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Item 7. Management’s Discussion and Analysis

2024-03-22 compared with 2023-03-09 · 328 added, 368 removed, 541 unchanged (56% of the section changed)

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Critical Accounting Estimates

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.

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States and prevailing practices within the banking industry.

All significant intercompany balances and transactions have been eliminated.

Certain reclassifications have been made to prior year’s balances to conform to classifications used in 2023.

Actual results may differ from those estimates under divergent conditions.

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

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

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

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

income taxes and deferred tax assets and liabilities, especially with regard to the ability of the Company to recover deferred tax assets as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis;

and goodwill and other intangible assets, which are evaluated annually for impairment and for which we have determined that no impairment exists, as discussed in Note 2 to the consolidated financial statements and in the “Other Assets” section of this discussion and analysis.

and Goodwill which is evaluated annually for impairment and for which we have determined that no impairment exists, as discussed in Note 2 to the consolidated financial statements and 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 the most recent expectations with regard to those areas.

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Operating Data

Net interest income

Credit loss expense

Noninterest income

Noninterest expense

Provision for income taxes

Selected Balance Sheet Summary

Total loans and leases, net

Total loans, net

Total deposits

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Net (recoveries) charge-offs to average loans

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

Allowance for credit losses on loans and leases to nonaccrual loans

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

Allowance for credit losses on loans to nonaccrual loans

Regulatory Capital Ratios:

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Performance ratios are based on average daily balances during the periods indicated.

(2) Performing TDR’s are not included in nonperforming loans and are therefore not included in the numerators used to calculate these ratios.

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

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The Company’s return on average assets and return on average equity were 0.94% and 11.30%, respectively, in 2023, as compared to 0.97% and 10.66%, respectively, in 2022 and 1.29% and 12.05%, respectively, for 2021.

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

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

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

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

● Net interest income improved by 3% in 2023 over 2022, and by 1% in 2022 over 2021, due to both growth and mix of earning assets partially offset by an increase in the cost of interest-bearing liabilities.

The increase in average earning assets in 2023 over 2022 was due primarily to purchases of investment securities, augmented with increases in the average balance of loans.

The average balance of investment securities increased $213.3 million while average gross loan balances increased $57.7 million.

We experienced an increase of $22.4 million in real estate loans, $27.1 million increase in mortgage warehouse line utilization, and a $7.9 million increase in other commercial loans.

The positive impact of average asset growth in 2023 along with a 100 basis points increase in yield was negatively impacted by a 161 basis points increase in yield on interest bearing liabilities due to a shift by our customers into higher cost certificates of deposits coupled with an increase in more expensive borrowed funds.

The net interest margin in 2023 was 10 basis points lower than 2022.

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

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

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

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

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

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

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

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

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

These two favorable impacts on margin were partially offset by a 46 basis point decline in yield on interest earning assets.

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

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

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

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

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

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

● We recorded a provision for credit losses on loans of $4.1 million in 2023, as compared to a $10.9 million provision in 2022 and $3.7 million benefit in 2021.

The Company's $6.8 million favorable decrease in credit loss expense on loans for the year ending 2023 as compared to the same period in 2022, is primarily due to the impact of lower net charge-offs during the year ending 2023.

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

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

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

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

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

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

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

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

● Noninterest income decreased by $0.4 million, or 1%, in 2023, and increased by $2.7 million or 10%, in 2022 over 2021.

The year over year decrease in 2023 was negatively impacted by 2022 events that did not recur in 2023, including $3.6 million in gains on the sale of other assets, and the $1.0 million recovery of prior period legal expenses.

These unfavorable variances were partially offset by favorable fluctuations in income on bank-owned life insurance (BOLI) with underlying investments mapped directly to the Company’s deferred compensation plan.

Also favorably impacting noninterest income was a $15.3 million gain on the sale of Bank owned branch buildings (subsequently leased back), mostly offset by realizing a $14.5 million loss on a securities strategy which identified $196.7 million in available-for-sale securities to be sold in January 2024.

The $2.7 million increase in 2022 as compared to 2021 was primarily due to a $0.7 million increase in service charge income, $1.5 million in gains on the sale of investment securities, a $0.8 million favorable change in other small business partnership expenses, and $3.2 million in gains on the sale of other assets.

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

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

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

● Noninterest expense increased by $7.9 million, or 9%, in 2023 as compared to 2022, and increased by $1.2 million, or 1%, in 2022 over 2021.

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

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

Deposit services and premises expense also contributed to the difference.

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

$14.2 million, or 24% of pre-tax income in 2021;

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

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

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

The increase in noninterest expense in 2023 was due mostly to a $3.9 million increase in salary and benefits expense for new lending teams and management staff along with reduction in force severance payments as discussed in the quarterly comparison, an unfavorable variance in director’s deferred compensation expense which is linked to the favorable changes in bank-owned life insurance income, mentioned above in the discussion of noninterest income, a $0.8 million increase in FDIC assessment costs and $0.5 million increase in fraud losses primarily due to our debit card conversion from Mastercard to VISA earlier in the year.

The increase in noninterest expense in 2022 was due mostly to a $4.6 million increase in salary and benefits expense primarily for new loan production teams and a $0.7 million restitution payment to customers charged nonsufficient fund fees on representments in the past five years, partially offset by lower legal costs, telecommunications, and a positive variance in director’s deferred compensation expense which is linked to the unfavorable changes in bank-owned life insurance income.

● The Company recorded income tax provisions of $11.6 million, $11.3 million and $14.2 million for the years ending 2023, 2022 and 2021 respectively, or 25% of pre-tax income.

Financial Condition Summary

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● Total assets increased by $121.2 million, or 3%.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

This was mostly as a result of a $67.5 million increase in investment securities, a $37.1 million increase in gross loans, and a $15.2 million increase in other assets, net of a $5.6 million decrease in Bank owned premises and equipment.

● Investment securities increased $67.5 million, or 5%.

This increase consisted primarily of increases in AAA tranches of collateralized loan obligations of $72.3 million and in callable government agency securities for $52.2 million, partially offset by decreases in mortgage-backed securities, corporate bonds and state and municipal bonds.

● Gross loans increased $37.1 million, or 2%.

This increase was primarily a result of a $50.6 million increase in mortgage warehouse utilization, $17.1 million increase in commercial real estate, and a $53.3 million increase in other commercial loans.

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

In particular there was a $46.1 million decrease in farmland, $12.2 million decrease in other construction and $25.4 million decrease in residential real estate.

