What changed in this filing

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Item 2. Management’s Discussion and Analysis

2023-05-05 compared with 2022-11-03 · 281 added, 359 removed, 407 unchanged (61% of the section changed)

13 unchanged sentences

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

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

● risks associated with inflation (including efforts by the Federal Open Market Committee of the Federal Reserve Bank to control the same);

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

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

● liquidity risks, including the ability to effectively manage the potential loss of deposits, the ability to maintain funding lines of credit;

and the loss of value of unencumbered investment securities;

● increases in nonperforming assets and credit losses that could occur, particularly in times of weak economic conditions or rising interest rates;

● reductions in the market value of available-for-sale securities that could result if interest rates increase substantially, or an issuer has real or perceived financial difficulties;

● the impact of adverse developments at other banks, including bank failures, that impact general sentiment regarding the stability and liquidity of banks;

● operational risks including the ability to detect and prevent errors and fraud;

● the Company’s ability to diversify and grow its loan portfolio;

● the Company’s ability to attract and retain skilled employees;

● the Company’s ability to successfully deploy new technology;

● the Company’s ability to successfully deploy new technology and manage cyber security risks;

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

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

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

● the effects of severe weather events, pandemics, other public health crises, acts of war or terrorism, and other external events;

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

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RESULTS OF OPERATIONS SUMMARY

Third Quarter 2022 compared to Third Quarter 2021

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

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

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

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

● Net interest income increased $2.2 million.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

First Quarter 2023 compared to First Quarter 2022

First quarter 2023 net income was $8.8 million, or $0.58 per diluted share, compared to $7.4 million, or $0.49 per diluted share in the first quarter of 2022.

The Company’s annualized return on average equity was 11.53% and annualized return on average assets was 0.97% for the quarter ended March 31, 2023, compared to 8.64% and 0.88%, respectively, for the same quarter in 2022.

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

● Net interest income increased $3.4 million or 14%.

This was due mostly to an $11.3 million increase in interest income partially offset by an $8.0 million increase in interest expense.

There was an increase in investment securities which contributed $9.6 million to the favorable interest income variance.

This increase in investments primarily consisted of floating rate collateralized loan obligations (CLOs), which contributed to $6.9 million or 61.0% of the interest income favorable variance, partially offset by an unfavorable increase in interest expense due to a shift of deposit balances into higher cost time certificates and an increase in borrowed funds.

● Noninterest income increased $0.5 million or 9% primarily due to $0.3 million gain on life insurance proceeds, $0.3 million in other foreclosed assets income, combined with favorable BOLI fluctuations associated with deferred compensation plans for $0.8 million.

The provision for credit losses at $0.3 million declined by $0.2 million, or 49% as a result of lower net loan charge-offs recognized in the first quarter of 2023.

● Total noninterest expense increased $2.8 million, or 14%, in the first quarter of 2023 as compared to the first quarter of 2022.

Salaries and benefits costs increased $1.0 million as we added new lending teams, and other noninterest expense increased $1.8 million mostly due to a $0.8 million increase in foreclosed asset expense, and a $0.5 million in directors deferred compensation expense, linked to favorable changes in BOLI income described above.

FINANCIAL CONDITION SUMMARY

September 30, 2022 relative to December 31, 2021

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

March 31, 2023 relative to December 31, 2022

The Company’s assets totaled $3.7 billion at March 31, 2023, an increase of $85.4 million, or 2% from December 31, 2022.

The following provides a summary of key balance sheet changes during the first three months of 2023:

● Investment securities increased by $101.8 million, or 8%, to $1.4 billion primarily due to strategic purchases of U.S.

government agency securities and CLOs.

● Gross loan balances declined by $19.0 million, due mostly to the foreclosure of $18.1 million of loans related to one dairy relationship in January 2023.

Further commercial real estate secured loans increased $8.7 million, and mortgage warehouse lines increased by $3.0 million.

● Deposits increased by $102.8 million, or 4%.

The growth in deposits came primarily from customer time and brokered deposits.

● Other short-term borrowings declined $42.2 million to $176.8 million at March 31, 2023 from $219.0 million at December 31, 2022 and consisted of overnight borrowings from correspondent banks and the FHLB.

Customer repurchase agreements, which are considered short-term as well, declined from $109.2 million at December 31, 2022 to $94.1 million at March 31, 2023.

● Long-term debt at March 31, 2023 consisted of $40.0 million of long-term FHLB advances and $49.2 million of subordinated debt.

This was an increase of $40.0 million from December 31, 2022 due to the $40.0 million in long-term FHLB advances, taken out as a partial hedge on longer term adjustable rate loans.

● Total capital of $307.0 million at March 31, 2023 reflects an increase of $3.4 million, or 1%, relative to year-end 2022.

The Company’s leverage ratio was 10.13% at March 31, 2023 as compared to 10.30% at December 31, 2022.

The increase in equity during the first three months of 2023 was due to the addition of $8.8 million in net income, a $0.5 million favorable swing in accumulated other comprehensive income/loss, due principally to changes in investment securities’ fair value, net of $2.7 million in share repurchases, and $3.5 million in

dividends paid.

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

EARNINGS PERFORMANCE

4 unchanged sentences

NET INTEREST INCOME AND NET INTEREST MARGIN

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Net interest income was $28.1 million, for the first quarter of 2023, a $3.4 million increase, or 14% over the first quarter of 2022.

For the first quarter of 2023 as compared to the same quarter in 2022, the $3.4 million increase in net interest income came from a $186.9 million increase in average earning asset balances, which consisted of increases of $104.8 million in average investment balances and $82.1 million in average loan balances.

In addition, there was a favorable rate variance on average earning assets of 121 basis points.

Offsetting these favorable interest income variances, average deposit balances increased $128.6 million, with all of the increase in higher cost time deposits.

Average borrowed funds increased $175.2 million, primarily for the purchase of floating rate collateralized loan obligations.

Deposit costs increased 118 basis points in the first quarter of 2023 as compared to the same quarter in 2022, along with a 201 basis point increase in the cost of borrowed funds.

Interest expense was $9.3 million for the first quarter of 2023, an increase of $8.0 million, relative to the first quarter of 2022.

