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Item 7. Management’s Discussion and Analysis

2023-03-09 compared with 2022-03-10 · 304 added, 339 removed, 605 unchanged (52% of the section changed)

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In Management’s opinion, the Company’s critical accounting estimates deal primarily with the following areas:

the establishment of an allowance for loan and lease losses, as explained in detail in Note 2 to the consolidated financial statements and in the “Provision for Loan and Lease Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis;

the establishment of an allowance for credit losses on loans and leases, as explained in detail in Note 2 to the consolidated financial statements and in the “Provision for Credit Losses on Loans and Leases” and “Allowance for Credit Losses on Loans and Leases” sections of this discussion and analysis;

the valuation of impaired loans and foreclosed assets, as discussed in Note 2 to the consolidated financial statements;

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Net (recoveries) charge-offs to average loans

Allowance for loan and lease losses to total loans at period end

Allowance for loan and lease losses to nonaccrual loans

Allowance for credit losses on loans and leases to total loans at period end

Allowance for credit losses on loans and leases to nonaccrual loans

Regulatory Capital Ratios:

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(3) For definitions and further information relating to regulatory capital requirements, see “Item 1, Business - Supervision and Regulation - Capital Adequacy Requirements” herein.

(4) 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.

Overview of the Results of Operations and Financial Condition

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The Company’s return on average assets and return on average equity were 0.97% and 10.66%, respectively, in 2022, as compared to 1.29% and 12.05%, respectively, in 2021 and 1.22% and 10.80%, respectively, for 2020.

Our financial results reached record levels over the past year due to a lower level of loan and lease loss provisioning, higher average volume of loans, and a strong base of lower cost core deposits, and a higher level of noninterest income, as discussed in greater detail in the applicable sections below.

Our financial results for 2022 were negatively impacted by a higher level of provisioning for credit losses on loans and leases, as discussed in greater detail in the applicable sections below.

The following is a summary of the major factors that impacted the Company’s results of operations for the years presented in the consolidated financial statements.

● Net interest income improved by 4% in 2021 over 2020 and 8% in 2020 over 2019, due primarily to a lower cost of interest-bearing liabilities and growth in earning assets.

The increase in average earning

assets in 2021 over 2020 was due primarily to a $207.7 million increase in average balance of real estate loans, partially offset by decreases in all of the other loan categories.

● Net interest income improved by 1% in 2022 over 2021 due to both growth and mix of earning assets partially offset by an increase in the cost of interest-bearing liabilities, and 4% in 2021 over 2020, due

primarily to a lower cost of interest-bearing liabilities and growth in earning assets, partially offset by lower yields on earning assets.

The increase in average earning assets in 2022 over 2021 was due primarily to purchases of investment securities, partially offset by decreases in the average balance of loans.

We experienced an increase of $13.5 million in real estate loans primarily driven by the purchase of $173.1 million in high quality 1-4 family residential real estate loans, while all other loan categories declined due to pay-downs, maturities, charge-offs and reduced credit line utilization.

The positive impact of average asset growth in 2022 along with a 15 bps increase in yield was negatively impacted by a 39 bps increase in yield on interest bearing liabilities due to certificates of deposits and shifting from a net sold position to a net purchased position.

The net interest margin in 2022 was 9 bps lower than 2021.

● The increase in average earning assets in 2021 over 2020 was due primarily to a $207.7 million increase in average balance of real estate loans, partially offset by decreases in all of the other loan categories.

We experienced a $73.3 million decline in average mortgage warehouse line utilization, and a $26.0 million decline in commercial loans mostly due to the forgiveness of SBA PPP loans.

The increase in real estate loans was primarily driven by the purchase of $208.0 million in 1-4 family residential real estate loans during the second half of 2021.

These loan purchases were designed as a bridge to organic loan growth as the Company recruits new lending teams across the footprint.

These loan purchases were made due to turnover of lending staff while the Company recruited new lending teams across the footprint.

The positive impact of average asset growth in 2021 was augmented by a 10 bps decrease in yield on interest bearing liabilities.

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The net interest margin in 2021 was 39 bps lower than 2020.

The increase in average earning assets in 2020 over 2019 was due primarily to a $170.2 million increase in average balance of real estate loans, a $62.2 million increase in average balances of commercial loans, and a $87.1 million increase in average balances of mortgage warehouse loans, partially offset by decreases in other loan categories.

The increase in real estate loans was organic, driven by concerted business development efforts by our loan production offices in 2020.

The increase in commercial loans was due to the Company’s participation in the SBA Paycheck Protection Program (PPP) lending initiative, in order to assist our customers impacted by the COVID-19 Pandemic.

The increase in average mortgage warehouse loans throughout 2020 was primarily a result of increased demand for housing and refinancing due to low rates in 2020 coupled with proactive mortgage warehouse pricing and marketing to mortgage lenders.

The positive impact of average asset growth in 2020 was augmented by a 54 bps decrease in yield on interest bearing liabilities but was partially offset by a 60 basis point decline in yield on interest earning assets.

The net interest margin in 2020 was 24 bps lower than 2019.

Net interest income has also been impacted by nonrecurring interest items, which added $1.6 million to interest income in 2022 relative to $3.5 million in 2021 and $1.2 million in 2020.

● We recorded a loan and lease loss benefit of $3.7 million in 2021, as compared to a $8.6 million provision in 2020 and $2.6 million provision in 2019.

● We recorded a provision for credit losses on loans and leases of $10.9 million in 2022, as compared to a $3.7 million benefit in 2021 and $8.6 million provision in 2020.

The 2022 provision for credit losses on loans and leases loss benefit arose from the impact of $11.5 million in net charge-offs during the year ending 2022.

The elevated net charge-offs were mostly due to two loan relationships;

one dairy loan relationship with total charge-offs of $8.7 million and a single office building loan relationship that was sold at a $1.9 million discount due to an increased risk of default that would have likely led to a prolonged collection period.

Refer to the discussion on loan services expense below, for more detailed information regarding the dairy loan relationship and events subsequent to year end 2022 regarding disposition of those assets.

The 2021 loan and lease loss benefit arose from our determination of the appropriate level for our allowance for loan and lease losses and was driven by declines in loan balances coupled with improved credit quality of existing loan balances and the influence of lower historical loan and lease losses.

We considered the continued uncertainty surrounding the estimated impact that COVID-19 has had on the economy and our loan customers overall, making appropriate changes to the qualitative loss factors governing these areas.

The 2020 and 2019 provisions were deemed necessary subsequent to our determination of the appropriate level for our allowance for loan and lease losses, taking into consideration overall credit quality, growth in outstanding loan balances, and reserves required for specifically identified impaired loan balances (including reserves in 2019 for a $2.8 million loan that was placed on non-accrual status shortly before the end of the third quarter and partially charged off in the fourth quarter of 2019.)

● Noninterest income increased by $2.7 million, or 10%, in 2022, and by $1.9 million or 7%, in 2021 over 2020.

The increase in 2022 was primarily due to a $0.7 million increase in service charge income, $1.5 million in gains on the sale of investment securities, a $0.8 million favorable change in other small business partnership expenses, and $3.2 million in gains on the sale of other assets.

These favorable variances were partially offset by a $3.7 million unfavorable fluctuation in income on Bank-Owned Life Insurance (BOLI) associated with deferred compensation plans.

The increase in 2021 was primarily due to a $1.5 million increase in debit card interchange income, a $0.3 million increase in life insurance proceeds, a decrease of $0.7 million in low-income housing tax credit fund amortization, an increase of $0.4 million in the valuation gain of restricted equity investments owned by the Company, partially offset by a $0.4 million decrease in the net gain on the sale of debt securities and a $1.3 million negative variance caused by the sale of certain real estate assets in our low income housing tax credit funds that have reached their life expectancy.

Fluctuations in BOLI associated with deferred compensation plans contributed $0.2 million of the increase.

The increase in 2020 was primarily due to a $1.5 million gain from the wrap up of low-income housing tax credit fund investments, a decrease of $0.9 million in low-income housing tax credit fund expenses, an increase of $0.2 million in the valuation gain of restricted equity investments owned by the Company and a $0.6 million increase in the net gain on the sale of debt securities.

Fluctuations in BOLI associated with deferred compensation plans contributed $0.2 million to the increase.

● Noninterest expense increased by $1.2 million, or 1%, in 2022 as compared to 2021, and increased by $7.6 million, or 10%, in 2021 over 2020.

The increase in noninterest expense in 2022 was due mostly to a $4.6 million increase in salary and benefits expense primarily for new loan production teams and a $0.7 million restitution payment to customers charged nonsufficient fund fees on representments in the past five

years, partially offset by lower legal costs, telecommunications, and a positive variance in director’s deferred compensation expense which is linked to the unfavorable changes in bank-owned life insurance income.

The increase in noninterest expense in 2021 was due mostly to a $2.3 million increase in salaries and benefits expense, a $3.8 million increase in professional services and a $1.2 million increase in data processing costs.

Deposit services and premises expense also contributed to the difference.

The increase in noninterest expense in 2020 was due mostly to a $4.2 million increase in salaries and benefits expense.

● The Company recorded income tax provisions of $11.3 million, or 25% of pre-tax income in 2022;

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and $11.1 million, or 24% of pre-tax income in 2020.

As expected, the overall tax rate remained relatively stable throughout 2021, 2020 and 2019.

The increase in tax rate in 2022 was due to the impact of the equity markets on our deferred compensation plan creating non-deductible losses on BOLI used to offset deferred compensation.

This negative impact on tax rate was partially offset by an increase in municipal bond income and lower overall pre-tax income in 2022.

Financial Condition Summary

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● Total assets increased by $237.6 million, or 7%.

The increase resulted primarily from a $429.3 million increase in investment securities and a $186.1 million increase in cash and due from banks, partially offset by a $468.6 million decrease in net loan and lease balances.

● Loans and leases (net of deferred fees) declined $468.6 million, or 19%.

The decline in loan balances during 2021 was due mostly to lower utilization of mortgage warehouse lines resulting in a $206.5 million decline in overall mortgage warehouse outstanding balances due primarily to reduced refinancing activity.

Other significant declines included a $155.7 million decline in real estate loans mostly due to lower commercial real estate and construction loan balances, and a $99.3 million decrease in commercial and industrial loans, which was predominately due to Small Business Administration Paycheck Protection Program (“SBA PPP”) loan forgiveness.

This was due mostly to loan growth and the purchase of investment securities, primarily funded through an increase in deposits and borrowed funds in 2022.

● Gross loans and leases increased $63.2 million, or 3%.

This increase was predominantly due to the purchase of $173.1 million in high quality jumbo single family mortgage loan pools during the year.

Organic loan production for the year ending 2022 was $292.2 million, as compared to $128.4 million for the comparative period in 2021.

These loan increases were offset by $317.8 million in loan maturities, charge-offs and payoffs, which occurred mostly during the first nine months of the year.

As interest rates began to rise, property values increased and as a result some of our borrowers sold their real estate.

We also had a $29.7 million decline in PPP balances due to loan forgiveness by the SBA, and a decline in credit line utilization of $84.3 million.

The decrease in line utilization includes a $35.7 million decline in mortgage warehouse line utilization due to higher interest rates reducing the demand for mortgages.

● Deposit balances reflect net growth of $64.6 million, or 2%.

Deposit growth in 2021 was primarily a result of organic growth of noninterest bearing or low-cost core transaction accounts, including savings accounts, while higher-cost time and wholesale brokered deposits decreased by $159.0 million, or 31%.

● Total capital increased by $18.6 million, or 5%, ending the year with a balance of $362.5 million.

The increase in capital is due mostly to the addition of net income and capital from stock options exercised, net of $13.2 million in dividends paid, $5.2 million in stock repurchases, and a $7.2 million unfavorable swing in accumulated other comprehensive income.

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

On January 31, 2020, the United States Department of Health and Human Services declared a public health emergency with respect to the Coronavirus Disease 2019 (COVID-19).

Subsequent to this date, federal, state, and local governmental agencies, regulatory agencies, and the Federal Reserve Board took many actions impacting the Company.

