Item 2. Management’s Discussion and Analysis
ITEM 2
MANAGEMENT’S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This Form 10- Q includes forward-looking statements that involve inherent risks and uncertainties. These forward-looking statements are within the meaning of Section 27A of the Securities Act of 1933 (“1933 Act”), as amended and Section 21E of the Securities Exchange Act of 1934 (“1934 Act”), as amended. Those sections of the 1933 Act and 1934 Act provide a “safe harbor” for forward-looking statements in order to encourage companies to provide prospective information about their financial performance as long as important factors that could cause actual results to differ significantly from projected results are identified with meaningful cautionary statements. Words such as “expects”, “anticipates”, “believes”, “projects”, “intends”, and “estimates” or variations of such words and similar expressions, as well as future or conditional verbs preceded by “will”, “would”, “should”, “could” or “may” are intended to identify forward-looking statements. These forward-looking statements are based on certain underlying assumptions and are not guarantees of future performance, as they could be impacted by several potential risks and developments that cannot be predicted with any degree of certainty.
These statements are based on management’s current expectations regarding economic, legislative, regulatory and other environmental issues that may affect our earnings in future periods. Therefore, actual outcomes and results may differ materially from what is expressed, forecast in, or implied by such forward-looking statements.
A variety of factors could have a material adverse impact on the Company’s financial condition or results of operations and should be considered when evaluating the Company’s potential future financial performance. They include, but are not limited to:
● risks associated with fluctuations in interest rates, including the impact on other comprehensive income (loss), the ability for customers to repay on floating or adjustable rates loans, and the impact on costs of deposits and funding, the impact on interest income on earning assets, and the impact on fair value of longer-term assets;
● 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 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, 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;
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● 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 risk to the Company’s operations and ability to serve customers due to the inability of a vendor to meet its service level agreements;
● the outcome of any existing or future legal action for which the Company or Bank is a defendant;
● 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;
● risks associated with the multitude of or changes to current and prospective laws and regulations, and related interpretations, to which the Company is and will be subject; and
● Our ability to remediate, on a timely basis, our material weakness in our control over financial reporting relating to the call report classification of loans for certain real estate secured loans miscoded.
Risk factors that could cause actual results to differ materially from results that might be implied by forward-looking statements include the risk factors detailed in the Company’s Form 10-K for the fiscal year ended December 31, 2022, and in Item 1A, herein. We do not update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events.
CRITICAL ACCOUNTING POLICIES
The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and incorporate various assumptions that are believed to be reasonable under current circumstances. Actual results may differ from those estimates under divergent conditions.
Critical accounting policies are those that involve the most complex and subjective decisions and assessments which have the greatest potential impact on the Company’s stated results of operations. In Management’s opinion, the Company’s critical accounting policies deal with the following areas:
● the establishment of the allowance for credit losses, as explained in detail in Note 10 to the consolidated financial statements and in the “Provision for Credit Losses” and “Allowance for Credit Losses” sections of this discussion and analysis;
● the valuation of individually evaluated loans and foreclosed assets, as discussed in Notes 8 and 10 to the consolidated financial statements;
● income taxes and related deferred tax assets and liabilities, regarding the ability of the Company to recover deferred tax assets as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; and
● goodwill and other intangible assets, which are evaluated annually for impairment and for which we have determined that no impairment exists, as discussed in the “Other Assets” section of this discussion and analysis.
Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate our most recent expectations regarding those areas.
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OVERVIEW OF THE RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
RESULTS OF OPERATIONS SUMMARY
Third Quarter 2023 compared to Third Quarter 2022
Third quarter 2023 net income was $9.9 million, unchanged from the third quarter of 2022 and $0.68 per diluted share in the third quarter of 2023 as compared to $0.66 per diluted share in the third quarter of 2022. The Company’s annualized return on average equity was 12.62% and annualized return on average assets was 1.04% for the quarter ended September 30, 2023, compared to 12.84% and 1.13%, respectively, for the same quarter in 2022. The primary drivers behind the variance in third quarter net income are as follows:
● Net interest income decreased $0.8 million or 3%. This was mostly due to a 33 bp decrease in net interest margin. There was a $231.9 million increase in average interest-earning assets with an increased yield of 94 bps, however this was more than offset by a $335.4 million increase in interest-bearing liabilities at 184 bps higher cost.
● Noninterest income increased $1.2 million or 17% primarily due to a $0.6 million increase in bank-owned life insurance, $0.3 million in life insurance proceeds and a $0.2 million increase in service charges on deposit accounts.
● Total noninterest expense increased $1.6 million, or 7%, in the third quarter of 2023 as compared to the third quarter of 2022. Salaries and Benefits were $1.1million, or 10%, higher in the third quarter of 2023 as compared to the third quarter of 2022 as we added new lending teams and certain management staff, and other noninterest expense increased $0.5 million, primarily driven by a $0.6 million unfavorable variance in directors deferred compensation expense, linked to the changes in BOLI income, higher FDIC assessment costs, increased marketing costs associated with a deposit acquisition campaign and elevated debit card losses. These increased expenses were partially offset by lower costs in core processing, debit card processing and ATM network costs.
First Nine Months 2023 compared to First Nine Months of 2022
Net income for the first nine months of 2023 was $28.6 million, or $1.93 per diluted share, compared to $26.5 million, or $1.76 per diluted share for the same period in 2022. The Company’s annualized return on average equity was 12.41% and annualized return on average assets was 1.03% for the nine months ended September 30, 2023, compared to a return on equity of 10.98% and return on assets of 1.03% for the nine months ended September 30, 2022. The primary drivers behind the variance in year-to-date net income are as follows:
● The provision for credit losses was $0.2 million, a decrease of $4.0 million due to a decrease in specific reserves on individual loans as well as lower net loan charge-offs.
● Net interest income increased $4.3 million or 5%. The increase is primarily due to rate increases on interest-earning assets which were partially offset by rate increases on both existing and new interest-bearing liabilities.
● Noninterest income decreased by $0.8 million, or 3%. In 2022 there was a $1.0 million recovery of prior year legal expenses, a $1.0 million gain on the sale of investment securities, and a $3.2 million gain on the sale of other assets with no like corresponding event in 2023. Positively impacting the first nine months of 2023 there was a $2.8 million positive variance in deferred compensation BOLI and a $0.4 million increase in life insurance proceeds.
● Noninterest expense increased $5.2 million, or 8%, due mostly to the increases in salary expense from annual performance increases along with new commercial and ag loan production teams and a negative variance in
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director’s deferred compensation expense which is linked to the favorable changes in bank-owned life insurance income described above.
FINANCIAL CONDITION SUMMARY
September 30, 2023 relative to December 31, 2022
The Company’s assets totaled $3.7 billion at September 30, 2023, an increase of $130.3 million, or 3.8% from December 31, 2022. The following provides a summary of key balance sheet changes during the first nine months of 2023:
● Investment securities increased $62.1 million, or 5%, to $1.3 billion primarily due to strategic purchases of high quality AAA and AA rated, collateralized loan obligations and government agency securities.
● Gross loans increased $47.9 million predominantly due to a $42.2 million increase in mortgage warehouse line utilization. In addition, C&I loans increased, but were partially offset by a decline in Farmland loans due to a foreclosure of a single dairy relationship in early 2023.
● Deposits increased by $23.6 million, or 1%. The growth in deposits came mostly from a $45.0 million increase in brokered deposits primarily acquired prior to March 2023 as part of the Company’s interest rate risk management and liquidity strategy.
● Short-term borrowings increased $3.7 million to $331.9 million at September 30, 2023 from $328.2 million at December 31, 2022 while long-term borrowings in the form of long-term FHLB advances increased $80.0 million for the first nine months of 2023, taken out as a partial on-balance sheet match against longer term production loans.
Total capital of $308.9 million at September 30, 2023 reflects an increase of $5.3 million, or 2%, relative to year-end 2022. The Company’s regulatory Tier 1 leverage ratio was 10.12% at September 30, 2023 as compared to 10.30% at December 31, 2022. The increase in equity during the first nine months of 2023 was due to the addition of $28.6 million in net income, offset by a $5.3 million unfavorable swing in accumulated other comprehensive income/loss, due principally to changes in investment securities’ fair value, $8.5 million in share repurchases, and $10.4 million in dividends paid. The remaining difference is related to the impact of restricted stock.