The significant increase in interest expense is attributable to an unfavorable shift in deposit mix and the impact of interest rate increases, as the average balance of higher cost time deposits, including variable rate time deposits and borrowed funds increased by $270.1 million and $175.2 million respectively in the first quarter of 2023 as compared to the first quarter of 2022.

The Company had $1.3 billion in adjustable and variable rate loans and $561.0 million in floating rate collateralized loan obligations, as compared to $464.7 million in floating rate CDs and $35.5 million in floating rate trust preferred securities at March 31, 2023.

$227.5 million of the Company’s adjustable and variable rate loans have the ability to reprice in the next twelve months.

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

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

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

These floating rate CDs increased $135.4 million or 41%, to $464.7 million at March 31, 2023, as compared to $329.3 million at December 31, 2022.

Due to the increases in the prime rate during 2022 and 2023, interest expense on floating rate CDs has increased $4.1 million for the first quarter of 2023 over the first quarter of 2022.

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

6 unchanged sentences

For the three months ended

September 30, 2022

September 30, 2021

Rate/Yield (2)

Interest-earning due from banks

Total investments

Loans and leases:

Mortgage warehouse lines

Total loans and leases

Total interest earning assets (4)

Other earning assets

Non-earning assets

Liabilities and shareholders' equity

Interest bearing deposits:

Demand deposits

Savings accounts

Time Deposits

Brokered deposits

Total interest bearing deposits

Borrowed funds:

Federal funds purchased

Repurchase agreements

Short term borrowings

Long-term debt

Subordinated debentures

Total borrowed funds

Total interest bearing liabilities

Demand deposits - noninterest bearing

Other liabilities

Shareholders' equity

Total liabilities and shareholders' equity

Interest income/interest earning assets

Interest expense/interest earning assets

Net interest income and margin (5)

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

(2) Yields and net interest margin have been computed on a tax equivalent basis utilizing a 21% effective tax rate.

(3) Loans are gross of the allowance for possible loan losses.

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

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

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

(5) Net interest margin represents net interest income as a percentage of average interest earning assets.

Average Balances and Rates

(Dollars in Thousands, Unaudited)

For the nine months ended

September 30, 2022

September 30, 2021

March 31, 2023

March 31, 2022

Rate/Yield (2)

2 unchanged sentences

Total investments

Loans and leases:

Mortgage warehouse lines

Total loans and leases

Total interest earning assets (4)

9 unchanged sentences

Borrowed funds:

Federal funds purchased

Repurchase agreements

Short term borrowings

Other borrowings

Long-term debt

10 unchanged sentences

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

(2) Yields and net interest margin have been computed on a tax equivalent basis utilizing a 21% effective tax rate.

(3) Loans are gross of the allowance for possible loan losses.

(2) Yields and net interest margin have been computed on a tax equivalent basis utilizing a 21% effective federal tax rate.

(3) Loans are gross of the allowance for expected credit losses.

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

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

Net loan (costs) fees and loan acquisition FMV amortization were $(0.1) million and $0.4 million for the quarters ended March 31, 2023 and 2022, respectively.

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

5 unchanged sentences

(dollars in thousands, unaudited)

Three months ended September 30,

Nine months ended September 30,

2022 over 2021

Three months ended March 31,

2023 over 2022

Increase (decrease) due to

Federal funds sold/due from time

Total investments (1)

Loans and leases:

Mortgage warehouse

Total loans and leases (1)

Total loans (1)

Total interest earning assets (1)

6 unchanged sentences

Borrowed funds:

Federal funds purchased

Repurchase agreements

Short term borrowings

Other Borrowings

Long-term debt

4 unchanged sentences

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

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

The volume variance calculated for the first quarter of 2023 relative to the first quarter of 2022 was a favorable $1.6 million;

this is primarily from a favorable volume variance of $1.8 million in interest earning assets, as the average balance of interest earning assets increased $186.9 million from the comparative quarters.

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

There was also a 40 basis point

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

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

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

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

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

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

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

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

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

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

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

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

There was a favorable rate variance of $6.3 million from the comparative quarters since the weighted average yield on interest earning assets more than offset the increase in the average yield unfavorable variance on interest bearing liabilities.

There was an unfavorable mix variance of $4.5 million primarily from the shift in customer deposit transaction accounts into higher

cost variable rate time certificates combined with a higher level of borrowed funds.

The Company’s net interest margin for the first quarter of 2023 was 3.47%, as compared to 3.21% for the first quarter of 2022.

At March 31, 2023, approximately 4% of our total portfolio, or $89.5 million, consists of variable rate loans.

At March 31, 2023, our outstanding fixed rate loans represented 36% of our loan portfolio.

The remaining 60% of our loan portfolio at March 31, 2023 consists of adjustable-rate loans;

68% of these loans (approximately $829.9 million) will not have the ability to reprice for at least another 3 years.

These loans are typically adjustable every five years after the initial adjustment.

Approximately $68.1 million of these adjustable-rate loans have the ability to reprice next quarter, which will have a positive impact on earnings.

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

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

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

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

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

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

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

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

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

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

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

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

Cash balances for the quarterly comparisons have decreased and have a positive impact on our net interest margin since cash balances earn considerably lower yields than other earning assets.

Average cash and due from banks was $83.1 million, a decrease of $188.5 million for the first three months of 2023 as compared to the same period last year.

Overall average investment securities increased by $294.4 million for the first quarter of March 31, 2023 as compared to March 31, 2022.

For the quarter ending March 31, 2023 over the same period for 2022, average non-taxable securities increased $66.9 million and taxable securities increased $227.5 million.

The overall investment portfolio had a tax-equivalent yield of 4.65% at March 31, 2023, with an average life of 6.41 years.

Interest expense was $9.3 million in the first quarter of 2023, an increase of $8.0 million compared to the first quarter of 2022.

The increase is attributable to a shift from being a net seller of Federal Funds at March 31, 2022, to a net purchaser of funds at March 31, 2023 coupled with a 380 to 450 basis point increase to the rate on the Prime Index Certificate of Deposit accounts offered by the bank.

The rate on the Prime Index account is tied to a spread to the Wall Street Journal Prime Rate and varies from Prime minus 400 basis points to Prime minus 325 basis points.