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

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

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

Impact of COVID-19 on the Company’s Operations

● Starting in April 2020, the Company took actions to mitigate the impact on credit losses including permitting short-term payment deferrals to current customers, as well as providing bridge loans and SBA Paycheck Protection Program (PPP) loans.

The Company had $10.4 million in classified assets to one borrower at December 31, 2021, from loans modified under the CARES Act, as amended, that were either not expected to make all principal and interest payments in a timely manner, or would need further modifications or assistance.

For further information on the principal and interest deferrals, please see the “Nonperforming Assets” section below.

● The uncertainty of national and local economic conditions had an impact on our provision for loan and lease losses in both 2021 and 2020.

The Company elected to defer the adoption of the Current Expected Credit Loss ("CECL") accounting method under FASB Accounting Standards Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326) to January 1, 2022 .

The Company’s decision to defer the adoption of CECL was done primarily to provide additional time to better assess the impact of the COVID-19 pandemic on the expected lifetime credit losses.

At the time the decision was made, there was a significant change in economic uncertainty on the local, regional, and national levels as a result of local and state stay-at-home orders, as well as relief measures provided at a national, state, and local level.

Further, the Company has taken actions to serve our communities during the pandemic, including permitting short-term payment deferrals to current customers, as well as originating bridge loans and SBA PPP loans.

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

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

As described above, in March 2020, the FOMC cut short-term rates by 150 basis points to near zero.

The uncertainty with COVID-19 and the lower targeted fed funds rates also impacted other rates including the Prime Rate and treasury yields, which the Company uses to price many of its loans.

These lower rates impacted our net interest margin.

Our net interest margin for the year ended December 31, 2021, was 3.56%, compared to a net interest margin of 3.95% for the same period in 2020.

Additional liquidity from significant deposit growth in 2021 coupled with lower loan balances has negatively impacted our net interest margin.

This additional liquidity was mostly deployed in overnight funding and lower yielding investment securities.

The average balance of overnight cash was $269.9 million in 2021, earning an average yield of 14 bps.

The average balance of investment securities was $665.3 million for 2021 yielding 2.22% which is down 50 bps from 2020.

The overall impact of a lower net interest margin was more than offset by higher earning assets in 2021 as compared to 2020.

Additionally, the FOMC has indicated it is likely to raise interest rates in 2022, in an effort to fight inflation, which should help our net interest margin.

● The COVID-19 pandemic has not adversely affected our capital or financial resources as of December 31, 2021.

During the year ending 2021, total shareholders’ equity increased by $18.6 million, or 5%, to $362.5 million.

The Company earned $43.0 million in net income during 2021 but had a decrease of $7.2 million in accumulated other comprehensive income as a result of decreases in the value of our investment portfolio due to higher interest rates.

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

In addition, during 2021, the Company repurchased stock for $5.2 million and paid dividends of $13.2 million.

The Company also paid a twenty-three cent per share dividend on February 14, 2022.

Although presently not expected, if the Company were to incur significant credit losses as a result of COVID-19’s impact on our customers’ ability to repay loans, capital could be adversely impacted.

With respect to liquidity, the Company maintains strong primary and secondary liquidity sources as further described under “Liquidity and Market Risk Management” below.

● The Company continues to serve its customers.

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

Most recently due to the surge of the Omicron variant, some branches have had to temporarily close their lobbies due to staffing issues, however walk-up or drive-up access is still available for the customers use.

Five branch locations were permanently closed in June 2021.

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

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

Many of our customers have found an added convenience and ease of transacting business through online and mobile banking services which precipitated our decision to close locations where in-person transaction volumes no longer warranted a traditional brick-and-mortar branch.

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

The acceleration of amortization of leasehold improvements for these locations increased depreciation expense by $0.5 million year-to-date 2021.

Most of the staff at these five locations were relocated to existing branches with position vacancies however, four individuals elected to leave the Company.

It is projected that closing these five branch locations in June 2021 will result in annual noninterest expense savings of between $0.8 and $1.0 million.

● All of our back office and corporate office staff have returned to normal work arrangements, although remote and hybrid work provisions are now defined as “normal” work arrangements for certain corporate and back office employees, depending on the nature of the position.

In addition, none of our internal controls have changed or are expected to change as a result of these work arrangements other than the use of remote approvals.

● To date, the Company did not experience any challenges in implementing its business continuity plans.

The Company’s Risk Management team began preparing in early 2020, with ordering of supplies such as hand sanitizer, masks cleaning supplies, as well as laptops for those who did not have one.

This enabled the Company to immediately communicate and implement plans to continue operations in our banking facilities while enabling those non-customer facing employees to immediately begin working remotely.

The Company did not face any material resource constraints in implementing these plans.

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

It is expected that SBA PPP loans will continue to be forgiven, with most of the remaining $31.8 million expected to be forgiven in 2022.

1-4 family residential real estate loan purchases of $208.0 million in the last half of 2021 were designed to bridge the gap until organic loan growth improves the Bank’s core pipeline.

The recent hiring of strategic lending team lift-outs are expected to expand the Bank’s agricultural and commercial and industrial (C&I) lending capabilities as well as refreshing mortgage warehouse loan programs and complementing existing commercial real estate lending initiatives.

● The Company loosened its vacation and sick-time policies to accommodate our employees who were affected by COVID-19.

The Company hired an additional 28 temporary employees throughout the pandemic related to higher demand for SBA PPP loan processing and forgiveness, and to provide enhanced customer service.

Those temporary assignments ended in the second quarter of 2021, although many of those employees have been redeployed within other areas of the Company.

Deposit growth in 2022 was primarily from an increase in time deposits of $165.7 million offset by a decrease in other deposit balances of $101.1 million.

● Total capital decreased by $58.9 million, or 16%, ending the year with a balance of $303.6 million.

The decrease in equity was primarily due to a $67.7 million unfavorable swing in accumulated other comprehensive income (loss), a one-time adjustment from the implementation of CECL on January 1, 2022, for $7.3 million, $13.9 million in dividends paid, and $4.9 million in share repurchases.

The declines were partially offset by $33.7 million in net income.

The remaining difference is related to stock options exercised and restricted stock granted during the year.

Results of Operations

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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.

Net interest income is also impacted by the acceleration of net deferred loan fees and

costs for loans paid off early (including SBA PPP loans forgiven), reversal of interest for loans placed on non-accrual status, and the recovery of interest on loans that had been on non-accrual and were paid off, sold, or returned to accrual status.

Net interest income is also impacted by the acceleration of net deferred loan fees and costs for loans paid off early (including SBA PPP loans forgiven), reversal of interest for loans placed on non-accrual status, and the recovery of interest on loans that had been on non-accrual and were paid off, sold, or returned to accrual status.

The following table shows average balances for significant balance sheet categories and the amount of interest income or interest expense associated with each category for each of the past three years.

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Year Ended December 31,

Federal funds sold/due from banks

Interest-earning due from banks

Total investments

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Long term debt

Subordinated debentures

Total borrowed funds

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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.

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 mix variance.

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Net interest income

Net interest income in 2021 as compared to 2020 was impacted by a favorable volume variance of $9.6 million partially offset by an unfavorable rate variance of $2.5 million and an unfavorable mix variance of $3.0 million.

For 2020 relative to 2019, net interest income reflects a favorable volume variance of $16.6 million partially offset by an unfavorable rate variance of $6.3 million and an unfavorable mix variance of $2.8 million.

The 2021 volume variance is due mostly to increases in average balances, resulting from the organic growth in commercial real estate loans, as well as increased investment portfolio balances.

The 2020 volume variance is due mostly to increases

in average balances, resulting from the organic growth in commercial real estate loans, growth in commercial loans due to our participation in the SBA PPP program and higher utilization of mortgage warehouse lines.

Net interest income in 2022 as compared to 2021 was impacted by a favorable volume variance of $0.4 million and a favorable mix variance of $2.0 million, partially offset by an unfavorable rate variance of $1.8 million.

For 2021 relative to 2020, net interest income reflects a favorable volume variance of $9.6 million partially offset by an unfavorable rate

variance of $2.5 million and an unfavorable mix variance of $3.0 million.

The 2022 versus 2021 volume variance is due mostly to increases in average balances, resulting from growth in investment portfolio balances, mostly in floating rate commercial loan obligations, partially offset by a decline in average loan balances.

The 2021 versus 2020 volume variance is due mostly to increases in average balances, resulting from the organic growth in commercial real estate loans, as well as increased investment portfolio balances.

The 2021 versus 2020 volume variance is due mostly to increases in average balances, resulting from the organic growth in commercial real estate loans, growth in commercial loans due to our participation in the SBA PPP program and higher utilization of mortgage warehouse lines.

Given the low rate environment, loan demand for our mortgage warehouse lines had increased, as demonstrated by the $3.7 million favorable volume variance.

The Company’s net interest margin, which is tax-equivalent net interest income as a percentage of average interest-earning assets declined by 9 basis points to 3.47% in 2022, and declined by 39 basis points to 3.56% in 2021 as compared to 2020.

There was an unfavorable rate variance of $2.5 million since the weighted average yield on interest-earning assets fell by 46 basis points and the weighted average cost of interest-bearing liabilities decreased by 10 basis points.

The change in the yield on interest-earning assets representing a much larger base than that of the interest-bearing liabilities.

There was also an unfavorable mix variance of $3.0 million primarily from the origination of real estate secured loan volumes at lower interest rates and a decline in new commercial and industrial loan volumes, albeit at higher rates due to the forgiveness of SBA PPP loans.

The rate and mix variance was negatively impacted by the following factors:

A shift in our earning asset mix into lower-yielding loans and investments, including cash invested overnight;

$75.3 million in average balances of low-yielding SBA PPP loans;

partially offset by lower costs of time-deposits and other interest-bearing liabilities.

The 2020 unfavorable rate and mix variance is due to a shift in our earning asset mix into lower-yielding loans and investments;

increased line utilization of mortgage warehouse lines;

$54.3 million in average balances of low-yielding SBA PPP loans;

partially offset by lower costs of time-deposits and other interest-bearing liabilities.

Investment yields have continued to decrease in all three years presented.

The decrease in 2021 and 2020 was due to the lower rate environment and its impact on all debt securities.

Net interest margin is expected to be affected by the overall rate environment.

A continued relatively low rate environment will result in lower earning asset yields, although there are indications of interest rates increasing in 2022 which would slow the negative impact that was experienced over the past two years, however no assurance can be given in this regard.

Thenet interest margin compression was caused by an unfavorable rate variance of $1.8 million since the weighted average yield on interest-earning assets increased by only 15 basis points and the weighted average cost of interest-bearing liabilities increased by 39 basis points in 2022 compared to 2021.

There was also a favorable mix variance of $2.0 million primarily from the purchase of CLOs at floating higher interest rates, which was partially offset by a decrease in loan and lease balances and an increase in higher cost interest bearing liabilities in 2022 compared to 2021.

The decrease in 2021 was due to the lower rate environment and its impact on all debt securities.

Rates paid on non-maturity deposits were approximately the same in 2022 but declined for 2021 over 2020.

There was a 2 basis point decrease on money market accounts in 2021 and a 5 basis points decrease in 2020 over 2019.

The weighted average cost of interest-bearing liabilities went down 10 bps in 2021 and 54 bps in 2020.

Since the Federal Open Markets Committee of the Federal Reserve System kept the federal funds target rate at historical lows throughout 2021 and 2020, customer time deposit rates in 2021 dropped 31 bps and 122 bps in 2020 due to the relatively short duration of our time deposit portfolio.

The 2019 increase was primarily because of higher rates paid on time deposits (including brokered deposits added in the last half of 2018).

Overnight borrowings and adjustable-rate trust-preferred securities (“TRUPS”) are also tied to short-term rates which began lowering in the second half of 2019, but still remained lower overall in 2020 as compared to 2019 and remained low throughout 2021.

Interest bearing demand accounts increased 2 basis points in 2022 but were the same in 2021 over 2020.

There was a 2 basis point decrease on money market accounts in 2022 over 2021 and in 2021 over 2020.