EARNINGS PERFORMANCE
The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on deposits and other borrowed money. The second is noninterest income, which primarily consists of customer service charges and fees but also comes from non-customer sources such as BOLI, equity investments, and investment gains. The majority of the Company’s noninterest expense is comprised of operating costs that facilitate offering a full range of banking services to our customers.
NET INTEREST INCOME AND NET INTEREST MARGIN
Net interest income was $28.1 million, for the third quarter of 2023, a $0.8 million decrease, or 3% over the third quarter of 2022, but increased $4.3 million, or 5%, to $84.5 million for the first nine months of 2023 relative to the same period in 2022.
Net interest income for the comparative year-to-date periods increased $4.3 million due primarily to the change in mix of interest-earning assets, moderated by an increase in interest rates paid on interest-bearing liabilities. There was a $64.0 million, or 3% increase in average loan and lease balances yielding 36 basis points higher for the same period, while average investment balances increased $157.0 million yielding 239 basis points higher for the same period as many investments are floating rate. Average interest-bearing liabilities increased $333.3 million, of which $47.1 million is an
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increase in deposit balances, $174.3 million is overnight or short-term borrowings, while $51.1 million is long term FHLB borrowings. The cost of interest-bearing liabilities was 171 bps higher for the comparative periods. The net impact of the mix and rate change was a 2 basis point decrease in our net interest margin for the nine-months ending September 30, 2023 as compared to the same period in 2022.
Interest expense was $14.3 million for the third quarter of 2023, an increase of $11.3 million, relative to the third quarter of 2022. For the first nine months of 2023, compared to the same period in 2022, interest expense increased $30.2 million to $36.1 million. The significant increase in interest expense is attributable to an unfavorable shift in interest-bearing liabilities and the impact of recent interest rate increases, as the average balance of deposits, including lower cost core deposits decreased $93.2 million while higher cost borrowed funds and wholesale brokered deposits increased by $352.7 million in the third quarter of 2023 as compared to the third quarter of 2022. For the year-to-date comparisons the increase is attributable to a shift from lower cost transaction accounts to higher cost time accounts as well as an increase in borrowed funds. For the first nine months of 2023, higher cost customer time deposits increased $218.9 million, wholesale brokered deposits increased $106.6 million and borrowed funds increased $247.5 million, while lower cost or no cost deposits decreased $278.4 million. Future interest expense could be adversely affected if the shift from lower cost transaction accounts to higher cost accounts continues in the current interest rate environment.
The Company had $1.3 billion in adjustable and variable rate loans and $569.8 million in floating rate collateralized loan obligations, as compared to $414.7 million in floating rate CDs and $35.6 million in floating rate trust preferred securities at September 30, 2023. $245.3 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 variable rate CDs which are indexed to prime. These variable rate CDs increased $85.4 million or 26%, to $414.7 million at September 30, 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 variable rate CDs has increased $14.0 million for the first nine months of 2023 over the first nine months of 2022. These CDs require a minimum balance and pay a rate that is 375 – 600 basis points below the Wall Street Journal Prime rate, with a 20 basis point minimum rate.
Our net interest margin was 3.30% for the third quarter of 2023, as compared to 3.39% for the linked quarter and 3.63% for the third quarter of 2022. While the yield of interest-earning assets increased 21 basis points for the third quarter of 2023 as compared to the linked quarter, the cost of interest-bearing liabilities increased 27 basis points for the same period of comparison. The average balance of interest-earning assets increased $24.7 million for the linked quarter while the increase in interest-bearing liabilities was $9.0 million for the same period. The shift in deposit balances from lower cost transaction accounts to higher cost time certificates and overnight borrowed funds exacerbates the margin compression in the linked quarter.
The level of net interest income we recognize in any given period depends on a combination of factors including the average volume and yield for interest-earning assets, the average volume and cost of interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities.
The following tables show average balances for significant balance sheet categories and the amount of interest income or interest expense associated with each category for the noted periods. The tables also display calculated yields on each major component of the Company’s investment and loan portfolios, average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin for the noted periods .
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Average Balances and Rates
(dollars in thousands, unaudited)
For the three months ended
For the three months ended
September 30, 2023
September 30, 2022
Assets
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Investments:
Interest-earning due from banks
$
23,760
$
415
6.93%
$
21,845
$
103
1.87%
Taxable
1,005,372
14,375
5.67%
851,683
7,646
3.56%
Non-taxable
345,645
2,679
3.89%
336,567
2,346
3.50%
Total investments
1,374,777
17,469
5.25%
1,210,095
10,095
3.51%
Loans: (3)
Real estate
1,854,055
20,764
4.44%
1,862,738
19,808
4.22%
Agricultural
37,096
649
6.94%
29,724
274
3.66%
Commercial
90,348
1,392
6.11%
75,482
973
5.11%
Consumer
4,303
87
8.02%
4,228
132
12.39%
Mortgage warehouse lines
100,549
2,004
7.91%
46,969
623
5.26%
Other
2,381
19
3.17%
2,349
23
3.88%
Total loans
2,088,732
24,915
4.73%
2,021,490
21,833
4.28%
Total interest-earning assets (4)
3,463,509
42,384
4.94%
3,231,585
31,928
4.00%
Other earning assets
17,355
15,717
Non-earning assets
275,883
255,529
Total assets
$
3,756,747
$
3,502,831
Liabilities and shareholders' equity
Interest-bearing deposits:
Demand deposits
$
141,745
$
413
1.16%
$
197,731
$
131
0.26%
NOW
427,278
68
0.06%
531,205
80
0.06%
Savings accounts
408,158
69
0.07%
485,167
73
0.06%
Money market
127,649
194
0.60%
151,816
25
0.07%
Time deposits
557,504
6,514
4.64%
313,764
1,377
1.74%
Brokered deposits
162,065
1,509
3.69%
63,529
75
0.47%
Total interest-bearing deposits
1,824,399
8,767
1.91%
1,743,212
1,761
0.40%
Borrowed funds:
Repurchase agreements
83,222
53
0.25%
113,933
70
0.24%
Other borrowings
330,221
4,286
5.15%
45,597
320
2.78%
Long-term debt
49,268
429
3.45%
49,182
427
3.44%
Subordinated debentures
35,590
762
8.49%
35,409
439
4.92%
Total borrowed funds
498,301
5,530
4.40%
244,121
1,256
2.04%
Total interest-bearing liabilities
2,322,700
14,297
2.44%
1,987,333
3,017
0.60%
Demand deposits - noninterest-bearing
1,064,962
1,140,840
Other liabilities
58,340
67,603
Shareholders' equity
310,745
307,055
Total liabilities and shareholders' equity
$
3,756,747
$
3,502,831
Interest income/interest-earning assets
4.94%
4.00%
Interest expense/interest-earning assets
1.64%
0.37%
Net interest income and margin (5)
$
28,087
3.30%
$
28,911
3.63%
(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 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 (costs) fees and loan acquisition FMV amortization were $(0.3) million and $0.1 million for the quarters ended September 30, 2023 and 2022, respectively.
(4) Nonaccrual loans have been included in total loans for purposes of computing total earning assets.
(5) Net interest margin represents net interest income as a percentage of average interest-earning assets.