The average cost of interest-bearing deposits increased by 118 basis points to 131 basis points for the first quarter of 2023 compared to the first quarter of 2022.

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

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

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

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

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

PROVISION FOR CREDIT LOSSES ON LOANS AND LEASES

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

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

The Wall Street Journal Prime rate has increased by 450 basis points for the twelve month period between March 31, 2023 and March 31, 2022.

The average cost of borrowed funds increased 201 basis points for the first quarter of 2023 as compared to the same period in 2022.

Non-interest-bearing demand deposits decreased $22.9 million or 2% for the first quarter of 2023 as compared to the first quarter of 2022.

PROVISION FOR CREDIT LOSSES ON LOANS

Credit risk is inherent in the business of making loans.

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

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

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

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

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

The Company recorded an expense related to a credit loss provision for loans of $0.3 million in the first quarter of 2023 relative to a provision for credit losses on loans of $0.6 million in the first quarter of 2022.

The Company's $0.3 million decrease in the provision for credit losses on loans in the first quarter of 2023 as compared to the first quarter of 2022 was primarily due to the impact of reduced net loan charge-offs in the first quarter of 2023.

Specifically identifiable and quantifiable loan losses are immediately charged off against the allowance, with subsequent recoveries reflected as an increase to the allowance.

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

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

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

The Company’s policies for monitoring the adequacy of the allowance, determining loan balances that should be charged off, and other detailed information with regard to changes in the allowance are discussed in Note 10 to the consolidated financial statements, and below, under “Allowance for Credit Losses.” The process utilized to establish an appropriate credit allowance for losses on loans and leases can result in a high degree of variability in the Company’s credit loss provision, and consequently in our net earnings.

The Company recorded net loan charge-offs of $0.2 million in the first quarter of 2023 as compared to $1.8 million for the first quarter of 2022.

The allowance for credit losses on loans 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.

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

NONINTEREST INCOME AND NONINTEREST EXPENSE

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

The following table provides details on the Company’s noninterest income and noninterest expense for the three- and nine-month periods ended March 31, 2023 and 2022:

Noninterest Income/Expense

(dollars in thousands, unaudited)

For the three months ended September 30,

For the nine months ended September 30,

For the three months ended March 31,

Noninterest income:

Service charges on deposit accounts

Other service charges and fees

Service charges and fees on deposit accounts

Net gains on sale of securities available-for-sale

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Salaries and employee benefits

Occupancy costs

Furniture & equipment

Occupancy and equipment costs

Advertising and marketing costs

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Other operating costs

Telephone & data communications

Postage & mail

Professional services costs

Legal & accounting services

Director's deferred compensation

Director's costs

Other professional service

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As a % of average interest earning assets (1)

Efficiency ratio (2)(3)

(1) Annualized

(2) Tax equivalent

(3) The efficiency ratio is a non-GAAP measure and is a calculation of noninterest expense as a percentage of the sum of net interest income and noninterest income excluding net gains (losses) from securities and bank owned life insurance income.

Noninterest Income:

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

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

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

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

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

Total noninterest income increased $0.5 million, or 9%, for the quarter ended March 31, 2023 as compared to the same quarter in 2022.

A favorable swing in the income on BOLI offset by lower service charges on deposits and lower gains on the sale of investment securities accounts for most of the positive variance.

Other service charges and fees on deposit accounts decreased $0.2 million or 3% for the first quarter of 2023 as compared to the same period in 2022.

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

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the amount to which the Company will pay overdrafts for customers) was increased by $250.

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

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

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

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

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

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

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

Such election by plan participants in the fixed income account is ignored which creates greater volatility of the corporate owned life insurance asset value as compared to the related liability balance for deferred compensation.

More specifically, the specific account life insurance policies are designed to hold similar assets to the deemed investments in the director and employee deferred compensation plans.

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

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

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

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

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

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

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

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

There were de minimis gains of the sales of securities for the first quarter of 2023, but there was a $1.0 million gain on the sale of securities in the first quarter of 2022.

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

BOLI income increased by $0.8 million for the first quarter of 2023 as compared to the first quarter of 2022.

The variance is due mostly to fluctuations in underlying values of assets in the separate account BOLI policies that are designed to have similar assets to those in the deferred compensation plans.

Thus, the lower quarterly values in BOLI policies are offset by lower deferred compensation expense reflected primarily in director fees expense.

At March 31, 2023, there was $43.2 million in traditional BOLI policies and $9.1 million in separate account BOLI policies associated with the deferred compensation plans.

In the “other” category of noninterest income the Company there was a $0.9 million increase in the first quarter of 2023 as compared to the first quarter of 2022.

The primary reason for the favorable variance was the receipt of $0.3 million in life insurance proceeds, $0.3 million in income on foreclosed assets and a $0.3 million increase in variable rate SBA loan fund income.

Noninterest Expense:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Total noninterest expense increased by $2.8 million, or 14%, in the first quarter of 2023 relative to the first quarter of 2022.

Salaries and Benefits were $1.0 million, or 9%, higher in the first quarter of 2023 as compared to the first quarter of 2022.

The reason for this increase is primarily due to several factors, including merit increases for employees due to annual performance evaluations during the first quarter of 2023, and the strategic hiring of lending and management staff to support expected loan growth.

There were 500 full-time equivalent employees at March 31, 2023 as compared to 484 at March 31, 2022.

Occupancy expenses were flat for the first quarter of 2023 as compared to the same quarter in 2022.

Other noninterest expense increased $1.8 million, or 29% for the first quarter 2023 as compared to the first quarter in 2022.

The variances for the first quarter of 2023 compared to the same period in 2022 was primarily driven by a $0.8 million increase in foreclosed asset expenses related to a foreclosed Dairy relationship that was sold during the quarter and an increase in directors deferred compensation expense for $0.5 million which is linked to the fluctuation in BOLI income.

PROVISION FOR INCOME TAXES

The Company sets aside a provision for income taxes on a monthly basis.

The amount of that provision is determined by first applying the Company’s statutory income tax rates to estimated taxable income, which is pre-tax book income adjusted for permanent differences, and then subtracting available tax credits.

