Bankwell Financial Group, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations This section presents management’s perspective on our financial condition and results of operations. The following discussion and analysis should be read in conjunction with the unaudited interim consolidated financial statements and related notes contained elsewhere in this report on Form 10-Q. To the extent that this discussion describes prior performance, the descriptions relate only to the periods listed, which may not be indicative of future financial outcomes. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause results to differ materially from management’s expectations. Factors that could cause such differences are discussed in the Company’s Form 10-K filed for the year ended December 31, 2021 in the sections titled “Cautionary Note Regarding Forward-Looking Statements” and “Risk Factors.” We assume no obligation to update any of these forward-looking statements. General Bankwell Financial Group, Inc. is a bank holding company headquartered in New Canaan, Connecticut. Through our wholly owned subsidiary, Bankwell Bank, or the Bank, we serve small and medium-sized businesses and retail customers. We have a history of building long-term customer relationships and attracting new customers through what we believe is our strong customer service and our ability to deliver a diverse product offering. The following discussion and analysis presents our results of operations and financial condition on a consolidated basis. However, because we conduct all of our material business operations through the Bank, the discussion and analysis relates to activities primarily conducted at the Bank. We generate most of our revenue from interest on loans and investments and fee-based revenues. Our primary source of funding for our loans is deposits. Our largest expenses are interest on deposits and salaries and related employee benefits. We measure our performance primarily through our net interest margin, efficiency ratio, ratio of allowance for loan losses to total loans, return on average assets and return on average equity, among other metrics, while maintaining appropriate regulatory leverage and risk-based capital ratios. Executive Overview We are focused on being the banking provider of choice and to serve as an alternative to our larger competitors. We aim to do this through: • Responsive, customer-centric products and services and a community focus; • Organic growth and strategic acquisitions when market opportunities present themselves; • Utilization of efficient and scalable infrastructure; and • Disciplined focus on risk management. Critical Accounting Policies and Estimates The discussion and analysis of our results of operations and financial condition are based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires us to make significant estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from our current estimates, as a result of changing conditions and future events. We believe that accounting estimates related to the measurement of the allowance for loan losses, the valuation of derivative instruments, investment securities and deferred income taxes, and the evaluation of investment securities for other than temporary impairment are particularly critical and susceptible to significant near-term change. 43 Earnings and Performance Overview For the three months ended September 30, 2022, net interest income was $24.6 million, an increase of $6.9 million or 38.8% when compared to the same period in 2021. For the nine months ended September 30, 2022, net interest income was $67.9 million, an increase of $19.0 million or 38.8% when compared to the same period in 2021. The increase in net interest income for the three and nine months ended September 30, 2022 was primarily due to an increase in interest and fees on loans due to loan growth and higher overall loan yields. The increase in loan yields was aided by elevated loan prepayment fees, which totaled $1.3 million for the three months ended September 30, 2022, compared to $0.1 million for the three months ended September 30, 2021. The increase in net interest income for the three months ended September 30, 2022 was partially offset by an increase in interest expense on deposits, resulting from an increase in rates necessary to remain competitive in the current economic environment. Noninterest income decreased $1.0 million to $0.4 million for the three months ended September 30, 2022 compared to the same period in 2021. Noninterest income decreased $2.3 million to $2.5 million for the nine months ended September 30, 2022 compared to the same period in 2021. The decrease in noninterest income was driven by a reduction in loan sales for the three and nine months ended September 30, 2022 when compared to the same periods in 2021. Loan sales decreased $0.9 million and $1.0 million for the three and nine months ended September 30, 2022, respectively. The Company intends to resume loan sales in 2023. In addition, noninterest income declined due to the absence of rental income recognized during the three and nine months ended September 30, 2021, as a result of the disposition of the Company's former headquarters building. Noninterest income also declined for the nine months ended September 30, 2022 due to a one-time federal payroll tax credit for COVID-19 of $0.9 million recognized in the three months ended March 31, 2021. Net income available to common shareholders was $9.2 million, or $1.18 per diluted share, and $6.9 million, or $0.87 per diluted share, for the three months ended September 30, 2022 and 2021, respectively. Net income available to common shareholders was $29.4 million, or $3.75 per diluted share, and $18.8 million, or $2.37 per diluted share, for the nine months ended September 30, 2022 and 2021, respectively. The increase in net income was primarily impacted by the aforementioned increases in net interest income, partially offset by an increase in noninterest expense and the provision for loan losses primarily driven by loan growth for the three and nine months ended September 30, 2022. Returns on average shareholders' equity