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Average Balances and Rates
(Dollars in Thousands, Unaudited)
For the nine months ended
For the nine months ended
September 30, 2023
September 30, 2022
Assets
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Average
Balance (1)
Income/
Expense
Average
Rate/Yield (2)
Investments:
Interest-earning due from banks
$
21,504
$
861
5.35%
$
120,359
$
466
0.52%
Taxable
991,302
39,848
5.37%
783,384
15,613
2.66%
Non-taxable
353,173
8,233
3.95%
305,212
5,926
3.29%
Total investments
1,365,979
48,942
5.00%
1,208,955
22,005
2.61%
Loans:(3)
Real estate
1,860,504
61,491
4.42%
1,820,568
57,792
4.24%
Agricultural
31,232
1,578
6.76%
31,376
809
3.45%
Commercial
81,397
3,564
5.85%
84,301
3,351
5.31%
Consumer
4,260
263
8.25%
4,313
545
16.89%
Mortgage warehouse lines
79,438
4,779
8.04%
52,650
1,626
4.13%
Other
2,443
61
3.34%
2,066
88
5.69%
Total Loans
2,059,274
71,736
4.66%
1,995,274
64,211
4.30%
Total interest-earning assets (4)
3,425,253
120,678
4.80%
3,204,229
86,216
3.66%
Other earning assets
16,680
15,675
Non-earning assets
271,949
235,516
Total assets
$
3,713,882
$
3,455,420
Liabilities and shareholders' equity
Interest-bearing deposits:
Demand deposits
$
145,316
$
731
0.67%
$
207,319
$
357
0.23%
NOW
454,900
214
0.06%
540,078
243
0.06%
Savings accounts
431,143
196
0.06%
477,904
210
0.06%
Money market
128,856
291
0.30%
152,912
71
0.06%
Time Deposits
520,105
17,043
4.38%
301,173
2,052
0.91%
Brokered deposits
167,782
4,235
3.37%
61,189
172
0.38%
Total interest-bearing deposits
1,848,102
22,710
1.64%
1,740,575
3,105
0.24%
Borrowed funds:
Repurchase agreements
88,707
199
0.30%
110,505
228
0.28%
Other borrowings
262,755
9,828
5.00%
15,480
322
2.78%
Long-term debt
49,246
1,286
3.49%
49,162
1,284
3.49%
Subordinated debentures
35,545
2,120
7.97%
35,365
1,024
3.87%
Total borrowed funds
436,253
13,433
4.12%
210,512
2,858
1.82%
Total interest-bearing liabilities
2,284,355
36,143
2.12%
1,951,087
5,963
0.41%
Demand deposits - noninterest-bearing
1,062,114
1,122,556
Other liabilities
59,674
58,393
Shareholders' equity
307,739
323,384
Total liabilities and shareholders' equity
$
3,713,882
$
3,455,420
Interest income/interest-earning assets
4.80%
3.66%
Interest expense/interest-earning assets
1.41%
0.25%
Net interest income and margin (5)
$
84,535
3.39%
$
80,253
3.41%
(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 federal 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 (costs) fees and loan acquisition FMV amortization were $(0.7) million and $0.9 million for the nine months ended September 30, 2023 and 2022, respectively.
(4) Nonaccrual loans have been included in total loans for purposes of computing total earning assets.
(5) Net interest margin represents net interest income as a percentage of average interest-earning assets.
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The Volume and Rate Variances table below sets forth the dollar difference for the comparative periods in interest earned or paid for each major category of interest-earning assets and interest-bearing liabilities, and the amount of such change attributable to fluctuations in average balances (volume) or differences in average interest rates. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates, and rate variances are equal to the change in rates multiplied by prior period average balances. Variances attributable to both rate and volume changes, calculated by multiplying the change in rates by the change in average balances, have been allocated to the rate variance.
Volume & Rate Variances
(dollars in thousands, unaudited)
Three months ended September 30,
Nine months ended September 30,
2023 over 2022
2023 over 2022
Increase (decrease) due to
Increase (decrease) due to
Assets:
Volume
Rate
Mix
Net
Volume
Rate
Mix
Net
Investments:
Federal funds sold/due from time
$
9
$
279
$
24
$
312
$
(383)
$
4,353
$
(3,575)
$
395
Taxable
1,380
4,531
818
6,729
4,144
15,877
4,214
24,235
Non-taxable
16
263
54
333
1,179
1,189
(61)
2,307
Total investments (1)
1,405
5,073
896
7,374
4,940
21,419
578
26,937
Loans:
Real estate
(92)
1,053
(5)
956
1,268
2,379
52
3,699
Agricultural
68
246
61
375
(4)
777
(4)
769
Commercial
192
190
37
419
(115)
340
(12)
213
Consumer
2
(46)
(1)
(45)
(7)
(278)
3
(282)
Mortgage warehouse
711
313
357
1,381
827
1,542
784
3,153
Other
—
(4)
—
(4)
16
(36)
(7)
(27)
Total loans (1)
881
1,752
449
3,082
1,985
4,724
816
7,525
Total interest-earning assets (1)
$
2,286
$
6,825
$
1,345
$
10,456
$
6,925
$
26,143
$
1,394
$
34,462
Liabilities
Interest-bearing deposits:
Demand deposits
$
(37)
445
(126)
$
282
$
(107)
$
686
(205)
$
374
NOW
(16)
5
(1)
(12)
(38)
11
(2)
(29)
Savings accounts
(12)
9
(1)
(4)
(21)
8
(1)
(14)
Money market
(4)
206
(33)
169
(11)
274
(43)
220
Time deposits
1,070
2,289
1,778
5,137
1,492
7,817
5,682
14,991
Brokered deposits
116
517
801
1,434
300
1,372
2,391
4,063
Total interest-bearing deposits (1)
1,117
3,471
2,418
7,006
1,615
10,168
7,822
19,605
Borrowed funds:
Repurchase agreements
(19)
3
(1)
(17)
(45)
20
(4)
(29)
Other Borrowings
1,997
272
1,697
3,966
5,144
257
4,105
9,506
Long-term debt
1
1
—
2
1
1
—
2
Subordinated debt
2
319
2
323
5
1,085
6
1,096
Total borrowed funds (1)
1,981
595
1,698
4,274
5,105
1,363
4,107
10,575
Total interest-bearing liabilities (1)
3,098
4,066
4,116
11,280
6,720
11,531
11,929
30,180
Net interest income (1)
$
(812)
$
2,759
$
(2,771)
$
(824)
$
205
$
14,612
$
(10,535)
$
4,282
(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 2023 relative to the third quarter of 2022 was an unfavorable $0.8 million; this is primarily from an unfavorable volume variance of $3.1 million in interest-bearing liabilities, as the average balance of interest-bearing liabilities increased $335.4 million from the comparative quarter. There was a favorable rate variance of $2.8 million from the comparative quarter 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 $2.8 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 third quarter of 2023 was 3.30%, as compared to 3.63% for the third quarter of 2022.
The volume variance calculated for the first nine months of 2023 relative to the first nine months of 2022 reflects a favorable variance of $0.2 million, a favorable rate variance of $14.6 million, and an unfavorable mix variance of $10.5 million. There were increases in loan and investment security balances for a favorable volume variance of $6.9 million
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which was mostly offset by a $6.7 million increase in interest-bearing liabilities. There was a positive rate variance on interest-earning assets of $26.1 million for the first nine months of 2023 partially offset by a $11.5 million rate increase in interest-earning liabilities. The Company’s net interest margin for the first nine months of 2023 was 3.39%, as compared to 3.41% in the first nine months of 2022.
At September 30, 2023, approximately 4% of our total portfolio, or $81.3 million, consists of variable rate loans. At September 30, 2023, our outstanding fixed rate loans represented 38% of our loan portfolio. The remaining 58% of our loan portfolio at September 30, 2023 consists of adjustable-rate loans; 67% of these loans (approximately $819.2 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 $100.6 million of these adjustable-rate loans have the ability to reprice in the fourth quarter of 2023, which will have a positive impact on earnings.
Cash balances for the quarterly comparisons have stabilized but for the year-to-date comparison have decreased, which had 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 $23.8 million, an increase of $1.9 million for the third quarter of 2023 as compared to the same period last year, and was $98.9 million lower for the first nine months of 2023 as compared to the same period in 2022.
Overall average investment securities increased by $162.8 million for the third quarter of September 30, 2023, as compared to September 30, 2022, and increased by $255.9 million for the first nine months of 2023 as compared to the same period in 2022. For the quarter ending September 30, 2023, over the same period for 2022, average non-taxable securities increased $9.1 million and taxable securities increased $153.7 million. For the first nine months of 2023 over the same period in 2022, average non-taxable securities increased $48.0 million and taxable securities increased $207.9 million. The overall investment portfolio had a tax-equivalent yield of 5.07% at September 30, 2023, with an average life of 7.07 years and average effective duration of 1.6 years for available-for-sale securities. Approximately $569.8 million of the investment securities reprice every 90 days and $52.2 million are subordinated debt with an initial fixed rate period of 5 years and floating thereafter.