The amount of that provision is determined by first applying the Company’s statutory income tax rates to estimated taxable income, which is pre-tax book income

adjusted for permanent differences, and then subtracting available tax credits.

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

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

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

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

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

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

The Company's provision for income taxes was 23.6% of pre-tax income in the first quarter of 2023 relative to 27.0% in the first quarter of 2022.

The decrease in effective tax rate is due to the volatility in the Corporate Owned Life Insurance asset value associated with our non-qualified deferred compensation plans.

In the first quarter of 2023, the investments associated with the non-qualified deferred compensation plans increased in value, resulting in a non-taxable income as compared to a decrease in value generating non-tax deductible expense for the first quarter of 2022.

BALANCE SHEET ANALYSIS

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The composition, growth characteristics, and credit quality of both of those components are significant determinants of the Company’s financial condition.

Investments are analyzed in the section immediately below, while the loan and lease portfolio and other factors affecting earning assets are discussed in the sections following investments.

Investments are analyzed in the section immediately below, while the loan portfolio and other factors affecting earning assets are discussed in the sections following investments.

The Company’s investments may at any given time consist of debt securities and marketable equity securities (together, the “investment portfolio”), investments in the time deposits of other banks, surplus interest earning balances in our Federal Reserve Bank account, and overnight fed funds sold.

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and 5) they can provide partially tax exempt income.

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

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

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

The investment portfolio is reflected on the balance sheet as investment securities and totaled $1.4 billion, or 37% of total assets at March 31, 2023, and $1.3 billion, or 35% of total assets at December 31, 2022.

The increase was primarily due to purchases of U.S.

government agency securities and AAA and AA tranches of collateralized loan obligations.

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

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

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

The expected effective duration was 1.6 years for available-for-sale investments and 6.3 years for held-to-maturity investments at March 31, 2023, as compared to 1.8 years for available-for-sale investments and 6.4 years for held-to-maturity investments at December 31, 2022.

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”.

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(dollars in thousands, unaudited)

September 30, 2022

March 31, 2023

December 31, 2022

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Total securities

Investment securities that were pledged as collateral for borrowings and/or potential borrowings from the Federal Home Loan Bank and the Federal Reserve Bank, customer repurchase agreements, and other purposes as required or permitted by law totaled $175.5 million at September 30, 2022 and $167.2 million at December 31, 2021, leaving $1.05 billion in unpledged debt securities at September 30, 2022 and $806.1 million at December 31, 2021.

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

LOAN AND LEASE PORTFOLIO

Investment securities that were pledged as collateral for borrowings and/or potential borrowings from the Federal Home Loan Bank and the Federal Reserve Bank, customer repurchase agreements, and other purposes as required or permitted by law totaled $186.3 million at March 31, 2023 and $183.5 million at December 31, 2022, leaving $1.2 billion in unpledged debt securities at March 31, 2023 and $1.1 billion at December 31, 2022.

Securities that were pledged in excess of actual pledging needs and were thus available for liquidity purposes, if needed, totaled $58.3 million at March 31, 2023 and $43.1 million at December 31, 2022.

ALLOWANCE FOR CREDIT LOSSES – AFS INVESTMENT SECURITIES

The allowance for credit losses on AFS investment securities, a contra-asset, is established through periodic provisions for credit losses on AFS investment securities.

It is maintained at a level that is considered adequate to measure expected losses across the classes of major investment security types related to fluctuations in market conditions, primarily interest rates, and not reflective of a deterioration in credit value.

The Company maintains that it has intent and ability to hold these securities until the amortized cost basis of each security is recovered and likewise concluded as of both January 1, 2022 and March 31, 2023 that it was not more likely than not that any of the securities in an unrealized loss position would be required to be sold.

The following bullets outline additional support for management’s conclusion that no amount of the unrealized loss of the securities in an unrealized loss position as of January 1, 2022 and March 31, 2023 was attributable to credit deterioration and a risk of loss, requiring an allowance for credit losses.

● US Government Agencies are supported by the full faith and credit-worthiness of the U.S.

Federal Government and the management did not consider a default, much less a loss on these securities to be a reasonable possibility as of either January 1, 2022 or March 31, 2023.

● Mortgage-backed securities issued by government sponsored entities (“GSEs”) carry an implicit guarantee by the U.S.

Federal Government, as the GSEs can draw funds from the U.S.

Federal Government up to a limit, with an implied ability to draw funds beyond the limit.

Management did not consider a default, much less a loss on these securities to be a reasonable possibility as of either January 1, 2022 or March 31, 2023.

● Management routinely monitors third party credit grades of the municipal issuers in the Company’s state and political subdivisions portfolio and as of both January 1, 2022 and March 31, 2023 noted that all municipal securities in an unrealized loss position were either investment grade rated or guaranteed.

On a quarterly basis management receives financial information from a third-party service in order to monitor the underlying issuer’s financial stability.

In addition, management performs annual reviews of the underlying municipal issuers financial statements in order to evaluate stability and repayment capacity and has noted no concerns with any of the bonds in the Company’s State and Local portfolio.

As of both January 1, 2022 and March 31, 2023 management concluded that no allowance for credit losses was warranted on any of the Company’s municipal securities and the unrealized loss position of each of the securities reflected fluctuations in market conditions, primarily interest rates, since the time of purchase.

● The Company has invested in corporate debt issuances of other financial institutions.

Various financial metrics of each of the issuing financial institutions are reviewed by management quarterly, these metrics include credit quality, reserve adequacy, profitability and capital.

Following review of the financial metrics available for each of the underlying institutions as of January 1, 2022 and March 31, 2023 management concluded that the unrealized loss position of these securities related exclusively to the fluctuation in market conditions, primarily interest rates, from the date of purchase, and were not reflective of any credit concerns with the issuing financial institution.

These bonds were subject to a credit review by the credit administration department prior to their purchase and are subject to ongoing quarterly reviews.

● The Company has invested exclusively in AA and AAA tranches of various collateralized loan obligations, which are securitizations of commercial loans.

Each purchase is subject to a credit, concentration, and structure review by the credit administration department prior to their purchase and are subject to ongoing quarterly reviews.

