PATHWARD FINANCIAL, INC. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. PATHWARD FINANCIAL, INC.® AND SUBSIDIARIES FORWARD-LOOKING STATEMENTS PATHWARD FINANCIAL, INC. TM ("Pathward Financial" or the "Company" or "us") and its wholly-owned subsidiary, Pathward TM , National Association ("Pathward, N.A" or "Pathward" or "the Bank") may from time to time make written or oral “forward-looking statements,” including statements contained in this Quarterly Report on Form 10-Q, the Company’s other filings with the Securities and Exchange Commission (the "SEC"), the Company’s reports to stockholders, and other communications by the Company and Pathward, National Association, which are made in good faith by the Company pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. You can identify forward-looking statements by words such as “may,” “hope,” “will,” “should,” “expect,” “plan,” “anticipate,” “intend,” “believe,” “estimate,” “predict,” “potential,” “continue,” “could,” “future,” or the negative of those terms, or other words of similar meaning or similar expressions. You should carefully read statements that contain these words because they discuss our future expectations or state other “forward-looking” information. These forward-looking statements are based on information currently available to us and assumptions about future events, and include statements with respect to the Company’s beliefs, expectations, estimates, and intentions, which are subject to significant risks and uncertainties, and are subject to change based on various factors, some of which are beyond the Company’s control. Such risks, uncertainties and other factors may cause our actual growth, results of operations, financial condition, cash flows, performance and business prospects and opportunities to differ materially from those expressed in, or implied by, these forward-looking statements. Such statements address, among others, the following subjects: future operating results including our performance expectations; the impact of measures expected to increase efficiencies or reduce expenses; customer retention; loan and other product demand; expectations concerning acquisitions and divestitures; new products and services; credit quality; the level of net charge-offs and the adequacy of the allowance for credit losses; technology; and the Company's employees. The following factors, among others, could cause the Company's financial performance and results of operations to differ materially from the expectations, estimates, and intentions expressed in such forward-looking statements: maintaining our executive management team; expected growth opportunities may not be realized or may take longer to realize than expected; the potential adverse effects of the ongoing COVID-19 pandemic and any governmental or societal responses thereto, or other unusual and infrequently occurring events, including the impact on financial markets from geopolitical conflicts such as the military conflict between Russia and Ukraine; our ability to achieve brand recognition for Pathward equal to or greater than we have enjoyed for MetaBank; our ability to successfully implement measures designed to reduce expenses and increase efficiencies; changes in trade, monetary, and fiscal policies and laws, including actual changes in interest rates and the Fed Funds rate; changes in tax laws; the strength of the United States' economy, and the local economies in which the Company operates; inflation, market, and monetary fluctuations; the timely and efficient development of new products and services offered by the Company or its strategic partners, as well as risks (including reputational and litigation) attendant thereto, and the perceived overall value of these products and services by users; Pathward's ability to maintain its Durbin Amendment exemption; the risks of dealing with or utilizing third parties, including, in connection with the Company’s prepaid card and tax refund advance businesses, the risk of reduced volume of refund advance loans as a result of reduced customer demand for or usage of Pathward’s strategic partners’ refund advance products; our relationship with, and any actions which may be initiated by, our regulators; changes in financial services laws and regulations, including laws and regulations relating to the tax refund industry and the insurance premium finance industry; technological changes, including, but not limited to, the protection of our electronic systems and information; the impact of acquisitions and divestitures; litigation risk; the growth of the Company’s business, as well as expenses related thereto; continued maintenance by Pathward of its status as a well-capitalized institution; changes in consumer spending and saving habits; losses from fraudulent or illegal activity; technological risks and developments and cyber threats, attacks, or events; and the success of the Company at maintaining its high quality asset level and managing and collecting assets of borrowers in default should problem assets increase. The foregoing list of factors is not exclusive. We caution you not to place undue reliance on these forward-looking statements. The forward-looking statements included in this Quarterly Report on Form 10-Q speak only as of the date hereof, and the Company does not undertake any obligation to update, revise, or clarify these forward-looking statements whether as a result of new information, future events or otherwise. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in its entirety by the cautionary statements contained or referred to in this section. Additional discussions of factors affecting the Company’s business and prospects are reflected under the caption “Risk Factors” of the Company’s Annual Report on Form 10-K for the Company’s fiscal year ended September 30, 2022, and in the Company's other filings made with the SEC. The Company expressly disclaims any intent or obligation to update any forward-looking statements, whether written or oral, that may be made from time to time by or on behalf of the Company or its subsidiaries, whether as a result of new information, changed circumstances, or future events or for any other reason. 33 Table of Contents GENERAL The Company, a registered bank holding company, is a Delaware corporation, the principal assets of which are all the issued and outstanding shares of the Bank, a national bank. Unless the context otherwise requires, references herein to the Company include Pathward Financial and the Bank, and all direct or indirect subsidiaries of Pathward Financial on a consolidated basis. The Company’s common stock trades on the NASDAQ Global Select Market under the symbol “CASH.” The following discussion focuses on the consolidated financial condition of the Company at December 31, 2022, compared to September 30, 2022, and the consolidated results of operations for the three months ended December 31, 2022 and 2021. This discussion should be read in conjunction with the Company’s consolidated financial statements, and notes thereto, for the fiscal year ended September 30, 2022 and the related management's discussion and analysis of financial condition and results of operations contained in the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2022. EXECUTIVE SUMMARY Business Highlights for the 2023 Fiscal First Quarter • During the first quarter of fiscal year 2023, the Company recognized the remaining $10.0 million as part of the agreement with Beige Key, LLC to cease all use of the Meta name and trademarks. The $10.0 million was recognized as noninterest income as a gain on sale of trademarks. As part of the corporate rebrand, the Company recognized $3.7 million of pre-tax expenses related to rebranding efforts during the first quarter of fiscal 2023. Since the first quarter of fiscal year 2022 through the first quarter of fiscal year 2023, the Company has recognized $16.9 million in expenses related to rebranding efforts. The Company does not anticipate any further material expenses related to rebranding efforts. Financial Highlights for the 2023 Fiscal First Quarter • Total revenue for the first quarter was $149.8 million, a decrease of $8.4 million, or 5%, compared to the same quarter in fiscal 2022, primarily driven by the $50.0 million gain on sale of trademarks recognized during the prior year period, partially offset by an increase in interest income and the $10.0 million gain on sale of trademarks recognized during the first quarter of fiscal year 2023 . • Net interest margin ("NIM") increased 103 basis points to 5.62% for the first quarter from 4.59% during the same period of last year. The prior year period was impacted by excess cash associated with the Company's participation in the U.S. Treasury Department's Economic Impact Program. • Total gross loans and leases at December 31, 2022 decreased $174.5 million, or 5%, to $3.51 billion compared to December 31, 2021 and decreased $26.6 million , or 1%, when compared to September 30, 2022. The decrease compared to the prior year quarter was primarily due to a reduction in warehouse finance loans and the sale of the $81.5 million student loan portfolio during the fiscal 2022 fourth quarter, partially offset by growth in the commercial finance portfolio. The primary driver for the decrease on a linked quarter basis was the reduction in warehouse finance loans. • During the fiscal 2023 first quarter, the Company repurchased 653,994 shares of common stock at an average share price of $38.10. FINANCIAL CONDITION At December 31, 2022, the Company’s total assets decreased by $88.2 million to $6.66 billion compared to September 30, 2022, primarily due to decreases of $35.1 million in securities available for sale, $26.6 million in total loans and leases, and $18.9 million in cash and cash equivalents. Total cash and cash equivalents was $369.2 million at December 31, 2022, decreasing from $388.0 million at September 30, 2022. The Company maintains its cash investments primarily in interest-bearing