Item 2. Management’s Discussion and Analysis
ITEM 2
MANAGEMENT’S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This Form 10- Q includes forward-looking statements that involve inherent risks and uncertainties. These forward-looking statements are within the meaning of Section 27A of the Securities Act of 1933 (“1933 Act”), as amended and Section 21E of the Securities Exchange Act of 1934 (“1934 Act”), as amended. Those sections of the 1933 Act and 1934 Act provide a “safe harbor” for forward-looking statements in order to encourage companies to provide prospective information about their financial performance as long as important factors that could cause actual results to differ significantly from projected results are identified with meaningful cautionary statements. Words such as “expects”, “anticipates”, “believes”, “projects”, “intends”, and “estimates” or variations of such words and similar expressions, as well as future or conditional verbs preceded by “will”, “would”, “should”, “could” or “may” are intended to identify forward-looking statements. These forward-looking statements are based on certain underlying assumptions and are not guarantees of future performance, as they could be impacted by several potential risks and developments that cannot be predicted with any degree of certainty.
These statements are based on management’s current expectations regarding economic, legislative, regulatory and other environmental issues that may affect our earnings in future periods. Therefore, actual outcomes and results may differ materially from what is expressed, forecast in, or implied by such forward-looking statements.
A variety of factors could have a material adverse impact on the Company’s financial condition or results of operations, and should be considered when evaluating the Company’s potential future financial performance. They include, but are not limited to:
● 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;
● increases in nonperforming assets and credit losses that could occur, particularly in times of weak economic conditions or rising interest rates;
● reductions in the market value of available-for-sale securities that could result if interest rates increase substantially or an issuer has real or perceived financial difficulties;
● the Company’s ability to diversify and grow its loan portfolio;
● the Company’s ability to attract and retain skilled employees;
● the Company’s ability to successfully deploy new technology;
● the Company’s ability to maintain a satisfactory rating under the Community Reinvestment Act;
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● the outcome of any existing or future legal action for which the Company or Bank is a defendant;
● 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;
● the success of acquisitions or branch expansions, closures or consolidations; and
● risks associated with the multitude of or changes to current and prospective laws and regulations, and related interpretations, to which the Company is and will be subject.
Risk factors that could cause actual results to differ materially from results that might be implied by forward-looking statements include the risk factors detailed in the Company’s Form 10-K for the fiscal year ended December 31, 2021 and in Item 1A, herein. We do not update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events.
CRITICAL ACCOUNTING POLICIES
The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and incorporate various assumptions that are believed to be reasonable under current circumstances. Actual results may differ from those estimates under divergent conditions.
Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations. In Management’s opinion, the Company’s critical accounting policies deal with the following areas:
● the establishment of the allowance for credit losses, as explained in detail in Note 10 to the consolidated financial statements and in the “Provision for Credit Losses” and “Allowance for Credit Losses” sections of this discussion and analysis;
● the valuation of individually evaluated loans and foreclosed assets, as discussed in Notes 8 and 10 to the consolidated financial statements;
● income taxes and related deferred tax assets and liabilities, especially with regard to the ability of the Company to recover deferred tax assets as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; and
● goodwill and other intangible assets, which are evaluated annually for impairment and for which we have determined that no impairment exists, as discussed in the “Other Assets” section of this discussion and analysis.
Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate our most recent expectations regarding those areas.
OVERVIEW OF THE RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
RESULTS OF OPERATIONS SUMMARY
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
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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:
● 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
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. Negatively
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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
The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on deposits and other borrowed money. The second is noninterest income, which primarily consists of customer service charges and fees but also comes from non-customer sources such as BOLI and investment gains. The majority of the Company’s noninterest expense is comprised of operating costs that facilitate offering a full range of banking services to our customers.
.
NET INTEREST INCOME AND NET INTEREST MARGIN
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
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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.
The following tables show average balances for significant balance sheet categories and the amount of interest income or interest expense associated with each category for the noted periods. The tables also display calculated yields on each major component of the Company’s investment and loan portfolios, average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin for the noted periods .