Since the Federal Open Markets Committee of the Federal Reserve System raised the federal funds target rate 425 basis points throughout 2022, both customer time and brokered deposits along with other borrowed funds were negatively impacted.

The weighted average cost of interest-bearing liabilities increased 39 basis points in 2022 and declined 10 basis points in 2021.

Customer time deposit rates in 2022 increased 124 basis points due to a floating rate time deposit product offered by the Bank along with a 69 basis point increase in the rate paid on brokered deposits.

The Bank offers a time deposit product with a rate set to a spread to prime.

The current spreads range from prime minus 400 bps to prime minus 325 bps.

Given the significant increase in the prime rate during 2022, the interest on such deposits increased during 2022 coupled with additional balances added to such accounts.

The 2021 decrease of 31 basis points was due to the relatively short duration of our time deposit portfolio in a historically low-rate environment in 2021.

Overnight borrowings and adjustable-rate trust-preferred securities (“TRUPS”) are also tied to short-term rates which increased during 2022, resulting in an unfavorable increase of 88 basis points.

During 2021 the cost of these same overnight borrowings and TRUPS were relatively low.

During the year, adjustments to interest income occur due to the following adjustments:

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Such adjustments totaled $1.6 million in 2022, $3.5 million in 2021, and $1.2 million in 2020.

Further, discount accretion on loans from whole-bank acquisitions enhanced our net interest margin by approximately two basis points in 2021, two basis points in 2020, and four basis points in 2019.

Further, discount accretion on loans from whole-bank acquisitions enhanced our net interest margin by approximately one basis point in 2022, two basis points in 2021, and two basis points in 2020.

Provision for Loan and Lease Losses and Provision for Credit Losses

Credit risk is inherent in the business of making loans.

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

The Company recorded a loan and lease loss benefit of $3.7 million in 2021;

a loan and lease loss provision of $8.6 million in 2020, and $2.6 million in 2019.

The Company is subject to the adoption of the Current Expected Credit Loss ("CECL") accounting method under FASB Accounting Standards Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326) in 2020 .

However, in March 2020, the Company elected to defer the adoption of the CECL accounting method under FASB Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326) to January 1, 2022 .

The Company’s decision to defer the adoption of CECL was done primarily to provide additional time to better assess the impact of the COVID-19 pandemic on the expected lifetime credit losses.

Upon adoption of CECL, the Company was required to make an adjustment to equity, net of taxes, equal to the difference between the allowance for credit losses calculated under the CECL method and the allowance for loan and lease

losses as calculated under the incurred loss method as of December 31, 2021.

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

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 loan and lease losses.

The Company recorded a provision for credit losses on loans and leases of $10.9 million in 2022;

a benefit for loan and lease losses of $3.7 million in 2021, and a provision for loan and lease losses of $8.6 million in 2020.

The Company was subject to the adoption of the Current Expected Credit Loss ("CECL") accounting method under FASB Accounting Standards Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326) and implemented the update on January 1, 2022.

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

The Company’s $14.5 million unfavorable increase for the year ending 2022 compared to the same period in 2021 is primarily due to the impact of $11.5 million in net charge-offs during the year ending 2022.

The elevated net charge-offs were mostly due to two loan relationships;

The Company's $12.2 million, favorable decline in provision for loan and lease losses for the year ending 2021 compared to the same period in 2020 is due mostly to lower historical loan loss rates, a decline in outstanding balances on loans, a change in the mix of loans, and net year-to-date 2021 recoveries of previously charged-off loan balances.

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Management evaluated its qualitative risk factors under the current incurred loss model and adjusted these factors for economic conditions, changes in the mix of the portfolio due to loans subject to a payment deferral, potential changes in collateral values due to reduced cash flows, and external factors such as government actions and the impact that COVID-19 may have on our customers.

In 2019, an additional reserve was booked in the third quarter 2019 for a $2.8 million loan placed on nonaccrual status resulting in a $1.2 million charge-off.

With the loan and lease loss benefit recorded in 2021 we were able to maintain our allowance for loan and lease losses at a level that, in Management’s judgment, is adequate to absorb probable loan and lease losses related to specifically identified impaired loans as well as probable incurred losses in the remaining loan portfolio.

With the provision for credit losses on loans and leases recorded in 2022 we were able to maintain our allowance for credit losses on loans and leases at a level that, in Management’s judgment, is adequate to absorb probable credit losses on loans and leases related to individually identified loans as well as probable credit losses in the remaining loan portfolio.

Specifically identifiable and quantifiable loan and lease losses are immediately charged off against the allowance.

The Company recorded net loan and lease recoveries of $0.2 million in 2021.

The Company experienced net loan and lease losses of $0.7 million in 2020 and $2.4 million in 2019, including a $1.2 million charge-off on the loan placed on nonaccrual status in the third quarter 2019 as mentioned above The loan and lease loss (benefit) provision for 2021, 2020 and 2019 has been favorably impacted by the following factors:

The Company recorded net loan and lease charge offs of $11.5 million in 2022.

The Company experienced net loan and lease recoveries of $0.2 million in 2021 and net loan and lease charge-offs of $0.7 million in 2020.

The provision for credit losses on loans and leases for 2022 was elevated due to the impact of two loan relationships as previously discussed above.

The loan and lease loss (benefit) provision for 2021 and 2020 were favorably impacted by the following factors:

most charge-offs were recorded against pre-established reserves, which alleviated what otherwise might have been a need for reserve replenishment;

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and, new loans booked have been underwritten using continued tighter credit standards.

As mentioned previously the loan and lease loss benefit for 2021 was also positively impacted by $0.2 million in net recoveries.

The Company’s policies for monitoring the adequacy of the allowance and determining loan amounts that should be charged off, and other detailed information with regard to changes in the allowance, are discussed in Note 2 to the consolidated financial statements and below under “Allowance for Loan and Lease Losses.” The process utilized to establish an appropriate allowance for loan and lease losses can result in a high degree of variability in the Company’s loan and lease loss provision, and consequently in our net earnings.

The Company’s policies for monitoring the adequacy of the allowance and determining loan amounts that should be charged off, and other detailed information with regard to changes in the credit allowance, are discussed in Note 2 to the consolidated financial statements and below under “Allowance for Credit Losses on Loans and Leases.” The process utilized to establish an appropriate allowance for credit losses on loans and leases can result in a high degree of variability in the Company’s provision for credit losses on loans and leases, and consequently in our net earnings.

Noninterest Revenue and Operating Expense

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Service charges on deposit accounts

Checkcard fees

Debit card fees

Other service charges and fees

Bank owned life insurance income

Bank owned life insurance (loss) income

Gain on sale of securities

Loss on tax credit investment

Gain (loss) on tax credit investment

Total noninterest income

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Legal and accounting

Acquisition costs

Other professional services costs

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(1) Tax Equivalent

(2) 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.

(2) 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.

Noninterest income in 2022 increased $2.7 million, or 10% as compared to an increase of $1.9 million, or 7%, in 2021.

Total noninterest income was 0.95% of average interest-earning assets in 2022 as compared to a ratio of 0.90% in 2021 and 0.97% in 2020.

The ratio declined in 2021 due to a 15% increase in average interest-earning assets.

The principal component of the Company’s noninterest revenue, service charges on deposit accounts, increased by $0.1 million, or 1%, in 2021 as compared to 2020.

The same line item declined by $1.0 million, or 8%, in 2020 over 2019.

The ratio increased in 2022 due to a 10% increase in noninterest income.

The principal component of the Company’s noninterest revenue, service charges on deposit accounts, increased by $0.7 million, or 6%, in 2022 as compared to 2021 and by $0.1 million, or 1%, in 2021 over 2020.

This line item is primarily driven by the volume of transaction accounts.

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This line item consists of a variety of fees including service charges on corporate accounts, treasury management fees, charges on corporate and consumer accounts including treasury management fees, ATM fees, overdraft income, and monthly service charges on certain accounts.

Overdraft income on both consumer and corporate accounts totaled $4.9 million in 2021;

Overdraft income on both consumer and corporate accounts totaled $4.6 million (net of restitution) in 2022;

$4.9 million in 2021 and $5.1 million in 2020.

Checkcard fees consists of interchange fees from our customers’ use of debit cards for electronic funds transactions.

This category increased by $1.5 million, or 21%, in 2021 as compared to 2020, and increased by $0.4 million, or 7%, in 2020 over 2019.

The increases in 2021 and 2020 are primarily a result of increased usage of debit cards by our customers.

Other service charges and fees increased by $0.7 million, or 17%, in 2021 over 2020, and declined by $0.1 million, or 3%, in 2020 over 2019.

This account includes certain transaction related fees including merchant income, currency orders, safe deposit box fees, wire fees, as well as dividends and changes in values related to our bank equity investments such as FHLB and Pacific Coast Bankers Bank (“PCBB”).

The increase in 2021, was due largely to a $0.9 million write-up of our investment in PCBB, due to Accounting Standards Update 2016-01 which required the Company to write the investment to fair value through earnings.

BOLI income generally fluctuates based on the market.

In both comparative years ending 2021 over 2020, and 2020 over 2019, BOLI income increased by $0.2 million or 10%.

BOLI income is derived from two types of policies owned by the Company, namely “separate account” and “general account” life insurance, and the year over year variances are due in large part to fluctuations in income on separate account BOLI.

The Company had $11.0 million invested in separate account BOLI at December 31, 2021, which produces income that helps offset expense accruals for deferred compensation accounts the Company maintains on behalf of certain directors and senior officers.

Those accounts have returns pegged to participant-directed investment allocations that can include equity, bond, or real estate indices, and are thus subject to gains or losses which often contribute to significant fluctuations in income (and associated expense accruals).

Gains on separate account BOLI totaled $1.7 million in 2021 as compared to $1.4 million in 2020, and net losses of $1.2 million in 2019.

This resulted in favorable variances of $0.2 million for both comparative years ending 2021 as compared to 2020 and 2020 as compared to 2019.

Debit card fees consists of interchange fees from our customers’ use of debit cards for electronic funds transactions.

This category was relatively flat in 2022 and 2021 but increased by $1.5 million, or 21%, in 2021 as compared to 2020.

The increases in 2021 were primarily a result of increased usage of debit cards by our customers as 2020 was impacted by the pandemic.

Other service charges and fees decreased by $0.1 million, or 2% in 2022 over 2021 and was mostly unchanged in 2021 over 2020..

This account includes certain transaction related fees including merchant income, currency orders, safe deposit box fees, and wire fees.

BOLI income generally fluctuates based on the market due to the Company’s “separate account” BOLI being invested in assets that closely mirror investments choices of deferred compensation participants.

There is also a part of BOLI that is “general account” and receives a standard crediting rate from the carrier which remains relatively stable year over year.

However, the separate-account BOLI used to offset deferred compensation fluctuates significantly from year-to-year as many of our deferred compensation participants are invested in equity-index style funds.

In the comparative years ending 2022 over 2021, BOLI income decreased $3.6 million, however in 2021 over 2020, BOLI income increased by $0.2 million or 10%.

The Company had $9.0 million invested in separate account BOLI at December 31, 2022.

This separate account BOLI closely matched participant-directed investment allocations that can include equity, bond, or real estate indices, and are thus subject to gains or losses which often contribute to significant fluctuations in income (and associated expense accruals).

Net losses on separate account BOLI totaled $2.0 million in 2022 as compared to gains of $1.7 million in 2021, and $1.4 million in 2020.

This resulted in unfavorable variances of $3.7 million for the comparative years ending 2022 as compared to 2021 and favorable variances of $0.2 million for the comparative years ending 2021 as compared to 2020.

As noted, gains and losses on separate account BOLI are related to expense accruals or reversals associated with participant gains and losses on deferred compensation balances, thus the overall net impact on taxable income tends to be minimal.

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Interest credit rates on general account BOLI do not change frequently so the income has typically been fairly consistent with $1.0 million, of general account BOLI income recorded for all three years ending December 31, 2022, 2021, and 2020.

The Company recognized a nominal gain on the sale of investment securities in 2021 as compared to a $0.4 million gain in 2020, and a $0.2 million loss in 2019.

