase, or 8% over the third quarter of 2021, but decreased $2.2 million, or 3% to $80.3 million for the first nine months of 2022 relative to the same period in 2021.

For the third quarter of 2022, growth in average interest-earning assets totaled $119.1 million, or 4%, as compared to the third quarter of 2021.

The yield on these balances was 42 basis points higher for the same period due mostly to a shift in the mix of earning assets and the result of recent interest rate increases by the Federal Open Market Committee.

This increase in yield was offset by a 40 basis point increase in the cost of our interest-bearing liabilities for the same period.

Although transaction and savings deposit rates have not changed, higher costs of time deposits and borrowed funds including overnight purchases are the primary reasons for the increase in interest expense.

Net interest income for the comparative year-to-date periods decreased $2.2 million or 3%, due to a change in mix of average interest-earning assets.

Investment balances, including overnight funds, with an average yield of 2.61% increased $360.0 million, while gross average loan balances yielding 4.30% decreased $215.4 million.

The overall yield on the average balances of earning assets was 11 basis points lower for the comparative periods, exacerbated by a 21 basis point increase in interest paid on liabilities.

The net impact was a 25 basis point decrease in our net interest margin for the nine-months ending September 30, 2022 as compared to the same period in 2021.

The increase in investments includes a net increase of $181.9 million of exclusively AAA and AA tranches of collateralized loan obligations, for a total cost basis of $514.7 million at September 30, 2022.

The average yield on such CLOs for September 2022 was 4.6% as compared to an average yield in December 2021 of 1.5%.

Interest expense was $3.0 million for the third quarter of 2022, an increase of $2.1 million, relative to the third quarter of 2021.

For the first nine months of 2022, compared to the same period in 2021, interest expense increased $3.2 million to $6.0 million.

The significant increase in interest expense is attributable to an unfavorable shift in deposit mix and the

impact of recent interest rate increased, as the average balance of higher cost time deposits, including variable rate time deposits and borrowed funds increased by $20.4 million and $125.9 million respectively in the third quarter of 2022 as compared to the third quarter of 2021.

For the year-to-date comparisons the increase is attributable to a $106.1 million increase in borrowed funds combined with the impact of recent interest rate increases.

The Company had $1.3 billion in adjustable and variable rate loans and $499.4 million in floating rate collateralized loan obligations, as compared to $279.5 million in floating rate CDs and $35.4 million in floating rate trust preferred securities at September 30, 2022.

$236.0 million of the Company’s adjustable and variable rate loans have the ability to reprice in the next twelve months.

The Company continues to offer floating rate CDs which are indexed to prime.

These floating rate CDs increased $40.6 million or 17%, to $279.5 million at September 30, 2022, as compared to $238.9 million at December 31, 2021.

Due to the increase in the prime rate during 2022, interest expense on floating rate CDs has increased $1.1 million for the third quarter of 2022 over the third quarter of 2021, and increased $1.3 million for the first nine months of 2022 as compared to the same period in 2021.

These CD’s require a minimum balance and pay a rate that is 325 – 400 basis points below the Wall Street Journal Prime rate, with a 20 basis point minimum rate.

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.

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For the three months ended

June 30, 2022

June 30, 2021

September 30, 2022

September 30, 2021

Rate/Yield (2)

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Loan fees have been included in the calculation of interest income.

Net loan fees and loan acquisition FMV amortization were $0.4 million and $1.0 million for the quarters ended June 30, 2022 and 2021, respectively.

Net loan fees and loan acquisition FMV amortization were $0.1 million and $1.0 million for the quarters ended September 30, 2022 and 2021, respectively.

(4) Non-accrual loans have been included in total loans for purposes of computing total earning assets.

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(Dollars in Thousands, Unaudited)

For the six months ended

June 30, 2022

June 30, 2021

For the nine months ended

September 30, 2022

September 30, 2021

Rate/Yield (2)

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Loan fees have been included in the calculation of interest income.

Net loan fees and loan acquisition FMV amortization were $0.8 million and $2.4 million for the six months ended June 30, 2022 and 2021, respectively.

Net loan fees and loan acquisition FMV amortization were $0.9 million and $3.4 million for the nine months ended September 30, 2022 and 2021, respectively.

(4) Non-accrual loans have been included in total loans for purposes of computing total earning assets.

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(dollars in thousands, unaudited)

Three months ended June 30,

Six months ended June 30,

Three months ended September 30,

Nine months ended September 30,

2022 over 2021

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(1) Subtotals are a sum of the categories above and are not recalculated on the portfolio totals.

The volume variance calculated for the second quarter of 2022 relative to the second quarter of 2021 was a favorable $0.1 million;

although average balances of interest earning assets were flat, we had an increase in investment securities, offset by a decrease in almost all categories of loans.

There was an unfavorable rate variance of $0.7 million for the comparative quarters since the weighted average yield on interest earning assets decreased by 11 basis points and the weighted average cost of interest-bearing liabilities increased by 13 basis points.

There was also an unfavorable mix

variance of $0.02 million primarily from the issuance of variable rate subordinated debentures issued in September of 2021.

The $0.7 million negative rate variance was impacted by the following factors:

relatively high average balances of cash and due from banks earning on average 74 bps, new loans and investments having lower yields overall, including low-yielding purchased 1-4 SFD mortgage loans.

Increased costs on interest bearing liabilities also had a negative impact on the variance primarily from two Federal Reserve fed funds rate increases in the second quarter of 2022 for a total of 125 basis points, and the issuance of subordinated debt mentioned above.

The Company’s net interest margin for the second quarter of 2022 was 3.40%, as compared to 3.60% for the second quarter of 2021.

The volume variance calculated for the first six months of 2022 relative to the first six months of 2021 reflects an unfavorable variance of $1.3 million, an unfavorable rate variance of $2.4 million, and an unfavorable mix variance of $0.7 million.

There was a decline in loan balances, partially offset by an increase in investment securities.

Interest bearing liabilities were relatively flat with an 11 basis point increase in cost, primarily from three Federal Reserve fed funds interest rate increases totaling 150 basis points and the issuance of variable rate subordinated debentures issued in September 2021.

The Company’s net interest margin for the first half of 2022 was 3.31%, as compared to 3.76% in the first half of 2021.

At June 30, 2022, approximately 8% of our total portfolio, or $122.7 million, consists of variable rate loans.

Of these variable rate loans, approximately $34.0 million have floors.

At June 30, 2022, our outstanding fixed rate loans represented 26% of our loan portfolio.

The remaining 66% of our loan portfolio at June 30, 2022 consists of adjustable-rate loans;

The volume variance calculated for the third quarter of 2022 relative to the third quarter of 2021 was a favorable $0.9 million;

this is primarily from a favorable volume variance of $1.4 million in interest earning assets, as the average balance of interest earning assets increased $119.1 million from the comparative quarters..

There was a favorable rate variance of $1.0 million from the comparative quarters since the weighted average yield on investment securities more than offset the unfavorable weighted average yield variance on loan and lease balances.

There was also a 40 basis point

increase in cost of interest bearing liabilities which negatively impacted the rate increase.

There was a favorable mix variance of $0.2 million primarily from the issuance of variable rate investment securities in the form of collateralized loan obligations.

The Company’s net interest margin for the third quarter of 2022 was 3.63%, as compared to 3.46% for the third quarter of 2021.

The volume, rate and mix variances calculated for the first nine months of 2022 relative to the first nine months of 2021 reflects an unfavorable volume variance of $1.0 million, an unfavorable rate variance of $2.9 million, and a favorable mix variance of $1.7 million.