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Average Balances and Rates
(dollars in thousands, unaudited)
For the three months ended
For the three months ended
September 30, 2022
September 30, 2021
Assets
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Investments:
Interest-earning due from banks
$
21,845
$
103
1.87%
$
379,597
$
146
0.15%
Taxable
851,683
7,646
3.56%
389,524
1,679
1.71%
Non-taxable
336,567
2,346
3.50%
259,996
1,578
3.05%
Total investments
1,210,095
10,095
3.51%
1,029,117
3,403
1.47%
Loans and leases: (3)
Real estate
1,862,738
19,808
4.22%
1,775,611
20,805
4.65%
Agricultural
29,724
274
3.66%
43,243
410
3.76%
Commercial
75,482
973
5.11%
140,105
1,796
5.09%
Consumer
4,228
132
12.39%
4,862
205
16.73%
Mortgage warehouse lines
46,969
623
5.26%
118,036
982
3.30%
Other
2,349
23
3.88%
1,463
28
7.59%
Total loans and leases
2,021,490
21,833
4.28%
2,083,320
24,226
4.61%
Total interest earning assets (4)
3,231,585
31,928
4.00%
3,112,437
27,629
3.58%
Other earning assets
15,717
15,713
Non-earning assets
255,529
212,116
Total assets
$
3,502,831
$
3,340,266
Liabilities and shareholders' equity
Interest bearing deposits:
Demand deposits
$
197,731
$
131
0.26%
$
148,175
$
86
0.23%
NOW
531,205
80
0.06%
605,620
115
0.08%
Savings accounts
485,167
73
0.06%
443,406
63
0.06%
Money market
151,816
25
0.07%
139,433
26
0.07%
Time Deposits
313,764
1,377
1.74%
293,379
248
0.34%
Brokered deposits
63,529
75
0.47%
72,283
53
0.29%
Total interest bearing deposits
1,743,212
1,761
0.40%
1,702,296
591
0.14%
Borrowed funds:
Federal funds purchased
183
1
2.17%
166
—
0.00%
Repurchase agreements
113,933
70
0.24%
78,965
41
0.21%
Short term borrowings
45,414
319
2.79%
1
—
0.00%
Long-term debt
49,182
427
3.44%
3,812
38
3.95%
Subordinated debentures
35,409
439
4.92%
35,229
243
2.74%
Total borrowed funds
244,121
1,256
2.04%
118,173
322
1.08%
Total interest bearing liabilities
1,987,333
3,017
0.60%
1,820,469
913
0.20%
Demand deposits - noninterest bearing
1,140,840
1,104,506
Other liabilities
67,603
53,134
Shareholders' equity
307,055
362,157
Total liabilities and shareholders' equity
$
3,502,831
$
3,340,266
Interest income/interest earning assets
4.00%
3.58%
Interest expense/interest earning assets
0.37%
0.12%
Net interest income and margin (5)
$
28,911
3.63%
$
26,716
3.46%
(1) Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.
(2) Yields and net interest margin have been computed on a tax equivalent basis utilizing a 21% effective tax rate.
(3) Loans are gross of the allowance for possible loan losses. Loan fees have been included in the calculation of interest income. Net loan fees and loan acquisition FMV amortization were $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.
(5) Net interest margin represents net interest income as a percentage of average interest earning assets.
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Average Balances and Rates
(Dollars in Thousands, Unaudited)
For the nine months ended
For the nine months ended
September 30, 2022
September 30, 2021
Assets
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Investments:
Interest-earning due from banks
$
120,359
$
466
0.52%
$
255,962
$
250
0.13%
Taxable
783,384
15,613
2.66%
351,109
4,835
1.84%
Non-taxable
305,212
5,926
3.29%
241,866
4,539
3.18%
Total investments
1,208,955
22,005
2.61%
848,937
9,624
1.71%
Loans and leases: (3)
Real estate
1,820,568
57,792
4.24%
1,826,476
63,211
4.63%
Agricultural
31,376
809
3.45%
44,441
1,237
3.72%
Commercial
84,301
3,351
5.31%
165,916
6,371
5.13%
Consumer
4,313
545
16.89%
5,085
594
15.62%
Mortgage warehouse lines
52,650
1,626
4.13%
167,293
4,061
3.25%
Other
2,066
88
5.69%
1,503
81
7.21%
Total loans and leases
1,995,274
64,211
4.30%
2,210,714
75,555
4.57%
Total interest earning assets (4)
3,204,229
86,216
3.66%
3,059,651
85,179
3.77%
Other earning assets
15,675
14,817
Non-earning assets
235,516
207,523
Total assets
$
3,455,420
$
3,281,991
Liabilities and shareholders' equity
Interest bearing deposits:
Demand deposits
$
207,319
$
357
0.23%
$
147,000
$
251
0.23%
NOW
540,078
243
0.06%
592,177
332
0.07%
Savings accounts
477,904
210
0.06%
419,861
175
0.06%
Money market
152,912
71
0.06%
138,408
86
0.08%
Time Deposits
301,173
2,053
0.91%
347,253
798
0.31%
Brokered deposits
61,189
172
0.38%
88,132
176
0.27%
Total interest bearing deposits
1,740,575
3,106
0.24%
1,732,831
1,818
0.14%
Borrowed funds:
Federal funds purchased
174
2
1.54%
2,032
1
0.07%
Repurchase agreements
110,505
228
0.28%
61,103
124
0.27%
Short term borrowings
15,306
319
2.79%
4,846
2
0.06%
Long-term debt
49,162
1,284
3.49%
1,285
38
0.040
Subordinated debentures
35,365
1,024
3.87%
35,186
736
2.80%
Total borrowed funds
210,512
2,857
1.81%
104,452
901
1.15%
Total interest bearing liabilities
1,951,087
5,963
0.41%
1,837,283
2,719
0.20%
Demand deposits - noninterest bearing
1,122,556
1,045,179
Other liabilities
58,393
45,191
Shareholders' equity
323,384
354,338
Total liabilities and shareholders' equity
$
3,455,420
$
3,281,991
Interest income/interest earning assets
3.66%
3.77%
Interest expense/interest earning assets
0.25%
0.12%
Net interest income and margin (5)
$
80,253
3.41%
$
82,460
3.66%
(1) Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.
(2) Yields and net interest margin have been computed on a tax equivalent basis utilizing a 21% effective tax rate.
(3) Loans are gross of the allowance for possible loan losses. Loan fees have been included in the calculation of interest income. Net loan fees and loan acquisition FMV amortization were $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.