Management monitors the credit rating of these investments on a quarterly basis in addition to various performance metrics available through a third-party informational service.

Following review of financial metrics as of both January 1, 2022 and March 31, 2023 management concluded that the unrealized loss position of these securities related exclusively to the fluctuation in market conditions, primarily interest rate spreads, from the date of purchase, and were not reflective of any credit concerns with the tranches comprising the Company’s investments.

LOAN PORTFOLIO

A distribution of the Company’s loans showing the balance and percentage of loans by type is presented for the noted periods in the table below.

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

Loan and Lease Distribution

Loan Distribution

(dollars in thousands, unaudited)

September 30, 2022

March 31, 2023

December 31, 2022

1-4 family residential construction

Other construction/land

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Consumer loans

Total loans and leases

Allowance for credit losses on loans

Total loans and leases, net

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

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

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

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

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

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

The following table presents a roll forward of the Company’s gross loan balances for each of the periods noted:

Total loans, net

Net loans at $2.0 billion, decreased $18.9 million during the first three months of 2023 with an overall 1% change.

The net change did have offsetting components with the larger fluctuations being a $3.0 million increase in mortgage warehouse line utilization, and an $18.7 million increase in non-owner occupied commercial real estate.

Unfavorable larger loan variances include a $20.5 million decrease in farmland, and a $10.0 million decrease in owner-occupied commercial real estate.

As indicated in the loan roll forward below, new credit extended for the first quarter of 2023 increased $30.1 million over the same period in 2022 but decreased $14.6 million for the linked quarter comparisons.

For the first three months ended 2023 we had $48.8 million in loan paydowns and maturities, along with a $3.0 million increase in mortgage warehouse line utilization and a $25.8 million decrease in line of credit utilization.

LOAN ROLLFORWARD

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For the three months ended:

For the nine months ended:

September 30, 2022

September 30, 2021

September 30, 2022

September 30, 2021

March 31, 2023

December 31, 2022

March 31, 2022

Gross loans beginning balance

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Gross loans ending balance

Deferred costs and (fees), net

Loans, net of deferred costs and (fees)

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

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

Total line utilization, excluding mortgage warehouse and consumer

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

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

Over the past two years, the Company has strategically focused on reducing concentrations in commercial real estate, especially amongst areas management deemed to be higher risk such as construction, office real estate, and hospitality.

At March 31, 2021, the total regulatory CRE ratio of total CRE over Tier 1 Capital plus allowance was 359%.

At March 31, 2023, this ratio had declined to 249% which positions us well for growth.

Further, the overall level of construction and land development lending had declined from 25% of regulatory capital plus allowance for credit losses at March 31, 2021, to 4% of regulatory capital plus allowance for credit losses at March 31, 2023.

Further, overall committed office

real estate is 8.4% of total commitments at March 31, 2023.

The office real estate loans are adjustable rates with most rate adjustments occurring beyond two years.

During the next twenty four months, we have 39 office commercial real estate loans totaling $15.4 million that have scheduled interest rate resets.

The Bank’s practice is to make commercial real estate loans with an “at origination” loan-to-value of 65% or lower using conservative underwriting standards.

Over the past two years, noting the affect the pandemic had on the office building sector, new production of commercial real estate loans in this segment have been discouraged, resulting in reduced loan originations.

Regarding line utilization, unused commitments, excluding mortgage warehouse and overdraft lines, were $223.6 million at March 31, 2023, compared to $219.7 million at December 31, 2022.

Total utilization excluding mortgage warehouse and overdraft lines was 57% at March 31, 2023, compared to 59% at December 31, 2022.

Mortgage warehouse utilization was 15% at March 31, 2023, compared to 10% at December 31, 2022.

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

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

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

There were eleven loans for $0.8 million outstanding at March 31, 2023, compared to fourteen loans for $1.8 million at December 31, 2022.

NONPERFORMING ASSETS

Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, in addition to foreclosed assets which is primarily OREO, but can include other foreclosed assets.

If the Company grants a concession to a borrower in financial difficulty, the loan falls into the category of a TDR, unless the modification was granted under section 4013 of the CARES Act or the April 7, 2020 Interagency Statement.

TDRs may be classified as either nonperforming or performing loans depending on their underlying characteristics and circumstances.

The following table presents comparative data for the Company’s nonperforming assets and performing TDRs as of the dates noted:

Nonperforming assets and performing troubled debt restructurings

Nonperforming assets

(dollars in thousands, unaudited)

September 30, 2022

March 31, 2023

December 31, 2022

September 30, 2021

March 31, 2022

NON-ACCRUAL LOANS:

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Total nonperforming assets

Performing TDRs (1)

Nonperforming loans as a % of total gross loans and leases

Nonperforming assets as a % of total gross loans and leases and foreclosed assets

(1) Performing TDRs are not included in nonperforming loans above, nor are they included in the numerators used to calculate the ratios disclosed in this table.

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

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

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

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

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

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

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

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

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

All foreclosed assets are periodically evaluated and written down to their fair value less expected disposition costs, if lower than the then-current carrying value.

An action plan is in place for each of our non-accruing loans and foreclosed assets and they are all being actively managed.

Nonperforming loans as a % of total gross loans

Nonperforming assets as a % of total gross loans and foreclosed assets

Total nonperforming assets, comprised of non-accrual loans and foreclosed assets, decreased by $18.6 million, or 95% during the first quarter of 2023.

The significant decrease resulted from a decrease in non-accrual loans, primarily as a result of one relationship in the dairy industry consisting of four separate loans that were foreclosed on and subsequently sold in the first quarter of 2023.

These loans were written down by $8.7 million during 2022 and no further allowance for credit losses was deemed necessary on these loans.

The Company's ratio of nonperforming assets to loans plus foreclosed assets decreased to 0.05% at March 31, 2023, from 0.95% at December 31, 2022 due primarily to the resolution of the loan relationship previously mentioned.

All of the Company's nonperforming assets are individually

evaluated for credit loss quarterly and management believes the established allowance for credit loss on such loans are appropriate.

There were no foreclosed assets at March 31, 2023 and December 31, 2022., however when the Company does own foreclosed assets, they are periodically evaluated and written down to their fair value less expected disposition costs, if lower than the then-current carrying value.