The unfavorable volume variance was attributed to a decline in loan balances, offset by an increase in investment securities, primarily variable collateralized loan obligations, and an increase in interest bearing liabilities, mostly higher cost borrowed funds.

The unfavorable rate variance came from lower yields on interest earning assets exacerbated by an increase in interest bearing liabilities which were negatively impacted from five Federal Reserve fed funds interest rate increases totaling 300 basis points.

The Company’s net interest margin for the first nine months of 2022 was 3.41%, as compared to 3.66% in the first nine months of 2021.

At September 30, 2022, approximately 5% of our total portfolio, or $99.7 million, consists of variable rate loans.

Of these variable rate loans, approximately $43.1 million have floors, although with the interest rate increases during the first nine months of 2022, most of these loans are no longer at their floors.

At September 30, 2022, our outstanding fixed rate loans represented 33% of our loan portfolio.

The remaining 62% of our loan portfolio at September 30, 2022 consists of adjustable-rate loans;

70% of these loans (approximately $862.0 million) will not begin adjusting for at least another 3 years, but up to 10 years.

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Approximately $60.5 million of these adjustable-rate loans have the ability to reprice next quarter, which will have a positive impact on earnings.

Cash balances for the quarter and year-to-date comparisons have decreased and having less of a negative impact on our net interest margin since cash balances earn considerably lower yields than other earning assets.

Average cash and due from banks was $146.3 million, a decrease of $162.2 million, or 53% for the second quarter of 2022, and was $22.7 million lower, or 12% for the first half of 2022 as compared to the same period in 2021.

Overall average investment securities increased by $452.7 million for the second quarter of June 30, 2022 as compared to June 30, 2021, and increased by $473.7 million for the first half of 2022.

For the quarter ending June 30, 2022 over the same period for 2021, average non-taxable securities increased $40.7 million and taxable securities increased $412.0 million.

For the first half of 2022 over the same period in 2021, average non-taxable securities increased $46.7 million and taxable securities increased $427.0 million.

The overall investment portfolio had a tax-equivalent yield of 2.65% at June 30, 2022, with an average life of 7.55 years.

Interest expense was $1.6 million for the second quarter of 2022, an increase of $0.7 million, or 80%, compared to the second quarter of 2021, and increased $1.1 million or 63% for the first six-months of 2022 as compared to the same period in 2021.

The increase in interest expense for the quarter is primarily attributable to the increase in the cost of time deposits tied to prime interest rate increases, while the year-to-date comparison included the increase in the cost of time deposits as well as the issuance of subordinated debentures in September of 2021 at a variable rate.

The average cost of interest-bearing deposits increased by 4 basis points to 18 basis points for the second quarter of 2022 compared to the second quarter of 2021, and by 2 basis points to 16 basis points for the first six-months of 2022 as compared to the same period in 2021.

The average cost of borrowed funds increased 52 basis points for the second quarter of 2022 as compared to the same period in 2021 and by 47 basis points for the first six-months of 2022 as compared to the first six-months of 2021.

Non-interest bearing demand deposits increased $80.1 million or 8% for the second quarter of 2022 as compared to the second quarter of 2021, and increased by $98.2 million or 10% for the first half of 2022 as compared to the first half of 2021.

Cash balances for the quarter and year-to-date comparisons have decreased and have less of a negative impact on our net interest margin since cash balances earn considerably lower yields than other earning assets.

Average cash and due from banks was $21.8 million, a decrease of $357.8 million, or 94% for the third quarter of 2022, and was $135.6 million lower, or 53% for the first nine months of 2022 as compared to the same period in 2021.

Overall average investment securities increased by $538.7 million for the third quarter of September 30, 2022 as compared to September 30, 2021, and increased by $495.6 million for the first nine months of 2022.

For the quarter ending September 30, 2022 over the same period for 2021, average non-taxable securities increased $76.6 million and taxable securities increased $462.2 million.

For the first nine months of 2022 over the same period in 2021, average non-taxable securities increased $63.3 million and taxable securities increased $432.3 million.

The overall investment portfolio had a tax-equivalent yield of 3.57% at September 30, 2022, with an average life of 7.67 years.

Included in investment securities are $499.4 million of collateralized-loan obligations with rates that adjust quarterly.

The increase in interest expense is attributable to the impact of higher rates on floating rate liabilities, including floating rate certificate of deposits.

In addition, the shift to being a net purchaser of funds during the third quarter of 2022 caused borrowed funds to increase.

Higher cost time deposits and borrowed funds increased by $20.4 million and $125.9 million respectively in the third quarter of 2022 as compared to the third quarter of 2021.

For the year-to-date comparisons the increase in interest expense is mostly attributable to a $106.1 million increase in borrowed funds combined with the impact of interest rate increases in 2022.

The average cost of interest-bearing deposits increased by 26 basis points to 40 basis points for the third quarter of 2022 compared to the third quarter of 2021, and by 10 basis points to 24 basis points for the first nine months of 2022 as compared to the same period in 2021.

This increase is almost entirely due to the prime-based certificate of deposit account that adjusts with each change in the Wall Street Journal Prime rate.

As described above, this certificate of deposit product pays between 325 and 400 basis points below the Wall Street Journal Prime rate.

The Wall Street Journal Prime rate has increased by 300 basis points for the first nine months of 2022.

The average cost of borrowed funds increased 96 basis points for the third quarter of 2022 as compared to the same period in 2021 and by 66 basis points for the first nine months of 2022 as compared to the first nine months of 2021.

Non-interest bearing demand deposits increased $36.3 million or 3% for the third quarter of 2022 as compared to the third quarter of 2021, and increased by $77.4 million or 7% for the first nine months of 2022 as compared to the first nine months of 2021.

PROVISION FOR CREDIT LOSSES ON LOANS AND LEASES

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The Company sets aside an allowance for credit losses on loans and leases, a contra-asset account, through periodic charges to earnings which are reflected in the income statement as the provision for credit losses on loans and leases.

The Company recorded an expense related to a credit loss provision for loans and leases of $2.5 million in the second quarter of 2022 relative to a provision for loan and lease losses benefit of $2.1 million in the second quarter of 2021, and a year-to-date credit loss provision for loans and leases of $3.1 million in 2022 as compared to a $1.9 million loan and lease loss provision benefit in 2021.

The higher provision for credit losses in the second quarter of 2022 over the same quarter in 2021, was primarily due to the impact of the change in reserve methodology from the incurred loss method to the current expected credit loss method combined with $2.3 million in net charge-offs in the second quarter of 2022 from a single office building loan relationship that was sold at a discount due to an increased risk of default that would have likely led to a prolonged collection period.

For the first six months of 2022 compared to the same period in 2021 the $5.0 million increase in provision for credit losses on loans and leases is due to the change in reserve methodology along with the impact of $4.1 million in net charge offs for the first six months of 2022.

The first half of 2022 was not only impacted by the loan relationship as mentioned above in the quarterly discussion but also by a charge-off on a single dairy loan relationship that defaulted in March 2022.

The Company recorded an expense related to a credit loss provision for loans and leases of $1.2 million in the third quarter of 2022 relative to a provision for loan and lease losses benefit of $0.6 million in the third quarter of 2021, and a year-to-date credit loss provision for loans and leases of $4.4 million in 2022 as compared to a $2.5 million loan and lease loss provision benefit in 2021.