(5) Net interest margin represents net interest income as a percentage of average interest-earning assets.
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The Volume and Rate Variances table below sets forth the dollar difference for the comparative periods in interest earned or paid for each major category of interest earning assets and interest-bearing liabilities, and the amount of such change attributable to fluctuations in average balances (volume) or differences in average interest rates. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates, and rate variances are equal to the change in rates multiplied by prior period average balances. Variances attributable to both rate and volume changes, calculated by multiplying the change in rates by the change in average balances, have been allocated to the rate variance.
Volume & Rate Variances
(dollars in thousands, unaudited)
Three months ended September 30,
Nine months ended September 30,
2022 over 2021
2022 over 2021
Increase (decrease) due to
Increase (decrease) due to
Assets:
Volume
Rate
Mix
Net
Volume
Rate
Mix
Net
Investments:
Federal funds sold/due from time
$
(138)
$
1,644
$
(1,549)
$
(43)
$
(132)
$
741
$
(393)
$
216
Taxable
1,992
1,817
2,157
5,967
5,952
2,163
2,663
10,778
Non-taxable
117
234
417
768
1,199
157
31
1,387
Total investments (1)
1,971
3,695
1,025
6,692
7,019
3,061
2,301
12,381
Loans and leases:
Real estate
1,021
(1,924)
(94)
(997)
(204)
(5,232)
17
(5,419)
Agricultural
(128)
(12)
4
(136)
(364)
(91)
27
(428)
Commercial
(828)
10
(5)
(823)
(3,134)
224
(110)
(3,020)
Consumer
(27)
(53)
7
(73)
(91)
49
(7)
(49)
Mortgage warehouse
(591)
583
(351)
(359)
(2,783)
1,106
(758)
(2,435)
Other
17
(14)
(8)
(5)
30
(17)
(6)
7
Total loans and leases (1)
(536)
(1,410)
(447)
(2,393)
(6,546)
(3,961)
(837)
(11,344)
Total interest earning assets (1)
$
1,435
$
2,285
$
578
$
4,299
$
473
$
(900)
$
1,464
$
1,037
Liabilities
Interest bearing deposits:
Demand deposits
$
29
12
4
$
45
$
103
$
2
1
$
106
NOW
(14)
(24)
3
(35)
(29)
(66)
6
(89)
Savings accounts
6
4
—
10
25
9
1
35
Money market
2
(3)
—
(1)
9
(22)
(2)
(15)
Time Deposits
17
1,040
72
1,129
(106)
1,569
(208)
1,255
Brokered deposits
(6)
32
(4)
22
(54)
72
(22)
(4)
Total interest bearing deposits (1)
34
1,061
75
1,170
(52)
1,564
(224)
1,288
Borrowed funds:
Federal funds purchased
—
1
—
1
(1)
22
(20)
1
Repurchase agreements
18
8
3
29
100
2
2
104
Short term borrowings
—
—
319
319
4
99
214
317
Long-term debt
452
(5)
(58)
389
1,415
(4)
(165)
1,246
Subordinated debt
1
194
1
196
4
283
1
288
Total borrowed funds (1)
471
198
265
934
1,522
402
32
1,956
Total interest bearing liabilities (1)
505
1,259
340
2,104
1,470
1,966
(192)
3,244
Net interest income (1)
$
930
$
1,026
$
238
$
2,195
$
(997)
$
(2,866)
$
1,656
$
(2,207)
(1) Subtotals are a sum of the categories above and are not recalculated on the portfolio totals.
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
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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. These loans are typically adjustable every five years after the initial adjustment. 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 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.
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PROVISION FOR CREDIT LOSSES ON LOANS AND LEASES
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 . 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.
Credit risk is inherent in the business of making loans. 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 $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 $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 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 credit losses in the remaining loan portfolio.
The Company’s policies for monitoring the adequacy of the allowance, determining loan balances that should be charged off, and other detailed information with regard to changes in the allowance are discussed in Note 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.
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NONINTEREST INCOME AND NONINTEREST EXPENSE
The following table provides details on the Company’s noninterest income and noninterest expense for the three- and nine-month periods ended September 30, 2022 and 2021:
Noninterest Income/Expense
(dollars in thousands, unaudited)
For the three months ended September 30,
For the nine months ended September 30,
Noninterest income:
2022
2021
2022
2021
Service charges on deposit accounts
$
3,216
$
3,186
$
9,460
$
8,677
Other service charges and fees
2,982
2,900
8,663
8,511
Net gains on sale of securities available-for-sale
—
11
1,032
11
Bank-owned life insurance
(23)
1,048
(1,251)
2,445
Other
437
390
5,210
1,333
Total noninterest income
$
6,612
$
7,535
$
23,114
$
20,977
As a % of average interest earning assets (1)
0.81%
0.96%
0.96%
0.92%
Noninterest expense:
Salaries and employee benefits
$
11,521
$
10,618
$
35,070
$
32,194
Occupancy costs
Furniture & equipment
399
406
1,363
1,312
Premises
2,071
1,953
5,807
6,160
Advertising and marketing costs
466
370
1,322
982
Data processing costs
1,564
1,470
4,574
4,409
Deposit services costs
2,450
2,402
7,112
6,752
Loan services costs
Loan processing
128
109
426
343
Foreclosed assets
(3)
(19)
84
78
Other operating costs
Telephone & data communications
358
534
1,179
1,582
Postage & mail
47
60
326
253
Other
507
470
2,374
1,269
Professional services costs
Legal & accounting services
535
966
1,753
2,091
Director's deferred compensation
(143)
531
(1,192)
1,133
Other professional service
855
789
2,306
2,086
Stationery & supply costs
114
107
315
259
Sundry & tellers
127
109
463
478
Total noninterest expense
$
20,996
$
20,875
$
63,282
$
61,381
As a % of average interest earning assets (1)
2.58%
2.66%
2.64%
2.68%
Efficiency ratio (2)(3)
58.10%
59.75%
61.10%
58.30%
(1) Annualized
(2) Tax equivalent
(3) The efficiency ratio is a non-GAAP measure and is a calculation of noninterest expense as a percentage of the sum of net interest income and noninterest income excluding net gains (losses) from securities and bank owned life insurance income.