and average assets for the three months ended September 30, 2022 were 15.73% and 1.47%, respectively, compared to 14.09% and 1.22%, respectively, for the three months ended September 30, 2021. Returns on average shareholders' equity and average assets for the nine months ended September 30, 2022 were 17.94% and 1.59%, respectively, compared to 13.29% and 1.12%, respectively, for the nine months ended September 30, 2021. Results of Operations Net Interest Income Net interest income is the difference between interest earned on loans and securities and interest paid on deposits and other borrowings, and is the primary source of our operating income. Net interest income is affected by the level of interest rates, changes in interest rates and changes in the amount and composition of interest earning assets and interest bearing liabilities. Included in interest income are certain loan fees, such as deferred origination fees and late charges. We convert tax-exempt income to a fully taxable equivalent ("FTE") basis using the statutory federal income tax rate adjusted for applicable state income taxes net of the related federal tax benefit. The average balances are principally daily averages. Interest income on loans includes the effect of deferred loan fees and costs accounted for as yield adjustments. Premium amortization and discount accretion are included in the respective interest income and interest expense amounts. FTE net interest income for the three months ended September 30, 2022 and 2021 was $24.7 million and $17.8 million, respectively. FTE net interest income for the nine months ended September 30, 2022 and 2021 was $68.1 million and $49.1 million, respectively. FTE interest income for the three months ended September 30, 2022 increased by $9.1 million, or 43.9%, to $29.7 million, compared to FTE interest income for the three months ended September 30, 2021. FTE interest income for the nine months ended September 30, 2022 increased by $18.9 million, or 31.6%, to $78.5 million, compared to FTE interest income for the nine months ended September 30, 2021. This increase was due to an increase in interest and fees on loans due to loan growth and higher overall loan yields. The increase in loan yields was aided by elevated loan prepayment fees, which totaled $1.3 million for the three months ended September 30, 2022, compared to $0.1 million for the three months ended September 30, 2021. 44 Interest expense for the three months ended September 30, 2022 increased by $2.2 million, or 76.0%, compared to interest expense for the three months ended September 30, 2021. Interest expense for the nine months ended September 30, 2022 decreased by $0.1 million, or 1.0%, compared to interest expense for the nine months ended September 30, 2021. The increase in interest expense for the three months ended September 30, 2022 was driven by an increase in interest expense on deposits, resulting from an increase in rates necessary to remain competitive in the current economic environment. The net interest margin increased by 73 basis points to 4.12% for the three months ended September 30, 2022, compared to the three months ended September 30, 2021 and the net interest margin increased by 73 basis points to 3.81% for the nine months ended September 30, 2022, compared to the nine months ended September 30, 2021. The increase in the net interest margin was due to an increase in overall loan yields and, to a lesser extent, elevated loan prepayment fees. 45 Distribution of Assets, Liabilities and Shareholders’ Equity; Interest Rates and Interest Differential The following tables present the average balances and yields earned on interest earning assets and average balances and weighted average rates paid on our funding liabilities for the three and nine months ended September 30, 2022 and 2021. Three Months Ended September 30, 2022 2021 (Dollars in thousands) Average Balance Interest Yield / Rate (4) Average Balance Interest Yield / Rate (4) Assets: Cash and Fed funds sold $ 130,440 $ 747 2.27 % $ 209,500 $ 88 0.17 % Securities (1) 120,092 829 2.76 105,030 766 2.92 Loans: Commercial real estate 1,512,381 18,830 4.87 1,270,375 14,345 4.42 Residential real estate 62,915 586 3.72 95,100 809 3.40 Construction 116,256 1,512 5.09 88,728 845 3.73 Commercial business 431,917 7,058 6.39 314,484 3,707 4.61 Consumer 12,145 142 4.65 8,870 89 3.99 Total loans 2,135,614 28,128 5.15 1,777,557 19,795 4.36 Federal Home Loan Bank stock 5,021 31 2.51 3,133 16 2.04 Total earning assets 2,391,167 $ 29,735 4.87 % 2,095,220 $ 20,665 3.86 % Other assets 89,173 131,670 Total assets $ 2,480,340 $ 2,226,890 Liabilities and shareholders' equity: Interest bearing liabilities: NOW $ 119,593 $ 52 0.17 % $ 111,813 $ 51 0.18 % Money market 828,541 2,346 1.12 824,203 1,053 0.51 Savings 189,279 474 0.99 182,848 96 0.21 Time 557,243 1,220 0.87 448,218 1,187 1.05 Total interest bearing deposits 1,694,656 4,092 0.96 1,567,082 2,387 0.60 Borrowed money 135,221 993 2.87 72,960 503 2.70 Total interest bearing liabilities 1,829,877 $ 5,085 1.10 % 1,640,042 $ 2,890 0.70 % Noninterest bearing deposits 383,048 341,303 Other liabilities 36,037 52,552 Total Liabilities 2,248,962 2,033,897 Shareholders' equity 231,378 192,993 Total liabilities and shareholders' equity $ 2,480,340 $ 2,226,890 Net interest income (2) $ 24,650 $ 17,775 Interest rate spread 3.77 % 3.16 % Net interest margin (3) 4.12 % 3.39 % (1) Average balances and yields for securities are based on amortized cost. (2) The adjustment for securities and loans taxable equivalency amounted to $49 thousand and $51 thousand for the three months ended September 30, 2022 and 2021, respectively. (3) Annualized net interest income as a percentage of earning assets. (4) Yields are calculated using the contractual day count convention for each respective product type. 46 Nine Months Ended September 30, 2022 2021 (Dollars in thousands) Average Balance Interest Yield / Rate (4) Average Balance Interest Yield / Rate (4) Assets: Cash and Fed funds sold $ 240,252 $ 1,350 0.75 % $ 315,102 $ 286 0.12 % Securities (1) 117,008 2,392 2.73 103,192 2,315 2.99 Loans: Commercial real estate 1,433,642 