The Company's $1.8 million increase in the provision for credit losses on loans and leases in the third quarter of 2022 as compared to the third quarter of 2021, and the $6.8 million year to date increase in the provision for credit losses on loans and leases, compared to the same period in 2021 was primarily due to the impact of $4.3 million in net charge-offs in the first nine months of 2022.

The increase in the provision for credit losses on loans and leases for the third quarter of 2022 was principally from an $1.2 million increase to the specific reserve on a single dairy relationship while the increase in the provision for credit losses on loans and leases year-to-date also included a charge off on the same loan relationship combined with a single office building loan relationship that was sold at a discount due to an increased risk of default that would have likely led to a prolonged collection period.

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 charge-offs of $2.3 million in the second quarter of 2022 as compared to net recoveries of $0.2 million for the comparative period of 2021.

For the first six months of 2022, net charge-offs were $4.1 million as compared to $0.5 million in net recoveries for the same period of 2021.

The allowance for credit losses on loans and leases is at a level that, in Management’s judgment, is adequate to absorb probable credit losses on loans related to individually identified loans as well as probable incurred credit losses in the remaining loan portfolio.

The Company recorded net charge-offs of $0.2 million in both third quarters of 2022 and 2021.

For the first nine months of 2022, net charge-offs were $4.3 million as compared to $0.3 million in net recoveries for the same period of 2021.

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 10 to the consolidated financial statements, and below, under “Allowance for Credit Losses.” The process utilized to establish an appropriate credit allowance for losses on loans and leases can result in a high degree of variability in the Company’s credit loss provision, and consequently in our net earnings.

NONINTEREST INCOME AND NONINTEREST EXPENSE

The following table provides details on the Company’s noninterest income and noninterest expense for the three- and six-month periods ended June 30, 2022 and 2021:

The following table provides details on the Company’s noninterest income and noninterest expense for the three- and nine-month periods ended September 30, 2022 and 2021:

Noninterest Income/Expense

(dollars in thousands, unaudited)

For the three months ended June 30,

For the six months ended June 30,

For the three months ended September 30,

For the nine months ended September 30,

Noninterest income:

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Professional services costs

Legal & accounting

Acquisition costs

Legal & accounting services

Director's deferred compensation

Other professional service

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Noninterest Income:

Total noninterest income increased by $3.8 million, or 58%, for the quarter ended June 30, 2022 as compared to the same quarter in 2021 and increased $3.1 million, or 23% for the comparable year-to-date periods.

Service charges on customer deposit account income increased by $0.5 million, or 18%, to $3.2 million in the second quarter of 2022 as compared to the second quarter of 2021.

This service charge income was $0.8 million higher, or 14% in the first six months of 2022, as compared to the same period in 2021.

These increases in the quarterly and year-to-date comparisons are primarily a result of increased analysis fees and overdraft income.

Overdraft fees and returned check charges increased $0.2 million to $1.4 million for the second quarter of 2022, and increased $0.4 million to $2.7 million for the first six months of 2022.

Total noninterest income decreased $0.9 million, or 12%, for the quarter ended September 30, 2022 as compared to the same quarter in 2021, and increased $2.1 million, or 10% for the year-to-date period ended September 30, 2022 as compared to the same period in 2021.

Service charges on customer deposit account income were relatively unchanged in the third quarter of 2022 as compared to the third quarter of 2021.

This service charge income was $0.8 million higher, or 9% in the first nine months of 2022, as compared to the same period in 2021.

These increase in the year-to-date comparisons are primarily a result of increased analysis fees and overdraft income.

Overdraft fees and returned check charges were unchanged for the third quarter of 2022 over the like quarter in 2021, and increased $0.4 million to $4.0 million for the first nine months of 2022.

Effective in the third quarter of 2022, the Company made several changes to its NSF fees (i.e.

returned item) and overdraft fees for customers.

In particular, NSF fees will no longer be charged, and overdraft fees will be limited to 4 per day and no continuous overdraft fee will be charged.

In particular NSF fees are no longer charged, and overdraft fees are limited to 4 per day and no continuous overdraft fee will be charged.

In addition, the amount of overdraft privilege (i.e.

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Although the exact impact of these changes is unknown, the combination of eliminating NSF fees and increasing overdraft privilege is not expected to have a material impact on overall overdraft income.

Other service charges and fees decreased $0.2 million or 5% for the second quarter of 2022 as compared to the same period in 2021, and increased $0.1 million for the first half of 2022 as compared to the same periods in 2021.

The unfavorable variance for the quarterly comparison is mostly due to lower miscellaneous loan fees while the increase for the year to date comparison is mainly due to an increase in debit card interchange fees from higher usage.

There were no gains of the sales of securities for the second quarter of 2022 or 2021, but there was a $1.0 million gain on the sale of securities for the first half of 2022 with no sales in the comparable year-to-date period of 2021.

The sale in the first half of 2022 was a strategic effort to rebalance the portfolio by selling longer duration and higher price volatility securities as a hedge against rising interest rates, due to likely persistent inflationary pressures in the near-intermediate term environment.

BOLI income decreased by $1.4 million for the second quarter of 2022 as compared to the second quarter of 2021.

At June 30, 2022, there was $42.9 million in traditional BOLI policies and $9.3 million in separate account corporate owned life insurance policies associated with the deferred compensation plans.

Other service charges and fees increased $0.1 million or 3% for the third quarter of 2022 as compared to the same period in 2021, and increased $0.2 million for the first nine months of 2022 as compared to the same period in 2021.

There were no gains of the sales of securities for the third quarter of 2022 or 2021, but there was a $1.0 million gain on the sale of securities for the first nine months of 2022 with no sales in the comparable year-to-date period of 2021.

The sale in the first nine months of 2022 was a strategic effort to rebalance the portfolio by selling longer duration and higher price volatility securities as a hedge against rising interest rates, due to likely persistent inflationary pressures in the near-intermediate term environment.

BOLI income decreased by $1.1 million for the third quarter of 2022 as compared to the third quarter of 2021.

At September 30, 2022, there was $43.1 million in traditional BOLI policies and $9.0 million in separate account corporate owned life insurance policies associated with the deferred compensation plans.

Investments in the separate account variable life insurance policies are invested in a similar proportionate mix of asset classes that our deferred compensation participants have elected, with the exception of participant elections in a fixed income account.

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Directors and officers are allowed to make a deemed investment in a fixed income account designed to mirror the crediting rate on one of the life insurance policies.

However, the amount of deferred compensation elected to attributed to the fixed income account significantly exceeds the amount of life insurance invested in a similar fixed income account.

However, the amount of deferred compensation attributed to the fixed income account significantly exceeds the amount of life insurance invested in a similar fixed income account.

As the life insurance funding does not closely match the deferred compensation deemed investments, fluctuations occur in earnings of the life insurance plan as compared to the related expense of the deferred compensation plan.

If earnings on the life insurance plan are negative, it creates a scenario where the negative income is not tax deductible and has an unfavorable impact on the Company’s tax rate.

This occurred in 2022 as the lower quarterly values in the life insurance policies were only partially offset by lower deferred compensation expense reflected primarily in director fees expense.

For the first half of 2022 as compared to the same period in 2021 life insurance income was $2.6 million lower and the related deferred compensation was $1.8 million lower.

In the “other” category of noninterest income the Company reflected a $4.9 million increase in the second quarter of 2022 as compared to the second quarter of 2021, and a $3.8 million increase in the first half of 2022 as compared to the same period in 2021.