overnight deposits with the FHLB of Des Moines and the FRB. At December 31, 2022, the Company did not have any federal funds sold. 34 Table of Contents The Company's investment security balances decreased $36.2 million, or 2%, to $1.89 billion at December 31, 2022, compared to $1.92 billion at September 30, 2022, due to maturities and principal pay downs. The Company’s portfolio of securities customarily consists primarily of MBS, which have expected lives much shorter than the stated final maturity, non-bank qualified obligations of states and political subdivisions, which mature in approximately 15 years or less, and other tax exempt municipal mortgage related pass through securities which have average lives much shorter than their stated final maturities. During the three months ended December 31, 2022, the Company made no purchases of investment securities. Loans held for sale at December 31, 2022 totaled $17.1 million, decreasing from $21.1 million at September 30, 2022. This decrease was driven by a reduction in consumer credit products held for sale at December 31, 2022 compared to September 30, 2022. Total gross loans and leases totaled $3.51 billion at December 31, 2022, as compared to $3.54 billion at September 30, 2022. The primary driver for the decrease on a linked quarter basis was a reduction in warehouse finance loans and commercial finance loans, partially offset by an increase in the consumer finance portfolio and the seasonal increase in tax services loans. See Note 5 to the “Notes to Condensed Consolidated Financial Statements” of this Quarterly Report on Form 10-Q. Commercial finance loans, which comprised 86% of the Company's gross loan and lease portfolio, totaled $3.01 billion at December 31, 2022 , reflecting a reduction of $16.8 million, or 1%, from September 30, 2022. Through the Bank, the Company owns stock in the FHLB due to the Bank’s membership and participation in this banking system as well as stock in the Federal Reserve Bank. The FHLB requires a level of stock investment based on a pre-determined formula. The Company’s investment in these stocks was $28.8 million at December 31, 2022 and at September 30, 2022, as purchases were offset by redemptions of FHLB membership stock during the three months ended December 31, 2022. Total end-of-period deposits decreased 1% to $5.79 billion at December 31, 2022, compared to September 30, 2022, primarily driven by a decrease in noninterest-bearing deposits of $68.0 million. The Company's total borrowings decreased $1.1 million, or 3%, from $36.0 million at September 30, 2022 to $35.0 million at December 31, 2022. At December 31, 2022, the Company’s stockholders’ equity totaled $659.1 million, an increase of $14.0 million, from $645.1 million at September 30, 2022. The increase was primarily attributable to a change in accumulated other comprehensive income ("AOCI"). The Company and Bank remained above the federal regulatory minimum capital requirements at December 31, 2022, and continued to be classified as well-capitalized, and in good standing with the regulatory agencies. See “Liquidity and Capital Resources” for further information. Noninterest-bearing Checking Deposits. The Company may hold negative balances associated with cardholder programs in the BaaS business line that are included within noninterest-bearing deposits on the Company's Condensed Consolidated Statements of Financial Condition. Negative balances can relate to any of the following payments functions: – Prefundings: The Company deploys funds to cards prior to receiving cash (typically 2-3 days) where the prefunding balance is netted at a pooled partner level utilizing ASC 210-20. – Discount fundings: The Company funds cards in alignment to expected breakage values on the card. Consumers may spend more than is estimated. These discounts are netted at a pooled partner level using ASC 210-20. The majority of these discount fundings relate to a small number of partners, and analyzed on an ongoing basis. – Demand Deposit Account ("DDA") overdrafts: Certain programs offered allow cardholders traditional DDA overdraft protection services whereby cardholders can spend a limited amount in excess of their available card balance. When overdrawn, these accounts are re-classed as loans on the balance sheet within the Consumer Finance category. 