The gain in 2020 was due to a net gain on the sale of debt securities, in an effort to restructure the portfolio primarily to eliminate small residual balances and reduce potential credit risk on certain municipal holdings.

The loss in 2019 was taken in order to sell several small balance and low-yielding bonds in order to replace them with fewer higher-yielding bonds.

The earn back of the transaction was less than a year.

Loss on tax credit investment reflects pass-through expenses associated with our investments in low-income housing tax credit funds and other limited partnerships.

Those expenses, which are netted out of revenue, decreased by $0.7 million, or 56%, in 2021 as compared to 2020.

In 2020 as compared to 2019, these expenses decreased by $0.9 million, or 43%.

The favorable variances in both 2021 and 2020 is due to the expiration of expense amortization on several funds which had reached the end of their useful tax benefit life.

The largest contribution to the favorable variance in 2019 came from a

$0.91 million adjustment to accelerate expense amortization on our tax credit investments, to ensure that the book value of each investment does not exceed its projected remaining tax benefits.

The other category, decreased to $0.8 million from $1.7 million in 2021.

The primary reason for the decrease was from a 2020 non- recurring gain as discussed in the prior year comparison, but was partially offset by a gain from life insurance proceeds and the sale of fixed assets.

In 2020 as compared to 2019 the other category increased to $1.7 million from $0.01 million.

The primary reason for this increase is due to a $1.5 million gain from the wrap up of low-income housing tax credit fund investments and a $0.2 million valuation gain on restricted equity investments owned by the Company.

There was a nominal increase in this category in 2019 as compared to 2018.

Total operating expense, or noninterest expense, increased by $7.6 million, or 10%, in 2021 as compared to 2020, and increased by $5.3 million, or 8%, in 2020 over 2019.

The primary increase in 2021 was in legal and accounting costs as discussed in further detail below.

In 2020 the largest increase was in salaries and benefits.

The Company recognized a $1.5 million gain on the sale of investment securities in 2022, as compared to a nominal gain in 2021 and a $0.4 million gain in 2020.

In 2022 the Company restructured the securities portfolio to decrease effective duration, taking advantage of slight rallies in the Treasury market in early and late 2022.

In 2020 of the Company sold debt securities, in an effort to restructure the portfolio primarily to eliminate small residual balances and reduce potential credit risk on certain municipal holdings.

The Gain(Loss) on tax credit investment reflects pass-through expenses associated with our investments in low-income housing tax credit funds and other limited partnerships.

Those expenses, which are netted out of revenue, decreased by $0.8 million, or 148%, in 2022 as compared to 2021, and increased by $0.7 million, or 56%, in 2021 as compared to 2020.

The variance in 2022 is due to a favorable adjustment of expenses, while in 2021 we had funds that had expired and had reached the end of their useful tax benefit life.

The other category, increased $3.4 million to $6.1 million in 2022 and decreased to $0.8 million from $1.7 million in 2021.

In 2022 we had non-recurring gains from the sale of other assets including $2.6 million from the sale of Visa B shares.

The primary reason for the decrease in 2021 was from a 2020 non- recurring gain as discussed in the prior year comparison, but was partially offset by a gain from life insurance proceeds and the sale of fixed assets.

Total operating expense, or noninterest expense, increased by $1.2 million, or 1%, in 2022 as compared to 2021, and by $7.6 million, or 10%, in 2021 as compared to 2020.

The increase in 2022 is due mostly to a $4.6 million increase in salary and benefits expense and a $0.7 million restitution payment to customers charged nonsufficient fund fees on representments in the past five years, partially offset by lower legal costs, telecommunications, and a positive variance in director’s deferred compensation expense which is linked to the unfavorable changes in bank-owned life insurance income The primary increase in 2021 was in legal and accounting costs as discussed in further detail below.

Noninterest expense as a percent of average interest-earning assets trended down each year.

This ratio was 2.6% in 2022, 2.7% in 2021 and 2.8% in 2020.

The largest component of noninterest expense, salaries, and employee benefits increased $2.3 million, or 6% in 2021 as compared to 2020.

The reason for the increase was mostly due to the $2.3 million decrease in deferred loan origination salaries associated with successful loan originations are accounted for in accordance with FASB guidelines on the recognition and measurement of non-refundable fees and origination costs for lending activities, and accruals associated with employee deferred compensation plans.

The largest component of noninterest expense, salaries, and employee benefits increased $4.6 million or 11% in 2022 as compared to 2021, and increased $2.3 million, or 6% in 2021 as compared to 2020.

The increase in 2022 was due mostly to the strategic hiring of new loan production teams, increases to the Company’s minimum wage, and standard annual increases to our employee’s base compensation.

The increase in 2021, was mostly due to the $2.3 million decrease in deferred loan origination salaries associated with successful loan originations which are accounted for in accordance with FASB guidelines on the recognition and measurement of non-refundable fees and origination costs for lending activities, and accruals associated with employee deferred compensation plans.

Loan origination salaries that were deferred from current expense for recognition over the life of related loans totaled $2.3 million in 2022, $1.1 million in 2021, and $3.3 million for 2020.

The $4.2 million increase, or 12%, in salaries and employee benefits in 2020 as compared to 2019 is due to several factors, including merit increases for employees due to annual performance evaluations, new loan production teams for the northern and southern California markets, and a focus on hiring additional senior-level staff and management.

Employee deferred compensation expense accruals totaled $0.2 million in 2021, 2020, and 2019.

Employee deferred compensation expense accruals totaled $0.1 million in 2022, and $0.2 million in 2021, and 2020.

As noted above in our discussion of BOLI income, employee deferred compensation plan accruals are related to separate account BOLI income and losses, as are directors deferred compensation accruals that are included in “other professional services,” and the net income impact of all income/expense accruals related to deferred compensation is usually minimal.

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The number of full-time equivalent staff employed by the Company totaled 491 at the end of 2022, as compared to 480 at December 31, 2021 and 501 at December 31, 2020.

Staff attrition throughout 2021 and 2020, without the need for immediate replacements due to temporary branch lobby closures or limited branch lobby hours attributed to the COVID-19 pandemic, was the primary reason for the FTE decline.

The increase in FTE during 2022 was due to the strategic hiring of lending and management staff.

Staff attrition throughout 2021, without the need for immediate replacements due to temporary branch lobby closures or limited branch lobby hours attributed to the COVID-19 pandemic, was the primary reason for the FTE decline.

As branch lobbies resumed normal operating hours and public access, during the summer of 2021, full-time equivalent staff were expected to increase, however finding talent was extremely challenging not only for the Company but for the entire industry.

2021 was the year of the “Great Resignation” with over 4.4 million people leaving their jobs according to the Bureau of Labor Statistics, with the recent surge in the Omicron variant is exacerbating the current talent shortage.

Total rent and occupancy expense, including furniture and equipment costs, were approximately the same in 2021, 2020 and 2019.

With the closure of five branch facilities in mid-2021, it is expected that rent and occupancy expense should decline in 2022, although no assurances can be given in that regard.

Advertising and promotion costs decreased by 19% to $1.5 million in 2021 as compared to 2019, and decreased by $0.7 million, or 26%, in 2020 over 2019.

2021 was the year of the “Great Resignation” with over 4.4 million people leaving their jobs according to the Bureau of Labor Statistics.

Total rent and occupancy expense, including furniture and equipment costs, decreased $0.1 million in 2022 as compared to 2021 due to the consolidation of five branch facilities in 2021.

For 2021 and 2022 rent and occupancy expense was approximately the same.

Advertising and promotion costs increased $0.2 million or 14%, in 2022 over 2021 and decreased by 19% to $1.5 million in 2021 as compared to 2020.

The increase in 2022 was due to the resumption of special events as COVID-19 restrictions were lifted.

The decrease in 2021 came from the cessation of special events and in-branch marketing campaigns necessitated by the COVID-19 pandemic.

Data processing costs increased by $1.2 million, or 26%, in 2021 as compared to 2020 and increased by $0.1 million, or 2%, in 2020 over 2019.

Data processing costs increased by $0.3 million or 5% in 2022 as compared to 2021 and increased by $1.2 million, or 26%, in 2021 as compared to 2020.

The increase in 2022 was primarily from an increase in core processing costs.

In late 2022, the Company renegotiated its core processing contract and expects annual savings from this renegotiation of approximately $1.0 million.

The increase in 2021 was due to higher disaster recovery and data back-up costs as a result of outsourcing this work in late 2020 rather than performing it in-house, higher core processing costs as we expand our data warehousing capabilities, and higher loan management software costs for the expansion of digital loan Platform.

Although as a whole the increase in 2020 was minimal, the Company did experience increases in loan management software expenses due to participation in the SBA PPP program and other costs incurred to implement remote working arrangements for staff;

which was offset by lower core software provider costs and other data processing costs.

Deposit services costs increased by $0.4 million or 5% in 2022 as compared to 2021 and increased by $0.6 million, or 7%, in 2021 over 2020.

Deposit costs have been impacted in both 2022 and 2021, by increases in debit card processing due to higher customer activity levels and increased utilization of armored car services.

These increases were partially offset by decreases in ATM servicing costs as we replaced most of our ATMs throughout 2021 with newer models that require less maintenance.

These increases in both years were partially offset by decreases in ATM servicing costs as we replaced most of our ATMs throughout 2021 with newer models

that require less maintenance.

Additionally, in the second quarter of 2023, the Company is expecting to convert its debit card processing to a new provider which should result in lower processing costs.

Loan services costs are comprised of loan processing costs, and net costs associated with foreclosed assets.

Loan processing costs, which include expenses for property appraisals and inspections, loan collections, demand and foreclosure activities, loan servicing, loan sales, and other miscellaneous lending costs, decreased by $0.6 million, or 49%, in 2021 as compared to 2020 and increased by $0.4 million, or 60%, in 2020 over 2019.

The decrease in 2021 as well as the increase in 2020 was due to smaller amounts in nearly every category of loan servicing.

The decrease in 2021 was also due to the reduction in the volume of loans made by the Company.

Loan processing costs, which include expenses for property appraisals and inspections, loan collections, demand and foreclosure activities, loan servicing, loan sales, and other miscellaneous lending costs, increased by $0.1 million or 10% in 2022 as compared to 2021 and decreased by $0.6 million, or 49%, in 2021 as compared to 2020.

The increase in 2022 was primarily due to an increase of $0.1 million in the provision for unfunded commitments.

The decrease in 2021 was due to smaller amounts in nearly every category of loan servicing and precipitated by the reduction in the volume of loans made by the Company.

Foreclosed assets costs are comprised of write-downs taken subsequent to reappraisals, OREO operating expense (including property taxes), and losses on the sale of foreclosed assets, net of rental income on OREO properties and gains on the sale of foreclosed assets.

There were expenses of $0.1 million in 2021 as compared to $0.03 million in 2020 and nominal expenses in 2019.

There were $0.1 million in expenses in both 2022 and 2021 as compared to $0.03 million in 2020.

These costs fluctuate based on market conditions of OREO relative to our holding value, the nature of the underlying properties and the volume of OREO properties in inventory.

At the end of 2021, the Company had only one OREO property remaining in inventory.

At the end of 2022, the Company had no OREO properties remaining in inventory.

Subsequent to year end, $18.1 million of nonaccrual loans within the aforementioned dairy relationship were foreclosed upon and were moved to other real estate owned or other foreclosed assets at net realizable value.

The Company sold a portion of such assets in the first quarter of 2023 for $7.7 million, which constituted book value.

The Company continues to actively work with interested buyers to sell the remaining assets of the dairy.

The “other operating costs” category includes telecommunications expense, postage, and other miscellaneous costs.

Telecommunications expense increased by 13% to $2.0 million in 2021, as compared to $1.8 million in 2020.

The telecommunications increase in 2021 was due to the improvement of our data infrastructure and a certain amount of redundancy during the transition.

The increase in 2020 was also due to an upgrade of telecommunications circuits, as well as additional costs from work-at-home arrangements during the COVID-19 pandemic.

Postage expense was slightly lower in 2021 as compared to 2020, but decreased by $0.1 million, or 26%, in 2020 as compared to 2019.