Further, SBA PPP loan forgiveness resulted in a $1.3 million decline in loan balances, included in the other commercial loan variance noted above.

● Other assets increased $15.2 million, or 7%.

This increase was mostly from a $18.8 million increase in operating leases from a sale leaseback of branch facilities discussed in “ Premises and Equipment ”, a $6.3 million increase in other miscellaneous investments including low income housing tax credit funds, partially offset by decreases in prepaid and deferred income taxes.

● Deposit balances declined $84.9 million, or 3%.

Core non-maturity deposits decreased by $255.4 million, or 11%, while customer time deposits increased by $155.5 million, or 39%.

Although there has been some attrition, our customers are becoming more rate sensitive in the current higher rate environment and have moved funds from lower or no cost transaction accounts into higher cost time deposits.

Wholesale brokered deposits increased by $15.0 million to $135.0 million.

Overall noninterest-bearing deposits as a percent of total deposits at December 31, 2023, decreased to 37.0%, as compared to 38.2% at December 31, 2022.

● Total capital increased by $34.5 million, or 11%, ending the year with a balance of $338.1 million.

The increase in equity was primarily due to $34.8 million in net income and a $20.6 million favorable swing in accumulated other comprehensive income (loss) partially offset by $13.7 million in dividends paid, and $8.5 million in share repurchases.

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

Results of Operations

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The first is net interest income, which is interest income generated by earning assets less interest expense on deposits and other borrowed money.

The second is noninterest income, which primarily consists of customer service charges and fees but also comes from non-customer sources such as BOLI and investment gains.

The second is noninterest income, which primarily consists of customer service charges and fees but also includes non-customer sources such as BOLI and investment gains.

The majority of the Company’s noninterest expense is comprised of operating costs that facilitate offering a full range of banking services to our customers.

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Total investments

Loans and Leases:

Mortgage warehouse

Total loans and leases

Total interest earning assets (4)

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Short term borrowings

Long term FHLB Advances

Long term debt

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(2) Yields and net interest margin have been computed on a tax equivalent basis.

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

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

Net loan fees have been included in the calculation of interest income.

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Variances attributable to both rate and volume changes, calculated by multiplying the change in rates by the change in average balances, have been allocated to the mix variance.

Volume & Rate Variances

Volume and Rate Variances

(dollars in thousands)

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Total investments

Loans and leases:

Mortgage warehouse

Total loans and leases

Total interest earning assets

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Borrowed funds:

Federal funds purchased

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Short term borrowings

Long-term FHLB Advances

Long term debt

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Net interest income

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Net interest income in 2023 as compared to 2022 was impacted by a favorable rate variance of $15.3 million, partially offset by an unfavorable mix variance of $11.0 million, and an unfavorable volume variance of $1.6 million.

For 2022 relative to 2021, net interest income reflects a favorable volume variance of $0.4 million and a favorable mix variance of $2.0 million, partially offset by an unfavorable rate variance of $1.8 million.

The 2023 versus 2022 favorable rate variance is due mostly to a 100 basis point increase in the yield on average earning assets, mostly in higher yielding floating rate commercial loan obligations (CLO), partially offset by a 161 basis point increase in interest expense on interest bearing liabilities.

The 2023 versus 2022 unfavorable volume variance mostly is due to larger increases in borrowed funds and interest bearing deposits over the increases in average earning assets.

There was also an unfavorable mix variance of $11.0 million which was mostly from the shift of non or low interest bearing deposits into higher rate time deposits as customers became more rate sensitive and higher volumes of borrowed funds at higher rates than the increases in rates on new volumes of interest earning assets.

Increases in higher yielding investment securities and an increase in usage of mortgage warehouse lines offset some of the unfavorable mix variance.

The 2022 versus 2021 volume variance is due mostly to increases in average balances, resulting from growth in investment portfolio balances, mostly in floating rate CLOs,

partially offset by a decline in average loan balances.

The Company’s net interest margin, which is tax-equivalent net interest income as a percentage of average interest-earning assets, declined by 10 basis points to 3.37% in 2023 and declined by nine basis points to 3.47% in 2022 as compared to 2021.

The net interest margin compression was mostly caused by an increase in rate and volume (mix) of higher cost of interest bearing liabilities over the increase of volume and yield (mix) on interest earning assets in 2023 as compared to 2022.

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

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

Rates paid on non-maturity deposits increased 15 basis points in 2023 over the same period in 2022 as competition for deposits has increased with customers becoming more rate sensitive.

Rates paid on non-maturity deposits were approximately the same in 2022 and 2021.

Interest bearing demand deposits increased 75 basis points in 2023 over 2022, an indication of the fierce competition for deposits industry-wide, while interest bearing demand accounts increased two basis points in 2022 over 2021.

There was a 47 basis point increase in money market accounts in 2023 over 2022, with a two basis point decrease on money market accounts in 2022 over 2021.

The weighted average cost of interest-bearing liabilities increased 161 basis points in 2023 and increased 39 basis points in 2022.

Customer time deposit rates in 2023 over 2022 increased 285 basis points due to a floating rate time deposit product offered by the Bank along with a 248 basis point increase in the rate paid on brokered deposits.

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

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

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

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

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

The current spreads range from prime minus 600 basis points to prime minus 375 basis points subject to a floor.

Two prime rate increases earlier in 2023, added to rate increases on such accounts.

Customer time deposit rates in 2022 increased 124 basis points over 2021, due to a floating rate time deposit account previously discussed, along with a 69 basis point increase in the rate paid on brokered deposits.

Short-term borrowings and adjustable-rate trust-preferred securities (“TRUPS”) are also tied to short-term rates which increased during 2023 over 2022 by an unfavorable 168 basis points.

In 2022, there was an unfavorable increase of 161 basis points over 2021.

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

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interest income recovered upon the resolution of nonperforming loans, the reversal of interest income when a loan is placed on non-accrual status, and accelerated fees or prepayment penalties recognized for early payoffs of loans.

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

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

Provision for Loan and Lease Losses and Provision for Credit Losses

Such adjustments totaled $0.9 million of income in 2023, $1.6 million of interest reversals in 2022, and $3.5 million of interest reversals in 2021.

Provision for Loan Losses and Provision for Credit Losses

Credit risk is inherent in the business of making loans.

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

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

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

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

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

The Company 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 provision for credit losses on loans of $4.1 million in 2023;

a provision for loan losses of $10.9 million in 2022, and a benefit for loan losses of $3.7 million in 2021.