Interest expense was $14.3 million for the third quarter of 2023, an increase of $11.3 million, relative to the third quarter of 2022. For the first nine months of 2023, compared to the same period in 2022, interest expense increased $30.2 million to $36.1 million. The significant increase in interest expense is attributable to an unfavorable shift in interest-bearing liabilities and the impact of interest rate increases, as the average balance of deposits, including lower cost core deposits decreased $93.2 million while higher cost borrowed funds and wholesale brokered deposits increased by $352.7 million in the third quarter of 2023 as compared to the third quarter of 2022. For the year-to-date comparisons the increase is attributable to a shift from lower cost transaction accounts to higher cost time accounts, as well as an increase in borrowed funds. For the first nine months of 2023, higher cost customer time deposits increased $218.9 million wholesale brokered deposits increased $106.6 million and borrowed funds increased $247.5 million, while lower cost or no cost deposits decreased $278.4 million.
Average noninterest-bearing demand deposits decreased $75.9 million or 7% for the third quarter of 2023 as compared to the third quarter of 2022 and decreased $60.4 million or 5% for the first nine months of 2023 as compared to the first nine months 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, 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 a benefit related to a credit loss provision for loans of $0.03 million in the third quarter of 2023 relative to a provision for credit losses on loans of $1.3 million in the third quarter of 2022 and a $0.2 million provision for credit losses on loans in the first nine months of 2023 as compared to $4.2 million in the same period in 2022. The Company's $1.3 million decrease in the provision for credit losses on loans in the third quarter of 2023 as compared to the third quarter of 2022, and the $4.0 million decrease for the first nine months of 2023 as
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compared to the same period in 2022 was favorably impacted by lower charge-offs of loans. The decrease in net charge-offs in the first nine months of 2023 was primarily related to 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 and a single dairy loan relationship.
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 loan charge-offs of $0.1 million in the third quarter of 2023 as compared to $0.2 million for the third quarter of 2022 and $0.4 million in the first nine months of 2023 as compared to $4.3 million for the comparative period in 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.
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 can result in a high degree of variability in the Company’s credit loss provision, and consequently in our net earnings.
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NONINTEREST INCOME AND NONINTEREST EXPENSE
The following table provides details on the Company’s noninterest income and noninterest expense for the three and nine-month periods ended September 30, 2023, and 2022:
Noninterest Income/Expense
(dollars in thousands, unaudited)
For the three months ended September 30,
For the nine months ended September 30,
Noninterest income:
2023
2022
2023
2022
Service charges and fees on deposit accounts
$
6,055
$
6,008
$
17,127
$
17,464
Net gains on sale of securities available-for-sale
—
—
396
1,032
Bank-owned life insurance
558
(23)
1,388
(1,252)
Other
1,149
627
3,444
5,870
Total noninterest income
$
7,762
$
6,612
$
22,355
$
23,114
As a % of average interest-earning assets (1)
0.89%
0.81%
0.87%
0.96%
Noninterest expense:
Salaries and employee benefits
$
12,623
$
11,521
$
37,567
$
35,070
Occupancy and equipment costs
2,482
2,470
7,251
7,170
Advertising and marketing costs
723
466
1,646
1,322
Data processing costs
1,369
1,564
4,433
4,574
Deposit services costs
2,048
2,450
6,603
7,112
Loan services costs
Loan processing
174
128
452
426
Foreclosed assets
(60)
(3)
665
84
Other operating costs
765
912
3,244
3,879
Professional services costs
Legal & accounting services
493
535
1,623
1,753
Director's costs
732
(143)
1,733
(1,192)
Other professional service
707
855
2,053
2,306
Stationery & supply costs
148
114
414
315
Sundry & tellers
358
127
838
463
Total noninterest expense
$
22,562
$
20,996
$
68,522
$
63,282
As a % of average interest-earning assets (1)
2.58%
2.58%
2.67%
2.64%
(1) Annualized
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Noninterest Income:
Total noninterest income increased $1.2 million, or 17%, for the quarter ended September 30, 2023, as compared to the same quarter in 2022, and decreased $.08 million, or 3% for the year-to-date period ended September 30, 2023 as compared to the same period in 2022. Service charges and fees on deposit accounts increased by $0.1 million, or 1%, to $6.1 million in the third quarter of 2023 as compared to the third quarter of 2022. This service charge income was $0.3 million lower, or 2% in the first nine months of 2023, as compared to the same period in 2022. These decreases in the quarterly and year-to-date comparisons are primarily due to decreases in ATM and debit card income.
BOLI income increased by $0.6 million for the third quarter of 2023 as compared to the third quarter of 2022, and $2.6 million for the first nine months of 2023 as compared to the same period in 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 higher values in BOLI policies are offset by higher deferred compensation expense reflected primarily in director fees expense. At September 30, 2023, there was $41.5 million in traditional BOLI policies and $9.9 million in separate account BOLI policies associated with the deferred compensation plans.
In the “other” category of noninterest income there was a $0.5 million increase in the third quarter of 2023 as compared to the third quarter of 2022, and a $2.4 million decrease in the first nine months of 2023 as compared to the same period in 2022. The quarterly comparison was positively impacted by an increase in life insurance proceeds for $0.3 million, and $0.4 million in quarterly income from an equity investment in an SBA loan fund. The year-to-date increases were unfavorably impacted by a $1.0 million gain on the sale of debt securities, $3.6 million from gains on the sale of other assets, and the recovery of prior period legal expenses in 2022 with no like sales or recoveries in 2023. Partially offsetting these 2022 events was year-to-date income from an equity investment in an SBA Loan fund for $1.0 million.
Noninterest Expense:
Total noninterest expense increased by $1.6 million, or 7%, in the third quarter of 2023 relative to the third quarter of 2022, and by $5.2 million, or 8%, for the first nine months of 2023 as compared to the same period in 2022. Salaries and Benefits were $1.1 million, or 10%, higher in the third quarter of 2023 as compared to the third quarter of 2022 and $2.5 million, or 7%, higher for the first nine months of 2023 compared to the same period in 2022. The reason for this increase is primarily due to increased salary expense due to the hiring of new lending teams and management staff for both the quarterly and year-to-date comparisons. There were 487 full-time equivalent employees at September 30, 2023 as compared to 491 at December 31, 2022 and 500 at September 30, 2022.
Occupancy expenses were relatively unchanged for the third quarter and the first nine-months of 2023 as compared to the same periods in 2022.
Other noninterest expense increased $0.5 million, or 6%, for the third quarter 2023 as compared to the third quarter in 2022, and increased $2.7 million, or 13% for the first nine months of 2023 as compared to the same period in 2022. The variances for the third quarter of 2023 compared to the same period in 2022 was primarily driven by a $0.6 million unfavorable variance in directors deferred compensation expense, linked to the changes in BOLI income, higher FDIC assessment costs, increased marketing costs associated with a deposit acquisition campaign and elevated debit card losses due to a conversion of debit card systems. These increased expenses were partially offset by lower costs in core processing, debit card processing and ATM network costs. For the year-over-year comparison, the categories of increase were the same as with the quarterly comparison, along with a $0.2 million decrease in deposit statement costs offset by increased foreclosed asset costs related to the foreclosure and subsequent sale of one large loan relationship in the first quarter of 2023.
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PROVISION FOR INCOME TAXES
The Company sets aside a provision for income taxes on a monthly basis. The amount of that provision is determined by first applying the Company’s statutory income tax rates to estimated taxable income, which is pre-tax book income adjusted for permanent differences, and then subtracting available tax credits. Permanent differences include but are not limited to tax-exempt interest income, BOLI income, and certain book expenses that are not allowed as tax deductions. Our tax credits consist primarily of those generated by investments in low-income housing tax credit funds. The Company's provision for income taxes was 25.8% of pre-tax income in the third quarter of 2023 relative to 25.1% in the third quarter of 2022, and 25.3% of pre-tax income for the first nine months of 2023 relative to 26.1% for the same period in 2022. The change in the effective tax rate for the quarter ended September 30, 2023 as compared to the same quarter in 2022 was due to a decrease in available tax credits. The change in effective tax rate for the 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 2023, the investments associated with the non-qualified deferred compensation plans increased in value, generating non-taxable income for the third quarter, and first nine months of 2023 while decreasing in value in the third quarter and first nine months of 2022 resulting in a non-deductible expense.
BALANCE SHEET ANALYSIS
EARNING ASSETS
The Company’s interest-earning assets are comprised of loans and investments, including overnight investments and surplus balances held in interest-earning accounts in our Federal Reserve Bank account. The composition, growth characteristics, and credit quality of both of those components are significant determinants of the Company’s financial condition. Investments are analyzed in the section immediately below, while the loan portfolio and other factors affecting earning assets are discussed in the sections following investments.