The quarterly and year-to-date comparison includes non-recurring gains resulting from the sale of Visa B stock of $2.6 million and a small business investment company fund investment of $0.6 million, as well as $0.4

million in life insurance proceeds, a $1.0 million recovery of prior year legal expenses, and a $0.2 million gain from a recovery on an acquired loan.

This scenario occurred in 2022 as the lower values of funds inside the life insurance policies were only partially offset by lower deferred compensation expense reflected primarily as negative deferred director fees expense.

For the first nine months of 2022 as compared to the same period in 2021 life insurance income was $3.7million lower and the related deferred compensation and deferred director’s fees was $2.5 million lower.

In the “other” category of noninterest income the Company there was relatively no change in the third quarter of 2022 as compared to the third quarter of 2021, and a $3.9 million increase in the first nine months of 2022 as compared to the same period in 2021.

The year-to-date comparison includes non-recurring gains resulting from the sale of Visa B stock of $2.6 million and a small business investment company fund investment of $0.6 million, as well as $0.4 million in life insurance proceeds, a $1.0 million recovery of prior year legal expenses, $0.2 million reduction in partnership costs, and a $0.2 million gain from a recovery on an acquired loan.

Noninterest Expense:

Total noninterest expense increased by $1.9 million, or 9%, in the second quarter of 2022 relative to the second quarter of 2021, and by $1.8 million, or 4%, in the first six months of 2022 as compared to the first six months of 2021.

The tax-equivalent efficiency ratio was 59.19% in the second quarter of 2022 as compared to 58.79% in the same quarter of 2021, and was 62.70% for the first half of 2022 as compared to 57.58% for the first half of 2021.

Total noninterest expense increased by $0.1 million, or 1%, in the third quarter of 2022 relative to the third quarter of 2021, and by $1.9 million, or 3%, in the first nine months of 2022 as compared to the first nine months of 2021.

The tax-equivalent efficiency ratio was 58.10% in the third quarter of 2022 as compared to 59.75% in the same quarter of 2021, and was 61.10% for the first nine months of 2022 as compared to 58.29% for the first nine months of 2021.

The efficiency ratio represents total noninterest expense divided by the sum of fully tax-equivalent net interest and noninterest income;

the provision for credit losses on loans and leases and investment gains/losses are excluded from the equation.

Salaries and Benefits were $1.3 million, or 13%, higher in the second quarter of 2022 as compared to the second quarter of 2021 and $2.0 million, or 9% higher for the first six months of 2022 compared to the same period in 2021.

Salaries and Benefits were $0.9 million, or 9%, higher in the third quarter of 2022 as compared to the third quarter of 2021 and $2.9 million, or 9%, higher for the first nine months of 2022 compared to the same period in 2021.

The reason for this increase is primarily due to increased salary expense due to the strategic hiring of lending and management staff for both the quarterly and year-to-date comparisons.

Overall full-time equivalent employees were 504 at June 30, 2022 as compared to 486 at June 30, 2021.

Occupancy expenses were $0.2 million lower for the second quarter of 2022 as compared to the same quarter in 2021 and $0.4 million lower for the first half of 2022 as compared to the first half of 2021.

The primary reason for this decrease was from a decrease in premises depreciation due to the sale of a branch building which was closed in the third quarter of 2021.

Other noninterest expense increased $0.8 million, or 11% for the second quarter 2022 as compared to the second quarter in 2021, and increased $0.2 million, or 2% for the first half of 2022 as compared to the same period in 2021.

The variance for the second quarter of 2022 compared to the same period in 2021 was driven by a $0.7 million accrual for restitution payments to customers charged nonsufficient fund fees in the past five years for representments.

This accrual was established after the FDIC published a change in its position in how such representments are characterized for regulatory purposes.

The Company also incurred higher costs of $0.3 million associated with postage and mailing of new account agreements to customers as well as higher professional fees associated with this matter.

Beginning in the third quarter of 2022, the Company will no longer charge customers for returned item fees, commonly referred to as nonsufficient fund fees.

In addition, the Company increased overdraft privilege for both commercial and consumer customers, but will limit the number of daily overdraft fees to four per day (previously five per day) and will no longer charge a fee for continuous overdrafts (previously a $35 charge after the 10 th consecutive day an account is in an overdraft position).

There were 500 full-time equivalent employees at September 30, 2022 as compared to 482 at September 30, 2021.

Occupancy expenses were $0.1 million higher for the third quarter of 2022 as compared to the same quarter in 2021 and $0.3 million lower for the first nine months of 2022 as compared to the same period in 2021.

The primary reason for increase in the quarterly comparisons was from increases in utility rate and usage.

For the year-to-date comparison the decreases came from the closure of five branch facilities in 2021.

Other noninterest expense decreased $0.9 million, or 11% for the third quarter 2022 as compared to the third quarter in 2021, and decreased $0.7 million, or 3% for the first nine months of 2022 as compared to the same period in 2021.

The variances for the third quarter of 2022 compared to the same period in 2021 was primarily driven by a decrease of $0.5 million in legal costs, a $0.7 million favorable variance in directors deferred compensation expense, linked to the changes in BOLI income, and lower telecommunications costs.

For the year-over-year comparison the categories of increase were the same as with the quarterly comparison, along with a $0.3 million decrease in consultant expenses partially offset by increases in hiring and recruiting costs, and a $0.7 million restitution payment to customers charged nonsufficient fund fees in the past five years for representments.

The restitution payment was made after the FDIC published supervisory guidance addressing certain consumer compliance risks associated with the treatment of non-sufficient fund charges on representments.

Beginning in the third quarter of 2022, the Company no longer charges customers for returned item fees, commonly referred to as nonsufficient fund fees.

In addition, the Company increased overdraft privilege for both commercial and consumer customers, but is limiting the number of daily overdraft fees to four per day (previously five per day) and is no longer charging a fee for continuous overdrafts (previously a $35 charge after the 10 th consecutive day an account is in an overdraft position).

These changes to our nonsufficient fund fees, overdraft fees and overdraft privilege program are not expected to have a material impact on deposit fee income.

In addition, there was a $0.4 million increase in recruitment costs associated with new lending teams and management staff.

For the quarterly and year-to-date comparisons decreases in deferred compensation expense for directors, which is linked to the changes in life insurance income partially offset the increases.

PROVISION FOR INCOME TAXES

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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 26.3% of pre-tax income in the second quarter of 2022 relative to 25.3% in the second quarter of 2021, and 26.6% of pre-tax income for the first half of 2022 relative to 25.4% for the same period in 2021.

The Company's provision for income taxes was 25.1% of pre-tax income in the third quarter of 2022 relative to 24.1% in the third quarter of 2021, and 26.1% of pre-tax income for the first nine months of 2022 relative to 25.0% for the same period in 2021.

The increase in effective tax rate for both the quarterly and year-to-date comparisons is due to the volatility in the Corporate Owned Life Insurance asset value associated with our non-qualified deferred compensation plans.

second quarter and first half of 2022, the investments associated with the non-qualified deferred compensation plans declined in value, resulting in a non-deductible expense as compared to an increase in value generating non-taxable income for the second quarter, and first half of 2021.

In the third quarter and first nine months of 2022, the investments associated with the non-qualified deferred

compensation plans declined in value, resulting in a non-deductible expense as compared to an increase in value generating non-taxable income for the third quarter, and first nine months of 2021.

BALANCE SHEET ANALYSIS

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and 5) they can provide partially tax exempt income.