Telecommunications expense decreased by 22% to $1.6 million in 2022 as compared to 2021, and increased by 13% to $2.0 million in 2021 over 2020.

The telecommunications decrease in 2022 was due to the reduction of redundancy in lines during 2021, while the increase in 2021 was due to the improvement of our data infrastructure and a certain amount of redundancy during the transition.

Postage expense increased by $0.1 million or 21% in 2022 as compared to 2021 and was slightly lower in 2021 as compared to 2020.

The increase in 2022 was due to deposit account disclosure mailings from the change in our overdraft and NSF fee practices.

The decrease in 2021 and 2020 was due to concentrated efforts to decrease our utilization of overnight mail services and increase usage of digital technologies.

The “Other” category under other operating costs increased by $0.5 million, or 32% in 2021 as compared to 2020, and decreased by $0.2 million, or 8%, in 2020 as compared to 2019.

The increases in 2021 were mostly due to higher consulting costs and expenses on discontinued branch leases.

The decrease in 2020 is due to the lack of participation in offsite conferences and training due to the COVID-19 pandemic.

Total Professional Services costs increased by $3.8 million, or 77%, in 2021 as compared to 2020, and by $0.4 million, or 9%, in 2020 as compared to 2019.

The “Other” category under other operating costs increased by $0.5 million or 25% in 2022 as compared to 2021 and increased by $0.5 million, or 32% in 2021 as compared to 2020.

The increase in 2022 were primarily due to restitution payments to customers charged nonsufficient fund fees on representments in the past five years.

The increase in 2021 were mostly due to higher consulting costs and expenses on discontinued branch leases.

Total Professional Services costs, which includes directors fees, decreased by $4.7 million or 53% in 2022 as compared to 2021 and increased by $3.8 million, or 77%, in 2021 as compared to 2020.

Professional Services costs consists of legal and accounting, acquisition, and other professional services costs.

Legal and Accounting costs increased by $2.8 million, or 141% in 2021 as compared to 2020, and decreased by $0.1 million, or 4%, in 2020 as compared to 2019.

Legal and Accounting costs decreased by $2.7 million or 56% in 2022 as compared to 2021 and increased by $2.8 million, or 141% in 2021 as compared to 2020.

The decrease in 2022 was mostly due to a decrease in legal costs and related legal reserves, along with lower costs related to certain audit functions that were previously outsourced.

The increase in 2021 was mostly due to an increase in legal costs, related legal reserves, and additional costs related to the outsourcing of certain audit functions.

The decrease in 2020 was due to lower internal audit costs as a result of moving some third-party branch reviews inhouse.

Other professional services costs include FDIC assessments and other regulatory expenses, directors’ costs, and certain insurance costs among other things.

This category increased by $1.0 million or 34%, in 2021 as compared to 2020, and increased by $0.5 million, or 20%, in 2020 as compared to 2019.

This category decreased by $2.0 million or 50% in 2022 as compared to 2021 and increased by $1.0 million or 34%, in 2021 as compared to 2020.

The decrease in 2022 was mostly from the change in director’s deferred compensation expense which is linked to the fluctuation in BOLI income.

The increase in 2021 was due to an increase in FDIC assessment expenses, increased director’s equity compensation expense, and professional services costs.

The increase in 2020 is primarily from an increase in FDIC assessment expenses as we utilized all of the available small bank assessment credits after the first quarter of 2020.

There was also a favorable swing in the director’s deferred compensation expense for both 2022 and 2021, which is mostly offset by higher BOLI income, as described above under the separate account BOLI.

Stationery and supply costs decreased by $0.1 million, or 23%, in 2021 as compared to 2020 and increased by $0.1 million, or 40%, in 2020 as compared to 2019.The decrease in 2021 over 2020, is mostly due to efficiencies gained as a result of movement towards a digital working environment and less reliance on paper.

The increase in 2020 as compared to 2019 was attributed to specialized supplies due to the COVID-19 pandemic.

Sundry and teller costs of $0.6 million in 2021 were essentially the same in 2020, and were $0.3 million in 2019.

Stationery and supply costs increased by $0.1 million or 41% in 2022 as compared to 2021 and decreased by $0.1 million, or 23%, in 2021 as compared to 2020.

The increase in 2022 was primarily from startup costs of new loan production offices while the decrease in 2021 over 2020, is mostly due to efficiencies gained as a result of movement towards a digital working environment and less reliance on paper.

Sundry and teller costs were $0.7 million in 2022, $0.6 million in 2021 and 2020.

In 2022, as well as 2021 and 2020, debit card losses are elevated and trending upwards consistent with the higher volume of debit card transactions.

These costs were $0.3 million higher in 2020 over 2019, mainly because of two large operational losses.

These costs are expected to decline in 2023 with the change to a new debit card processor during the second quarter, although no assurance can be given that this will be the case.

The Company’s tax-equivalent overhead efficiency ratio was 60.2% in 2022, 59.9% in 2021, and 57.2% in 2020.

The overhead efficiency ratio represents total noninterest expense divided by the sum of fully tax-equivalent net interest and noninterest income, with the provision for loan and lease losses and investment gains/losses excluded from the equation.

The ratio trended downward in 2020, due to continued efforts to control costs, as well as higher income which is the denominator of the equation but spiked higher in 2021 due mainly to elevated nonrecurring noninterest expense.

Our income tax provision was $14.2 million, or 24.8% of pre-tax income in 2021 as compared to 2020 and $11.1 million, or 23.8% of pre-tax income in 2020 as compared to $11.8 million, or 24.6% of pre-tax income in 2019.

The tax accrual rate was higher in 2021 due to a lower proportion of non-taxable income, and slightly lower in 2020 due to a higher proportion of non-taxable income.

The Company is continually working on efforts to control costs, as well as higher income which is the denominator of the equation.

Several strategic projects in 2023 are expected to have a positive impact on this ratio.

Our income tax provision was $11.3 million, or 25.1% of pre-tax income in 2022, $14.2 million, or 24.8% of pre-tax income in 2021 and $11.1 million, or 23.8% of pre-tax income in 2020.

The tax accrual rate was higher in 2022 and 2021 due to a lower proportion of non-taxable income primarily due to losses on separate-account BOLI described above.

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.

Permanent differences include but are not limited to tax-exempt interest income, BOLI income or loss, and certain book expenses that are not allowed as tax deductions.

The Company’s investments in state, county and municipal bonds provided $8.8 million of federal tax-exempt income in 2022, $6.2 million in 2021, and $5.7 million in 2020.

Moreover, in addition to life insurance proceeds of $0.4 million in 2021, and $0.07 million in 2020, net increases in the cash surrender value of bank-owned life insurance added $2.6 million to tax-exempt income in 2021;

$2.4 million in 2020;

and $2.2 million in 2019.

Our tax credits consist primarily of those generated by investments in low-income housing tax credit funds, and California state employment tax credits.

Moreover, in addition to life insurance proceeds of $0.4 million in both 2022 and 2021 and $0.07 million in 2020, net increases in the cash surrender value of bank-owned life insurance added $2.6 million to tax-exempt income in 2021;

and $2.4 million in 2020, but reduced tax-exempt income by $1.0 million in 2022.

Our tax credits consist primarily of those generated by investments in low-income housing tax credit funds.

We had a total of $10.1 million invested in low-income housing tax credit funds as of December 31, 2022 and $2.9 million as of December 31, 2021, which are included in other assets rather than in our investment portfolio.

Those investments have generated substantial tax credits over the past few years, with about $0.5 million in credits available for the 2021 tax year;

$0.5 million for the 2020 tax year, and $0.5 million in 2019.

Those investments have generated substantial tax credits over the past few years, with about $0.5 million in credits available for each of the three tax years:

2022, 2021, and 2020.

The credits are dependent upon the occupancy level of the housing projects and income of the tenants and cannot be projected with certainty.

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Assets totaled $3.6 billion at December 31, 2022, an increase of $237.6 million, or 7%, for the year.

Assets increased in 2021 primarily a result of increases in cash and due from banks and investments securities of $186.1 million and $429.3 million, respectively, net of a $468.6 million decrease in net loan balances.

Assets increased in 2022 primarily a result of a $298.5 million increase in investment securities, a $63.2 million increase in gross loans and leases, a $67.6 million increase in other assets, net of a $180.4 million decrease in cash and due from banks.

Deposits were up $64.6 million, or 2%.

Total capital increased by $18.6 million, or 5%.

Total capital decreased by $58.9 million, or 16%.

The major components of the Company’s balance sheet are individually analyzed below, along with information on off-balance sheet activities and exposure.

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The balances for each loan type include nonperforming loans, if any, but do not reflect any deferred or unamortized loan origination, extension, or commitment fees, or deferred loan origination costs.

Although not reflected in the loan totals below and not currently comprising a

material part of our lending activities, the Company also occasionally originates and sells, or participates out portions of, loans to non-affiliated investors.

Although not reflected in the loan totals below and not currently comprising a material part of our lending activities, the Company also occasionally originates and sells, or participates out portions of, loans to non-affiliated investors.

Loan and Lease Distribution

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Total loans and leases

Allowance for credit losses on loans

Total loans and leases, net

Percentage of Total Loans and Leases

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Consumer loans

The Company’s loan and lease balances declined in 2021 due to management actions to reduce non-owner occupied commercial real estate concentrations after a period of strong growth in 2020, a decline in utilization of mortgage warehouse lines, and SBA PPP loan forgiveness.

Conversely, the Company experienced net growth in each of the four years from 2017 through 2020, despite fluctuations caused by variability in outstanding balances on mortgage warehouse lines, reductions associated with the resolution of impaired loans, weak loan demand in some years, tightened underwriting standards, and intense competition.

This growth over these four years was due in part to acquisitions, including Coast National Bank in 2016 and Ojai Community Bank in 2017, as well as whole loan purchases and participations, and participation in the SBA PPP loan program in 2020.

For 2021, gross loans were down by $473.4 million, or 19%, primarily as a result of a $206.5 million decline in mortgage warehouse line utilization, an $87.6 million decline in SBA PPP loans due mostly to forgiveness of such loans, and a net decrease of $155.7 million in real estate secured loans, primarily from construction and other commercial real estate loans.

The overall decline in real estate secured loans during 2021 was partially offset by an increase of $149.6 million in 1-4 family residential real estate loans due to the $208.0 million purchase of jumbo mortgage loans during the second half of 2021.

These mortgage loan purchases in 2021 and additional purchases in 2022, were designed as a bridge to organic loan growth with the Bank’s recent hiring of strategic lending team lift-outs as detailed below:

● The Bank’s mortgage warehouse team program will be refreshed and rebuilt under the direction and leadership of a new Mortgage Warehouse Market President, who was hired for this role in the fourth quarter of 2021.

● The Real Estate Industries Group (REIG) hired two new commercial real estate loan officers who are expected to continue the Bank’s commitment to serving the commercial real estate markets.

Commercial Loan Officers were appointed to complement the REIG.

In addition, further lending teams are currently being recruited along with additional underwriters to support the REIG.

● Expansion of the agricultural lending and commercial & industrial (C&I) lending capabilities of the Bank is a key third element.

In December 2021, the Company hired a new Agricultural and Commercial Lending President.

We are actively recruiting additional lenders to expand the Agricultural and C&I teams with key lender lift outs across our footprint.

Like the other groups, these relationship managers will be complemented with a team of portfolio managers who will assist with underwriting support, portfolio management, and identification of opportunities for additional credit extensions.

It is recognized that we are unable to rely upon relationship managers alone for loan growth.

Instead, a full team to support prudently underwritten loans is needed to minimize risk.

As demonstrated by the expansion of the lending teams, management remains focused on organic loan growth.

No assurance can be provided with regard to future net growth in aggregate loan balances given occasional surges in prepayments, continued forgiveness of PPP loans;

fluctuations in mortgage warehouse lending;

The Company’s loan and lease balances increased in 2022, mostly from the purchase of high quality jumbo mortgage pools early in the year.

The decline in 2021 was due to management actions to reduce non-owner occupied commercial real estate concentrations after a period of strong growth in 2020, a decline in utilization of mortgage warehouse lines, and SBA PPP loan forgiveness.