INVESTMENTS
The Company’s investments may at any given time consist of debt securities and marketable equity securities (together, the “investment portfolio”), investments in the time deposits of other banks, surplus interest-earning balances in our Federal Reserve Bank account, and overnight fed funds sold. The Company’s investments can serve several purposes, including the following: 1) they can provide liquidity for potential funding needs; 2) they provide a source of pledged assets for securing public deposits, bankruptcy deposits and certain borrowed funds which require collateral; 3) they constitute a large base of assets with structural characteristics that can be changed more readily than loan or deposit portfolios, as might be required for interest rate risk management purposes; 4) they are another interest-earning option for the placement of surplus funds when loan demand is light; and 5) they can provide partially tax exempt income.
The investment portfolio is reflected on the balance sheet as investment securities and totaled $1.3 billion, or 36% of total assets at September 30, 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 adjustable rate 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 1.6 years for available-for-sale investments and 6.7 years for held-to-maturity investments at September 30, 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”. Those securities were transferred at fair market value on the date of the transfer. The transfer was initiated to reduce the effect of potential future rate increases on the available-for-sale
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portfolio, mark-to-market, other comprehensive income and equity. See Note 9, Investment Securities for additional information.
The following table sets forth the carrying amount for available-for-sale securities, at fair value, and held-to-maturity securities, at amortized cost, net of the allowance for credit losses of the Company’s investment portfolio by investment type as of the dates noted:
Investment Portfolio
(dollars in thousands, unaudited)
September 30, 2023
December 31, 2022
Carrying Amount
Percent
Carrying Amount
Percent
Available for sale
U.S. government agencies
$
107,084
8.03%
$
50,599
3.98%
Mortgage-backed securities
102,951
7.72%
122,532
9.63%
State and political subdivisions
178,314
13.37%
205,980
16.20%
Corporate bonds
52,235
3.92%
57,435
4.52%
Collateralized loan obligations
569,793
42.70%
498,377
39.18%
Total available for sale
1,010,377
75.74%
934,923
73.51%
Held to maturity
U.S. government agencies
5,557
0.42%
6,047
0.48%
Mortgage-backed securities
145,658
10.92%
157,473
12.38%
State and political subdivisions
172,329
12.92%
173,361
13.63%
Total held to maturity
323,544
24.26%
336,881
26.49%
Total securities
$
1,333,921
100.00%
$
1,271,804
100.00%
Investment securities that were pledged as collateral for borrowings and/or potential borrowings from the Federal Home Loan Bank and the Federal Reserve Bank, customer repurchase agreements, and other purposes as required or permitted by law totaled $477.4 million at September 30, 2023 and $183.5 million at December 31, 2022, leaving $0.9 million in unpledged debt securities at September 30, 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 $326.3 million at September 30, 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 September 30, 2023 and December 31, 2022 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 September 30, 2023 and December 31, 2022 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 September 30, 2023 or December 31, 2022.
● 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 September 30, 2023 or December 31, 2022.
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● Management routinely monitors third party credit grades of the municipal issuers in the Company’s state and political subdivisions portfolio and as of both September 30, 2023 and December 31, 2022 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 September 30, 2023 and December 31, 2022 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 September 30, 2023 and December 31, 2022 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 September 30, 2023 and December 31, 2022 management concluded that the unrealized loss position of these securities related exclusively to the fluctuation in market conditions, primarily interest rate spreads due to changes in supply or demand, 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. The balances in the table are after deferred or unamortized loan origination, extension, or commitment fees, and deferred origination costs. While not reflected in the loan totals and not currently comprising a material segment of our lending activities, the Company also occasionally originates and sells, or participates out portions of loans to non-affiliated investors.
Loan Distribution
(dollars in thousands, unaudited)
September 30, 2023
December 31, 2022
Amount
Percent
Amount
Percent
Real estate:
Residential real estate
$
419,940
20.21%
$
438,731
21.61%
Commercial real estate
1,331,894
64.10%
1,308,328
64.47%
Other construction/land
7,376
0.35%
18,358
0.90%
Farmland
91,217
4.39%
113,594
5.60%
Total real estate
1,850,427
89.04%
1,879,011
92.57%
Other commercial
138,786
6.68%
104,135
5.13%
Mortgage warehouse lines
107,584
5.18%
65,439
3.22%
Consumer loans
4,176
0.20%
4,232
0.21%
Total loans
2,100,973
101.11%
2,052,817
101.14%
Allowance for credit losses on loans
(23,060)
(1.11)%
(23,060)
(1.14)%
Total loans, net
$
2,077,913
100.00%
$
2,029,757
100.00%
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Gross loans at $2.1 billion, increased $48.2 million during the first nine months of 2023 with an overall 2% change year-to-date. The net change did have offsetting components with the larger fluctuations being a $42.1 million increase in mortgage warehouse line utilization, a $22.7 million increase in commercial real estate, and a $35.5 million increase in other commercial loans. Unfavorable larger loan variances include an $18.7 million decrease in residential real estate, a $22.4 million decrease in farmland and an $11.0 million decrease in other construction.
As indicated in the loan roll forward below, new credit extended for the third quarter of 2023 decreased $14.0 million and for the first nine months of 2023 decreased $66.4 million over the same periods in 2022. For the nine months ended 2023, we had $111.2 million in loan paydowns and maturities, along with a $42.1 million increase in mortgage warehouse line utilization and a $41.7 million decrease in line of credit utilization.
LOAN ROLLFORWARD
(Dollars in Thousands, Unaudited)
For the three months ended:
For the nine months ended:
September 30, 2023
June 30, 2023
September 30, 2022
September 30, 2023
September 30, 2022
Gross loans beginning balance
$
2,094,391
$
2,033,968
$
2,022,662
$
2,052,940
$
1,989,726
New credit extended
68,980
37,030
82,958
158,619
225,054
Loan purchases
—
—
—
—
173,082
Changes in line of credit utilization
(22,517)
6,622
(7,811)
(41,685)
(45,201)
Change in mortgage warehouse
(3,032)
42,145
(11,581)
42,146
(54,630)
Pay-downs, maturities, charge-offs and amortization (1)
(37,012)
(25,374)
(65,864)
(111,210)
(267,667)
Gross loans ending balance
2,100,810
2,094,391
2,020,364
2,100,810
2,020,364
(1) Includes $1.6 million from the sale of a performing loan during the second quarter of 2022.
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 and office real estate. At September 30, 2023 the total regulatory CRE ratio of total CRE over Tier 1 Capital plus allowance was 243%, compared to 243% for the linked quarter and 246% at December 31, 2022 which positions us well for growth. Further, the overall level of construction and land development lending had declined to 2% of regulatory capital plus allowance for credit losses at September 30, 2023. Overall committed non-owner occupied commercial real estate is 253% of regulatory capital plus allowance for credit losses and is 13.6% of total commitments at September 30, 2023. Office real estate loans are 48% of regulatory capital plus allowance for credit losses and are adjustable rates with most rate adjustments occurring beyond two years. During the next twenty-four months, we have 43 office commercial real estate loans totaling $40.9 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 $216.8 million at September 30, 2023, compared to $219.7 million at December 31, 2022. Total utilization excluding mortgage warehouse and overdraft lines was 60% at September 30, 2023 and 59% at December 31, 2022. Mortgage warehouse utilization was 30% at September 30, 2023, compared to 10% at December 31, 2022.
It should be noted that 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.
PPP loans continue to decline as borrowers receive forgiveness on these loans. There were nine loans for $0.4 million outstanding at September 30, 2023, compared to fourteen loans for $1.8 million at December 31, 2022.
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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.