51,104 4.70 1,188,049 40,802 4.53 Residential real estate 67,705 1,810 3.56 104,320 2,669 3.41 Construction 108,249 4,482 5.46 97,828 2,769 3.73 Commercial business 402,876 17,011 5.57 302,019 10,495 4.58 Consumer 7,844 290 4.94 7,601 226 3.97 Total loans 2,020,316 74,697 4.88 1,699,817 56,961 4.42 Federal Home Loan Bank stock 3,715 61 2.19 4,608 72 2.09 Total earning assets 2,381,291 $ 78,500 4.35 % 2,122,719 $ 59,634 3.70 % Other assets 89,747 119,098 Total assets $ 2,471,038 $ 2,241,817 Liabilities and shareholders' equity: Interest bearing liabilities: NOW $ 122,792 $ 158 0.17 % $ 110,637 $ 148 0.18 % Money market 909,106 4,672 0.69 781,178 2,944 0.50 Savings 194,013 678 0.47 170,749 313 0.24 Time 487,792 2,773 0.76 532,278 4,840 1.22 Total interest bearing deposits 1,713,703 8,281 0.65 1,594,842 8,245 0.69 Borrowed money 101,685 2,137 2.77 108,737 2,280 2.77 Total interest bearing liabilities 1,815,388 $ 10,418 0.77 % 1,703,579 $ 10,525 0.83 % Noninterest bearing deposits 398,728 303,421 Other liabilities 37,784 46,023 Total Liabilities 2,251,900 2,053,023 Shareholders' equity 219,138 188,794 Total liabilities and shareholders' equity $ 2,471,038 $ 2,241,817 Net interest income (2) $ 68,082 $ 49,109 Interest rate spread 3.58 % 2.87 % Net interest margin (3) 3.81 % 3.08 % (1) Average balances and yields for securities are based on amortized cost. (2) The adjustment for securities and loans taxable equivalency amounted to $148 thousand and $151 thousand for the nine months ended September 30, 2022 and 2021, respectively. (3) Annualized net interest income as a percentage of earning assets. (4) Yields are calculated using the contractual day count convention for each respective product type. 47 Effect of changes in interest rates and volume of average earning assets and average interest bearing liabilities The following table shows the extent to which changes in interest rates and changes in the volume of average earning assets and average interest bearing liabilities have affected net interest income. For each category of earning assets and interest bearing liabilities, information is provided relating to: changes in volume (changes in average balances multiplied by the prior year’s average interest rates); changes in rates (changes in average interest rates multiplied by the prior year’s average balances); and the total change. Changes attributable to both volume and rate have been allocated proportionately based on the relationship of the absolute dollar amount of change in each. Three Months Ended September 30, 2022 vs 2021 Increase (Decrease) Nine Months Ended September 30, 2022 vs 2021 Increase (Decrease) (In thousands) Volume Rate Total Volume Rate Total Interest and dividend income: Cash and Fed funds sold $ (45) $ 704 $ 659 $ (83) $ 1,147 $ 1,064 Securities 105 (42) 63 293 (216) 77 Loans: Commercial real estate 2,915 1,570 4,485 8,705 1,597 10,302 Residential real estate (294) 71 (223) (974) 115 (859) Construction 306 361 667 320 1,393 1,713 Commercial business 1,643 1,708 3,351 3,957 2,559 6,516 Consumer 37 16 53 7 57 64 Total loans 4,607 3,726 8,333 12,015 5,721 17,736 Federal Home Loan Bank stock 11 4 15 (14) 3 (11) Total change in interest and dividend income 4,678 4,392 9,070 12,211 6,655 18,866 Interest expense: Deposits: NOW 3 (2) 1 15 (5) 10 Money market 6 1,287 1,293 537 1,191 1,728 Savings 3 375 378 47 318 365 Time 260 (227) 33 (377) (1,690) (2,067) Total deposits 272 1,433 1,705 222 (186) 36 Borrowed money 455 35 490 (148) 5 (143) Total change in interest expense 727 1,468 2,195 74 (181) (107) Change in net interest income $ 3,951 $ 2,924 $ 6,875 $ 12,137 $ 6,836 $ 18,973 Provision for Loan Losses The provision for loan losses is based on management’s periodic assessment of the adequacy of our allowance for loan losses which, in turn, is based on interrelated factors such as the composition of our loan portfolio and its inherent risk characteristics, the level of nonperforming loans and net charge-offs, both current and historic, local economic and credit conditions, the direction of real estate values, and regulatory guidelines. The provision for loan losses is charged against earnings in order to maintain our allowance for loan losses and reflects management’s best estimate of probable losses inherent in our loan portfolio as of the balance sheet date. The provision for loan losses for the three months ended September 30, 2022 was $2.4 million compared to a provision for loan losses of $134.0 thousand for the three months ended September 30, 2021. The provision for loan losses for the nine months ended September 30, 2022 was $1.2 million compared to a credit for loan losses of $0.2 million for the nine months ended September 30, 2021. The increase in the provision for loan losses for the three and nine months ended September 30, 2022 was primarily driven by loan growth. 48 Noninterest Income Noninterest income is a component of our revenue and is comprised primarily of fees generated from deposit relationships with our customers, fees generated from sales and referrals of loans, income earned on bank-owned life insurance and gains on sales of investment securities. The following tables compare noninterest income for the three and nine months ended September 30, 2022 and 2021: Three Months Ended September 30, Change (Dollars in thousands) 2022 2021 $ % Bank-owned life insurance $ 271 $ 271 $ — — % Service charges and fees 240 199 41 20.6 (Losses) gains and fees from sales of loans (15) 924 (939) (101.6) Other (94) 43 (137) (318.6) Total noninterest income $ 402 $ 1,437 $ (1,035) (72.0) % Nine Months Ended September 30, Change (Dollars in thousands) 2022 2021 $ % Gains and fees from sales of loans $ 1,224 $ 2,251 $ (1,027) (45.6) % Bank-owned life insurance 796 753 43 5.7 Service charges and fees 729 615 114 18.5 Other (237) 1,213 (1,450) (119.5) Total noninterest income $ 2,512 $ 4,832 $ (2,320) (48.0) % Noninterest income decreased by $1.0 million to $0.4 million for the three months ended September 30, 2022 compared to the three months ended September 30, 2021. Noninterest income decreased by $2.3 million to $2.5 million for the nine months ended September 30, 2022 compared to the nine months ended September 30, 2021. The decrease in noninterest income was driven by a reduction in loan sales for the three and nine months ended September 30, 2022 when compared to the same periods in 2021. Loan sales decreased $0.9 million and $1.0 million for the three and nine months ended September 30, 2022, respectively. In addition, noninterest income declined due to the absence of rental income recognized during the three and nine months ended September 30, 2021, as a result of the disposition of the Company's former headquarters building. Noninterest income also declined for the nine months ended September 30, 2022 due to a one-time federal payroll tax credit for COVID-19 of $0.9 million recognized in the quarter ended March 31, 2021. 