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Noninterest Income:
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 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. the amount to which the Company will pay overdrafts for customers) was increased by $250. 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 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. Such election by plan participants in the fixed income account is ignored which creates greater volatility of the corporate owned life insurance asset value as compared to the related liability balance for deferred compensation. More specifically, the specific account life insurance policies are designed to hold similar assets to the deemed investments in the director and employee deferred compensation plans. 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 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 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.
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Noninterest Expense:
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 $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. 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.
PROVISION FOR INCOME TAXES
The Company sets aside a provision for income taxes on a monthly basis. The amount of that provision is determined by first applying the Company’s statutory income tax rates to estimated taxable income, which is pre-tax book income adjusted for permanent differences, and then subtracting available tax credits. Permanent differences include but are not limited to tax-exempt interest income, BOLI income, and certain book expenses that are not allowed as tax deductions. Our tax credits consist primarily of those generated by investments in low-income housing tax credit funds. The Company's provision for income taxes was 25.1% 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. In the third quarter and first nine months of 2022, the investments associated with the non-qualified deferred
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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
EARNING ASSETS
The Company’s interest earning assets are comprised of loans and investments, including overnight investments and surplus balances held in interest earning accounts in our Federal Reserve Bank account. The composition, growth characteristics, and credit quality of both of those components are significant determinants of the Company’s financial condition. Investments are analyzed in the section immediately below, while the loan and lease portfolio and other factors affecting earning assets are discussed in the sections following investments.
INVESTMENTS
The Company’s investments may at any given time consist of debt securities and marketable equity securities (together, the “investment portfolio”), investments in the time deposits of other banks, surplus interest earning balances in our Federal Reserve Bank account, and overnight fed funds sold. The Company’s investments can serve several purposes, including the following: 1) they can provide liquidity for potential funding needs; 2) they provide a source of pledged assets for securing public deposits, bankruptcy deposits and certain borrowed funds which require collateral; 3) they constitute a large base of assets with structural characteristics that can be changed more readily than loan or deposit portfolios, as might be required for interest rate risk management purposes; 4) they are another interest earning option for the placement of surplus funds when loan demand is light; and 5) they can provide partially tax exempt income.
The investment portfolio is reflected on the balance sheet as investment securities and totaled $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 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. The transfer was initiated to reduce the effect of potential future rate increases on the available-for-sale portfolio, mark-to-market, other comprehensive income and equity. See Note 9, Investment Securities for additional information.
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The following table sets forth the carrying amount for available-for-sale securities, at fair value, and held-to-maturity securities, at amortized cost, net of the allowance for credit losses of the Company’s investment portfolio by investment type as of the dates noted:
Investment Portfolio
(dollars in thousands, unaudited)
September 30, 2022
December 31, 2021
Carrying Amount
Percent
Carrying Amount
Percent
Available for sale
U.S. government agencies
$
3,955
0.32%
$
1,574
0.16%
Mortgage-backed securities
191,022
15.59%
306,727
31.52%
State and political subdivisions
320,729
26.17%
304,268
31.26%
Corporate bonds
54,336
4.43%
28,529
2.93%
Collateralized loan obligations
499,392
40.74%
332,216
34.13%
Total available for sale
1,069,434
87.25%
973,314
100.00%
Held to maturity
U.S. government agencies
6,113
0.50%
—
0.00%
Mortgage-backed securities
100,792
8.23%
—
0.00%
State and political subdivisions
49,306
4.02%
—
0.00%
Total held to maturity
156,211
12.75%
—
0.00%
Total securities
$
1,225,645
100.00%
$
973,314
100.00%
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 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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Loan and Lease Distribution
(dollars in thousands, unaudited)
September 30, 2022
December 31, 2021
Amount
Percent
Amount
Percent
Real estate:
1-4 family residential construction
$
—
—
$
21,369
1.08%
Other construction/land
18,255
0.91%
25,299
1.28%
1-4 family - closed-end
421,136
21.10%
289,457
14.65%
Equity lines
21,441
1.07%
26,588
1.35%
Multi-family residential
69,569
3.49%
53,458
2.71%
Commercial real estate - owner occupied
324,715
16.27%
334,446
16.93%
Commercial real estate - non-owner occupied
894,213
44.80%
882,888
44.69%
Farmland
117,559
5.89%
106,706
5.40%
Total real estate
1,866,888
93.52%
1,740,211
88.09%
Agricultural
31,528
1.58%
33,990
1.72%
Commercial and industrial
70,844
3.55%
109,791
5.56%
Mortgage warehouse lines
46,554
2.33%
101,184
5.12%
Consumer loans
4,202
0.21%
4,550
0.23%
Total loans and leases
2,020,016
101.19%
1,989,726
100.72%
Allowance for credit losses on loans
(23,790)
(1.19)%
(14,256)
(0.72)%
Total loans and leases, net
$
1,996,226
100.00%
$
1,975,470
100.00%
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.