Nonperforming assets
(dollars in thousands, unaudited)
September 30, 2023
December 31, 2022
September 30, 2022
Nonperforming Loans:
Real estate:
Residential real estate
$
446
$
688
$
546
Farmland
—
15,812
18,270
Total Real Estate nonperforming loans
446
16,500
18,816
Other commercial
335
3,072
7,956
Consumer loans
—
7
—
Total Nonperforming Loans
781
19,579
26,772
Foreclosed assets
—
—
—
Total Nonperforming Assets
$
781
$
19,579
$
26,772
Nonperforming loans as a % of total gross loans
0.04%
0.95%
1.33%
Nonperforming assets as a % of total gross loans and foreclosed assets
0.04%
0.95%
1.33%
Total nonperforming assets, comprised of nonaccrual loans and foreclosed assets, decreased by $18.8 million to $0.8 million for the first nine months of 2023. The Company's ratio of nonperforming loans to gross loans decreased to 0.4% at September 30, 2023 from 0.95% at December 31, 2022. The decrease resulted from a decrease in non-accrual loan balances, primarily as a result of the foreclosure and sale of one loan relationship in the dairy industry consisting of four separate loans in the first quarter of 2023. All the Company's nonperforming assets are individually evaluated for credit loss quarterly and management believes the established allowance for credit loss on such loans is appropriate.
There were no foreclosed assets at September 30, 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. In January 2023, the Company foreclosed on $18.1 million of loans and the properties were sold prior to March 31, 2023.
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 $1.9 million in loans past due 30-89 days at September 30, 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
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. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when sufficient cash payments are received subsequent to the charge off.
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Due to the uncertainty of national and local economic conditions, the Company deferred implementation of the CECL accounting method under Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326) under section 4014 of the CARES Act. The Company implemented CECL on January 1, 2022, and recorded a $10.4 million increase in the allowance for credit losses, which included a $0.9 million reserve for unfunded commitments as an adjustment to equity, net of deferred taxes.
The Company's allowance for credit losses on loans was $23.1 million both at September 30, 2023, and December 31, 2022, and $23.8 million at September 30, 2022. The allowance was 1.10% of total loans at September 30, 2023, 1.12% of total loans at December 31, 2022, and 1.18% of total loans at September 30, 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 September 30, 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 $0.6 million for potential credit losses inherent in unused commitments is included in other liabilities at September 30, 2023, down $0.2 million 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.
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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)
For the three
months ended
For the three
months ended
For the nine
months ended
For the nine
months ended
For the year ended
September 30,
September 30,
September 30,
September 30,
December 31,
Balances:
2023
2022
2023
2022
2022
Average gross loans outstanding during period (1)
$
2,088,732
$
2,021,490
$
2,059,274
$
1,995,274
$
2,006,283
Gross Loans outstanding at end of period
$
2,100,810
$
2,020,364
$
2,100,810
$
2,020,364
$
2,052,940
Allowance for credit losses on loans:
Balance at beginning of period
$
23,010
$
22,802
$
23,060
$
14,256
$
14,256
Adoption of ASC 326
—
—
—
9,454
9,454
Provision charged to expense
117
1,212
444
4,360
10,898
Charge-offs
Real estate
Commercial real estate
—
—
—
1,911
1,911
Farmland
—
—
1,248
1,958
4,418
Total real estate
—
—
1,248
3,869
6,329
Other commercial
115
84
505
456
5,109
Consumer loans
426
372
1,292
984
1,396
Total
$
541
$
456
$
3,045
$
5,309
$
12,834
Recoveries
Real estate
Residential real estate
$
—
$
—
$
205
$
99
$
99
Commercial real estate
—
—
17
—
—
Other construction/land
—
—
—
259
260
Farmland
—
—
257
—
—
Total real estate
—
—
479
358
359
Other commercial
224
36
1,352
118
163
Consumer loans
250
196
770
553
764
Total
$
474
$
232
$
2,601
$
1,029
$
1,286
Net loan charge offs
$
67
$
224
$
444
$
4,280
$
11,548
Balance at end of period
$
23,060
$
23,790
$
23,060
$
23,790
$
23,060
RATIOS
Net charge-offs to average Loans (annualized)
0.01%
0.04%
0.03%
0.29%
0.58%
Allowance for credit losses on Loans to gross Loans at end of period
1.10%
1.18%
1.10%
1.18%
1.12%
Net loan charge-offs to allowance for credit losses on Loans at end of period
0.29%
0.94%
1.93%
17.99%
50.08%
Net loan charge-offs to provision for credit losses on Loans
57.26%
18.48%
100.00%
98.17%
105.96%
(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 at September 30, 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.
OFF-BALANCE SHEET ARRANGEMENTS
The Company maintains commitments to extend credit in the normal course of business, as long as there are no violations of conditions established in the outstanding contractual arrangements. It is unlikely that all unused commitments will ultimately be drawn down. Unused commitments to extend credit, which included standby letters of credit, totaled $548.8 million at September 30, 2023 and $895.6 million at December 31, 2022, representing approximately 44% of gross loans outstanding at September 30, 2023 and 44% at December 31, 2022. Included in
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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 $254.4 million at September 30, 2023 and $594.6 million at December 31, 2022. The decline in unused commitments during 2023 is primarily due to a decline in mortgage warehouse lines as the Company strategically reduced availability under the existing lines while increasing the number of lines outstanding. Unused commitments exclusive of mortgage warehouse lines and overdraft lines of credit, have decreased $2.9 million or 1% for the first nine months of 2023 and are due to a decrease in new lines of credit. The Company also had undrawn letters of credit issued to customers totaling $6.0 million at both September 30, 2023 and 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 $72.6 million at September 30, 2023. That letter of credit is backed by loans that are pledged to the FHLB by the Company. For more information on the Company’s off-balance sheet arrangements, see Note 7 to the consolidated financial statements located elsewhere herein.
OTHER ASSETS
Interest-earning cash balances were discussed above in the “Investments” section, but the Company also maintains a certain level of cash on hand in the normal course of business as well as non-earning deposits at other financial institutions. Our balance of cash and due from banks depends on the timing of collection of outstanding cash items (checks), the amount of cash held at our branches, and our reserve requirement among other things, and it is subject to significant fluctuations in the normal course of business. While cash flows are normally predictable within limits, those limits are fairly broad and the Company manages its short-term cash position through the utilization of overnight loans to, and borrowings from, correspondent banks, including the Federal Reserve Bank and the Federal Home Loan Bank. Should a large “short” overnight position persist for any length of time, the Company typically raises money through focused retail deposit gathering efforts or by adding brokered time deposits. If a “long” position is prevalent, we could let brokered deposits or other wholesale borrowings roll off as they mature, or we might invest excess liquidity into investments or loans, subject to the bank’s risk tolerances. The Company’s balance of non-earning cash and due from banks was $88.5 million at September 30, 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 $0.6 million during the first nine months of 2023, to $21.9 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, 2023, unchanged during the first nine months of 2023. Goodwill is tested for impairment annually, unless events and circumstances exist which indicate that an impairment test should be performed. The annual goodwill impairment test was last performed on October 1, 2023, and it was determined that no impairment existed. Management continues 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 in 2024.
Bank-owned life insurance, with a balance of $51.3 million at September 30, 2023, is discussed in detail above in the “Noninterest Income and Noninterest Expense” section.
DEPOSITS AND INTEREST-BEARING LIABILITIES
DEPOSITS
Deposits represent another key balance sheet category impacting the Company’s net interest income and profitability metrics. Deposits provide liquidity to fund growth in earning assets, and the Company’s net interest margin is improved
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to the extent that growth in deposits is concentrated in less volatile and typically less costly non-maturity accounts such as demand deposit accounts, NOW accounts, savings accounts, and money market demand accounts. Information concerning average balances and rates paid by deposit type is included in the Average Balances and Rates tables appearing above, in the section titled “Net Interest Income and Net Interest Margin.” A distribution of the Company’s deposits by type, showing the period-end balance and percentage of total deposits, is presented as of the dates indicated in the following table.
Deposit Distribution
(dollars in thousands, unaudited)
September 30, 2023
December 31, 2022
Amount
Percent
Amount
Percent
Noninterest-bearing demand deposits
$
1,059,878
36.94%
$
1,088,199
38.23%
Interest-bearing demand deposits
134,117
4.67%
150,875
5.30%
NOW
427,140
14.88%
490,707
17.24%
Savings
400,940
13.97%
456,980
16.06%
Money market
130,914
4.56%
139,795
4.91%
Time
551,731
19.23%
399,608
14.04%
Brokered deposits
165,000
5.75%
120,000
4.22%
Total deposits
$
2,869,720
100.00%
$
2,846,164
100.00%
Deposit balances grew by $23.6 million, or 1%, during the first nine months of 2023 to $2.9 billion at September 30, 2023. Core non-maturity deposits decreased $173.6 million, or 7%, for the first nine months of 2023, while customer time deposits increased by $152.1 million, or 38% due mostly to an increase in variable rate CD accounts by existing customers seeking higher interest rates on their deposits. Brokered deposits increased $45.0 million during the first nine months of 2023, or 38%; to take advantage of preferential pricing over other forms of borrowed funds. Overall noninterest-bearing deposits as a percent of total deposits decreased to 36.9% at September 30, 2023, compared to 38.2% at December 31, 2022, and from 38.8% at September 30, 2022.