The investment portfolio is reflected on the balance sheet as investment securities and totaled $1.03 billion, or 30% of total assets at June 30, 2022, and $973.3 million, or 29% of total assets at December 31, 2021.

The increase was primarily due to purchases of $215.3 million to deploy cash into interest earning assets and to provide Balance Sheet diversification.

In addition, within the Cash and Due from Banks account on the balance sheet was $79.8 million of surplus interest earning balances in our Federal Reserve Bank account at June 30, 2022, as compared to $193.2 million at December 31, 2021.

Surplus balances in our Federal Reserve Bank account and fed funds sold to correspondent banks typically represent the temporary investment of excess liquidity.

The investment portfolio is reflected on the balance sheet as investment securities and totaled $1.2 billion, or 35% of total assets at September 30, 2022, and $973.3 million, or 29% of total assets at December 31, 2021.

The increase was primarily due to purchases of municipal bonds for $65.8 million, corporate securities of $25.8 million, and AAA and AA tranches of collateralized loan obligations of $167.2 million, partially offset by decreases in government and agency securities, including mortgage-backed securities and collateralized mortgage obligations of $6.4 million.

The Company carries “available for sale” investments at their fair market values and “held to maturity” investments at amortized cost.

We currently have the intent and ability to hold our investment securities to maturity, but the securities are all marketable.

The expected average duration was 3.2 years at June 30, 2022, and at year-end 2021.

In the second quarter of 2022 the Company transferred $162.1 million of “available for sale” investments to “held to maturity”.

The expected effective duration was 2.7 years for available-for-sale investments and 6.8 years for held-to-maturity investments at September 30, 2022, as compared to 3.2 years for available-for-sale investments at December 31, 2021.

In the second and fourth quarters of 2022 the Company transferred $162.1 million and $198.3 million, respectively of “available for sale” investments to “held to maturity”.

Those securities were transferred at fair market value on the date of the transfer.

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(dollars in thousands, unaudited)

June 30, 2022

September 30, 2022

December 31, 2021

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Total securities

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 $169.2 million at June 30, 2022 and $167.2 million at December 31, 2021, leaving $842.1 million in unpledged debt securities at June 30, 2022 and $806.1 million at December 31, 2021.

Securities that were pledged in excess of actual pledging needs and were thus available for liquidity purposes, if needed, totaled $38.2 million at June 30, 2022 and $47.0 million at December 31, 2021.

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 $175.5 million at September 30, 2022 and $167.2 million at December 31, 2021, leaving $1.05 billion in unpledged debt securities at September 30, 2022 and $806.1 million at December 31, 2021.

Securities that were pledged in excess of actual pledging needs and were thus available for liquidity purposes, if needed, totaled $34.6 million at September 30, 2022 and $47.0 million at December 31, 2021.

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.

The balances in the table are after 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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(dollars in thousands, unaudited)

June 30, 2022

September 30, 2022

December 31, 2021

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Total loans and leases, net

Gross loans and leases at $2.0 billion, increased $32.9 million during the first half of 2022 with an overall 2% change.

The increase in gross loan balances as compared to December 31, 2021 was primarily a result of an increase in 1-4 family residential real estate loans, mostly from the purchase of $173.1 million in high quality jumbo mortgage loans designed as a bridge to organic growth, and a $12.8 million organic increase in multi-family residential loans.

Organic loan production for the first half of 2022 was $142.1 million, a 61% increase, as compared to $88.3 million for the comparative period in 2021, as the new lending teams hired earlier in the year have been gaining traction in our market.

Counterbalancing these positive variances were loan paydowns, charge-offs and maturities resulting in net declines in many categories even with higher loan production.

In particular, there was a $20.4 million net decrease in construction loans, a $9.9 million net decline in commercial real estate loans, a $37.0 million net reduction in commercial and industrial loans, a $43.0 million unfavorable change in mortgage warehouse line utilization, and a $10.2 million net decline in agricultural loans.

Net loans and leases at $2.0 billion, increased $22.6 million during the first nine months of 2022 with an overall 1% change.

The increase was primarily a result of an increase in 1-4 family residential real estate loans, mostly from the purchase of $173.1 million in high quality fixed-rate jumbo mortgage loans.

Other positive variances from organic growth included a $10.8 million increase in ag real estate, a $16.2 million increase in multi-family real estate, and an increase of $4.1 million in commercial real estate.

Negatively impacting these positive variances were loan paydowns and maturities resulting in net declines in many categories even with solid loan production.

In particular there was a $28.3 million net decrease in construction loans, a $38.4 million decrease in commercial and industrial loans, and a $54.6 million unfavorable variance in mortgage warehouse loans.

Further, SBA PPP loan forgiveness resulted in a $27.6 million decline in loan balances, included in the commercial and industrial variance noted above.

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For the three months ended:

For the six months ended:

June 30, 2022

March 31, 2022

June 30, 2021

June 30, 2022

June 30, 2021

For the nine months ended:

September 30, 2022

September 30, 2021

September 30, 2022

September 30, 2021

Gross loans beginning balance

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Loans, net of deferred costs and (fees)

The Company’s regulatory commercial real estate concentration ratio decreased to 238% at June 30, 2022 as compared to 248% at December 31, 2021.

Unused commitments, excluding mortgage warehouse and overdraft lines, were $199.4 million at June 30, 2022, compared to $242.3 million at December 31, 2021.

Total line utilization, excluding mortgage warehouse and consumer overdraft lines, was 61.2% at June 30, 2022 and 61.0% at December 31, 2021.

Mortgage warehouse utilization declined significantly to 12% at June 30, 2022, as compared to 28% at December 31, 2021.

It should be noted that approximately $278.0 million of the mortgage warehouse lines were moved to repurchase agreement lines that provide stronger credit protection to the Company, as well as more favorable regulatory capital treatment as these repurchase lines are not considered off-balance sheet commitments.

The Company’s regulatory commercial real estate concentration ratio decreased to 235% at September 30, 2022 as compared to 248% at December 31, 2021.

Unused commitments, excluding mortgage warehouse and overdraft lines, were $228.4 million at September 30, 2022, compared to $219.6 million at December 31, 2021.

Total line utilization, excluding mortgage warehouse and consumer

overdraft lines, was 57.9% at September 30, 2022 and 61.4% at December 31, 2021.

Mortgage warehouse utilization declined significantly to 9% at September 30, 2022, as compared to 28% at December 31, 2021.

It should be noted that the majority of the mortgage warehouse lines were moved to repurchase agreement lines that provide stronger credit protection to the Company, as well as more favorable regulatory capital treatment as these repurchase lines are not considered off-balance sheet commitments.

As expected, PPP loans continue to decline as borrowers receive forgiveness on these loans.

There were 107 loans for $8.2 million outstanding at June 30, 2022, compared to 438 loans for $31.8 million at December 31, 2021.

There were 43 loans for $3.6 million outstanding at September 30, 2022, compared to 438 loans for $31.8 million at December 31, 2021.

NONPERFORMING ASSETS

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(dollars in thousands, unaudited)

June 30, 2022

September 30, 2022

December 31, 2021

June 30, 2021

September 30, 2021

NON-ACCRUAL LOANS:

Other construction/land

1-4 family - closed-end

Commercial real estate - owner occupied

Commercial real estate - non-owner occupied

TOTAL REAL ESTATE

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(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 $25.1 million, to $29.7 million during the first half of 2022, primarily as a result of a downgrade in the first quarter of 2022, consisting of one relationship in the dairy industry comprising four separate loans.