49 Noninterest Expense The following tables compare noninterest expense for the three and nine months ended September 30, 2022 and 2021: Three Months Ended September 30, Change (Dollars in thousands) 2022 2021 $ % Salaries and employee benefits $ 5,876 $ 4,782 $ 1,094 22.9 % Occupancy and equipment 2,035 2,615 (580) (22.2) Professional services 994 498 496 99.6 Data processing 626 632 (6) (0.9) Director fees 325 324 1 0.3 FDIC insurance 255 298 (43) (14.4) Marketing 102 186 (84) (45.2) Other 818 1,035 (217) (21.0) Total noninterest expense $ 11,031 $ 10,370 $ 661 6.4 % Nine Months Ended September 30, Change (Dollars in thousands) 2022 2021 $ % Salaries and employee benefits $ 16,249 $ 13,511 $ 2,738 20.3 % Occupancy and equipment 6,378 8,271 (1,893) (22.9) Professional services 2,975 1,632 1,343 82.3 Data processing 1,969 1,977 (8) (0.4) Director fees 1,016 968 48 5.0 FDIC insurance 740 1,001 (261) (26.1) Marketing 254 317 (63) (19.9) Other 2,311 2,383 (72) (3.0) Total noninterest expense $ 31,892 $ 30,060 $ 1,832 6.1 % Noninterest expense increased by $0.7 million to $11.0 million for the three months ended September 30, 2022 compared to the three months ended September 30, 2021. Noninterest expense increased by $1.8 million to $31.9 million for the nine months ended September 30, 2022 compared to the nine months ended September 30, 2021. The increase in noninterest expense was primarily driven by an increase in salaries and employee benefits expense and professional services expense, partially offset by a decrease in occupancy and equipment expense. Salaries and employee benefits expense totaled $5.9 million for the three months ended September 30, 2022, an increase of $1.1 million when compared to the same period in 2021. Salaries and employee benefits expense totaled $16.2 million for the nine months ended September 30, 2022, an increase of $2.7 million when compared to the same period in 2021. The increase in salaries and employee benefits expense was driven by an increase in full time equivalent employees, as well as an increase in variable compensation as a result of the Bank's overall growth and improved performance. Full time equivalent employees totaled 140 at September 30, 2022 compared to 134 for the same period in 2021. Average full time equivalent employees totaled 131 for the nine months ended September 30, 2022 compared to 127 for the same period in 2021. The increase in salaries and employee benefits expense was partially offset by higher loan originations, which enabled the Bank to defer a greater amount of expenses. Professional services expense totaled $1.0 million for the three months ended September 30, 2022, an increase of $0.5 million when compared to the same period in 2021. Professional services expense totaled $3.0 million for the nine months ended September 30, 2022, an increase of $1.3 million when compared to the same period in 2021. The increase in professional services expense was primarily driven by consulting fees associated with various projects, including our core system conversion. 50 Occupancy and equipment expense totaled $2.0 million for the three months ended September 30, 2022, a decrease of $0.6 million when compared to the same period in 2021. Occupancy and equipment expense totaled $6.4 million for the nine months ended September 30, 2022, a decrease of $1.9 million when compared to the same period in 2021. The decrease in occupancy and equipment expense was primarily driven by the curtailment of additional cleaning costs associated with precautions taken to prevent the spread of COVID-19 during the nine months ended September 30, 2021. In addition, the decrease in occupancy and equipment expense was impacted by a reduction in lease expense as a result of the branch closure in New Canaan, which occurred during the third quarter of 2021. Income Taxes Income tax expense for the three months ended September 30, 2022 and 2021 totaled $2.4 million and $1.8 million, respectively. The effective tax rates for the three months ended September 30, 2022 and 2021 were 20.9% and 20.8%, respectively. Income tax expense for the nine months ended September 30, 2022 and 2021 totaled $8.0 million and $5.1 million, respectively. The effective tax rates for the nine months ended September 30, 2022 and 2021 were 21.3% and 21.5%, respectively. Financial Condition Summary At September 30, 2022 total assets were $2.7 billion, a $266.7 million, or 10.9% increase, compared to December 31, 2021. The increase in assets was primarily due to loan growth and a corresponding increase in deposits and borrowings. Gross loans totaled $2.3 billion at September 30, 2022, an increase of $391.9 million compared to December 31, 2021. Deposits totaled $2.3 billion at September 30, 2022, compared to $2.1 billion at December 31, 2021. Total shareholders’ equity at September 30, 2022 and December 31, 2021 was $231.5 million and $202.0 million, respectively. The increase in shareholders' equity was primarily driven by (i) net income of $29.4 million for the nine months ended September 30, 2022 and (ii) an $8.4 million favorable impact to accumulated other comprehensive income driven by fair value marks related to hedge positions involving interest rate swaps, partially offset by fair value marks on the Company's investment portfolio. The Company's interest rate swaps are used to hedge interest rate