Overall uninsured deposits are estimated to be approximately $830.3 million, or 29% 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 $225 million of combined pass-through FDIC insurance per customer 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 September 30, 2023, the Company had approximately 121,000 accounts and the 25 largest deposit balance customers had balances of approximately 12% of overall deposits . During the second and third quarters of 2023, except for seasonality fluctuations in the normal course of business there has been no change in the composition of our 25 largest deposit balance customers.
OTHER INTEREST-BEARING LIABILITIES
The Company’s non-deposit borrowings may, at any given time, include fed funds purchased from correspondent banks, borrowings from the Federal Home Loan Bank, advances from the Federal Reserve Bank, securities sold under agreements to repurchase, subordinated notes and/or junior subordinated debentures. The Company uses short-term FHLB advances and fed funds purchased on unsecured lines to support liquidity needs created by seasonal deposit flows, to temporarily satisfy funding needs from increased loan demand, and for other short-term purposes. The FHLB line consists of both a secured and unsecured component. The secured component depends on the level of pledged collateral.
Total non-deposit interest-bearing liabilities increased by $83.9 million, during the first nine months of 2023 primarily due to an increase in long term FHLB borrowings. This was a strategic decision to take advantage of longer term pricing as a partial on-balance sheet match to longer term loans due to the current inverted yield curve and to provide longer-term interest rate risk mitigation.
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Customer repurchase agreements declined from $109.2 million at December 31, 2022 to $94.9 million at September 30, 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.
Overnight and short-term borrowings increased $18.0 million to $237.0 million at September 30, 2023 from $219.0 million at December 31, 2022 and consist of overnight borrowings from correspondent banks and the FHLB, and short-term FHLB borrowings.
Long-term debt at September 30, 2023 consisted of $49.3 million of subordinated debt. This remained relatively unchanged from December 31, 2022. Subordinated debentures related to $35.6 million of trust preferred securities at September 30, 2023 and $35.5 million at December 31, 2022. Trust preferred securities are variable rate instruments benchmarked against the Secured Overnight Financing Rate (SOFR).
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 $62.9 million at September 30, 2023 as compared to $45.1 million at December 31, 2022, an increase of $17.8 million or 39%. The increase was primarily driven by ICS transactions that have not settled as of September 30, 2023.
LIQUIDITY AND MARKET RISK MANAGEMENT
LIQUIDITY
The Company continues to have substantial liquidity though unencumbered assets and available borrowings. In addition, the Company’s loan-to-deposit ratio was 73% at September 30, 2023 and 72% at December 31, 2022.
Liquidity management refers to the Company’s ability to maintain cash flows that are adequate to fund operations and meet other obligations and commitments in a timely and cost-effective manner. Detailed cash flow projections are reviewed by Management on a monthly basis, with various stress scenarios applied to assess our ability to meet liquidity needs under unusual or adverse conditions. Liquidity ratios are also calculated and reviewed on a regular basis. While those ratios are merely indicators and are not measures of actual liquidity, they are closely monitored, and we are committed to maintaining adequate liquidity resources to draw upon should unexpected needs arise.
The Company, on occasion, experiences cash needs as the result of loan growth, deposit outflows, asset purchases or liability repayments. To meet these short-term needs, we can borrow overnight funds from other financial institutions, draw advances via Federal Home Loan Bank lines of credit, or solicit brokered deposits if customer deposits are not immediately obtainable from local sources.
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At September 30, 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, 2023
December 31, 2022
Cash and cash equivalents
$
88,542
$
77,131
Unpledged investment securities
854,730
1,097,164
Excess pledged securities
326,343
43,096
FHLB borrowing availability
657,548
718,842
Unsecured lines of credit
362,785
237,000
Funds available through fed discount window
383,943
42,278
Totals
$
2,673,891
$
2,215,511
The Company did not participate in the Federal Reserve Bank Term Funding Program in 2023. Unpledged investment securities include $290.5 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 nine months 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, 2023 and December 31, 2022. Other sources of liquidity include the brokered deposit market, deposit listing services, Intrafi, 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.
The Company’s primary liquidity ratio and net loans to deposits were 31.5% and 71.8%, respectively, at September 30, 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 September 30, 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.
The holding company’s primary uses of funds include operating expenses incurred in the normal course of business, interest on trust preferred securities and subordinated debt, shareholder dividends, and share repurchases. Its primary source of funds is dividends from the Bank since the holding company does not conduct regular banking operations. As of September 30, 2023, the holding company maintained a cash balance of $14.7 million. Management anticipates that the holding company has sufficient liquidity to meet its funding requirements for the foreseeable future. Both the holding company and the Bank are subject to legal and regulatory limitations on dividend payments, as outlined in Item 5(c) Dividends in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022 which was filed with the SEC.
INTEREST RATE RISK MANAGEMENT
Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company does not engage in the trading of financial instruments, nor does it have exposure to currency exchange rates. Our market risk exposure is primarily that of interest rate risk, and we have established policies and procedures to monitor and limit our earnings and balance sheet exposure to changes in interest rates. The principal objective of interest rate risk management is to manage the financial components of the Company’s balance sheet in a manner that will optimize the risk/reward equation for earnings and capital under a variety of interest rate scenarios.
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To identify areas of potential exposure to interest rate changes, we utilize commercially available modeling software to perform monthly earnings simulations and calculate the Company’s market value of portfolio equity under varying interest rate scenarios. The model imports relevant information for the Company’s financial instruments and incorporates Management’s assumptions on pricing, duration, and optionality for anticipated new volumes. Assumptions regarding deposit betas in the up cycles can range from 25 to 100% and from 0 to 50% in the down cycles depending on the deposit type. Deposit decay rate assumptions range from 5 to 10% and are based on historical averages. Prepayment speeds are based on three year historical averages. Various rate scenarios consisting of key rate and yield curve projections are then applied in order to calculate the expected effect of a given interest rate change on interest income, interest expense, and the value of the Company’s financial instruments. The rate projections can be shocked (an immediate and parallel change in all base rates, up or down), ramped (an incremental increase or decrease in rates over a specified time period), economic (based on current trends and econometric models) or stable (unchanged from current actual levels).
In addition to a stable rate scenario, which presumes that there are no changes in interest rates, we typically use at least eight other interest rate scenarios in conducting our rolling 12-month net interest income simulations: upward shocks of 100, 200, 300, and 400 basis points, and downward shocks of 100, 200, and 300 basis points. Those scenarios may be 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, 2023
September 30, 2022
Immediate change in Interest Rates (basis points)
% Change in Net Interest Income
$ Change in Net Interest Income
% Change in Net Interest Income
$ Change in Net Interest Income
+400
(2.2)%
$
(2,606)
6.4%
$
8,374
+300
(1.6)%
$
(1,880)
5.0%
$
6,497
+200
(0.9)%
$
(1,132)
3.6%
$
4,729
+100
(0.4)%
$
(520)
2.2%
$
2,917
Base
-100
(3.2)%
$
(3,872)
(5.6)%
$
(7,353)
-200
(5.0)%
$
(6,062)
(11.9)%
$
(15,551)
-300
(9.1)%
$
(11,051)
N/A
N/A
-400
(13.4)%
$
(16,227)
N/A
N/A
For the period ending September 30, 2023, 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 September 30, 2022 to slightly liability sensitive at September 30, 2023, is primarily due to the change in assumptions regarding low cost deposits and loan betas. The base scenarios utilize a dynamic balance sheet based on expected growth.