These loans were written down by $1.96 million and no further allowance for credit losses was deemed necessary on these loans.

The Company's ratio of nonperforming loans to gross loans increased to 1.47% at June 30, 2022 from 0.23% at December 31, 2021.

All of the Company's nonperforming assets are periodically reviewed and are either well-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 $4.7 million in loans classified as performing TDRs on which we were still accruing interest as of June 30, 2022, a decrease of $0.2 million, or 4%, relative to December 31, 2021.

Foreclosed assets had a carrying value of $0.002 million at June 30, 2022 and $0.1 million December 31, 2021 comprised of one property classified as OREO.

Total nonperforming assets increased by $22.2 million, to $26.8 million during the first nine months of 2022, primarily as a result of an increase in non-accrual loan balances and the downgrade in the first quarter of 2022, consisting of one relationship in the dairy industry comprising four separate loans.

These loans were written down by $1.96 million with a corresponding charge-off in the first quarter of 2022.

A $1.2 million allowance for credit losses was recorded in the third quarter of 2022 based on management’s most recent estimate of net realizable value on the related collateral.

The Company's ratio of nonperforming loans to gross loans increased to 1.33% at September 30, 2022 from 0.23% at December 31, 2021.

All of the Company's nonperforming assets are periodically reviewed and are either well-reserved

based on current loss expectations or are carried at the fair value of the underlying collateral, net of expected disposition costs and management believes the established allowance for credit loss on such loans is appropriate based primarily on recent independent appraisals.

As shown in the table, we also had $4.6 million in loans classified as performing TDRs on which we were still accruing interest as of September 30, 2022, a decrease of $0.3 million, or 6%, relative to December 31, 2021.

There were no foreclosed assets at September 30, 2022 and $0.1 million at December 31, 2021, comprised of one property classified as OREO.

The property was written down to fair value less disposition costs in the second quarter of 2022 and subsequently sold in the third quarter of 2022.

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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 $5.3 million in loans past due 30-59 days at June 30, 2022.

This is an increase of $3.1 million over the balance at December 31, 2021.

The Company had $1.2 million in loans past due 30-59 days at September 30, 2022.

This is a decrease of $1.0 million over the balance at December 31, 2021.

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.

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recoveries are generally recorded only when sufficient cash payments are received subsequent to the charge off.

After deferring implementation of the CECL accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326) under section 4014 of the CARES Act, the Company implemented CECL on January 1, 2022 .

Upon implementation the Company recorded a $10.4 million increase in the allowance for credit losses, which included a $0.9 million reserve for unfunded commitments as an adjustment to equity, net of deferred taxes.

The Company's allowance for credit losses on loans and leases was $22.8 million at June 30, 2022, as compared to $14.3 million at December 31, 2021, and $16.4 million at June 30, 2021.

The $8.5 million increase in the allowance for credit losses on loans and leases during the first half of 2022 is due to a $9.5 million one-time adjustment from the implementation of CECL on January 1, 2022, a $3.1 million provision for credit losses on loans and leases, and net loan charge-offs of $4.1 million.

The allowance was 1.13% of gross loans at June 30, 2022, 0.72% of gross loans at December 31, 2021, and 0.77% of total loans at June 30, 2021.

Management's detailed analysis indicates that the Company's allowance for credit losses on loans and leases should be sufficient to cover credit losses for the life of the loans and leases outstanding as of June 30, 2022, but no assurance can be given that the Company will not experience substantial future losses relative to the size of the loan and lease loss allowance.

A separate allowance of $0.9 million for potential credit losses inherent in unused commitments is included in other liabilities at June 30, 2022, as compared to $0.2 million at December 31, 2021.

As mentioned previously a $0.9 million

one-time adjustment was recorded to the reserve for unfunded commitments on January 1, 2022 upon the implementation of CECL.

Due to the uncertainty of national and local economic conditions, the Company deferred implementation of the CECL accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326) under section 4014 of the CARES Act.

The Company implemented CECL on January 1, 2022, and recorded a $10.4 million increase in the allowance for credit losses, which included a $0.9 million reserve for unfunded commitments as an adjustment to equity, net of deferred taxes.

The Company's allowance for credit losses on loans and leases was $23.8 million at September 30, 2022, as compared to $14.3 million at December 31, 2021, and $15.6 million at September 30, 2021.

The $9.5 million increase in the allowance for credit losses on loans and leases during the first nine months of 2022 is due to a $9.5 million one-time adjustment from the implementation of CECL on January 1, 2022, a $4.4 million provision for credit losses on loans and leases, and net loan charge-offs of $4.3 million.

The allowance for credit losses on loans and leases was 1.18% of gross loans at September 30, 2022, and 0.72% of gross loans at December 31, 2021.

Management's detailed analysis indicates that the Company's allowance for credit losses on loans and leases should be sufficient to cover credit losses for the life of the loans and leases outstanding as of September 30, 2022, but no assurance can be given that the Company will not experience substantial future losses relative to the size of the loan and lease loss allowance.

A separate allowance of $0.9 million for potential credit losses inherent in unused commitments is included in other liabilities at September 30, 2022, as compared to $0.2 million at December 31, 2021.

As mentioned previously a $0.9 million one-time adjustment was recorded to the reserve for unfunded commitments on January 1, 2022 upon the implementation of CECL.

The following table summarizes activity in the credit allowance for losses on loans and leases for the noted periods:

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For the year ended

September 30,

Average gross loans and leases outstanding during period (1)

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(1) Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.

The Company’s credit allowance for losses on loans and leases at June 30, 2022 represents Management’s best estimate of expected 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.

The Company’s credit allowance for losses on loans and leases at September 30, 2022 represents Management’s best estimate of expected 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.

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It is unlikely that all unused commitments will ultimately be drawn down.

Unused commitments to extend credit, which included standby letters of credit, totaled $513 million at June 30, 2022 and $561 million at December 31, 2021, representing approximately 25% of gross loans outstanding at June 30, 2022 and 28% at December 31, 2021.

The decrease in unused commitments is due in large part to the decrease in loan balances with unfunded commitments.

The Company also had undrawn letters of credit issued to customers totaling $3.6 million at June 30, 2022 and December 31, 2021.

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.

Unused commitments to extend credit, which included standby letters of credit, totaled $798.8 million at September 30, 2022 and $560.7 million at December 31, 2021, representing approximately 40% of gross loans outstanding at September 30, 2022 and 28% at December 31, 2021.

Included in unused commitments are mortgage warehouse lines which are mostly in the form of repo lines and are unconditionally cancellable.

Unused commitments on mortgage warehouse lines were $488.4 million at September 30, 2022 and $272.8 million at December 31, 2021.

The increase in unused commitments on mortgage warehouse lines is due in large part to the decrease in funded commitments due to the impact of recent interest rate increases.

Unused commitments exclusive of mortgage warehouse lines have increased $8.8 million or 4% for the first nine months of 2022 and are due to an increase in new lines of credit.

The Company also had undrawn letters of credit issued to customers totaling $2.9 million at September 30, 2022 and December 31, 2021.

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 $125 million letter of credit issued by the Federal Home Loan Bank on the Company’s behalf as security for certain local agency deposits which totaled $77.5 million at June 30, 2022.

That letter of credit is backed by loans that are pledged to the FHLB by the Company.

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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 investments or loans, subject to the bank’s risk tolerances.

The Company’s balance of non-earning cash and due from banks was $82.1 million at June 30, 2022 relative to $63.1 million at December 31, 2021.