The following table presents a roll forward of the Company’s gross loan balances for each of the periods noted:
LOAN ROLLFORWARD
(Dollars in Thousands, Unaudited)
For the three months ended:
For the nine months ended:
September 30, 2022
June 30,
2022
September 30, 2021
September 30, 2022
September 30, 2021
Gross loans beginning balance
$
2,022,662
$
1,983,331
$
2,144,796
$
1,989,726
$
2,463,111
New credit extended
82,958
119,553
4,656
225,054
92,950
Loan purchases
—
46,364
122,291
173,082
122,291
Changes in line of credit utilization
(7,811)
(17,837)
(15,852)
(45,201)
(55,509)
Change in mortgage warehouse
(11,581)
956
(23,865)
(54,630)
(181,192)
Pay-downs, maturities, charge-offs and amortization (1)
(65,864)
(109,705)
(92,200)
(267,667)
(301,825)
Gross loans ending balance
2,020,364
2,022,662
2,139,826
2,020,364
2,139,826
Deferred costs and (fees), net
(348)
(1,081)
(2,612)
(348)
(2,612)
Loans, net of deferred costs and (fees)
$
2,020,016
$
2,021,581
$
2,137,214
$
2,020,016
$
2,137,214
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
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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 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
Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, in addition to foreclosed assets which is primarily OREO, but can include other foreclosed assets.
If the Company grants a concession to a borrower in financial difficulty, the loan falls into the category of a TDR, unless the modification was granted under section 4013 of the CARES Act or the April 7, 2020 Interagency Statement. TDRs may be classified as either nonperforming or performing loans depending on their underlying characteristics and circumstances. The following table presents comparative data for the Company’s nonperforming assets and performing TDRs as of the dates noted:
Nonperforming assets and performing troubled debt restructurings
(dollars in thousands, unaudited)
September 30, 2022
December 31, 2021
September 30, 2021
NON-ACCRUAL LOANS:
Real estate:
1-4 family - closed-end
$
485
$
1,023
$
1,418
Equity lines
61
892
1,962
Commercial real estate - owner occupied
—
1,234
1,251
Farmland
18,270
—
419
TOTAL REAL ESTATE
18,816
3,149
5,050
Agriculture
7,731
378
471
Commercial and industrial
225
973
1,245
Consumer loans
—
22
22
TOTAL NONPERFORMING LOANS
26,772
4,522
6,788
Foreclosed assets
—
93
93
Total nonperforming assets
$
26,772
$
4,615
$
6,881
Performing TDRs (1)
$
4,639
$
4,910
$
5,509
Nonperforming loans as a % of total gross loans and leases
1.33%
0.23%
0.32%
Nonperforming assets as a % of total gross loans and leases and foreclosed assets
1.33%
0.23%
0.32%
(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 $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
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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. All foreclosed assets are periodically evaluated and written down to their fair value less expected disposition costs, if lower than the then-current carrying value.
An action plan is in place for each of our non-accruing loans and foreclosed assets and they are all being actively managed. Collection efforts are continuously pursued for all nonperforming loans, but we cannot provide assurance that they will be resolved in a timely manner or that nonperforming balances will not increase.
The Company had $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.
ALLOWANCE FOR CREDIT LOSSES – LOANS AND LEASES RECEIVABLE
The allowance for credit losses on loans and leases, a contra-asset, is established through periodic provisions for credit losses on loans and leases. It is maintained at a level that is considered adequate to measure expected losses on individually identified loans, as well as expected losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when sufficient cash payments are received subsequent to the charge off.
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.