Upon implementation the Company recorded a $10.4 million pre-tax 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 $6.8 million favorable decrease for the year ending 2023 compared to the same period in 2022 is primarily due to the impact of lower net charge-offs during the year ending 2023.

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

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

During 2021, management adjusted its qualitative risk factors under our current incurred loss model for improved economic conditions, improvements in the severity and volume of past due loans, and a reduction in the level of concentrations of credit in non-owner occupied real estate loans.

The growth in the provision for loan and lease losses in 2020, was due to the strong organic non-owner occupied commercial real estate loan growth generated in the second half of 2020 and the continued uncertainty surrounding the estimated impact that COVID-19 has had on the economy.

The provision was also impacted by downgrades of certain loans deferred under section 4013 of the CARES Act, including 10 loans for $1.4 million placed on non-accrual at the end of the deferral period.

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

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

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

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

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

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

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

With the provision for credit losses on loans recorded in 2023 we were able to maintain our allowance for credit losses on loans at a level that, in Management’s judgment, is adequate to absorb expected credit losses over the remaining contractual life on loans related to individually identified loans as well as expected credit losses over the remaining contractual life in the remaining loan portfolio.

Specifically identifiable and quantifiable credit losses on loans are immediately charged off

against the allowance.

The Company experienced net loan charge offs of $3.6 million in 2023, $11.5 million in 2022 and net loan recoveries of $0.2 million in 2021.

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

The loan loss (benefit) provision for 2021 was favorably impacted by the following factors:

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

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

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

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

Noninterest Revenue and Operating Expense

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Service charges on deposit accounts

Debit card fees

Other service charges and fees

Bank owned life insurance (loss) income

Gain on sale of securities

Gain (loss) on tax credit investment

Gain (loss) on sale of fixed assets

Bank owned life insurance income (loss)

Realized loss on available-for-sale securities

Total noninterest income

As a % of average interest-earning assets

OTHER OPERATING EXPENSES:

NONINTEREST EXPENSES:

Salaries and employee benefits

Occupancy costs

Furniture and equipment

Advertising and promotion costs

Occupancy and equipment costs

Advertising and marketing costs

Data processing costs

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Other operating costs

Telephone and data communications

Postage and mail

Professional services costs

Legal and accounting

Director's cost

Other professional services costs

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Sundry & tellers

Total other operating expense

Total noninterest expense

As a % of average interest-earning assets

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

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

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

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

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

Noninterest income in 2023 decreased $0.4 million or 1% over 2022 and, increased $2.7 million, or 10% in 2022 over 2021.

Total noninterest income was 0.89% of average interest-earning assets in 2023 as compared to a ratio of 0.95% in 2022.

The ratio decreased in 2023 mostly to an increase in interest-earning assets while noninterest income including service charges on deposit accounts were mostly flat.

The principal component of the Company’s noninterest revenue, service charges on deposit accounts were flat in 2023 as compared to 2022, and increased by $0.8 million, or 4%, in 2022 as compared to 2021.

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

As a percent of average transaction account balances, service charge income was 1.4% in 2023, 1.3% in 2022 and 1.2% in 2021.

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

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

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

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

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

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

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

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

Overdraft income on both consumer and corporate accounts totaled $5.3 million in 2023;

$4.6 million (net of restitution) in 2022 and $4.9 million in 2021.

Debit card fees (included in service charges on deposit accounts) consists of interchange fees from our customers’ use of debit cards for electronic funds transactions.

This category decreased in 2023 over 2022 by $0.2 million but was relatively flat in 2022 and 2021.

The unfavorable variance in 2023 was a result of a brand change later in the year from Mastercard to VISA.

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

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

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

In the comparative years ending 2023 over 2022, BOLI income increased $2.8 million;

however, in 2022 over 2021, BOLI income decreased $3.6 million.

The Company had $9.9 million invested in separate account BOLI at December 31, 2023.

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

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

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

Net gains on separate account BOLI totaled $0.9 million in 2023 as compared to net losses of $2.0 million in 2022 and gains of $1.7 million in 2021.

This resulted in a favorable variance of $2.9 million for the comparative years ending 2023 as compared to 2022 and an unfavorable variance of $3.7 million for the comparative years ending 2022 as compared to 2021.

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

The Company’s books also reflect a net cash surrender value for general account BOLI of $43.2 million at December 31, 2022 and 2021.

The Company’s books also reflect a net cash surrender value for general account BOLI of $41.7 million and $43.2 million, respectively for the years ending December 31, 2023 and 2022.

General account BOLI produces income that is used to help offset expenses associated with executive salary continuation plans, director retirement plans and other employee benefits.

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

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

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

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

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

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

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

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

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

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

Interest credit rates on general account BOLI do not change frequently so the income has typically been fairly consistent with $0.9 million of general account BOLI income recorded for the year ending December 31, 2023 and $1.0 million record for the two ending December 31, 2022 and 2021.

Gain on the sale of fixed assets for $15.3 million for the year ending 2023, was due to the sale of 11 Bank owned branch buildings that were subsequently leased back.

This transaction and related gain was part of an overall balance sheet restructuring.

The Company recognized a $14.5 million loss for the year ending December 31, 2023 on investment securities intended for sale in December 2023 and subsequently sold in January 2024.

This securities strategy identified $196.7 million in bonds yielding 2.61% to be sold in January 2024 at a loss of $14.5 million.

The proceeds from the securities strategy went to paydown a portion of other borrowed funds with an average rate of 5.52%.

The Company also realized a $0.4 million gain on the sale of securities during the year ending December 31, 2023, a $1.5 million gain for the same period in 2022 from a portfolio restructure to decrease effective duration, taking advance of slight rallies in the Treasury market in early and late 2022, as well as a nominal gain for the same period in 2021.

The other category, decreased $2.8 million to $4.4 million in 2023 and increased to $7.2 million in 2022 from $2.9 million in 2021.

The year over year decrease in 2023 over 2022 was a result of 2022 events that did not recur in 2023 including $3.6 million from the sale of other assets, and the recovery of prior period legal expenses.

Total operating expense, or noninterest expense, increased by $7.9 million, or 9%, in 2023 as compared to 2022, and by $1.2 million, or 1%, in 2022 as compared to 2021.

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

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

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

The largest component of noninterest expense, salaries, and employee benefits increased $3.9 million or 8% in 2023 as compared to 2022, and increased $4.6 million, or 11% in 2022 as compared to 2021.

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

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

The increase in 2023 was due to the strategic hiring of new loan production teams and certain management positions, and standard annual increases to our employee’s base compensation.