Conversely, the Company experienced net growth in each of the three years from 2018 through 2020, despite fluctuations caused by variability in outstanding balances on mortgage warehouse lines, reductions associated with the resolution of impaired loans, weak loan demand in some years, tightened underwriting standards, and

intense competition.

This growth over these three years was due in part to acquisitions, as well as whole loan purchases and participations, and participation in the SBA PPP loan program in 2020.

For 2022, the Company had $173.1 million in loan purchases which were designed as a bridge to organic loan growth with the recent hiring of new ag loan production teams.

These new ag loan production teams were hired to develop relationships within our footprint for both loans and deposits.

These new loans should provide additional diversification of the loan portfolio and provide floating rate loan products which complement the fixed rate real estate loans.

As demonstrated by the expansion of the lending teams both in 2022 and 2021, management remains focused on organic loan growth which totaled $292.2 million during 2022.

No assurance can be provided with regard to future net growth in aggregate loan balances given occasional surges in prepayments, fluctuations in mortgage warehouse lending;

and maintaining concentrations in certain sectors within our risk management parameters.

For 2020, gross loans were up by $700.5 million, or 40%, due largely to $649.9 million of organic growth in commercial real estate non-owner occupied loans.

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In general, the guidelines, as amended, establish the following supervisory criteria as preliminary indications of possible CRE concentration risk:

(1) the institution’s total construction, land development and other land loans represent 100% or more of Tier 1 risk-based capital plus allowance for loan and lease losses;

or (2) total CRE loans as defined in the regulatory guidelines represent 300% or more of Tier 1 risk-based capital plus allowance for loan and lease losses, and the institution’s CRE loan portfolio has increased by 50% or more during the prior 36 month period.

(1) the institution’s total construction, land development and other land loans represent 100% or more of Tier 1 risk-based capital plus allowance for credit losses loans and leases;

or (2) total CRE loans as defined in the regulatory guidelines represent 300% or more of Tier 1 risk-based capital plus allowance for credit losses on loans and leases, and the institution’s CRE loan portfolio has increased by 50% or more during the prior 36 month period.

This ratio was 249% at December 31, 2021 and declined to 246% at December 31, 2022.

At December 31, 2021, the Bank’s total construction, land development and other land loans represented 12% of Tier 1 risk-based capital plus allowance for loan and lease losses.

At December 31, 2022, the Bank’s total construction, land development and other land loans represented 5% of Tier 1 risk-based capital plus allowance for credit losses on loans and leases.

The Bank believes as indicated by the guidelines that it does not have a concentration in CRE loans at December 31, 2022.

However, given that the Bank has recently had a CRE concentration ratio in excess of 300%, the Bank and its board of directors have discussed the guidelines and believe that the Bank’s underwriting policies, management information systems, independent credit administration process, and monitoring of real estate loan concentrations are sufficient to address the risk management of CRE under the guidelines.

The Bank and its board of directors have discussed the guidelines and believe that the Bank’s underwriting policies, management information systems, independent credit administration process, and monitoring of real estate loan concentrations are sufficient to address the risk management of CRE under the guidelines.

Loan and Lease Maturities

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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.

Unused commitments to extend credit totaled $561 million at December 31, 2021, and $450 million at December 31, 2020, although it is not likely that all of those commitments will ultimately be drawn down.

The increase in 2021 is due in part to a lower utilization of mortgage warehouse lines in 2021.

Unused commitments, excluding mortgage warehouse and overdraft lines, were $219.7 million at December 31, 2022, compared to $219.6 million at December 31, 2021.

Total line utilization, excluding mortgage warehouse and overdraft lines, was 59% at December 31, 2022 and 61% at December 31, 2021 and was 32% at December 31, 2022 and 48% at December 31, 2021, including mortgage warehouse lines.

Mortgage warehouse utilization declined to 10% at December 31, 2022, as compared to 27% at December 31, 2021.

Total mortgage warehouse availability increased to $594.6 million at December 31, 2022 as compared to $276.8 million at December 31, 2021 due to adding new customers.

It is not likely that all of those commitments will ultimately be drawn down.

Unused commitments represented approximately 40% of gross loans outstanding at December 31, 2022 and 25% at December 31, 2021.

The Company also had undrawn letters of credit issued to customers totaling $6.0 million and $6.7 million at December 31, 2022 and 2021, respectively.

Off-balance sheet obligations pose potential credit risk to the Company, and a $0.2 million reserve for unfunded commitments is reflected as a liability in our consolidated balance sheet at December 31, 2021, down $0.1 million from the previous year.

Off-balance sheet obligations pose potential credit risk to the Company, and a $0.8 million reserve for unfunded commitments is reflected as a liability in our consolidated balance sheet at December 31, 2022, up $0.6 million from the previous year.

The unused commitments related to mortgage warehouse are unconditionally cancellable at any time.

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(2) Loans deferred under the CARES act are not included in nonperforming loans above, nor are they included in the numerators used to calculate the ratios disclosed in the table.

NPAs totaled $4.6 million, or 0.2% of gross loans and leases plus foreclosed assets at the end of 2021, down from $8.6 million, or 0.4% of gross loans and leases plus foreclosed assets at the end of 2020.

NPAs increased $2.0 million in 2020, of which $1.4 million was a result of 10 loans previously deferred under section 4013 of the CARES Act, that were unable to resume their scheduled payments at the end of the deferral period.

Nonperforming loans secured by real estate comprised $3.1 million of total nonperforming loans at December 31, 2021, a decrease of $3.1 million, or 50%, since December 31, 2020.

NPAs totaled $19.6 million, or 1.0% of gross loans and leases plus foreclosed assets at the end of 2022, up from $4.6 million, or 0.2% of gross loans and leases plus foreclosed assets at the end of 2021.

NPAs decreased $3.1 million or 50% in 2021.

Nonperforming loans secured by real estate comprised $16.5 million of total nonperforming loans at December 31, 2022, an increase of $13.4 million, since December 31, 2021.

There was also an increase of $2.5 million in agricultural production loans but a decrease of $0.8 million in commercial and industrial loans.

Consumer nonperforming loans were mostly unchanged during 2021.

Consumer nonperforming loans were nominal at December 31, 2022.

Nonperforming loan balances at December 31, 2022 include $0.6 million in TDRs and other loans that were paying as agreed, but which met the technical definition of nonperforming and were classified as such.

We also had $10.4 million in loans deferred under the CARES Act, which are not treated as TDRs and were still accruing interest at December 31, 2021, and $4.9 million in loans classified as performing TDRs for which we were still accruing interest at December 31, 2021, a decrease of $6.5 million, or 57%, relative to December 31, 2020.

We also had $4.5 million in loans classified as performing TDRs for which we were still accruing interest at December 31, 2022, an decrease of $0.4 million, or 8%, relative to December 31, 2021.

Notes 2 and 4 to the consolidated financial statements provide a more comprehensive disclosure of TDR balances and activity within recent periods.

Loan modifications not treated as TDRs were $10.4 million at December 31, 2021 and are made to one borrower.

Of the total loans modified at year end, 100%, are lessors of non-residential buildings.

All of the loans currently under modification have maturities within 90 days.

All loans are well secured based on the most recent appraisal.

The balance of foreclosed assets had a carrying value of $0.1 million at December 31, 2021, comprised of one property classified as OREO.

At the end of 2020 foreclosed assets totaled $1.0 million, consisting of 7 properties classified as OREO.

The Company had no foreclosed assets at December 31, 2022.

At the end of 2021 foreclosed assets totaled $0.1 million, which was comprised of one property that was subsequently sold in 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.

Allowance for Loan and Lease Losses/Allowance for Credit Losses

The allowance for loan and lease losses, a contra-asset, is established through a provision for loan and lease losses.

It is maintained at a level that is considered adequate to absorb probable losses on specifically identified impaired loans, as well as probable incurred losses inherent in the remaining loan portfolio.

Allowance for Credit Losses/Allowance for Loan and Lease Losses

The allowance for credit losses on loans and leases, a contra-asset, is established through a provision for credit losses on loans and leases.

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.

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.

Note 2 to the consolidated financial statements provides a more comprehensive discussion of the accounting guidance we conform to and the methodology we use to determine an appropriate allowance for loan and lease losses, including information regarding the Company’s decision to defer implementation of Current Expected Credit Loss ("CECL") accounting method.

The Company’s allowance for loan and lease losses was $14.3 million, or 0.7% of gross loans at December 31, 2021, relative to $17.7 million, or 0.7% of gross loans at December 31, 2020.

The decrease in the allowance resulted from the release of $3.7 million in loan and lease loss reserves in 2021, plus $0.2 million in net loan recoveries.

Reserves were established for losses inherent in incremental loan balances and unanticipated charge-offs in 2021.

The net decrease in the allowance might have resulted in an increase if not for the following circumstances:

charge-offs were recorded against pre-established reserves, which alleviated what otherwise might have been a need for reserve replenishment;

all acquired loans were booked at their fair values, and thus did not initially require a loan and lease loss allowance;

and loan and lease loss rates have been declining, having a positive impact on general reserves established for performing loans.

The Company’s allowance for credit losses on loans and leases was $23.1 million, or 1.12% of gross loans at December 31, 2022, relative to $14.3 million, or 0.7% of gross loans at December 31, 2021.

The increase in the allowance resulted from an increase in non-accrual loan balances, primarily as a result of a downgrade in the first quarter of 2022 of one loan relationship in the dairy industry consisting of four separate loans.

At December 31, 2022, nonaccrual loans totaled $19.6 million compared to $4.5 million at December 31, 2021.

All of the Company’s impaired assets are periodically reviewed and are either well-reserved based on current loss expectations or are carried at the fair value of the underlying collateral, net of expected disposition costs.

The ratio of the allowance to nonperforming loans was 118% at December 31, 2022, relative to 315% at December 31, 2021, and 233% at December 31, 2020.

As described above, a separate allowance of $0.8 million for potential losses inherent in unused commitments is included in other liabilities at December 31, 2022.

The Company recorded a loan and lease loss benefit of $3.7 million in 2021 compared to a loan and lease loss provision of $8.6 million in 2020, and $2.6 million in 2019.

Our allowance for probable losses on specifically identified impaired loans decreased $0.2 million, or 20%, during 2021, whereas it increased $0.2 million, or 20%, during 2020.

The allowance for probable losses inherent in non-impaired loans decreased by $3.3 million, or 20%, as a result of continued improvements in the overall economy, a reduction in historical loss rates, net loan recoveries in 2021, a change in the mix of loans, and lower outstanding balances of net loans and leases.

The Company recorded a provision for loan and lease losses of $10.9 million in 2022 as compared to a loan and lease loss benefit of $3.7 million in 2021, and a loan and lease loss provision of $8.6 million in 2020.

Our allowance for probable losses on individually identified loans decreased $0.4 million, or 46%, during 2022, and $0.2 million, or 20%, during 2021.

The allowance for probable losses inherent in the remaining portfolio increased by $9.2 million, or 68%.

The primary reason for this increase is the $9.4 million CECL transition amount from the adoption of FASB Accounting Standards Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326).

The following table sets forth the Company’s net charge-offs as a percentage to the average loan balances in each loan category, as well as other credit related ratios at or for the periods indicated:

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Consumer loans

Allowance for loan and lease losses to gross loans and leases at end of period

Allowance for credit losses on loans and leases to gross loans and leases at end of period

Nonaccrual loans to gross loans and leases at end of period

Allowance for loan and lease losses to nonaccrual loans

Allowance for credit losses on loans and leases to nonaccrual loans

Provided below is a summary of the allocation of the allowance for loan and lease losses for specific loan categories at the dates indicated.

The allocation presented should not be viewed as an indication that charges to the allowance will be incurred in these amounts or proportions, or that the portion of the allowance allocated to a particular loan category represents the total amount available for charge-offs that may occur within that category.