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The following table summarizes activity in the credit allowance for losses on loans and leases for the noted periods:
Allowance for Credit Losses on Loans and Leases
(dollars in thousands, unaudited)
For the three
months ended
For the three
months ended
For the nine
months ended
For the nine
months ended
For the year ended
September 30,
September 30,
September 30,
September 30,
December 31,
Balances:
2022
2021
2022
2021
2021
Average gross loans and leases outstanding during period (1)
$
2,021,490
$
2,083,320
$
1,995,274
$
2,210,714
$
2,169,582
Gross loans and leases outstanding at end of period
$
2,020,364
$
2,139,826
$
2,020,364
$
2,139,826
$
1,989,726
Allowance for credit losses on loans and leases:
Balance at beginning of period
$
22,802
$
16,421
$
14,256
$
17,738
$
17,738
Adoption of ASC 326
—
—
9,454
—
—
Provision charged to expense
1,212
(600)
4,360
(2,450)
(3,650)
Charge-offs
Real estate
1-4 family residential construction
—
—
—
—
—
Other construction/land
—
—
—
—
—
1-4 family - closed-end
—
—
—
—
—
Equity lines
—
—
—
12
12
Multi-family residential
—
—
—
—
—
Commercial real estate- owner occupied
—
—
—
233
233
Commercial real estate- non-owner occupied
—
—
1,911
—
—
Farmland
—
—
1,958
—
—
Total real estate
—
—
3,869
245
245
Agricultural
—
—
212
50
50
Commercial and industrial
84
52
244
129
159
Consumer loans
372
274
984
606
946
Total
$
456
$
326
$
5,309
$
1,030
$
1,400
Recoveries
Real estate
1-4 family residential construction
—
—
—
—
—
Other construction/land
—
—
259
328
328
1-4 family - closed-end
—
(84)
87
(78)
(67)
Equity lines
—
25
12
25
25
Multi-family residential
—
—
—
—
—
Commercial real estate- owner occupied
—
—
—
233
233
Commercial real estate- non-owner occupied
—
—
—
82
82
Farmland
—
—
—
—
—
Total real estate
—
(59)
358
590
601
Agricultural
—
—
—
—
—
Commercial and industrial
36
11
118
203
223
Consumer loans
196
170
553
566
744
Total
$
232
$
122
$
1,029
$
1,359
$
1,568
Net loan charge offs (recoveries)
$
224
$
204
$
4,280
$
(329)
$
(168)
Balance at end of period
$
23,790
$
15,617
$
23,790
$
15,617
$
14,256
RATIOS
Net charge-offs (recoveries) to average loans and leases (annualized)
0.04%
0.04%
0.29%
(0.02)%
(0.01)%
Allowance for credit losses on loans and leases to gross loans and leases at end of period
1.18%
0.73%
1.18%
0.73%
0.72%
Allowance for credit losses on loans and leases to nonperforming loans
88.86%
230.07%
88.86%
230.07%
315.26%
Net loan charge-offs (recoveries) to allowance for credit losses on loans and leases at end of period
0.94%
1.31%
17.99%
(2.11)%
(1.18)%
Net loan charge-offs (recoveries) to provision for credit losses on loans and leases
18.48%
(34.00)%
98.17%
13.43%
4.60%
(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 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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OFF-BALANCE SHEET ARRANGEMENTS
The Company maintains commitments to extend credit in the normal course of business, as long as there are no violations of conditions established in the outstanding contractual arrangements. It is unlikely that all unused commitments will ultimately be drawn down. Unused commitments to extend credit, which included standby letters of credit, totaled $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 $51.6 million at September 30, 2022. That letter of credit is backed by loans that are pledged to the FHLB by the Company. For more information on the Company’s off-balance sheet arrangements, see Note 7 to the consolidated financial statements located elsewhere herein.
OTHER ASSETS
Interest earning cash balances were discussed above in the “Investments” section, but the Company also maintains a certain level of cash on hand in the normal course of business as well as non-earning deposits at other financial institutions. Our balance of cash and due from banks depends on the timing of collection of outstanding cash items (checks), the amount of cash held at our branches, and our reserve requirement among other things, and it is subject to significant fluctuations in the normal course of business. While cash flows are normally predictable within limits, those limits are fairly broad and the Company manages its short-term cash position through the utilization of overnight loans to, and borrowings from, correspondent banks, including the Federal Reserve Bank and the Federal Home Loan Bank. Should a large “short” overnight position persist for any length of time, the Company typically raises money through focused retail deposit gathering efforts or by adding brokered time deposits. If a “long” position is prevalent, we could let brokered deposits or other wholesale borrowings roll off as they mature, or we might invest excess liquidity into investments or loans, subject to the bank’s risk tolerances. 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 $0.9 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 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.
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DEPOSITS AND INTEREST BEARING LIABILITIES
DEPOSITS
Deposits represent another key balance sheet category impacting the Company’s net interest income and profitability metrics. Deposits provide liquidity to fund growth in earning assets, and the Company’s net interest margin is improved to the extent that growth in deposits is concentrated in less volatile and typically less costly non-maturity accounts such as demand deposit accounts, NOW accounts, savings accounts, and money market demand accounts. Information concerning average balances and rates paid by deposit type is included in the Average Balances and Rates tables appearing above, in the section titled “Net Interest Income and Net Interest Margin.” A distribution of the Company’s deposits by type, showing the period-end balance and percentage of total deposits, is presented as of the dates indicated in the following table.
Deposit Distribution
(dollars in thousands, unaudited)
September 30, 2022
December 31, 2021
Amount
Percent
Amount
Percent
Noninterest bearing demand deposits
$
1,118,245
38.76%
$
1,084,544
38.98%
Interest bearing demand deposits
187,467
6.50%
129,783
4.67%
NOW
545,001
18.89%
614,770
22.10%
Savings
481,882
16.70%
450,785
16.21%
Money market
140,620
4.87%
147,793
5.31%
Time
332,253
11.51%
293,897
10.57%
Brokered deposits
80,000
2.77%
60,000
2.16%
Total deposits
$
2,885,468
100.00%
$
2,781,572
100.00%
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 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, subordinated notes 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 $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
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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 $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
LIQUIDITY
Liquidity management refers to the Company’s ability to maintain cash flows that are adequate to fund operations and meet other obligations and commitments in a timely and cost-effective manner. Detailed cash flow projections are reviewed by Management on a monthly basis, with various stress scenarios applied to assess our ability to meet liquidity needs under unusual or adverse conditions. Liquidity ratios are also calculated and reviewed on a regular basis. While those ratios are merely indicators and are not measures of actual liquidity, they are closely monitored, and we are committed to maintaining adequate liquidity resources to draw upon should unexpected needs arise.