The Company also incurred severance payments of $0.9 million due to a strategic reduction in force on 14 positions eliminated through efficiencies gained from operational reorganization and the deployment of new technologies, partially offset by a $0.5 million reduction in the bonus accrual.

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

Loan origination salaries that were deferred from current expense for recognition over the life of related loans totaled $2.7 million in 2023, $2.3 million in 2022, and $1.1 million for 2021.

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

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

Salaries and benefits were 55% of total operating expense in 2022, relative to 51% in 2021 and 53% in 2020.

Salaries and benefits were 55% of total operating expense in both 2023 and 2022 and were 51% in 2021.

The number of full-time equivalent staff employed by the Company totaled 485 at the end of 2023, as compared to 491 at December 31, 2022 and 480 at December 31, 2021.

The decrease for the year ending 2023 in FTE was due to the reduction in force as several management positions were eliminated due to operational efficiencies.

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

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

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

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

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

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

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

Total rent and occupancy expense, including furniture and equipment costs, increased $0.4 million in 2023 as compared to 2022, and decreased $0.1 million in 2022 as compared to 2021.

The increase in 2023 was due to a one-time payment of $0.2 million for home office stipends for staff that work remotely and regular rent escalations.

The decrease in 2022 over 2021 was due to the consolidation of five branch facilities in 2021.

The sale leaseback transaction of 11 Bank-owned buildings discussed in “ Premises and Equipment ” is expected to add approximately $0.5 million of rent expense in 2024.

Advertising and promotion costs increased $0.5 million or 28%, in 2023 over 2022, and increased $0.2 million or 14%, in 2022 over 2021.

The increase in 2023 was mostly due to a $0.3 million increase in deposit program costs due to a deposit acquisition campaign.

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

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

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

Data processing costs decreased by $0.4 million or 6% in 2023 as compared to 2022 increased by $0.3 million or 5% in 2022 as compared to 2021.

The decrease in 2023 was mostly from a $0.6 million decrease in core processing costs and lower internet banking costs, partially offset by higher Visa conversion costs.

The Company renegotiated its core processing contract which resulted in overall savings.

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

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

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

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

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

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

that require less maintenance.

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

Deposit services costs decreased by $0.7 million or 8% in 2023 as compared to 2022 and increased by $0.4 million or 5% in 2022 as compared to 2021.

Deposit costs favorable variance in 2023 over 2022 were due to a decrease in deposit statement costs, and lower ATM network costs.

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

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

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

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

Loan processing costs, which include expenses for property appraisals and inspections, loan collections, demand and foreclosure activities, loan servicing, loan sales, and other miscellaneous lending costs, increased by $0.1 million or 9% in 2023 as compared to 2022 and increased by $0.1 million or 10% in 2022 as compared to 2021.

The increase in 2023 was due to a $0.6 million increase in foreclosed asset expenses related to the foreclosure and subsequent sale of one large loan relationship in the first quarter of 2023.

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

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

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

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

There were $0.7 million expenses in 2023 and $0.1

million in expenses in both 2022 and 2021.

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

At the end of 2023, the Company had no OREO properties remaining in inventory.

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

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

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

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

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

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

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

Telecommunications expense was flat at $1.6 million in 2023 as compared to 2022 and decreased by 22% to $1.6 million in 2022 as compared to 2021.

The decrease in 2022 was due to the reduction of redundancy in lines during 2021.

Postage expense decreased by $0.2 million or 41% in 2023 over 2022 and increased by $0.1 million or 21% in 2022 as compared to 2021.

The decrease in 2023 was due to additional disclosure mailings in 2022 that did not recur in 2023.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Other miscellaneous costs under other operating costs was primarily unchanged in 2023 over 2022 but increased by $0.5 million or 25% in 2022 as compared to 2021.

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

Total Professional Services costs, which consists of legal and accounting, acquisition, directors fees, and other professional services costs, increased by $3.1 million in 2023 as compared to 2022 and decreased by $4.7 million or 53% in 2022 as compared to 2021.

Legal and Accounting costs increased $0.1 million or 5% in 2023 as compared to 2022 and decreased by $2.7 million or 56% in 2022 as compared to 2021.

The increase in 2023 was primarily from an increase in audit costs, while the decrease in 2022 was mostly due to a decrease in legal costs and related legal reserves, along with lower costs related to certain audit functions that were previously outsourced.

Directors’ costs increased $2.1 million in 2023 as compared to 2022 primarily due to an increase in deferred compensation expense which is linked to the favorable fluctuation in BOLI income, while the decrease in 2022 was mostly from the inverse change in the same categories.

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

This category increased $0.9 million or 46% in 2023 as compared to 2022 and decreased by $0.1 million or 7% in 2022 as compared to 2021.

The increase in 2023 was primarily from an in increase in FDIC assessment expenses.

Employee deferred compensation expense accruals totaled $0.2 million in 2023, $0.1 million in 2022, and $0.2 million in 2021, and are included in “salaries and employee benefits’ noted above.

Directors deferred compensation plan accruals totaled $0.8 million in 2023, and $1.1 million in both 2022 and 2021, and are included in “other professional services” above.

As previously mentioned in our discussion of BOLI income, deferred compensation plan accruals are related to separate account BOLI income and losses and the net income impact of all income/expense accruals related to deferred compensation is usually minimal.

Stationery and supply costs were mostly unchanged in 2023 as compared to 2022 but increased by $0.1 million or 41% in 2022 as compared to 2021.

The increase in 2022 was primarily from startup costs of new loan production offices.

Sundry and teller costs were $1.3 million in 2023, $0.7 million in 2022, and $0.6 million in 2021.

In 2023, as well as 2022 and 2021, debit card losses are elevated and trending upwards consistent with the higher volume of debit card transactions.

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

These debit card dispute and fraud costs increased in 2023 with our debit card conversion from Mastercard to Visa earlier in the year, and are expected to decline in 2024.

The Company’s tax-equivalent overhead efficiency ratio was 63.9% in 2023, 60.2% in 2022, and 59.9% in 2021.

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

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

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

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

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

Our income tax provision was $11.6 million, or 25.0% of pre-tax income in 2023, $11.3 million, or 25.1% of pre-tax income in 2022 and $14.2 million, or 24.8% of pre-tax income in 2021.

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

The tax accrual rate was higher in 2023 and in 2022 due to a lower proportion of non-taxable income to taxable income.