The Company’s balance of non-earning cash and due from banks was $82.3 million at September 30, 2022 relative to $63.1 million at December 31, 2021.

Foreclosed assets are discussed above in the section titled “Nonperforming Assets.”

Net premises and equipment decreased by $0.6 million during the first half of 2022, to $22.9 million.

This decline was primarily a result of normal depreciation, net of new purchases.

Goodwill was $27.4 million at June 30, 2022, unchanged during the first half of 2022.

Net premises and equipment decreased by $0.9 million during the first nine months of 2022, to $22.7 million.

This decline was primarily a result of normal depreciation, the disposal of obsolete equipment, net of new purchases.

Goodwill was $27.4 million at September 30, 2022, unchanged during the first nine months of 2022.

Goodwill is tested for impairment annually, unless events and circumstances exist which indicate that an impairment test should be performed.

A Goodwill impairment test was last performed during the fourth quarter 2021 and determined that no impairment existed.

There have been no triggering events in the first six months of 2022 that would require the Company to perform a Goodwill impairment test, however the Company will continue to monitor its Goodwill for potential impairment.

Bank-owned life insurance, with a balance of $52.2 million at June 30, 2022, is discussed in detail above in the “Noninterest Income and Noninterest Expense” section.

There have been no triggering events in the first nine months of 2022 that would require the Company to perform a Goodwill impairment test, however the Company will continue to monitor its Goodwill for potential impairment.

Bank-owned life insurance, with a balance of $52.1 million at September 30, 2022, is discussed in detail above in the “Noninterest Income and Noninterest Expense” section.

DEPOSITS AND INTEREST BEARING LIABILITIES

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(dollars in thousands, unaudited)

June 30, 2022

September 30, 2022

December 31, 2021

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Total deposits

Percentage of Total Deposits

Noninterest bearing demand deposits

Interest bearing demand deposits

Brokered deposits

Deposit balances reflect net growth of $69.4 million, or 2%, during the first half of 2022.

Time deposits were $299.8 million at June 30, 2022 as compared to $293.9 million at December 31, 2021.

Brokered deposits were unchanged at $60.0 million at June 30, 2022 from December 31, 2021.

Non-maturity deposit growth of $63.5 million for the first half of 2022 was primarily the result of increases in balances of existing customers as the total number of customers was relatively unchanged.

Deposit balances reflect net growth of $103.9 million, or 4%, during the first nine months of 2022.

Time deposits were $332.3million at September 30, 2022 as compared to $293.9 million at December 31, 2021.

Most of the increase in time deposits was for the Prime Index Certificate of Deposit account that is floating rate and pays the current Wall Street Journal Prime rate minus a spread of 325 to 400 basis points, with a minimum rate of 20 basis points.

Brokered deposits increased $20.0 million or 33% to $80.0 million at September 30, 2022 as compared to $60.0 million at December 31, 2021.

Non-maturity deposit growth of $45.5 million for the first nine months of 2022 was primarily the result of increases in balances of existing customers as the total number of customers was relatively unchanged.

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 39.3% at June 30, 2022 as compared to 39.0% at December 31, 2021.

In particular, the Company’s ratio of noninterest-bearing deposits to total deposits was 38.8% at September 30, 2022 as compared to 39.0% at December 31, 2021.

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.

Total non-deposit interest-bearing liabilities increased by $11.2 million, during the first half of 2022 primarily due to an increase in customer repurchase agreements.

Repurchase agreements totaled $118.0 million at June 30, 2022 relative to a balance of $106.9 million at year-end 2021.

Total non-deposit interest-bearing liabilities increased by $108.4 million, during the first nine months of 2022 primarily due to an increase in customer repurchase agreements and overnight borrowings.

Repurchase agreements totaled $112.0 million at September 30, 2022 relative to a balance of $106.9 million at year-end 2021.

Repurchase agreements represent “sweep accounts”, where certain customers have elected to have their commercial deposit balances above a specified threshold transferred at the close of each business day into non-deposit investments accounts.

The balance in the investment account is used to have the customer purchase securities or a perfected interest in specifically identified pledged securities from the bank, which are then repurchased by the bank from the customer the next business day.

The Company had Long term debt totaling $49.2 million and $49.1 million at June 30, 2022 and December 31, 2021, respectively, in the form of 3.25% fixed – floating subordinated debt with a ten-year maturity and junior subordinated debentures totaling $35.4 million at June 30, 2022 and $35.3 million at December 31, 2021, in the form of long-term borrowings from trust subsidiaries formed specifically to issue trust preferred securities.

The balance in the

investment account is used to have the customer purchase securities or a perfected interest in specifically identified pledged securities from the bank, which are then repurchased by the bank from the customer the next business day.

FHLB advances comprised all of the $103.1 million in overnight borrowings at September 30, 2022 relative to no like borrowings at year-end 2021.

The Company had Long term debt totaling $49.2 million and $49.1 million at September 30, 2022 and December 31, 2021, respectively, in the form of 3.25% fixed – floating subordinated debt with a ten-year maturity and junior subordinated debentures totaling $35.4 million at September 30, 2022 and $35.3 million at December 31, 2021, 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 $43.1 million at June 30, 2022 as compared to $35.4 million at December 31, 2021, an increase of $7.8 million or 22%.

The increase was primarily driven by the Company’s investment commitment in a $2.0 million low income housing tax credit fund and $5.0 million investment commitment in a FinTech Fund.

The Company’s balance of other liabilities was $51.1 million at September 30, 2022 as compared to $35.4 million at December 31, 2021, an increase of $15.7 million or 44%.

The increase was primarily driven by the Company’s investment commitment in a $2.6 million low-income housing tax credit fund, a $5.0 million investment commitment in a FinTech Fund and $6.8 million in unsettled investment security transactions.

LIQUIDITY AND MARKET RISK MANAGEMENT

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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 June 30, 2022 and December 31, 2021, the Company had the following sources of primary and secondary liquidity (dollars in thousands):

At September 30, 2022 and December 31, 2021, the Company had the following sources of primary and secondary liquidity (dollars in thousands):

Primary and secondary liquidity sources

June 30, 2022

September 30, 2022

December 31, 2021

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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.

Cash and cash equivalents during the first half of 2022, declined $95.7 million due to increases in investment securities and loans and leases.

Utilization of remaining excess liquidity is expected to come from a combination of new organic loan originations, and new investment purchases, mostly in the form of collateralization loan obligations.

In addition, it is possible that a portion of the deposits built-up during the COVID-19 pandemic could be withdrawn by customers.

When looking to reduce these low-yielding cash balances with earning assets, management considers interest rate risk, including duration and extension risk;

and the liquidity risk of such alternative assets.

Cash and cash equivalents during the first nine months of 2022, declined $170.8 million due to increases in investment securities, mostly in the form of collateralized loan obligations.

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.

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 $125 million at June 30, 2022 and December 31, 2021.

That letter of credit, which is backed by loans pledged to the FHLB by the Company, totaled $125 million at September 30, 2022 and December 31, 2021.

Other sources of liquidity include 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 primary liquidity ratio and net loans to deposits were 36.56% and 70.11%, respectively, at June 30, 2022, as compared to internal policy guidelines of “greater than 15%” and “less than 95%.” Ratios and sub-limits for the various components comprising wholesale funding, which were all well within policy guidelines at June 30, 2022, are also periodically reviewed by Management and the Board.