The Company, on occasion, experiences cash needs as the result of loan growth, deposit outflows, asset purchases or liability repayments. To meet these short-term needs, we can borrow overnight funds from other financial institutions, draw advances via Federal Home Loan Bank lines of credit, or solicit brokered deposits if customer deposits are not immediately obtainable from local sources.
At 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
September 30, 2022
December 31, 2021
Cash and cash equivalents
$
86,683
$
257,528
Unpledged investment securities
1,041,115
806,132
Excess pledged securities
34,606
47,024
FHLB borrowing availability
724,047
787,519
Unsecured lines of credit
305,000
305,000
Funds available through fed discount window
34,235
50,608
Totals
$
2,225,686
$
2,253,811
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 nine months of 2022, declined $170.8 million due to increases in investment securities, mostly in the form of collateralized loan obligations.
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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 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 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.
The holding company’s primary uses of funds include operating expenses incurred in the normal course of business, interest on trust preferred securities and subordinated debt, shareholder dividends, and share repurchases. Its primary source of funds is dividends from the Bank since the holding company does not conduct regular banking operations. 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. Both the holding company and the Bank are subject to legal and regulatory limitations on dividend payments, as outlined in Item 5(c) Dividends in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021 which was filed with the SEC.
INTEREST RATE RISK MANAGEMENT
Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company does not engage in the trading of financial instruments, nor does it have exposure to currency exchange rates. Our market risk exposure is primarily that of interest rate risk, and we have established policies and procedures to monitor and limit our earnings and balance sheet exposure to changes in interest rates. The principal objective of interest rate risk management is to manage the financial components of the Company’s balance sheet in a manner that will optimize the risk/reward equation for earnings and capital under a variety of interest rate scenarios.
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. The model imports relevant information for the Company’s financial instruments and incorporates Management’s assumptions on pricing, duration, and optionality for anticipated new volumes. Various rate scenarios consisting of key rate and yield curve projections are then applied in order to calculate the expected effect of a given interest rate change on interest income, interest expense, and the value of the Company’s financial instruments. The rate projections can be shocked (an immediate and parallel change in all base rates, up or down), ramped (an incremental increase or decrease in rates over a specified time period), economic (based on current trends and econometric models) or stable (unchanged from current actual levels).
In addition to a stable rate scenario, which presumes that there are no changes in interest rates, we typically use at least eight other interest rate scenarios in conducting our rolling 12-month net interest income simulations: upward shocks of 100, 200, 300, and 400 basis points, and downward shocks of 100, 200, and 300 basis points. Those scenarios may be
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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:
September 30, 2022
September 30, 2021
Immediate change in Interest Rates (basis points)
% Change in Net Interest Income
$ Change in Net Interest Income
% Change in Net Interest Income
$ Change in Net Interest Income
+400
6.4%
$
8,374
16.1%
$
17,379
+300
5.0%
$
6,497
13.2%
$
14,317
+200
3.6%
$
4,729
9.8%
$
10,592
+100
2.2%
$
2,917
5.7%
$
6,188
Base
-100
(5.6)%
$
(7,353)
(11.0)%
$
(11,936)
-200
(11.9)%
$
(15,551)
N/A
N/A
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. If there were an immediate and sustained upward adjustment of 100 basis points in interest rates, all else being equal, net interest income over the next 12 months is projected to improve by $2.9 million, or 2%, relative to a stable interest rate scenario, with the favorable variance increasing marginally as interest rates rise higher.
If there was an immediate downward adjustment of 100 basis points in interest rates, net interest income would drop $7.4 million or a negative variance of 6%. The change in net interest income in the down 200 basis point scenario is a decrease of $15.6 million or 12%. 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%. The reason for the drop in net interest income is, most deposit products are at their floors of 0.10% and cannot be re-priced lower, while non-floored interest earning assets such as loans and securities can theoretically still be re-priced lower in a falling rate environment. Due to the historically low current rate environment, we view any material interest rate reductions as unlikely in the near term. However, the potential percentage drop in net interest income in the “down 100 basis points” interest rate scenario exceeds our internal policy guidelines and we will continue to monitor our interest rate risk profile and implement remedial changes if deemed appropriate.
In addition to the net interest income simulations shown above, we run stress scenarios for the unconsolidated Bank where we model the possibility of no balance sheet growth, the potential runoff of “surge” core deposits which flowed into the Bank in the most recent economic cycle, and unfavorable movement in deposit rates relative to yields on earning assets (i.e., higher deposit betas). When a static balance sheet and a stable interest rate environment are assumed, projected annual net interest income is $6.9 million lower than in our standard simulation.
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. 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 September 30, 2022 and 2021, respectively, as the Company’s balance sheet evolves and interest rate and yield curve assumptions are updated.
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The change in economic value under different interest rate scenarios depends on the characteristics of each class of financial instrument, including stated interest rates or spreads relative to current or projected market-level interest rates or spreads, the likelihood of principal prepayments, whether contractual interest rates are fixed or floating, and the average remaining time to maturity. As a general rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the greater the impact a rate change will have on its value. In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based on historical patterns and Management’s best estimates.