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

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The Company’s investments in state, county and municipal bonds provided $10.9 million of federal tax-exempt income in 2023, $8.8 million in 2022, and $6.2 million in 2021.

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

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

Moreover, in addition to life insurance proceeds of $0.9 million in 2023 and $0.4 million in both 2022 and 2021, net increases in the cash surrender value of bank-owned life insurance added $1.8 million to tax-exempt income in 2023, and $2.6 million to tax-exempt income in 2021, but reduced tax-exempt income by $1.0 million in 2022.

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

We had a total of $14.4 million invested in low-income housing tax credit funds as of December 31, 2023 and $10.1 million as of December 31, 2022, which are included in other assets rather than in our investment portfolio.

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

2022, 2021, and 2020.

Those investments have generated substantial tax credits over the past few years, with about $0.8 million in credits available for the 2023 tax year and $0.5 million in credits available for each of the tax years 2022, and 2021.

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

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Assets totaled $3.7 billion at December 31, 2023, an increase of $121.2 million, or 3%, for the year.

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

Deposits were up $64.6 million, or 2%.

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

Assets increased in 2023 primarily as a result of a $67.5 million increase in investment securities, a $37.1 million increase in gross loans, and a $15.2 million increase in other assets, net of a $5.6 million decrease in Bank owned premises and equipment.

Deposits declined $84.9 million, or 3%.

Total capital increased by $34.5 million, or 11%.

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

Loan and Lease Portfolio

The Company’s loan and lease portfolio represents the single largest portion of invested assets, substantially greater than the investment portfolio or any other asset category, and the quality and diversification of the loan and lease portfolio are important considerations when reviewing the Company’s financial condition.

The Loan and Lease Distribution table that follows sets forth by loan type the Company’s gross loans and leases outstanding, and the percentage distribution in each category at the dates indicated.

Loan Portfolio

The Company’s loan portfolio represents the single largest portion of invested assets, substantially greater than the investment portfolio or any other asset category, and the quality and diversification of the loan portfolio are important considerations when reviewing the Company’s financial condition.

The Loan Distribution table that follows sets forth by loan type the Company’s gross loans outstanding and the percentage distribution in each category at the dates indicated.

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

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

Loan and Lease Distribution

Loan Distribution

(dollars in thousands)

As of December 31,

1-4 family residential construction

Residential real estate

Commercial real estate

Other construction/land

1-4 family - closed-end

Multi-family residential

Commercial real estate - owner occupied

Commercial real estate - non-owner occupied

Total real estate

Commercial and industrial

Other commercial

Mortgage warehouse lines

Consumer loans

Total loans and leases

Allowance for credit losses on loans

Total loans and leases, net

Percentage of Total Loans and Leases

1-4 family residential construction

Total loans, net

Percentage of Total loans

Residential real estate

Commercial real estate

Other construction/land

1-4 family - closed-end

Multi-family residential

Commercial real estate - owner occupied

Commercial real estate - non-owner occupied

Total real estate

Commercial and industrial

Other commercial

Mortgage warehouse lines

Consumer loans

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

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

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

intense competition.

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

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

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

The Company’s loan balances increased $37.1 million or 2% in 2023.

The increase was primarily a result of a $50.6 million increase in mortgage warehouse utilization, $17.1 million increase in commercial real estate, and a $53.3 million increase in other commercial loans.

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

In particular there was a $46.1 million decrease in farmland, $12.2 million decrease in other construction and $25.4 million decrease in residential real estate.

Further, SBA PPP loan forgiveness resulted in a $1.3 million decline in loan balances, included in the other commercial loan variance noted above.

The increase in 2021 was mostly from the purchase of high quality jumbo mortgage pools early in the year.

For 2022, the Company had $173.1 million in loan purchases which were designed as a bridge to organic loan growth with the hiring of loan production teams in both 2023 and 2022.

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

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

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

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

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

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

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

This growth was a deliberate effort of our Northern and Southern market loan production teams and was facilitated by the opening of a loan production office in Northern California (Roseville, California) and an expansion of the loan team in Southern California.

This growth was complimented by an increase of $118.6 million, or 63% in mortgage warehouse lines and an increase of $93.5 million, or 82% in commercial and industrial loans due to our participation in the SBA PPP loan program.

Multi-family residential loans increased $7.4 million or 14%.

These increases were partially offset by declines in all other loan categories.

As demonstrated by the expansion of the lending teams both in 2023 and 2022, management remains focused on organic loan growth which totaled $185.3 million and $292.2 million, respectively during the years ending 2023 and 2022.

No assurance can be provided with regard to future net growth in aggregate loan balances given occasional surges in prepayments, fluctuations in mortgage warehouse lending and maintaining concentrations in certain sectors within our risk management parameters.

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

As a part of their regulatory oversight, the federal regulators have issued guidelines on sound risk management practices with respect to a financial institution’s concentrations in commercial real estate (“CRE”) lending activities.

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

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

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

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

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

This ratio was 246% at December 31, 2022 and declined to 243% at December 31, 2023.

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

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

At December 31, 2023, the Bank’s total construction, land development and other land loans represented 1% of Tier 1 risk-based capital plus allowance for credit losses on loans.

The Bank believes that it does not have a concentration in CRE loans at December 31, 2023, above the prudential regulatory guidelines note above.

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

Loan and Lease Maturities

The following table shows the maturity distribution for total loans and leases outstanding as of December 31, 2022, including non-accruing loans, grouped by remaining scheduled principal payments:

Loans and Lease Maturity

Loan Maturities

The following table shows the maturity distribution for total loans outstanding as of December 31, 2023, including non-accruing loans, grouped by remaining scheduled principal payments:

Loan Maturities

(dollars in thousands)

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Generally, the Company’s contractual life of loans matches the loan’s amortization period, which is generally 25 years.

Rates on loans longer than five years typically adjust starting before ten years and each five years thereafter.

Rates on nonresidential loans longer than five years typically adjust starting before ten years and each five years thereafter.

For a comprehensive discussion of the Company’s liquidity position, balance sheet repricing characteristics, and sensitivity to interest rates changes, refer to the “Liquidity and Market Risk” section of this discussion and analysis.

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Total line utilization, excluding mortgage warehouse and overdraft lines, was 62% at December 31, 2023 and 59% at December 31, 2022 and was 53% at December 31, 2023 and 32% at December 31, 2022, including mortgage warehouse lines.

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

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

Mortgage warehouse utilization increased to 36% at December 31, 2023, as compared to 10% at December 31, 2022.