risk. The increase in shareholders’ equity was partially offset by dividends paid of $4.7 million and common stock repurchases of $5.5 million. Loan Portfolio We originate commercial real estate loans, including construction loans, commercial business loans and other consumer loans. Our loan portfolio is the largest category of our earning assets. Total loans before deferred loan fees and the allowance for loan losses were $2.29 billion at September 30, 2022 and $1.89 billion at December 31, 2021. Total gross loans increased $391.9 million as of September 30, 2022 compared to the year ended December 31, 2021. The following table compares the composition of our loan portfolio for the dates indicated: (In thousands) At September 30, 2022 At December 31, 2021 Change Real estate loans: Residential $ 61,664 $ 79,987 $ (18,323) Commercial 1,647,928 1,356,709 291,219 Construction 117,355 98,341 19,014 1,826,947 1,535,037 291,910 Commercial business 443,288 350,975 92,313 Consumer 16,558 8,869 7,689 Total loans $ 2,286,793 $ 1,894,881 $ 391,912 51 Asset Quality We actively manage asset quality through our underwriting practices and collection operations. Our Board of Directors monitors credit risk management. The Directors Loan Committee ("DLC") has primary oversight responsibility for the credit-granting function including approval authority for credit-granting policies, review of management’s credit-granting activities and approval of large exposure credit requests, as well as loan review and problem loan management and resolution. The committee reports the results of its respective oversight functions to our Board of Directors. In addition, our Board of Directors receives information concerning asset quality measurements and trends on a monthly basis. While we continue to adhere to prudent underwriting standards, our loan portfolio is not immune to potential negative consequences as a result of general economic weakness, such as a prolonged downturn in the housing market on a national scale. Decreases in real estate values could adversely affect the value of property used as collateral for loans. In addition, adverse changes in the economy could have a negative effect on the ability of borrowers to make scheduled loan payments, which would likely have an adverse impact on earnings. The Company has established credit policies applicable to each type of lending activity in which it engages. The Company evaluates the creditworthiness of each customer and extends credit of up to 80% of the market value of the collateral, depending on the borrower's creditworthiness and the type of collateral. The borrower’s ability to service the debt is monitored on an ongoing basis. Real estate is the primary form of collateral. Other important forms of collateral are business assets, time deposits and marketable securities. While collateral provides assurance as a secondary source of repayment, the Company ordinarily requires the primary source of repayment for commercial loans, to be based on the borrower’s ability to generate continuing cash flows. In the fourth quarter of 2017 management made the strategic decision to no longer originate residential mortgage loans. As of the beginning of the third quarter of 2019, the Company no longer offered home equity loans or lines of credit. The Company’s policy for residential lending generally required that the amount of the loan may not exceed 80% of the original appraised value of the property. In certain situations, the amount may have exceeded 80% LTV either with private mortgage insurance being required for that portion of the residential loan in excess of 80% of the appraised value of the property or where secondary financing is provided by a housing authority program second mortgage, a community’s low/moderate income housing program, or a religious or civic organization. Credit risk management involves a partnership between our relationship managers and our credit approval, portfolio management, credit administration and collections personnel. Disciplined underwriting, portfolio monitoring and early problem recognition are important aspects of maintaining our high credit quality standards and low levels of nonperforming assets since our inception in 2002. Nonperforming assets . Nonperforming assets include nonaccrual loans and property acquired through foreclosures or repossession. The following table presents nonperforming assets and additional asset quality data for the dates indicated: (In thousands) At September 30, 2022 At December 31, 2021 Nonaccrual loans: Real estate loans: Residential $ 2,137 $ 2,380 Commercial 2,894 3,482 Commercial business 2,380 1,728 Construction 9,382 8,997 Total nonaccrual loans 16,793 16,587 Other real estate owned — — Total nonperforming assets $ 16,793 $ 16,587 Nonperforming assets to total assets 0.62 % 0.68 % Nonaccrual loans to total gross loans 0.73 % 0.88 % Total past due loans to total gross loans 0.78 % 1.72 % Nonperforming assets totaled $16.8 million and represented 0.62% of total assets at September 30, 2022, compared to $16.6 million and 0.68% of total assets at December 31, 2021. Nonaccrual loans totaled $16.8 million at September 30, 2022 and $16.6 million at December 31, 2021. There was no other real estate owned at September 30, 2022 or December 31, 2021. Past 52 due loans decreased to $17.8 million, or 0.78% of total loans, as of September 30, 2022, compared to $32.6 million, or 1.72% of total loans, as of December 31, 2021. Allowance for Loan Losses We evaluate the adequacy of the allowance for loan losses at least quarterly, and in determining our allowance for loan losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of our allowance for loan losses is based on internally assigned risk classifications of loans, the Bank’s and peer banks’ historical loss experience, changes in the nature of the loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates. Our general practice is to identify problem credits early and recognize full or partial charge-offs as promptly as practicable when it is determined that it is probable that the loan will not be repaid according to its original contractual