Our EVE increased in the past twelve months primarily driven by an increase in deposits and an increase in deposit values. The tables below show estimated changes in the Company’s EVE as modeled under different interest rate scenarios relative to the base case:
September 30, 2022
September 30, 2021
Immediate change in Interest Rates (basis points)
% Change in Fair Value of Equity
$ Change in Fair Value of Equity
% Change in Fair Value of Equity
$ Change in Fair Value of Equity
+400
9.3%
$
68,762
38.1%
$
218,354
+300
7.7%
$
56,711
35.7%
$
204,153
+200
5.4%
$
39,603
29.9%
$
171,390
+100
2.4%
$
17,782
17.6%
$
100,607
Base
-100
(14.4)%
$
(106,169)
(23.1)%
$
(132,270)
-200
(31.1)%
$
(229,698)
N/A
N/A
The table shows that our EVE is modeled to deteriorate in declining rate scenarios but should benefit from a parallel shift upward in the yield curve. The rate of increase in EVE accelerates the higher interest rates rise. This increase in sensitivity is caused by the increase in gross deposits, namely, an increase in noninterest bearing deposits which become more valuable as interest rates rise. We also run stress scenarios for the unconsolidated Bank’s EVE to simulate the possibility of adverse movement in loan prepayment rates, unfavorable changes in deposit rates, and higher deposit decay rates. Model results are highly sensitive to changes in assumed decay rates for non-maturity deposits, in particular, with material unfavorable variances occurring relative to the standard simulations shown above as decay rates are increased. Furthermore, while not as extreme as the variances produced by increasing non-maturity deposit decay rates, EVE also displays a relatively high level of sensitivity to unfavorable changes in deposit rate betas in rising interest rate scenarios.
The potential percentage drop in EVE in the “down 100 and 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 EVE exceeding internal policy guidelines will most likely continue until interest rates and deposit rates return to historically higher levels.
CAPITAL RESOURCES
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 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 Company’s strong liquidity position enabled the transfer of $162.1 million of “available-for-sale” investment securities to “held-to-maturity” classification effective April 1, 2022. 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 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. Management reviews these capital measurements on a quarterly basis and takes appropriate action to help ensure that they meet or surpass established internal and external guidelines. As permitted by the regulators for financial institutions that are not deemed to be “advanced approaches” institutions, the Company has elected to opt out of the Basel III requirement to include accumulated other comprehensive income in risk-based capital. The following table sets forth the Bank’s regulatory capital ratios as of the dates indicated.
Regulatory Capital Ratios
Minimum
Minimum
Requirement
Required
September 30,
December 31,
to be
Community Bank
2022
2021
Well Capitalized (1)
Leverage Ratio (2)
Bank of the Sierra
Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio") (3)
11.54
%
11.31
%
8.50
%
9.00
%
Sierra Bancorp
Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio") (3)
10.45
%
10.43
%
8.50
%
N/A
(1) The Company was subject to these minimum requirements under the regulatory framework for Prompt Corrective Action at December 31, 2019.
(2) If the subsidiary bank’s Leverage Ratio exceeds the minimum ratio under the Community Bank Leverage Ratio Framework, it is deemed to be “well capitalized” under all other regulatory capital requirements. The Company may revert back to the regulatory framework for Prompt Corrective Action if the subsidiary bank’s Leverage Ratio falls below the minimum under the Community Bank Leverage Ratio Framework.
(3) The Company has elected to phase in the impact of implementing CECL on regulatory capital over a three-year period.
The federal banking agencies published a final rule on November 13, 2019, that provided a simplified measure of capital adequacy for qualifying community banking organizations. A qualifying community banking organization that opts into the community bank leverage ratio framework and maintains a leverage ratio greater than 9 percent will be considered to have met the minimum capital requirements, the capital ratio requirements for the well capitalized category under the Prompt Corrective Action framework, and any other capital or leverage requirements to which the qualifying banking organization is subject. A qualifying community banking organization with a leverage ratio of greater than 9 percent may opt into the community bank leverage ratio framework if has average consolidated total assets of less than $10 billion, has off-balance-sheet exposures of 25% or less of total consolidated assets, and has total trading assets and trading liabilities of 5 percent or less of total consolidated assets. Further, the bank must not be an advance approaches banking organization.
The final rule became effective January 1, 2020 and banks that meet the qualifying criteria can elect to use the community bank leverage framework starting with the quarter ended March 31, 2020. The CARES Act reduced the required community bank leverage ratio to 8% until the earlier of December 31, 2020, or the national emergency is declared over. Beginning in 2021 the CBLR was increased to 8.5% for the calendar year with the CBLR increasing to 9% on January 1, 2022. The federal bank regulatory agencies adopted an interim final rule to implement this change from the CARES Act. At September 30, 2021, the Company and the Bank met the criteria outlined in the final rule and the interim final rule and elected to measure capital adequacy under the CBLR framework.
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PART I – FINANCIAL INFORMATION
ITEM 3
QUALITATIVE & QUANTITATIVE DISCLOSURES
ABOUT MARKET RISK
The information concerning quantitative and qualitative disclosures about market risk is included in Part I, Item 2 above. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Market Risk Management.”
PART I – FINANCIAL INFORMATION
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.