Total mortgage warehouse availability declined to $204.5 million at December 31, 2023 as compared to $594.6 million at December 31, 2022.

With current industry volumes down due to decreased purchase and refinance activity we experienced some lenders leaving the Bank and others decreasing their lines of credit to match their current volumes.

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

Unused commitments represented approximately 20% of gross loans outstanding at December 31, 2023 and 40% at December 31, 2022.

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

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

The Company also had undrawn letters of credit issued to customers totaling $5.0 million at both December 31, 2023 and 2022.

Off-balance sheet obligations pose potential credit risk to the Company, and a $0.5 million reserve for unfunded commitments is reflected as a liability in our consolidated balance sheet at December 31, 2023, down $0.3 million from the previous year.

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

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Nonperforming assets (“NPAs”) are comprised of loans for which the Company is no longer accruing interest, and foreclosed assets which primarily consists of OREO.

If the Company grants a concession to a borrower in financial difficulty, the loan falls into the category of a troubled debt restructuring (“TDR”), which may be designated as either nonperforming or performing depending on the loan’s accrual status.

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

Nonperforming Assets and Performing TDRs

The following table presents comparative data for the Company’s NPAs as of the dates noted:

Nonperforming Assets

(dollars in thousands)

As of December 31,

Residential real estate

Commercial real estate

Other construction/land

1-4 family – closed-end

Commercial real estate – owner occupied

Commercial real estate – non-owner occupied

TOTAL REAL ESTATE

Commercial and industrial

Other commercial

Consumer loans

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Total nonperforming assets

Performing TDRs (1)

Loans deferred under CARES Act (1)

Nonperforming loans as a % of total gross loans and leases

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

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

Nonperforming loans as a % of total gross loans

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

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

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

NPAs decreased $3.1 million or 50% in 2021.

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

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

Consumer nonperforming loans were nominal at December 31, 2022.

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

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

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

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

At the end of 2021 foreclosed assets totaled $0.1 million, which was comprised of one property that was subsequently sold in 2022.

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

Allowance for Credit Losses/Allowance for Loan and Lease Losses

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

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

NPAs totaled $8.0 million, or 0.4% of gross loans plus foreclosed assets at the end of 2023, down from $19.6 million, or 1.0% of gross loans plus foreclosed assets at the end of 2022.

NPAs at the end of 2023 consist primarily of one commercial real estate loan secured by an office building for which foreclosure proceedings have been initiated.

NPAs increased $15.0 million or 324% in 2022.

Nonperforming loans secured by real estate comprised $7.9 million of total nonperforming loans at December 31, 2023, a decrease of $8.6 million, since December 31, 2022.

Nonperforming loans secured by real estate at December 31, 2023 is primarily composed of one non-owner occupied commercial real estate loan secured by an office building with a book balance of $7.5 million.

The Company had no foreclosed assets at December 31, 2023 and 2022.

When the Company has foreclosed asset, they are periodically evaluated and written down to their fair value less expected disposition costs, if lower than the then-current carrying value.

Allowance for Credit Losses/Allowance for Loan Losses

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

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

Specifically identifiable and quantifiable losses are immediately charged off against the allowance;

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

Note 2 to the consolidated financial statements provides a more comprehensive discussion of the accounting guidance we conform to and the methodology we use to determine an appropriate allowance for credit losses on loans and leases.

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

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

The Company’s allowance

for credit losses on loans was $23.5 million, or 1.12% of gross loans at December 31, 2023, relative to $23.1 million, or 1.12% of gross loans at December 31, 2022.

The increase in the allowance resulted from an increase in individual loan reserves, primarily as a result of a downgrade in the fourth quarter of 2023 of one commercial real estate loan on an office building.

This increase was partially offset by a five basis point decrease in qualitative reserves.

At December 31, 2023, nonaccrual loans totaled $8.0 million compared to $19.6 million at December 31, 2022.

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As described above, a separate allowance of $0.5 million for potential losses inherent in unused commitments is included in other liabilities at December 31, 2023.

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

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

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

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

The Company recorded a provision for credit losses on loans of $4.1 million in 2023 as compared to $10.9 million in 2022, and a loan loss benefit of $3.7 million in 2021.

Our credit allowance for expected losses on individually identified loans increased $1.5 million, 351% during 2023, and decreased $0.2 million, or 36%, during 2022.

The allowance for expected losses inherent in the remaining portfolio decreased by $1.1 million, or 5%.

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

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Consumer loans

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

Nonaccrual loans to gross loans and leases at end of period

Allowance for credit losses on loans and leases to nonaccrual loans

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

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

Nonaccrual loans to gross loans at end of period

Allowance for credit losses on loans to nonaccrual loans

Provided below is a summary of the allocation of the allowance for credit losses on loans for specific loan categories at the dates indicated.

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

Allocation of Allowance for Credit Losses on Loans and Leases

Allocation of Allowance for Credit Losses on Loans

(dollars in thousands)

As of December 31,

Commercial and industrial (2)

Other commercial (2)

Consumer loans

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(2) Includes mortgage warehouse lines

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

The Company’s allowance for credit losses on loans at December 31, 2023 represents Management’s best estimate of expected losses over the remaining contractual life of loans 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.

The Company adopted the current expected credit losses methodology on January 1, 2020, under FASB Accounting Standards Update 2016-03 and related amendments, Financial Instruments – Credit Losses (Topic 326) to January 1, 2022.

However, as previously noted under the Allowance for Loan and Lease Losses section above in March 2020, the Company elected under Section 4014 of the Coronavirus Aid, Relief, and Economic Security (CARES) Act to defer the implementation of CECL.

However, as previously noted under the Allowance for Loan Losses section above in March 2020, the Company elected under Section 4014 of the Coronavirus Aid, Relief, and Economic Security (CARES) Act to defer the implementation of CECL.

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

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

Upon adoption of CECL, the Company was required to make an adjustment to equity, net of taxes, equal to the difference between the allowance for credit losses calculated under the CECL method and the allowance for loan and lease losses as calculated under the incurred loss method as of December 31, 2021.

Upon adoption of CECL, the Company was required to make an adjustment to equity, net of taxes, equal to the difference between the allowance for credit losses calculated under the CECL method and the allowance for loan losses as calculated under the incurred loss method as of December 31, 2021.

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

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Aggregate investments totaled $1.3 billion, or 36% of total assets at December 31, 2023, as compared to $1.3 billion, or 35% of total assets at December 31, 2022.

As noted above, approximately $197 million in investments, with an unrealized loss of $14.5 million, were identified with an intent to sell at December 31, 2022, and were sold in January 2024.