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 primary liquidity ratio and net loans to deposits were 39.12% and 70.01%, respectively, at September 30, 2022, as compared to internal policy guidelines of “greater than 15%” and “less than 95%.” Ratios and sub-limits for the various components comprising wholesale funding, which were all well within policy guidelines at September 30, 2022, are also periodically reviewed by Management and the Board.

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.

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Its primary source of funds is dividends from the Bank since the holding company does not conduct regular banking operations.

As of June 30, 2022, the holding company maintained a cash balance of $7.5 million.

As of September 30, 2022, the holding company maintained a cash balance of $12.4 million.

Management anticipates that the holding company has sufficient liquidity to meet its funding requirements for the foreseeable future.

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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.

The Company reclassified $162.1 million of securities that have the highest level of volatility to changes in interest rates from available-for-sale to held-to-maturity to mitigate the impact on tangible capital.

In the second quarter of 2022, the Company reclassified $162.1 million of securities that have the highest level of volatility to changes in interest rates from available-for-sale to held-to-maturity to mitigate the impact on tangible capital.

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.

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upward shocks of 100, 200, 300, and 400 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.

The downward shock scenarios of 200 300 and 400 basis points were temporarily suspended in the second quarter of 2020 after concurrence by the Company’s Board of Directors, due to the fact that in these down scenarios, projected interest rates would be near or below zero.

At the June 2022 Finance & Sustainability Committee Meeting, Management reinstituted the down 200 scenario, due to the Federal Open Market Committee increasing rates by 150 basis points during the quarter.

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.

Pursuant to policy guidelines, we generally attempt to limit the projected decline in net interest income relative to the 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:

June 30, 2022

June 30, 2021

September 30, 2022

September 30, 2021

Immediate change in Interest Rates (basis points)

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$ Change in Net Interest Income

For the periods ending June 30, 2022 and June 30, 2021, management believes that the Company was asset sensitive, with net income increasing in a rising rate environment in all scenarios but declining in the down shocks.

The Company’s asset sensitivity based on its interest rate risk model at June 30, 2022 as compared to June 30, 2021, is similar.

In the up 400 basis point shock scenario, expected net interest income over the next twelve months increases $11.6 million, or 10%, to $132.7 million at June 30, 2022 compared to an 11% increase or $11.6 million for the same period in 2021.

Over the next twelve months, $161.9 million in surplus cash is projected to decline due to expected core loan growth as our pipelines begin to increase, and a redeployment of excess cash into variable rate investment vehicles such as collateralized loan obligations.

Further, a portion of the significant increase in deposits during the COVID-19 pandemic could be withdrawn by customers.

These expected changes in earnings assets, including overnight cash, are not modeled in the immediate rate shock model described above.

Although the cost of interest-bearing liabilities will also increase in a rate shock, the deposit betas utilized in the interest rate model mitigate the magnitude of a deposit rate increase.

For the periods ending September 30, 2022 and September 30, 2021, management believes that the Company was asset sensitive, with net income increasing in a rising rate environment in all scenarios but declining in the down shocks.

There is a change in the magnitude of the Company’s asset sensitivity based on its interest rate risk model at September 30, 2022 as compared to September 30, 2021, due to the level of overnight cash held with the Federal Reserve Bank.

The Company had $3.2 million in overnight cash at September 30, 2022 as compared to $355.0 million at September 30, 2021;

this reduction in excess funds tempered the degree in which net interest income would increase in the up shocks over the two quarterly comparisons presented.

In the up 400 basis point shock scenario, expected net interest income over the next twelve months increases $8.4 million, or 6%, to $140.0 million at September 30, 2022 compared to an 16.1% increase or $17.4 million for the same period in 2021.

The change in net interest income is similar for the up 100, 200, 300, and 400 basis point scenarios.

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The change in net interest income in the down 200 basis point scenario is a decrease of $15.6 million or 12%.

The reason for the drop in net interest income in the down 200 basis points scenario over the 100 basis point scenario is that many of the deposit products reach their floors and cannot be repriced lower while, non-floored interest earning assets such as loans and securities can theoretically still be re-priced lower in a falling rate environment.

The potential percentage drop in net interest income in the “down 200 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 if deemed appropriate.

The percentage drop in net interest income exceeding internal policy guidelines will most likely continue until interest rates return to historically higher levels.

All interest rate shock scenarios are within our internal policy guidelines, and we will continue to monitor our interest rate risk profile and implement remedial changes if deemed appropriate.

If there was an immediate downward adjustment of 100 basis points in interest rates, net interest income would drop $8.3 million or a negative variance of 8%.

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The modeled 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.

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 June 30, 2022 and 2021, respectively, as the Company’s balance sheet evolves and interest rate and yield curve assumptions are updated.

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 September 30, 2022 and 2021, 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.

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The tables below show estimated changes in the Company’s EVE as modeled under different interest rate scenarios relative to the base case:

June 30, 2022

June 30, 2021

September 30, 2022

September 30, 2021

Immediate change in Interest Rates (basis points)

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CAPITAL RESOURCES

The Company had total shareholders’ equity of $299.0 million at June 30, 2022, comprised of $111.7 million in common stock, $4.6 million in additional paid-in capital, $233.2 million in retained earnings, and accumulated other

comprehensive loss of $50.4 million.

The Company had total shareholders’ equity of $295.1 million at September 30, 2022, comprised of $112.1 million in common stock, $4.5 million in additional paid-in capital, $239.5 million in retained earnings, and accumulated other comprehensive loss of $61.0 million.

At the end of 2021, total shareholders’ equity was $362.5 million.

The decrease in equity during the first half of 2022 is due to net income of $16.6 million, offset by a $7.0 million dividend paid to shareholders, $4.9 million in share repurchases, a $61.6 million unfavorable swing in other comprehensive income/loss due principally to changes in investment securities' fair value and a $7.3 million decrease in retained earnings due to the cumulative effect of a change in accounting principal from the implementation of CECL, topic 326.

The decrease in equity during the first nine months of 2022 is due to net income of $26.5 million, offset by a $10.4 million dividend paid to shareholders, $4.9 million in share repurchases, a $72.2 million unfavorable swing in other comprehensive income/(loss) due principally to changes in investment securities' fair value and a $7.3 million decrease in retained earnings due to the cumulative effect of a change in accounting principal from the implementation of CECL, topic 326.

The remaining difference is related to stock options exercised and restricted stock compensation recognized during the quarter.

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The transfer was initiated to reduce the effect of future rate increases on the available-for-sale portfolio, mark-to-market adjustments, comprehensive income and equity.

The Company approved a new share repurchase program (the 2021 Share Repurchase Plan) on October 21, 2021 and authorized one million shares to be repurchased under this plan.

The previous 2003 Share Repurchase Plan was cancelled and the 268,301 shares remaining in that plan were incorporated into the 2021 Share Repurchase Plan.

There were 182,562 shares repurchased in the first half of 2022, with 630,000 shares remaining to be repurchased under the 2021 Share Repurchase Plan.

The Company approved a new share repurchase program on October 20, 2022 (the 2022 Share Repurchase Plan) that is effective upon the expiration of the prior 2021 Share Repurchase Plan on October 31, 2022.

The 2022 Share Repurchase Plan authorizes 630,000 shares to be repurchased and expires on October 31, 2023.

Under the 2021 Share Repurchase Program, there were 182,562 shares repurchased in the first nine months of 2022.

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.

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Regulatory Capital Ratios

September 30,

Community Bank

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

What changed 10-Q

Item 2. Management’s Discussion and Analysis