terms, including principal and interest. Full or partial charge-offs on collateral dependent impaired loans are recognized when the collateral is deemed to be insufficient to support the carrying value of the loan. We do not recognize a recovery when an updated appraisal indicates a subsequent increase in value of the collateral. Our charge-off policies, which comply with standards established by our banking regulators, are consistently applied from period to period. Charge-offs are recorded on a monthly basis, as incurred. Partially charged-off loans continue to be evaluated on a monthly basis and additional charge-offs or loan loss provisions may be recorded on the remaining loan balance based on the same criteria. The following table presents the activity in our allowance for loan losses and related ratios for the dates indicated: Three Months Ended September 30, Nine Months Ended September 30, (Dollars in thousands) 2022 2021 2022 2021 Balance at beginning of period $ 15,773 $ 16,672 $ 16,902 $ 21,009 Charge-offs: Commercial real estate — — — (3,977) Commercial business — — — (51) Consumer (8) (15) (12) (33) Total charge-offs (8) (15) (12) (4,061) Recoveries: Commercial real estate — — 77 — Commercial business 21 11 34 27 Consumer — 1 1 10 Total recoveries 21 12 112 37 Net recoveries (charge-offs) 13 (3) 100 (4,024) Provision (credit) charged to earnings 2,381 134 1,165 (182) Balance at end of period $ 18,167 $ 16,803 $ 18,167 $ 16,803 Net charge-offs to average loans — % — % — % 0.24 % Allowance for loan losses to total gross loans 0.79 % 0.92 % 0.79 % 0.92 % At September 30, 2022, our allowance for loan losses was $18.2 million and represented 0.79% of total gross loans, compared to $16.9 million, or 0.89% of total gross loans, at December 31, 2021. 53 The following table presents the allocation of the allowance for loan losses and the percentage of these loans to total loans for the dates indicated: At September 30, 2022 At December 31, 2021 (Dollars in thousands) Amount Percent of Loan Portfolio Amount Percent of Loan Portfolio Residential real estate $ 172 2.70 % $ 504 4.22 % Commercial real estate 12,926 72.06 12,751 71.60 Construction 133 5.13 4 5.19 Commercial business 4,808 19.39 3,590 18.52 Consumer 128 0.72 53 0.47 Total allowance for loan losses $ 18,167 100.00 % $ 16,902 100.00 % The allocation of the allowance for loan losses at September 30, 2022 reflects our assessment of credit risk and probable loss within each portfolio. We believe that the level of the allowance for loan losses at September 30, 2022 is appropriate to cover probable losses. Reserve for Unfunded Commitments The reserve for unfunded commitments provides for probable losses inherent with funding the unused portion of legal commitments to lend. The unfunded reserve calculation is primarily based on our allowance for loan loss methodology for funded loans, adjusted for utilization expectations. The reserve for unfunded credit commitments is included within other liabilities in the accompanying Consolidated Balance Sheets. Changes in the reserve are reported as a component of other noninterest expense in the accompanying Consolidated Statements of Income. Investment Securities At September 30, 2022, the carrying value of our investment securities portfolio totaled $113.1 million and represented 4.2% of total assets, compared to $108.4 million, or 4.4% of total assets, at December 31, 2021. The net unrealized loss position on our investment portfolio at September 30, 2022 was $10.4 million and included gross unrealized losses of $10.4 million. The net unrealized gain position on our investment portfolio at December 31, 2021 was $4.5 million and included gross unrealized losses of $0.5 million. Deposit Activities and Other Sources of Funds September 30, 2022 December 31, 2021 (Dollars in thousands) Amount Percent Amount Percent Noninterest bearing demand $ 380,365 16.63 % $ 398,956 18.78 % NOW 115,200 5.04 119,479 5.62 Money market 836,564 36.58 954,674 44.95 Savings 183,576 8.03 193,631 9.12 Time 770,997 33.72 457,258 21.53 Total deposits $ 2,286,702 100.00 % $ 2,123,998 100.00 % Total deposits were $2.3 billion at September 30, 2022, an increase of $162.7 million, from the balance at December 31, 2021. The increase in deposits is primarily a result of an increase in brokered time deposits to fund the significant loan growth during the three months ended September 30, 2022, increasing $338.1 million compared to December 31, 2021. Brokered certificates of deposits totaled $587.5 million at September 30, 2022 and $249.4 million at December 31, 2021. There were no certificates of deposits from national listing services at September 30, 2022 or December 31, 2021. Brokered money market accounts totaled $30.2 million at September 30, 2022 and $104.0 million at December 31, 2021. Brokered deposits 54 represent brokered certificates of deposit, brokered money market accounts, one way buy Certificate of Deposit Account Registry Service (CDARS), and one way buy Insured Cash Sweep (ICS). At September 30, 2022 and December 31, 2021, time deposits with a denomination of $100 thousand or more, including CDARS and other brokered deposits, totaled $710.7 million and $391.2 million, respectively, maturing during the periods indicated in the table below: (Dollars in thousands) September 30, 2022 December 31, 2021 Maturing: Within 3 months $ 231,096 $ 80,417 After 3 but within 6 months 178,139 21,935 After 6 months but within 1 year 168,445 25,625 After 1 year 133,057 263,216 Total $ 710,737 $ 391,193 We utilize advances from the Federal Home Loan Bank of Boston, or FHLB, as part of our overall funding strategy and to meet short-term liquidity needs, and to a lesser degree, manage interest rate risk arising from the difference in asset and liability maturities. Total FHLB advances were $90.0 million and $50.0 million at September 30, 2022 and December 31, 2021, respectively. The Bank has additional borrowing capacity at the FHLB up to a certain percentage of the value of qualified collateral. In accordance with agreements with the FHLB, the qualified collateral must be free and clear of liens, pledges and encumbrances. At