We had no fed funds sold at the end of the reporting periods, and interest-bearing balances held primarily in our Federal Reserve Bank account totaled $3.7 million at December 31, 2023, as compared to $3.2 million at December 31, 2022.

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

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

The Company’s investment securities portfolio had a book balance of $1.3 billion at December 31, 2023and December 31, 2022.

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

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

The expected effective duration was 1.83 years for available-for-sale investments and 6.4 years for held-to-maturity investments at December 31, 2022, as compared to 3.2 years for available-for-sale investments at December 31, 2021.In the second and fourth quarters of 2022 the Company transferred $162.1 million and $198.3 million, respectively of “available for sale” investments to “held to maturity”.

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

The expected effective duration was 1.39 years for available-for-sale investments and 5.9 years for held-to-maturity investments at December 31, 2023, as compared to 1.83 years for available-for-sale investments and 6.4 years for held-to-maturity investments at December 31, 2022.

In early 2024, the Company initiated a strategic securities transaction by selling $196.7 million of bonds.

These securities were identified as an intent to be sold at December 31, 2023.

This transaction realized a $14.5 million loss in the fourth quarter of 2023.

The average yield on these bonds was 2.61% and the proceeds were used to paydown short-term borrowings at an average rate of 5.52%.

This transaction is expected to increase our earnings stream beginning in 2024 by increasing net interest income as interest expense on borrowed funds will be reduced by more than the reduction in interest income on the securities sold.

In the second and fourth quarters of 2022 the Company transferred $162.1 million and $198.3 million, respectively of “available for sale” investments to “held to maturity.” Those securities were transferred at fair market value on the date of the transfer.

The transfer was initiated to reduce the effect of potential future rate increases on accumulated other comprehensive income due to changes in estimated fair value.

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

Investment Portfolio-Available for Sale

Investment Portfolio

(dollars in thousands)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

In addition, the Company determined there was a $0.02 million credit loss expected on the held-to-maturity debt securities portfolio which was recorded as an allowance for credit losses on held-to-maturity securities.

Investment securities that were pledged as collateral for Federal Home Loan Bank borrowings, repurchase agreements, public deposits and other purposes as required or permitted by law totaled $183.5 million at December 31, 2022 and $167.2 million at December 31, 2021, leaving $1.1 billion in unpledged debt securities at December 31, 2022 and $806.1 million at December 31, 2021.

Investment securities that were pledged as collateral for Federal Home Loan Bank borrowings, repurchase agreements, public deposits and other purposes as required or permitted by law totaled $543.9 million at December 31, 2023 and $165.8 million at December 31, 2022, leaving $793.0 million in unpledged debt securities at December 31, 2023 and $1.1 billion in unpledged debt securities at December 31, 2022.

Securities that were pledged in excess of actual pledging needs and were thus available for liquidity purposes, if needed, totaled $383.0 million at December 31, 2023 and $43.1 million at December 31, 2022.

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Leasehold improvements

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

The net book value of the Company’s premises and equipment was 0.5% of total assets at December 31, 2023, and 0.6% of total assets at December 31, 2022.

Depreciation and amortization included in occupancy and equipment expense totaled $2.2 million in 2023 and $2.4 million in 2022.

In December 2023, the Company sold 11 Bank owned branch buildings with a book value of $4.8 million, for a gain on sale of $15.3 million.

These branch buildings were subsequently leased back to the Company and are reflected in footnote 6 of the Financial Statements.

Goodwill totaled $27.4 million at December 31, 2023, unchanged for the year and other intangible assets were $1.4 million, a decrease of $0.9 million, or 39%, as a result of amortization expense recorded on core deposit intangibles.

The Company’s goodwill and other intangible assets are evaluated annually for potential impairment following FASB guidelines and based on those analytics Management has determined that no impairment exists as of December 31, 2023.

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

The net cash surrender value of bank-owned life insurance policies decreased to $51.6 million at December 31, 2023 from $52.2 million at December 31, 2022, due to certain death benefits paid on former officers of the Company and the decline of BOLI income from net cash surrender values.

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

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

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

The total operating lease right-of-use asset recorded on the books is $30.5 million less accumulated amortization of $4.7 million.

The bank stocks include Pacific Coast Bankers Bank stock and restricted stock related to the Federal Home Loan Bank of San Francisco stock held in conjunction with our FHLB borrowings and is not deemed to be marketable or liquid.

The bank stocks include Pacific Coast Bankers Bank (PCBB) stock (marked to market value annually) and restricted stock related to the Federal Home Loan Bank of San Francisco (FHLB SF) stock held in conjunction with our FHLB borrowings.

Both the PCBB and FHLB SF stock is not deemed to be marketable or liquid.

Our net deferred tax asset is evaluated as of every reporting date pursuant to FASB guidance, and we have determined that no impairment exists.

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Deposits provide liquidity to fund growth in earning assets, and the Company’s net interest margin is improved to the extent that growth in deposits is concentrated in less volatile and typically less costly non-maturity deposits such as demand deposit accounts, NOW accounts, savings accounts, and money market demand accounts.

distribution of the Company’s deposits showing the period-end balance and percentage of total deposits by type is presented as of the dates noted in the following table:

Information concerning average balances and rates paid by deposit type for the past three fiscal years is contained in the Distribution, Rate, and Yield table located in the previous section under “Results of Operations–Net Interest Income and Net Interest Margin.” A distribution of the Company’s deposits showing the period-end balance and percentage of total deposits by type is presented as of the dates noted in the following table:

Deposit Distribution

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Brokered deposits

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

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

Noninterest bearing demand deposit balances were up $3.7 million;

Deposit balances reflected a decline of $84.9 million, or 3%, in 2023 and $64.6 million, or 2%, in 2022.

The 2023 decline in deposits came primarily from a $175.1 million decrease in transaction accounts, an $80.4 million decrease in savings and money market accounts offset by an increase in customer time deposit balances of $155.5 million as customers moved their funds to higher interest-bearing type accounts and a $15.0 million increase in wholesale brokered deposits.

The increase in 2022 was primarily from brokered deposits.

Noninterest bearing demand deposit balances were down $67.4 million or 6%;

NOW and interest-bearing demand accounts decreased by $107.6 million, or 17% in 2023.

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Uninsured time deposits

See Liquidity and Market Risk Management below in this 10-K for a discussion on liquidity management the Company maintains to meet liquidity needs under unusual conditions such as uncommon deposit outflows of uninsured deposits.