Allocation of Allowance for Loan and Lease Losses

Allocation of Allowance for Credit Losses on Loans and Leases

(dollars in thousands)

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(2) Includes mortgage warehouse lines

The Company’s allowance for loan and lease losses at December 31, 2021 represents Management’s best estimate of probable losses in the loan portfolio as of that date, but no assurance can be given that the Company will not experience substantial losses relative to the size of the allowance.

The Company’s allowance for credit losses on loans and leases at December 31, 2022 represents Management’s best estimate of probable losses in the loan portfolio as of that date, but no assurance can be given that the Company will not experience substantial losses relative to the size of the allowance.

Furthermore, fluctuations in credit quality, changes in economic conditions, updated accounting, or regulatory requirements, and/or other factors could induce us to augment or reduce the allowance.

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and 5) they can provide partially tax exempt income.

Aggregate investments totaled $1.2 billion, or 35% of total assets at December 31, 2021, as compared to $547.5 million, or 17% of total assets at December 31, 2020.

Aggregate investments totaled $1.3 billion, or 35% of total assets at December 31, 2022, as compared to $1.2 billion, or 35% of total assets at December 31, 2021.

We had no fed funds sold at the end of the reporting periods, and interest-bearing balances held primarily in our Federal Reserve Bank account totaled $3.2 million at December 31, 2022, as compared to $193.3 million at December 31, 2021.

The average rate on the interest-bearing balances was 0.57% for 2022.

Due to the low rate on this investment, the Company worked diligently to identify earning assets for purchase.

With respect to the investment portfolio, the Company purchased $332.8 million of AAA and AA-rated Collateralized Loan Obligations (“CLOs”).

These structured investments complement our fixed-rate earning assets as CLOs have rates that adjust quarterly.

In addition, certain loan purchases The Company’s investment securities portfolio had a book balance of $973.3 million at December 31, 2021, compared to $544.0 million at December 31, 2020, reflecting a net increase of $429.3 million, or 79%.

The Company carries investments at their fair market values.

We currently have the intent and ability to hold our investment securities to maturity, but the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management.

The expected average life for bonds in our investment portfolio was 5.7 years and their average effective duration was 3.2 years at December 31, 2021, as compared to an expected average life of 4.2 years and an average effective duration of 2.4 years at year-end 2020.

The following Investment Portfolio table reflects the amortized cost and fair market values for each primary category of investment securities for the past three years:

In an effort to change the mix of lower rate earning assets, the Company worked diligently to identify higher yielding earning assets, within the Company’s risk profile for purchase.

With respect to the investment portfolio, the Company purchased $181.5 million of AAA and AA-rated Collateralized Loan Obligations (“CLOs”) bringing the total CLOs to $498.4 million at December 31, 2022.

These structured investments complement our fixed-rate earning assets, including fixed rate loans, as CLOs have rates that adjust quarterly.

The Company’s investment securities portfolio had a book balance of $1.3 billion at December 31, 2022, compared to $973.3 million at December 31, 2021, reflecting a net increase of $298.5 million, or 31%.

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 1.83 years for available-for-sale investments and 6.4 years for held-to-maturity investments at December 31, 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 accumulated other comprehensive income due to changes in estimated fair value..

See Note 3, Investment Securities for additional information.

The following Investment Portfolio table reflects the carrying amount for each primary category of investment securities for the past three years:

Investment Portfolio-Available for Sale

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As of December 31,

Carrying Amount

Available for sale

government agencies

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Collateralized loan obligations

Total available for sale

Held to maturity

government agencies

Mortgage-backed securities

State and political subdivisions

Total held to maturity

Total securities

The net unrealized gain on our investment portfolio, or the amount by which aggregate fair market values exceeded the amortized cost, was $15.9 million at December 31, 2021 as compared to $26.1 million at December 31, 2020, a decrease of $10.2 million.

The change in 2021 was caused by higher market interest rates on fixed-rate bond values.

The balance of U.S.

Government agency securities in our portfolio declined by $0.2 million, or 13%, during 2021 due primarily to bond maturities.

Similarly, mortgage-backed securities decreased by $7.7 million, or 2% due to prepayments not being reinvested.

Municipal bond balances increased by $76.5 million, or 34% due to purchases.

Municipal bonds purchased in recent periods have strong underlying ratings, and all municipal bonds in our portfolio undergo a detailed quarterly review for potential impairment.

CLOs, all AAA or AA rated, were purchased during 2021 for $332.2 million as an asset class diversification strategy as management continues to utilize available liquidity and improve asset sensitivity, as described above.

Investment securities that were pledged as collateral for Federal Home Loan Bank borrowings, repurchase agreements, public deposits and other purposes as required or permitted by law totaled $167.2 million at December 31, 2021 and $232.0 million at December 31, 2020, leaving $806.1 million in unpledged debt securities at December 31, 2021 and $312.0 million at December 31, 2020.

Based on an analysis of its available for sale securities with unrealized losses as of December 31, 2022, The Company determined their decline in value was unrelated to credit loss and was primarily the result of interest rate changes and market spreads subsequent to acquisition.

The fair value of debt securities is expected to recover as payments are received and the debt securities approach maturity.

In addition, the Company determined there was a $0.1 million credit loss expected on the held-to-maturity debt securities portfolio which was recorded as an allowance for credit losses on held-to-maturity securities.

Investment securities that were pledged as collateral for Federal Home Loan Bank borrowings, repurchase agreements, public deposits and other purposes as required or permitted by law totaled $183.5 million at December 31, 2022 and $167.2 million at December 31, 2021, leaving $1.1 billion in unpledged debt securities at December 31, 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 $43.1 million at December 31, 2022 and $47.0 million at December 31, 2021.

The table below groups the Company’s investment securities by their remaining time to maturity as of December 31, 2022, and provides weighted average yields for each segment.

Maturity and Yield of Held-to-Maturity Investment Portfolio

(dollars in thousands)

December 31, 2022

After Five Years

Mortgage-Backed Securities

Held to maturity

government agencies

Mortgage-backed securities

State and political subdivisions

Total securities

Cash and Due from Banks

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The Company’s balance of noninterest earning cash and balances due from correspondent banks totaled $72.8 million, or 2% of total assets at December 31, 2022, and $63.1 million, or 2% of total assets at December 31, 2021.

The average balance of non-earning cash and due from banks, which can be used to determine trends, was $75.7 million for 2021 and $72.0 million for 2020 and 2019.

The average balance of non-earning cash and due from banks, which can be used to determine trends, was $79.3 million for 2022, $75.7 million for 2021 and $72.0 million for 2020.

Premises and Equipment

Premises and equipment are stated on our books at cost, less accumulated depreciation, and amortization.

The cost of furniture and equipment is expensed as depreciation over the estimated useful life of the related assets, and leasehold

improvements are amortized over the term of the related lease or the estimated useful life of the improvements, whichever is shorter.

The cost of furniture and equipment is expensed as depreciation over the estimated useful life of the related assets, and leasehold improvements are amortized over the term of the related lease or the estimated useful life of the improvements, whichever is shorter.

The following premises and equipment table reflects the original cost, accumulated depreciation and amortization, and net book value of fixed assets by major category, for the years noted:

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Leasehold improvements

Construction in progress

The net book value of the Company’s premises and equipment was 1% of total assets at both December 31, 2022, and December 31, 2021.

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The Company’s goodwill and other intangible assets are evaluated annually for potential impairment following FASB guidelines and based on those analytics Management has determined that no impairment exists as of December 31, 2022.

The net cash surrender value of bank-owned life insurance policies increased to $54.2 million at December 31, 2021 from $52.5 million at December 31, 2020, due to the addition of BOLI income to net cash surrender values.

Refer to the “Noninterest Revenue and Operating Expense” section above for a more detailed discussion of BOLI and the income it generates.

The net cash surrender value of bank-owned life insurance policies decreased to $52.2 million at December 31, 2022 from $54.2 million at December 31, 2021, due to the decline of BOLI income from net cash surrender values.

Refer to the “Noninterest Revenue and Operating Expense” section above for a more detailed discussion of BOLI and the income/expense it generates.

The remainder of other assets consists primarily of right-of-use assets tied to operating leases, accrued interest receivable, deferred taxes, investments in bank stocks, other real estate owned, prepaid assets, investments in low-income housing credits, investments in SBA loan funds, and other miscellaneous assets.

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Deposit balances reflect net growth of $64.6 million, or 2%, in 2022 and $157.0 million, or 6%, during 2021.

The increase in 2021 and 2020 is primarily due to organic growth as both consumer and commercial existing customers increased their deposit account balances.

Noninterest bearing demand deposit balances were up $140.9 million, or 15%;

NOW and interest-bearing demand accounts increased by $16.1 million, or 1% in 2021.

Overall non-maturity deposits increased by $316.0 million, or 15%, to $2.4 billion at December 31, 2021.

The increase in 2022 was primarily from brokered deposits while the increase in 2021 was primarily due to organic growth as both consumer and commercial existing customers increased their deposit account balances.

Noninterest bearing demand deposit balances were up $3.7 million;

NOW and interest-bearing demand accounts decreased by $103.0 million, or 14% in 2022.

Overall non-maturity deposits decreased by $0.1 million, or 4%, to $2.3 billion at December 31, 2022.

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.

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The FHLB line is committed, but the amount of available credit depends on the level of pledged collateral.

Total non-deposit interest-bearing liabilities decreased $25.8 million, or 12%, in 2021, due primarily to decreases in overnight fed funds purchased, and FHLB advances.

Total non-deposit interest-bearing liabilities increased $221.5 million, or 116%, in 2022, due primarily to increases in overnight fed funds purchased, customer repurchase agreements, and FHLB advances.

Non-deposit interest-bearing liabilities decreased $25.8 million, or 12%, in 2021, due primarily to decreases in overnight fed funds purchased, and FHLB advances.

The decreases were partially offset by increases in customer repurchase agreements and long-term debt.

Non-deposit interest-bearing liabilities increased $136.5 million, or 298%, in 2020, due to increases in overnight fed funds purchased, FHLB advances, and customer repurchase agreements.

These increases were primarily to fund fluctuations in our mortgage warehouse loan balances.

The Company had no overnight fed funds purchased, overnight FHLB advances or short-term borrowings from the FHLB at December 31, 2021, as compared to $100.0 million in overnight fed funds purchased, $37.9 million in overnight FHLB advances and $5.0 million in short-term borrowings from the FHLB at December 31, 2020.

The Company had $125.0 million in overnight fed funds purchased and $94.0 million in overnight FHLB advances at December 31, 2022 as compared to, no overnight fed funds purchased, overnight FHLB advances or short-term borrowings from the FHLB at December 31, 2021.

Repurchase agreements totaled $109.2 million at year-end 2022 relative to a balance of $106.9 million at year-end 2021.

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The small increase resulted from the amortization of discount on junior subordinated debentures that were part of our acquisition of Coast Bancorp in 2016.

Long term debt increased to $49.1 million for the year ended December 31, 2021, from the issuance of $50 million in 3.25% fixed – floating subordinated debt with a ten-year maturity in the third quarter of 2021.

The Company contributed $25 million of additional capital to the Bank in the fourth quarter of 2021 and is utilizing the remainder of the funds for general corporate purposes, which includes repurchasing shares of common stock, among other things.

Long term debt was $49.2 million at December 31, 2022 as compared to $49.1 million for the year ended December 31, 2021.

The small increase resulted from the amortization of debt issuance costs.

The details of the Company’s short-term borrowings are presented in the table below, for the years noted:

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The Company’s balance of other liabilities increased by $9.8 million, or 28%, during 2022.

The primary reason for this increase was a commitment in low income housing tax credit funds and an increase in accrued interest payable due to the increase in interest rates during 2022.

Capital Resources

The Company had total shareholders’ equity of $303.6 million at December 31, 2022 as compared to $362.5 million at December 31, 2021.

The increase of $18.6 million, or 5%, is due to $43.0 million in net income and approximately $1.2 million in additional capital related to equity compensation, net of a $7.2 million decrease in our accumulated other comprehensive income, $13.2 million in dividends paid and $5.2 million in stock repurchased.