September 30, 2022, the Bank had pledged $946.9 million of eligible loans as collateral to support borrowing capacity at the FHLB of Boston. As of September 30, 2022, the Bank had immediate availability to borrow an additional $426.4 million based on qualified collateral. Liquidity and Capital Resources Liquidity Management Liquidity is defined as the ability to generate sufficient cash flows to meet all present and future funding requirements at reasonable costs. Our primary source of liquidity is deposits. While our generally preferred funding strategy is to attract and retain low cost deposits, our ability to do so is affected by competitive interest rates and terms in the marketplace. Other sources of funding include discretionary use of purchased liabilities (e.g., FHLB term advances and other borrowings), cash flows from our investment securities portfolios, loan sales, loan repayments and earnings. Investment securities designated as available for sale may also be sold in response to short-term or long-term liquidity needs. The Bank’s liquidity positions are monitored daily by management. The Asset Liability Committee ("ALCO") establishes guidelines to ensure maintenance of prudent levels of liquidity. ALCO reports to the Company’s Board of Directors. The Bank has a detailed liquidity funding policy and a contingency funding plan that provide for the prompt and comprehensive response to unexpected demands for liquidity. We employ a stress testing methodology to estimate needs for contingent funding that could result from unexpected outflows of funds in excess of “business as usual” cash flows. The Bank has established unsecured borrowing capacity with the Atlantic Community Bankers Bank ("ACBB"), Zion’s Bank and Texas Capital Bank and also maintains additional collateralized borrowing capacity with the FHLB in excess of levels used in the ordinary course of business. Our sources of liquidity include cash, unpledged investment securities, borrowings from the FHLB, lines of credit from ACBB, Zion’s Bank and Texas Capital Bank, the brokered deposit market and national CD listing services. The Company anticipates that it will have sufficient funds available to meet its current loan and other commitments. As of September 30, 2022, the Company had cash and cash equivalents of $223.1 million and available-for-sale securities of $95.1 million. At September 30, 2022, outstanding commitments to originate loans totaled $187.3 million and undisbursed funds from approved lines of credit, home equity lines of credit and secured commercial lines of credit totaled $318.8 million. 55 Capital Resources Shareholders’ equity totaled $231.5 million as of September 30, 2022, an increase of $29.5 million compared to December 31, 2021, primarily a result of (i) net income of $29.4 million for the nine months ended September 30, 2022 and (ii) an $8.4 million favorable impact to accumulated other comprehensive income driven by fair value marks related to hedge positions involving interest rate swaps, partially offset by fair value marks on the Company's investment portfolio. The Company's interest rate swaps are used to hedge interest rate risk. The increase in shareholders’ equity was partially offset by dividends paid of $4.7 million and common stock repurchases of $5.5 million. As of September 30, 2022, the tangible common equity ratio and fully diluted tangible book value per share were 8.41% and $29.68, respectively. The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. At September 30, 2022, the Bank met all capital adequacy requirements to which it was subject and exceeded the regulatory minimum capital levels to be considered well-capitalized under the regulatory framework for prompt corrective action. At September 30, 2022, the Bank’s ratio of Common Equity Tier 1 capital to risk-weighted assets was 11.42%, total capital to risk-weighted assets was 12.16%, Tier 1 capital to risk-weighted assets was 11.42% and Tier 1 capital to average assets was 11.31%. In July 2013, the Federal Reserve published Basel III rules establishing a new comprehensive capital framework of U.S. banking organizations. Under the rules, effective January 1, 2015 for the Company and the Bank, the minimum capital ratios became a) 4.5% Common Equity Tier 1 to risk-weighted assets, b) 6.0% Tier 1 capital to risk weighted assets and c) 8.0% total capital to risk-weighted assets. In addition, the new regulations imposed certain limitations on dividends, share buy-backs, discretionary payments on Tier 1 instruments and discretionary bonuses to executive officers if the banking organization does not hold a “capital conservation buffer” consisting of 2.5% of common equity to risk weighted assets, in addition to the amounts necessary to meet the minimum risk-based capital requirements described above. Asset/Liability Management and Interest Rate Risk We measure interest rate risk using simulation analysis to calculate earnings and equity at risk. These risk measures are quantified using simulation software from one of the leading firms in the field of asset/liability modeling. Key assumptions relate to the behavior of interest rates and spreads, prepayment speeds and the run-off of deposits. From such simulations, interest rate risk, or IRR, is quantified and appropriate strategies are formulated and implemented. We model IRR by using two primary risk measurement techniques: simulation of net interest income and simulation of economic value of equity. These two measurements are complementary and provide both short-term and long-term risk profiles for the Company. Because both baseline simulations assume that our balance sheet will remain static over the simulation horizon, the results do not reflect adjustments in strategy that ALCO could implement in response to rate shifts. The simulation analyses are updated quarterly. We use a net interest income at risk simulation to measure the sensitivity of net interest income to changes in market rates. This simulation captures underlying product behaviors, such as asset and liability repricing dates, balloon dates, interest rate indices and spreads, rate caps and