Other Borrowings

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

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

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

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

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

Total non-deposit interest-bearing liabilities increased $139.7 million, or 28%, in 2023, due primarily to increases in term FHLB advances.

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

The Company had $130.0 million in overnight fed funds purchased, $25.5 million in overnight FHLB advances, and $205.0 million in term FHLB advances at December 31, 2023 as compared to, $125.0 million in overnight fed funds purchased and $94.0 million in overnight FHLB advances at December 31, 2022.

There were no FHLB term advances at December 31, 2022.

Repurchase agreements totaled $107.1 million at year-end 2023 relative to a balance of $109.2 million at year-end 2022.

As noted above, after year end, the Company sold approximately $197 million in bonds and used the proceeds to pay down overnight and short-term advances.

Repurchase agreements represent “sweep accounts”, where commercial deposit balances above a specified threshold are transferred at the close of each business day into non-deposit accounts secured by investment securities.

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The Company’s balance of other liabilities increased by $32.2 million, or 71%, during 2023.

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

The primary reason for this increase was due to the change in the Company’s operating lease liability stemming from the sale leaseback transaction of 11 Bank-owned buildings discussed in “ Premises and Equipment ”.

The Company also committed funds to a new Small Business Investment Company and a Low Income Housing Tax Credit Fund.

An increase in accrued interest payable was also a factor due to the increase in interest rates in 2023.

Capital Resources

The Company had total shareholders’ equity of $338.1 million at December 31, 2023 as compared to $303.6 million at December 31, 2022.

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

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

The increase of $34.5 million, or 11%, is due to $34.8 million in net income and a $20.6 million favorable swing in accumulated other comprehensive income partially offset by $13.7 million in dividends paid, and $8.5 million in share repurchases.

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

The federal banking agencies published a final rule on November 13, 2019, that provided a simplified measure of capital adequacy for qualifying community banking organizations.

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The final rule became effective January 1, 2020 and banks that met the qualifying criteria were able to elect to use the community bank leverage framework starting with the quarter ended March 31, 2020.

The CARES Act reduced the required community bank leverage ratio to 8% until the earlier of December 31, 2020, or the national emergency is declared over.

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

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

The Company uses a variety of

measures to evaluate its capital adequacy, including the community bank leverage ratio, and risk-based capital and leverage ratios in preceding years, that are calculated separately for the Company and the Bank.

Management reviews these capital measurements on a quarterly basis and takes appropriate action to help ensure that they meet or surpass established internal and external guidelines.

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

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

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

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

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

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

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

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

Similarly, as described above, the Company moved $360.4

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

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

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

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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.

Detailed cash flow projections are reviewed by Management on a quarterly 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.

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.

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

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

As of December 31, 2023, unpledged debt securities plus pledged securities in excess of current pledging requirements comprised $1.2 billion of the Company’s investment balances, as compared to $1.1 billion at December 31, 2022.

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

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Funds available through fed discount window

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

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

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

The Company’s primary liquidity ratio and net loans to deposits ratio was 31% and 76%, respectively, at December 31, 2023, as compared to internal policy guidelines of “greater than 15%” and “less than 95%.” Other liquidity ratios reviewed periodically by Management and the Board include the Community Bank leverage ratio, net change in overnight position and wholesale funding to total assets (including ratios and sub-limits for the various components comprising wholesale funding).

All ratios were within policy guidelines at December 31, 2023, except for the non-core funding dependence ratio.

At 25.15% this ratio was 15 basis points above the policy guideline of “less than 25%.” With the “Securities Strategy” completed in January of 2024 it is anticipated that this ratio will come into policy guideline.

Nevertheless, management is closely watching all Company liquidity metrics and will take appropriate action if deemed necessary.

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

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At December 31, 2023, the holding company maintained a cash balance of $10.4 million.

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

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

Interest Rate Risk Management

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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.

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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December 31, 2022

% Change in Net

$ Change in Net

% Change in Net

$ Change in Net

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

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

Interest Income

The simulation for the period ending December 31, 2023, indicates that the Company is slightly asset sensitive, with net interest income increasing in rising rate scenarios and declining in decreasing rate scenarios, with a continued drop in interest rates having the most substantial negative impact.

The change in the magnitude of the Company’s asset sensitivity based on its interest rate risk model at December 31, 2023, as compared to December 31, 2022, is due mostly to the decrease in the level of overnight borrowings both in Fed Funds purchased and overnight FHLB borrowings.

In addition, adding to our asset sensitivity, variable rate investment securities in the form of CLOs increased $72.3 million along with a change in the mix of fixed rate versus variable rate loans in 2023 as compared to 2022.

At December 31, 2023, the Company had $155.0 million in overnight borrowings as compared to $219.0 million in overnight borrowings at December 31, 2022.

The securities strategy mentioned earlier enabled most of the overnight borrowings to be paid off in early January.

These overnight borrowings had an average rate of 5.52% while the bonds sold had an average book yield of 2.61%.

The Company has approximately $204.5 million of unfunded mortgage warehouse lines at December 31, 2023.

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

For the period ending December 31, 2022, the simulation indicated that the Company was slightly liability sensitive, with net interest income decreasing in rising and declining rate scenarios, with a continued drop in interest rates having the

most substantial negative impact.

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

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

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

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

At December 31, 2021, the Company had $193.2 million in overnight cash with the Federal Reserve Bank compared to $2.4 million at December 31, 2020.

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

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

When no balance sheet growth is incorporated and a stable interest rate environment is assumed, projected annual net interest income is about $11.7 million lower, or 9% than in our standard simulation.

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

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

The difference between the projected fair value of the Company’s financial

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

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 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.

The table below shows estimated changes in the Company’s EVE as of December 31, 2022, and 2021, under different interest rate scenarios relative to a base case of current interest rates (dollars in thousands):

December 31, 2022

December 31, 2021

Immediate change in Interest Rates (basis points)

% Change in Fair Value of Equity

$ Change in Fair Value of Equity

% Change in Fair Value of Equity

$ Change in Fair Value of Equity

The table shows that our EVE will generally deteriorate in declining rate scenarios but should benefit from a parallel shift upward in the yield curve.

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

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

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

All up-shock scenarios fall within Policy guidelines.

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

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

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.

However, the stressed simulations reveal that the Company’s greatest potential pressure on net interest income would result from the declining rate scenarios, in which our net interest income could reduce by 10% in the event of a 300 basis point downward shock.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

What changed 10-K

Item 7. Management’s Discussion and Analysis