An action plan is in place for each of our non-accruing loans and they are all being actively managed.

Collection efforts are continuously pursued for all nonperforming loans, but we cannot provide assurance that they will be resolved in a timely manner or that nonperforming balances will not increase.

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

The Company had $1.5 million in loans past due 30-59 days at March 31, 2023.

This is a decrease of $0.3 million over the balance at December 31, 2022.

All of these past due loans are under management supervision and every effort is being taken to assist the borrowers and manage credit risk in this regard.

ALLOWANCE FOR CREDIT LOSSES – LOANS AND LEASES RECEIVABLE

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

ALLOWANCE FOR CREDIT LOSSES – LOANS RECEIVABLE

The allowance for credit losses on loans, a contra-asset, is established through periodic provisions for credit losses on loans.

It is maintained at a level that is considered adequate to measure expected losses on individually identified loans, as well as expected losses inherent in the remaining loan portfolio.

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

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

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

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

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

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

The Company's allowance for credit losses on loans was $23.1 million at both March 31, 2023, and December 31, 2022, and $22.5 million at March 31, 2022.

The allowance was 1.14% of total loans at March 31, 2023, 1.12% of total loans at December 31, 2022, and 1.14% of total loans at March 31, 2022.

Management's detailed analysis indicates that the Company's allowance for credit losses on loan should be sufficient to cover credit losses for the life of the loans outstanding as of March 31, 2023, but no assurance can be given that the Company will not experience substantial future losses relative to the size of the credit loss allowance for loans.

A separate allowance of $0.9 million for potential credit losses inherent in unused commitments is included in other liabilities at March 31, 2023, unchanged from December 31, 2022.

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

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

Allowance for Credit Losses on Loans and Leases

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

Allowance for Credit Losses on Loans

(dollars in thousands, unaudited)

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For the year ended

September 30,

Average gross loans and leases outstanding during period (1)

Gross loans and leases outstanding at end of period

Allowance for credit losses on loans and leases:

Average gross loans outstanding during period (1)

Gross Loans outstanding at end of period

Allowance for credit losses on loans:

Balance at beginning of period

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Balance at end of period

Net charge-offs (recoveries) to average loans and leases (annualized)

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

Allowance for credit losses on loans and leases to nonperforming loans

Net loan charge-offs (recoveries) to allowance for credit losses on loans and leases at end of period

Net loan charge-offs (recoveries) to provision for credit losses on loans and leases

Net charge-offs (recoveries) to average Loans (annualized)

Allowance for credit losses on Loans to gross Loans at end of period

Net loan charge-offs (recoveries) to allowance for credit losses on Loans at end of period

Net loan charge-offs (recoveries) to provision for credit losses on Loans

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

The Company’s credit allowance for losses on loans and leases at September 30, 2022 represents Management’s best estimate of expected losses in the loan portfolio as of that date, but no assurance can be given that the Company will not experience substantial losses relative to the size of the allowance.

The Company’s credit allowance for losses on loans at March 31, 2023 represents Management’s best estimate of expected losses in the loan portfolio as of that date, but no assurance can be given that the Company will not experience substantial losses relative to the size of the allowance.

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

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

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

Unused commitments to extend credit, which included standby letters of credit, totaled $705.2 million at March 31, 2023 and $895.6 million at December 31, 2022, representing approximately 35% of gross loans outstanding at March 31, 2023 and 44% at December 31, 2022.

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

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

Unused commitments on mortgage warehouse lines were $401.5 million at March 31, 2023 and $594.6 million at December 31, 2022.

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

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

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

Unused commitments exclusive of mortgage warehouse lines have increased $2.7 million or 1% for the first three months of 2023 and are due to an increase in new lines of credit.

The Company also had undrawn letters of credit issued to customers totaling $6.1 million at March 31, 2023 and $6.0 million at December 31, 2022.

The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of commitments to provide credit cannot be reasonably predicted because there is no guarantee that the lines of credit will ever be used.

However, the “Liquidity” section in this Form 10-Q outlines resources available to draw upon should we be required to fund a significant portion of unused commitments.

In addition to unused commitments to provide credit, the Company is utilizing a $125 million letter of credit issued by the Federal Home Loan Bank on the Company’s behalf as security for certain local agency deposits which totaled $51.6 million at September 30, 2022.

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

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If a “long” position is prevalent, we could let brokered deposits or other wholesale borrowings roll off as they mature, or we might invest excess liquidity into investments or loans, subject to the bank’s risk tolerances.

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

The Company’s balance of non-earning cash and due from banks was $81.7 million at March 31, 2023 relative to $72.8 million at December 31, 2022.

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

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

Net premises and equipment decreased by $0.2 million during the first three months of 2023, to $22.3 million.

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

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

Goodwill was $27.4 million at March 31, 2023, unchanged during the first three months of 2023.

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

A Goodwill impairment test was last performed during the fourth quarter 2022 and determined that no impairment existed.

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

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

During the first three months of 2023, overall bank stock prices declined significantly after the liquidity events that led to the voluntary liquidation of one California bank, the failure of a $200 billion California Bank (second largest bank failure in history) and the failure of a $100 billion bank in New York.

Given the recent events management felt it prudent to perform a current valuation in light of the recent slide in the Company’s stock price relative to the entire banking sector.

After performing such valuation, management concluded that no impairment of the Company existed at March 31, 2023.

Management will continue to evaluate whether or not a triggering event occurs, or circumstances

change that would more likely than not reduce the fair value of the Company below its carrying amount before the next annual test.

Bank-owned life insurance, with a balance of $52.3 million at March 31, 2023, is discussed in detail above in the “Noninterest Income and Noninterest Expense” section.

DEPOSITS AND INTEREST-BEARING LIABILITIES

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(dollars in thousands, unaudited)

September 30, 2022

March 31, 2023

December 31, 2022

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Total deposits

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

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

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

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

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

Deposit balances grew by $102.8 million, or 4%, during the first quarter of 2023 to $2.9 billion at March 31, 2023.

Core non-maturity deposits decreased $82.3 million, or 4%, for the first three months of 2023, while customer time deposits increased by $120.2 million.