floors, as well as other behavioral attributes. The simulation of net interest income also requires a number of key assumptions such as: (i) prepayment projections for loans and securities that are projected under each interest rate scenario using internal and external mortgage analytics; (ii) new business loan rates that are based on recent new business origination experience; and (iii) deposit pricing assumptions for non-maturity deposits reflecting the Bank’s limited history, management judgment and core deposit studies. Combined, these assumptions can be inherently uncertain, and as a result, actual results may differ from simulation forecasts due to the timing, magnitude and frequency of interest rate changes, future business conditions, as well as unanticipated changes in management strategies. We use two sets of standard scenarios to measure net interest income at risk. For the Parallel Ramp Scenarios, rate changes are ramped over a twelve-month horizon based upon a parallel yield curve shift and then maintained at those levels over the remainder of the simulation horizon. Parallel Shock Scenarios assume instantaneous parallel movements in the yield curve compared to a flat yield curve scenario. Simulation analysis involves projecting a future balance sheet structure and interest income and expense under the various rate scenarios. Internal policy regarding internal rate risk simulations currently specifies that for instantaneous parallel shifts of the yield curve, estimated net interest income at risk for the subsequent one-year period should not decline by more than: 6% for a 100 basis point shift; 12% for a 200 basis point shift; and 18% for a 300 basis point shift. Per Company policy, the Bank should not be outside these limits for twelve consecutive months unless the Bank's forecasted capital ratios are considered to be "well capitalized". As of September 30, 2022, the Bank met all minimum regulatory capital requirements to be considered "well capitalized" (reference footnote 7 to the consolidated financial statements for more detail). 56 The following tables set forth the estimated percentage change in our net interest income at risk over one-year simulation periods beginning September 30, 2022 and December 31, 2021: Parallel Ramp Estimated Percent Change in Net Interest Income Rate Changes (basis points) September 30, 2022 December 31, 2021 -100 2.60 % (0.80) % +200 (5.70) (2.20) Parallel Shock Estimated Percent Change in Net Interest Income Rate Changes (basis points) September 30, 2022 December 31, 2021 -100 3.50 % (1.70) % +100 (4.10) (1.00) +200 (8.80) (1.90) +300 (13.00) (2.40) The net interest income at risk simulation results indicate that, as of September 30, 2022, we remain liability sensitive. The liability sensitivity is due to the fact that there are more liabilities than assets subject to repricing as market rates change. We conduct an economic value of equity at risk simulation in tandem with net interest income simulations, to ascertain a longer term view of our interest rate risk position by capturing longer-term repricing risk and options risk embedded in the balance sheet. It measures the sensitivity of economic value of equity to changes in interest rates. The economic value of equity at risk simulation values only the current balance sheet and does not incorporate the growth assumptions used in one of the income simulations. As with the net interest income simulation, this simulation captures product characteristics such as loan resets, repricing terms, maturity dates, rate caps and floors. Key assumptions include loan prepayment speeds, deposit pricing elasticity and non-maturity deposit attrition rates. These assumptions can have significant impacts on valuation results as the assumptions remain in effect for the entire life of each asset and liability. All key assumptions are subject to a periodic review. Base case economic value of equity at risk is calculated by estimating the net present value of all future cash flows from existing assets and liabilities using current interest rates. The base case scenario assumes that future interest rates remain unchanged. The following table sets forth the estimated percentage change in our economic value of equity at risk, assuming various shifts in interest rates: Estimated Percent Change in Economic Value of Equity ("EVE") Rate Changes (basis points) September 30, 2022 December 31, 2021 -100 1.70 % (21.40) % +100 (3.50) 3.10 +200 (8.50) 3.60 +300 (13.00) 4.50 While ALCO reviews and updates simulation assumptions and also periodically back-tests the simulation results to ensure that the assumptions are reasonable and current, income simulation may not always prove to be an accurate indicator of interest rate risk or future net interest margin. Over time, the repricing, maturity and prepayment characteristics of financial instruments and the composition of our balance sheet may change to a different degree than estimated. ALCO recognizes that deposit balances could shift into higher yielding alternatives as market rates change. ALCO has modeled increased costs of deposits in the rising rate simulation scenarios presented above. 57 It should be noted that the static balance sheet assumption does not necessarily reflect our expectation for future balance sheet growth, which is a function of the business environment and customer behavior. Another significant simulation assumption is the sensitivity of core deposits to fluctuations in interest rates. Income simulation results assume that changes in both core savings deposit rates and balances are related to changes in short-term interest rates. Lastly, mortgage-backed securities and mortgage loans involve a level of risk that unforeseen changes in prepayment speeds may cause related cash flows to vary significantly in differing rate environments. Such changes could affect the level of reinvestment risk associated with cash flow from these instruments, as well as their market value. Changes in prepayment speeds could also increase or decrease the amortization of premium or accretion of discounts related to such instruments, thereby affecting interest income.