At September 30, 2023, it was assumed that over twelve months, a portion of low-cost deposits would shift into higher cost deposits thus making the company slightly liability sensitive. Thus, as rates increase, more deposits will shift into higher-cost deposits. In addition, based on the magnitude of rate changes, interest rates on new loans did not increase at the rates modeled in 2022. To address this, the beta on loan yields was lowered in modeling interest rate risk in 2023, which has the impact of lowering the effect of future rate increases on interest income. Further, the Company has more variable rate liabilities at September 30, 2023 including overnight borrowings both in Fed Funds purchased and overnight FHLB borrowings and in customer time deposits tied to the prime interest rate. Any change in interest rate in the model would expect to decrease net interest income. At September 30, 2023, the Company had $331.9 million in overnight and short term borrowings as compared to $215.1 million at September 30, 2022.
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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 decline by $0.5 million, or 0.4%, relative to a stable interest rate scenario, with the unfavorable variance increasing as interest rates rise higher.
If there was an immediate downward adjustment of 100 basis points in interest rates, net interest income would drop $3.9 million or a negative variance of 3%. The change in net interest income in the down 200 basis point scenario is a decrease of $6.1 million or 5%. 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. However, floating rate earning assets (loans and deposits) would reprice downward more than the decline in floating rate liabilities. All interest rate shock scenarios are within our internal policy guidelines, and we will continue to monitor our interest rate risk profile and implement remedial changes if deemed appropriate.
If there was an immediate downward adjustment of 100 basis points in interest rates, net interest income would drop $8.3 million or a negative variance of 8%. The reason for the drop in net interest income is, most deposit products are at their floors of 0.10% and cannot be re-priced lower, while non-floored interest earning assets such as loans and securities can theoretically still be re-priced lower in a falling rate environment. Due to the historically low current rate environment, we view any material interest rate reductions as unlikely in the near term. However, the potential percentage drop in net interest income in the “down 100 basis points” interest rate scenario exceeds our internal policy guidelines and we will continue to monitor our interest rate risk profile and implement remedial changes if deemed appropriate.
In addition to the net interest income simulations shown above, we run stress scenarios for the unconsolidated Bank where we model the possibility of no balance sheet growth, the potential runoff of “surge” core deposits which flowed into the Bank in the most recent economic cycle, and unfavorable movement in deposit rates relative to yields on earning assets (i.e., higher deposit betas). The most significant impact to net interest income in the net interest income simulations is the reduction or migration of low-cost deposits.
The modeled economic value (or “fair value”) of financial instruments on the Company’s balance sheet will also vary under the interest rate scenarios previously discussed. The difference between the projected fair value of the Company’s financial assets and the fair value of its financial liabilities is referred to as the economic value of equity (“EVE”), and changes in EVE under different interest rate scenarios are effectively a gauge of the Company’s longer-term exposure to interest rate fluctuations. Fair values for financial instruments are estimated by discounting projected cash flows (principal and interest) at anticipated replacement interest rates for each account type, while the fair value of non-financial accounts is assumed to equal their book value for all rate scenarios. An economic value simulation is a static measure utilizing balance sheet accounts at a given point in time, and the measurement can change substantially over time, as is evident in the tables below for the periods ending September 30, 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. As a general rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the greater the impact a rate change will have on its value. In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based on historical patterns and Management’s best estimates in the current rate environment.
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, 2023
September 30, 2022
Immediate change in Interest Rates (basis points)
% Change in Fair Value of Equity
$ Change in Fair Value of Equity
% Change in Fair Value of Equity
$ Change in Fair Value of Equity
+400
9.0%
$
46,030
9.3%
$
68,762
+300
8.1%
$
41,401
7.7%
$
56,711
+200
6.8%
$
35,006
5.4%
$
39,603
+100
4.2%
$
21,321
2.4%
$
17,782
Base
-100
(3.8)%
$
(19,482)
(14.4)%
$
(106,169)
-200
(18.7)%
$
(95,916)
(31.1)%
$
(229,698)
-300
(22.0)%
$
(112,501)
N/A
N/A
-400
(9.5)%
$
(48,392)
N/A
N/A
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The table shows that our EVE is modeled to deteriorate in declining rate scenarios but should benefit from a parallel shift upward in the yield curve. The rate of increase in EVE accelerates the higher interest rates rise. This increase in sensitivity is caused by the increase in gross deposits, namely, an increase in noninterest-bearing deposits which become more valuable as interest rates rise. We also run stress scenarios for the unconsolidated Bank’s EVE to simulate the possibility of adverse movement in loan prepayment rates, unfavorable changes in deposit rates, and higher deposit decay rates. Model results are highly sensitive to changes in assumed decay rates for non-maturity deposits, in particular, with material unfavorable variances occurring relative to the standard simulations shown above as decay rates are increased. Furthermore, while not as extreme as the variances produced by increasing non-maturity deposit decay rates, EVE also displays a relatively high level of sensitivity to unfavorable changes in deposit rate betas in rising interest rate scenarios.
The potential percentage 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 $308.9 million at September 30, 2023, comprised of $109.6 million in common stock, $4.9 million in additional paid-in capital, $227.6 million in retained earnings, and accumulated other comprehensive loss of $61.9 million. At the end of 2022, total shareholders’ equity was $303.6 million. The increase in equity during the first nine months of 2023 is due to net income of $28.6 million, offset by a $10.4 million dividend paid to shareholders, $8.5 million in share repurchases, and a $5.3 million unfavorable swing in other comprehensive income/(loss) due principally to changes in investment securities' fair value. The remaining difference is related to stock options and restricted stock during the first nine months of 2023.
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 2023 Share Repurchase Plan authorizes 630,000 shares to be repurchased and expires on October 31, 2023. Under the 2023 Share Repurchase Program, there were 481,094 shares repurchased in the first nine 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. Management reviews these capital measurements on a quarterly basis and takes appropriate action to help ensure that they meet or surpass established internal and external guidelines. As permitted by the regulators for financial institutions that are not deemed to be “advanced approaches” institutions, the Company has elected to opt out of the Basel III requirement to include accumulated other comprehensive income in risk-based capital. The following table sets forth the Bank’s regulatory capital ratios as of the dates indicated.
Regulatory Capital Ratios
Minimum
Minimum
Requirement
Required
September 30,
December 31,
to be
Community Bank
2023
2022
Well Capitalized (1)
Leverage Ratio (2)
Bank of the Sierra
Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio") (3)
11.05
%
10.99
%
9.00
%
9.00
%
Sierra Bancorp
Tier 1 Capital to Adjusted Average Assets ("Leverage Ratio") (3)
10.12
%
10.30
%
9.00
%
N/A
(1) The Company was subject to these minimum requirements under the regulatory framework for Prompt Corrective Action at December 31, 2019.
(2) If the subsidiary bank’s Leverage Ratio exceeds the minimum ratio under the Community Bank Leverage Ratio Framework, it is deemed to be “well capitalized” under all other regulatory capital requirements. The Company may revert back to the regulatory framework for Prompt Corrective Action if the subsidiary bank’s Leverage Ratio falls below the minimum under the Community Bank Leverage Ratio Framework.
(3) The Company has elected to phase in the impact of implementing CECL on regulatory capital over a three-year period.
The federal banking agencies published a final rule on November 13, 2019, that provided a simplified measure of capital adequacy for qualifying community banking organizations. A qualifying community banking organization that opts into
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the community bank leverage ratio framework and maintains a leverage ratio greater than 9 percent will be considered to have met the minimum capital requirements, the capital ratio requirements for the well capitalized category under the Prompt Corrective Action framework, and any other capital or leverage requirements to which the qualifying banking organization is subject. A qualifying community banking organization with a leverage ratio of greater than 9 percent may opt into the community bank leverage ratio framework if has average consolidated total assets of less than $10 billion, has off-balance-sheet exposures of 25% or less of total consolidated assets, and has total trading assets and trading liabilities of 5 percent or less of total consolidated assets. Further, the bank must not be an advance approaches banking organization.
The final rule became effective January 1, 2020 and banks that meet the qualifying criteria can elect to use the community bank leverage framework starting with the quarter ended March 31, 2020. The federal bank regulatory agencies adopted an interim final rule to implement this change from the CARES Act. At September 30, 2021, the Company and the Bank met the criteria outlined in the final rule and the interim final rule and elected to measure capital adequacy under the CBLR framework.
PART I – FINANCIAL INFORMATION
ITEM 3
QUANTITATIVE & QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The information concerning quantitative and qualitative disclosures about market risk is included in Part I, Item 2 above. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Market Risk Management.”
PART I – FINANCIAL INFORMATION
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.