Brokered deposits increased $65.0 million during the quarter;

to take advantage of preferential pricing over other forms of borrowed funds.

Overall noninterest-bearing deposits as a percent of total deposits decreased to 35.3% at March 31, 2023, compared to 38.2% at December 31, 2022, and from 38.6% at March 31, 2022.

From March 10, 2023 to March 31, 2023, overall deposits decreased by less than 0.04%.

Overall uninsured deposits are estimated to be approximately $858.4 million, or 30% of total deposit balances, excluding public agency deposits that are subject to collateralization through a letter of credit issued by the FHLB.

In addition, uninsured deposits of the bank’s customers are eligible for FDIC pass-through insurance if the customer opens an IntraFi Insured Cash Sweep account or a reciprocal time deposit through the Certificate of Deposit Account Registry System (CDARS).

IntraFi allows for up to $150 million of combined pass-through FDIC insurance which would more than cover each of the Bank’s deposit customers if such customer desired to have such pass-through insurance.

The Bank maintains a diversified deposit base with no significant customer concentrations and does not bank any cryptocurrency companies.

At March 31, 2023, the Company had approximately 122,000 accounts and the 25 largest deposit balance customers had balances of less than 9% of overall deposits .

Management is of the opinion that a relatively high level of core customer deposits is one of the Company’s key strengths, and we continue to strive for core deposit retention and growth.

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

In particular, the Company’s ratio of noninterest-bearing deposits to total deposits was 35.3% at March 31, 2023 as compared to 38.2% at December 31, 2022.

OTHER INTEREST-BEARING LIABILITIES

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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 increased by $108.4 million, during the first nine months of 2022 primarily due to an increase in customer repurchase agreements and overnight borrowings.

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

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

The balance in the

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

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

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

Total non-deposit interest-bearing liabilities decreased by $17.2 million, during the first three months of 2023.

primarily due to a decrease in customer repurchase agreements and overnight borrowings.

Customer repurchase agreements declined from $109.2 million at December 31, 2022 to $94.1 million at March 31, 2023.

Customer repurchase agreements provide collateral for customers that sweep excess deposit balances each day into a separate repurchase agreement account where the Company effectively sells certain government bonds to customers daily and then repurchase the same bonds on the next business day.

Although these accounts are not deposits and are not FDIC insured, they provide customers with larger account balances the ability to have their account secured with collateral.

Other borrowings declined $2.2 million to $216.8 million at March 31, 2022 from $219.0 million at December 31, 2022 and consist of overnight borrowings from correspondent banks and FHLB advances.

Overall borrowings from the FHLB and correspondent banks remained relatively unchanged during the first quarter of 2023.

Long-term debt at March 31, 2023 consisted of $49.2 million of subordinated debt.

This remained unchanged from December 31, 2022.

Subordinated debentures related to $35.5 million of trust preferred securities at both March 31, 2023 and December 31, 2022.

OTHER NONINTEREST-BEARING LIABILITIES

Other liabilities are principally comprised of operating lease right-of-use liabilities, accrued interest payable, other accrued but unpaid expenses, and certain clearing amounts.

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

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

The Company’s balance of other liabilities was $41.5 million at March 31, 2023 as compared to $45.1 million at December 31, 2022, a decrease of $3.6 million or 8%.

The decrease was primarily driven a reduced in accrued expenses.

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 these short-term needs, we can borrow overnight funds from other financial institutions, draw advances via Federal Home Loan Bank lines of credit, or solicit brokered deposits if customer deposits are not immediately obtainable from local sources.

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

To meet these short-term needs, we can borrow overnight funds from other financial institutions,

draw advances via Federal Home Loan Bank lines of credit, or solicit brokered deposits if customer deposits are not immediately obtainable from local sources.

The Company continues to have substantial liquidity though unencumbered assets and available borrowings.

In addition, the Company’s loan-to-deposit ratio declined from 72% at December 31, 2022 to 69% at March 31, 2023.

At March 31, 2023, and December 31, 2022, the Company had the following sources of primary and secondary liquidity (dollars in thousands):

Primary and secondary liquidity sources

September 30, 2022

March 31, 2023

December 31, 2022

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Funds available through fed discount window

In addition to the above sources, the Company could obtain brokered deposits, obtain deposits via deposit listing services, or offer higher rate time deposits within our market.

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

The Company did not participate in the new Federal Reserve Bank Term Funding Program.

Unpledged investment securities include $561.0 million of CLOs.

As CLOs have a rate that resets every 90 days to current rates, the volatility of pricing of these securities is limited and the Company could sell such securities for liquidity at a significantly lower loss than selling lower rate fixed term securities such as US government bonds or municipal bonds.

During the first quarter of 2023, the Bank sold a few CLOs at a modest gain and expects to continue to utilize the CLO portfolio for both interest rate risk management and liquidity purposes.

The Company performs regular stress tests on its liquidity and at this time, believes that we have sufficient primary and secondary liquidity sources for operations.

The Company has a higher level of actual balance sheet liquidity than might otherwise be the case, since we utilize a letter of credit from the FHLB rather than investment securities for certain pledging requirements.

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

That letter of credit, which is backed by loans pledged to the FHLB by the Company, totaled $125 million at March 31, 2023 and December 31, 2022.

Other sources of liquidity include the brokered deposit market, deposit listing services, and the ability to offer local time-deposit campaigns.

Management is of the opinion that available investments and other potentially liquid assets, along with standby funding sources it has arranged, are more than sufficient to meet the Company’s current and anticipated short-term liquidity needs and that its liquidity has not been adversely impacted by COVID-19.

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

The Company’s primary liquidity ratio and net loans to deposits were 32.4% and 69.0%, respectively, at March 31, 2023, as compared to internal policy guidelines of “greater than 15%” and “less than 95%.” Ratios and sub-limits for the various components comprising wholesale funding, which were all well within policy guidelines at March 31, 2023, are also periodically reviewed by Management and the Board.

The Company has been able to maintain a robust liquidity position in recent periods, but no assurance can be provided that our liquidity position will continue at current strong levels.

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

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

As of March 31, 2023, the holding company maintained a cash balance of $27.8 million.