The decrease of $58.9 million, or 16%, is due to $33.7 million in net income and approximately $1.3 million in additional capital related to equity compensation, net of a $67.7 million decrease in our accumulated other comprehensive income, $13.9 million in dividends paid and $7.3 million from the cumulative effect of a change in accounting principal from the implementation of CECL, topic 326.

One of our strategies for managing the potential for future unrealized losses in our securities portfolio to limit impacts to accumulated other comprehensive income and tangible capital was the movement of certain securities from available for sale to the held to maturity category, more fully discussed above under “Investments” and further below.

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.

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The federal bank regulatory agencies adopted an interim final rule to implement this change from the CARES Act.

The Company and the Bank meet the criteria outlined in the final rule and the interim final rule and adopted the community bank leverage ratio framework in the first quarter 2020.The Company uses a variety of measures to evaluate its capital adequacy, including the community bank leverage ratio, which the Company adopted in 2020, and risk-based capital and

leverage ratios in preceding years, that are 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.

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Bank of the Sierra

(1) The community bank leverage ratio minimum requirement is 8% as of December 31, 2020, 8.5% for calendar year 2021, and 9% for calendar year 2022 and beyond

(1) Under interim transition final guidance, the community bank leverage ratio minimum requirement was reduced to 8.5% for calendar year 2021.

At the end of 2022, as our Community Bank Leverage Ratio exceeded 9.0%, the Company and the Bank were both classified as “well capitalized,” the highest rating of the categories defined under the Bank Holding Company Act and the Federal Deposit Insurance Corporation Improvement Act of 1991, and our regulatory capital ratios remained above the median for peer financial institutions.

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For additional details on risk-based and leverage capital guidelines, requirements, and calculations and for a summary of changes to risk-based capital calculations which were recently approved by federal banking regulators, see “Item 1, Business – Supervision and Regulation – Capital Adequacy Requirements” and “Item 1, Business – Supervision and Regulation – Prompt Corrective Action Provisions” herein.

In addition to monitoring regulatory capital ratios, the Company monitors its tangible common equity ratio (TCE Ratio).

The TCE Ratio declined from 9.93% at December 31, 2021 to 7.65% at December 31, 2022.

This decline was primarily a result in a decrease in Accumulated Other Comprehensive Income due to the impact of higher interest rates on the value of investments available for sale.

As the change in estimated fair value of securities available for sale are included in Other Comprehensive Income, if values decline due to changes in interest rates, liquidity, or spreads, equity is also reduced.

Similarly, if values increase for the same reasons, equity is also increased.

Although the Company elected to exclude changes in Accumulated Other Comprehensive Income for regulatory capital purposes, such changes do impact the stated book equity and tangible common equity.

One of the reasons the Company purchases floating rate investments is to minimize the impact of changes in rates on tangible equity.

Similarly, as described above, the Company moved $360.4

million in securities from available for sale to held to maturity.

At December 31, 2022, approximately 66% of the Company’s investment portfolio is either floating rate or held to maturity.

The Company also looks at the double leverage ratio, which is a measure of the reliance on the holding company’s borrowings that are injected into the subsidiary Bank as capital.

As holding company borrowings are primarily serviced by the receipt of dividends from the subsidiary Bank, this ratio is monitored as well as cash at the holding company for purposes of servicing the cash needs at the holding company level.

This ratio is calculated by dividing subsidiary Bank capital by the holding company/consolidated capital.

The Company generally maintains a double leverage ratio of under 125%.

The double leverage ratio was 119.9% at December 31, 2022 as compared to 118.1% at December 31, 2021.

Liquidity and Market Risk Management

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The Company, on occasion, experiences cash needs as the result of loan growth, deposit outflows, asset purchases or liability repayments.

To meet 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.

Availability on lines of credit from correspondent banks and the FHLB totaled $1.1 billion at December 31, 2021.

Availability on lines of credit from correspondent banks and the FHLB totaled $955.9 million at December 31, 2022.

The Company was also eligible to borrow approximately $42.3 million at the Federal Reserve Discount Window based on pledged assets at December 31, 2022.

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In addition, the Company can raise immediate cash for temporary needs by selling under agreement to repurchase those investments in its portfolio which are not pledged as collateral.

As of December 31, 2021, unpledged debt securities plus pledged securities in excess of current pledging requirements comprised $853.2 million of the Company’s investment balances, as compared to $364.9 million at December 31, 2020.

As of December 31, 2022, unpledged debt securities plus pledged securities in excess of current pledging requirements comprised $1.1 billion of the Company’s investment balances, as compared to $853.2 million at December 31, 2021.

Other sources of potential liquidity include but are not necessarily limited to any outstanding fed funds sold and vault cash.

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Funds available through fed discount window

The Company did not experience a change in its ability to access traditional funding sources due to the COVID-19 pandemic.

The Company had adequate sources of cash to accommodate pandemic related cash needs over the past two years such as the ability to defer $424.0 million in loans under the CARES act and to fund $177.9 million in SBA PPP loans.

There were no material operational expenditures related to the COVID-19 pandemic, other than $0.1 million for software purchased to accommodate the processing of SBA PPP loans.

The Company’s net loans to assets and available investments to assets ratios were 59% and 31%, respectively, at December 31, 2021, as compared to internal policy guidelines of “less than 78%” and “greater than 3%.” Other liquidity ratios reviewed periodically by Management and the Board include net loans to total deposits and wholesale funding to total assets (including ratios and sub-limits for the various components comprising wholesale funding), which were all well within policy guidelines at December 31, 2021.

The holding company’s primary uses of funds include operating expenses incurred in the normal course of business, shareholder dividends, and stock repurchases.

The Company’s primary liquidity ratio and net loans to deposits ratio was 40% and 72%, respectively, at December 31, 2022, as compared to internal policy guidelines of “greater than 15%” and “less than 95%.” Other liquidity ratios reviewed

periodically by Management and the Board include the Community Bank leverage ratio, net change in overnight position and wholesale funding to total assets (including ratios and sub-limits for the various components comprising wholesale funding).

All ratios were within policy guidelines at December 31, 2022.

The holding company’s primary uses of funds include operating expenses incurred in the normal course of business, debt servicing, shareholder dividends, and stock repurchases.

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

At December 31, 2022, the holding company maintained a cash balance of $26.1 million.

Management anticipates that the Bank will have sufficient earnings to provide dividends to the holding company to meet its funding requirements for the foreseeable future and the Bank is not subject to any regulatory restrictions for paying dividends to the holding company, other than the legal and regulatory limitations on dividend payments, as outlined in Item 5(c) Dividends in this Form 10-K.

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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.

The principal objective of interest rate risk management is to manage the financial components of the Company’s balance sheet in a manner that will optimize the risk/reward equation for earnings and capital under a variety of interest rate scenarios.

To identify areas of potential exposure to interest rate changes, we utilize commercially available modeling software to perform monthly earnings simulations and calculate the Company’s market value of portfolio equity under varying interest rate scenarios.

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Those scenarios may be supplemented, reduced in number, or otherwise adjusted as determined by Management to provide the most meaningful simulations in light of economic conditions and expectations at the time.

Given the current near zero interest rate environment it is unlikely that rates could decline much further beyond the downward shock of 100 basis points, therefore the downward shock scenarios of 200 and 300 basis points are temporarily being suspended after concurrence by the Company’s Board of Directors.

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.

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$ Change in Net Interest Income

The simulation for the period ending December 31, 2021, indicates that the Company is asset sensitive, with sizeable increases in net interest income in rising rate scenarios, however a continued drop in interest rates could have a substantial negative impact.

The simulation for the period ending December 31, 2022, indicates that the Company is slightly liability sensitive, with net interest income decreasing in rising and declining rate scenarios, with a continued drop in interest rates having the most substantial negative impact.

The change in the magnitude of the Company’s asset sensitivity based on its interest rate risk model at December 31, 2022, as compared to December 31, 2021, is due mostly to the level of overnight borrowings both in Fed Funds purchased and overnight FHLB borrowings and in customer time deposits tied to the prime interest rate.

In addition, based on the magnitude of rate changes, interest rates on new loans did not increase at the rates modeled in 2021 and therefore, the beta on loan yields was lowered in modeling interest rate risk in 2022.

Any change in interest rate in the model would expect to decrease net interest income.

At December 31, 2022, the Company had $219.0 million in overnight borrowings as compared to none at December 31, 2021.

At December 31, 2021, the Company had $193.2 million in overnight cash held with the Federal Reserve bank as compared to $3.2 million at December 31, 2022.

The Company has approximately $594.6 million of unfunded mortgage warehouse lines at December 31, 2022.

If rates decrease, it would be expected that a significant portion of the unfunded mortgage warehouse lines would become funded and thereby, mitigate the impact of lower rates on the balance sheet through higher utilization.

For the period ending December 31, 2021, the simulation indicated that the Company is asset sensitive, with sizeable increases in net interest income in rising rate scenarios, however a continued drop in interest rates could have a substantial negative impact.

The change in the magnitude of the Company’s asset sensitivity based on its interest rate risk model at December 31, 2021, as compared to December 31, 2020, is due mostly to the level of overnight cash held as an interest bearing deposit at the Federal Reserve Bank.

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As this cash is held overnight, any change in interest rate in the model would increase the yield on such overnight cash immediately, therefore, increasing the Company’s asset sensitivity.

For the prior year ending December 31, 2020 the simulations indicate that the Company’s net interest income will remain relatively flat over the next 12 months in the up 100 and 200 basis point scenarios but declines after that in a rising rate environment, indicating that the Company was potentially liability sensitive;

furthermore, a drop in interest rates could have had a substantial negative impact on earnings.

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 $5.8 million, or 6%, relative to a stable interest rate scenario, with the favorable variance increasing as interest rates rise higher.

If interest rates were to decline by 100 basis points, however, net interest income would likely be around $10.5 million lower than in a stable interest rate scenario, for a negative variance of 10%.

In addition to the net interest income simulations shown above, we run stress scenarios for the unconsolidated Bank modeling the possibility of no balance sheet growth, the potential runoff of “surge” core deposits which flowed into the Bank in the most recent economic cycle, and unfavorable movement in deposit rates relative to yields on earning assets (i.e., higher deposit betas).

When no balance sheet growth is incorporated and a stable interest rate environment is assumed, projected annual net interest income is about $2.6 million lower, or 2% than in our standard simulation.

However, the stressed simulations reveal that the Company’s greatest potential pressure on net interest income would result from excessive non-maturity deposit runoff and/or unfavorable deposit rate changes in rising rate scenarios, which could reduce our net interest income by 14% in the event of a 30% decay/shift in such balances.

The economic value (or “fair value”) of financial instruments on the Company’s balance sheet will also vary under the interest rate scenarios previously discussed.

The difference between the projected fair value of the Company’s financial assets and the fair value of its financial liabilities is referred to as the economic value of equity (“EVE”), and changes in EVE under different interest rate scenarios are effectively a gauge of the Company’s longer-term exposure to interest rate fluctuations.

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.

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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.

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.

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The increase in value of the Company’s large volume of stable DDA balances is expected to outweigh the decrease in value of the fixed rate assets, causing the overall net increase in EVE in the up-shock scenarios.

Our EVE deltas have increased given the relative starting points of our non-maturity deposits in the current rate environment.

Specifically, as the current rates are very low, the value of the non-maturity deposits is lower than it has been historically.

The impact of an increase in rates has an expected greater magnitude impact on the value of such deposits.

Our EVE sensitivity is decreasing in the current interest rate environment and fell considerably over the last twelve months ending December 31, 2022 given the higher rate environment at December 31, 2022 as compared to December 31, 2021.

Sensitively decreased from 16% to 3% in the Up 100 shock and decreased from 36% to 7% in the Up 400 shock.

All up-shock scenarios fall within Policy guidelines.

All the down shock scenarios have exceeded the Policy guidelines and will continue to exceed them until deposit rates move back up to more normalized higher levels.

We also run stress scenarios for the unconsolidated Bank’s EVE to simulate the possibility of slower loan prepayment speeds in the up-shock scenarios and faster prepayment speeds in the down-shock scenarios as well as unfavorable changes in deposit rates, and higher deposit decay rates.

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

What changed 10-K

Item 7. Management’s Discussion and Analysis