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

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

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

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

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upward shocks of 100, 200, 300, and 400 basis points, and downward shocks of 100, 200, and 300 basis points.

Those scenarios may be

supplemented, reduced in number, or otherwise adjusted as determined by Management to provide the most meaningful simulations considering economic conditions and expectations at the time.

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.

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

Pursuant to policy guidelines, we generally attempt to limit the projected decline in net interest income relative to the stable rate scenario to no more than 5% for a 100 basis point interest rate shock, 10% for a 200 basis point shock, 15% for a 300 basis point shock, and 20% for a 400 basis point shock.

The Company had the following estimated net interest income sensitivity profiles over one-year, without factoring in any potential negative impact on spreads resulting from competitive pressures or credit quality deterioration:

September 30, 2022

September 30, 2021

March 31, 2023

March 31, 2022

Immediate change in Interest Rates (basis points)

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$ Change in Net Interest Income

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

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

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

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

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

For the periods ending March 31, 2023 and March 31, 2022, management believes that the Company was liability sensitive, with net income decreasing in a rising and declining rate scenarios.

The shift from being asset sensitive at March 31, 2022 to slightly liability sensitive at March 31, 2023, is primarily due to the change in assumption regarding low cost deposits.

At March 31, 2023, it was assumed that over twelve months, a small portion of low-cost deposits would shift into higher cost deposits thus making the company slightly liability sensitive.

Further, the Company has more variable rate liabilities at March 31, 2023 including 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 2022 and therefore, the beta on loan yields was lowered in modeling interest rate risk in 2023.

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

At March 31, 2023, the Company had $176.8

million in overnight borrowings as compared to none at March 31, 2022.

At March 31, 2022, the Company had $186.4 million in overnight cash held with the Federal Reserve bank as compared to $0.7 million at March 31, 2023.

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

If there were an immediate and sustained upward adjustment of 100 basis points in interest rates, all else being equal, net interest income over the next 12 months is projected to improve by $2.9 million, or 2%, relative to a stable interest rate scenario, with the favorable variance increasing marginally as interest rates rise higher.

If there 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 decline by $6.5 million, or 6%, relative to a stable interest rate scenario, with the favorable variance increasing marginally as interest rates rise higher.

If there was an immediate downward adjustment of 100 basis points in interest rates, net interest income would drop $3.2 million or a negative variance of 3%.

The change in net interest income in the down 200 basis point scenario is a decrease of $7.5 million or 6%.

As a significant portion of the Company’s deposits remain in noninterest bearing accounts or low-cost deposit accounts, in a down rate scenario, these rates would not change or only change slightly.

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

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Fair values for financial instruments are estimated by discounting projected cash flows (principal and interest) at anticipated replacement interest rates for each account type, while the fair value of non-financial accounts is assumed to equal their book value for all rate scenarios.

An economic value simulation is a static measure utilizing balance sheet accounts at a given point in time, and the measurement can change substantially over time, as is evident in the tables below for the periods ending September 30, 2022 and 2021, respectively, as the Company’s balance sheet evolves and interest rate and yield curve assumptions are updated.

An economic value simulation is a static measure utilizing balance sheet accounts at a given point in time, and the measurement can change substantially over time, as is evident in the tables below for the periods ending March 31, 2023 and 2022, respectively, as the Company’s balance sheet evolves and interest rate and yield curve assumptions are updated.

The change in economic value under different interest rate scenarios depends on the characteristics of each class of financial instrument, including stated interest rates or spreads relative to current or projected market-level interest rates or spreads, the likelihood of principal prepayments, whether contractual interest rates are fixed or floating, and the average remaining time to maturity.

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In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based on historical patterns and Management’s best estimates.

Our EVE increased in the past twelve months primarily driven by an increase in deposits and an increase in deposit values.

Our EVE decreased in the past twelve months primarily from an increase in decay rates on certain non-maturity deposit accounts which significantly lowered the deposit values.

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

September 30, 2022

September 30, 2021

March 31, 2023

March 31, 2022

Immediate change in Interest Rates (basis points)

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Furthermore, while not as extreme as the variances produced by increasing non-maturity deposit decay rates, EVE also displays a relatively high level of sensitivity to unfavorable changes in deposit rate betas in rising interest rate scenarios.

The potential percentage drop in EVE in the “down 100 and 200 basis points” interest rate scenario exceeds our internal policy guidelines, and we will continue to monitor our interest rate risk profile and implement remedial changes if deemed appropriate.

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

The potential percentage change in EVE in all rate shock interest rate scenarios is within our internal policy guidelines.

We continue to monitor our interest rate risk profile and implement remedial changes if deemed appropriate.

CAPITAL RESOURCES

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

The Company had total shareholders’ equity of $307.0 million at March 31, 2023, comprised of $111.8 million in common stock, $4.6 million in additional paid-in capital, $246.7 million in retained earnings, and accumulated other comprehensive loss of $56.1 million.

At the end of 2022, total shareholders’ equity was $303.6 million.

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

The increase in equity during the first three months of 2022 is due to net income of $8.8 million, offset by a $3.5 million dividend paid to shareholders, $2.7 million in share repurchases, and a $0.5 million favorable swing in other comprehensive income/(loss) due principally to changes in investment securities' fair value.

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

The Company’s strong liquidity position enabled the transfer of $162.1 million of “available-for-sale” investment securities to “held-to-maturity” classification effective April 1, 2022.

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

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

The Company approved a new share repurchase program on October 20, 2022 (the 2023 Share Repurchase Plan) that was effective upon the expiration of the prior 2021 Share Repurchase Plan on October 31, 2022.

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

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

Under the 2023 Share Repurchase Program, there were 146,418 shares repurchased in the first three months of 2023.

The Company uses a variety of measures to evaluate its capital adequacy, including the leverage ratio which is calculated separately for the Company and the Bank.

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Regulatory Capital Ratios

September 30,

Community Bank

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PART I – FINANCIAL INFORMATION

QUALITATIVE & QUANTITATIVE DISCLOSURES

QUANTITATIVE & QUALITATIVE DISCLOSURES

ABOUT MARKET RISK

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

What changed 10-Q

Item 2. Management’s Discussion and Analysis