35 Table of Contents The Company meets the Right of Set off criteria in ASC 210-20, Balance Sheet - Offsetting, for all payments negative deposit balances with the exception of DDA overdrafts. The following table summarizes the Company's negative deposit balances within the BaaS business line: (Dollars in thousands) December 31, 2022 September 30, 2022 Noninterest-bearing deposits $ 5,903,642 $ 5,916,142 Prefunding (292,943) (244,462) Discount funding (22,652) (15,991) DDA overdrafts (8,921) (8,587) Noninterest-bearing checking, net $ 5,579,126 $ 5,647,102 Custodial Off-Balance Sheet Deposits. The Bank utilizes a custodial deposit transference structure for certain prepaid and deposit programs whereby the Bank, acting as custodian of cardholder funds, places a portion of such cardholder funds that are not needed to support near term settlement at one or more third-party banks insured by the FDIC (each, a “Program Bank”). Accounts opened at Program Banks are established in the Bank’s name as custodian, for the benefit of the Bank’s cardholders. The Bank remains the issuer of all cards and holder of all accounts under the applicable cardholder agreements and has sole custodial control and transaction authority over the accounts opened at Program Banks. The Bank maintains the records of each cardholder’s deposits maintained at Program Banks. Program Banks undergo robust due diligence prior to becoming a Program Bank and are also subject to continuous monitoring. In return for record keeping services at Program Banks, the Bank receives a servicing fee (“Servicing Fee”). For the three months ended December 31, 2022, the Company recognized $12.9 million in servicing fee income as compared to an insignificant amount for the three months ended December 31, 2021. The Servicing Fee has been typically reflective of the EFFR upon a renegotiation of the contracts with Program Banks. As of December 31, 2022, the Company managed $2.23 billion of customer deposits at other banks in its capacity as custodian. The balance of these deposits increased $915.9 million as of December 31, 2022 as compared to $1.31 billion at September 30, 2022 primarily due to seasonal activity. These deposits provide the Company with excess deposits that can earn record keeping service fee income, typically reflective of the EFFR. Approximately 43% of the deposit portfolio as of December 31, 2022 are subject to variable card processing expenses that are derived from the terms of contractual agreements with certain BaaS partners. These agreements are tied to a rate index, typically the EFFR. RESULTS OF OPERATIONS General The Company recorded net income of $27.8 million, or $0.98 per diluted share, for the three months ended December 31, 2022, compared to net income of $61.3 million, or $2.00 per diluted share, for the three months ended December 31, 2021. Total revenue for the fiscal 2023 first quarter was $149.8 million, a decrease of $8.4 million, or 5%, compared to the same quarter in fiscal 2022, primarily driven by the $50.0 million gain on sale of trademarks recognized during the prior year period, partially offset by an increase in interest income and the $10.0 million gain on sale of trademarks recognized during the three months ended December 31, 2022 . Net Interest Income Net interest income for the fiscal 2023 first quarter was $84.1 million, an increase of 17%, from the same quarter in fiscal 2022. The increase was mainly attributable to increased yields and an improved earning asset mix. 36 Table of Contents The first quarter average outstanding balance of loans and leases decreased $182.1 million compared to the same quarter of the prior year, primarily due to a reduction in warehouse finance loans and the sales of the remaining community bank and student loan portfolios, partially offset by an increase in the commercial finance loans. The Company’s average interest-earning assets for the first fiscal quarter decreased by $249.2 million to $5.93 billion compared with the same quarter in fiscal 2022, primarily due to a reduction in cash balances as a result of high cash levels during the prior year period related to the Company's participation in government stimulus programs. The decrease in interest-earnings assets was partially offset by growth in total investments and commercial finance loans and leases. Fiscal 2023 first quarter NIM increased to 5.62% from 4.59% in the first fiscal quarter of last year. The overall reported tax equivalent yield (“TEY”) on average earning assets increased by 101 basis points to 5.70% compared to the prior year quarter, primarily driven by an increase in loan and lease and investment securities yields, along with a decrease in lower-yielding cash balances. The yield on the loan and lease portfolio was 7.70% compared to 6.96% for the comparable period last year and the TEY on the securities portfolio was 2.76% compared to 1.58% for that same period. The Company's cost of funds for all deposits and borrowings averaged 0.07% during the fiscal 2023 first quarter, as compared to 0.08% during the prior year quarter. The Company's overall cost of deposits was 0.01% in the fiscal 2023 first quarter, the same as the prior year quarter. 37 Table of Contents The following tables present, for the periods indicated, the Company’s total dollar amount of interest income from average interest-earning assets and the resulting yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates. The balances presented in the table below are calculated on a daily average balance. Tax-equivalent adjustments have been made in yield on interest-bearing assets and net interest margin. Nonaccruing loans and leases have been included in the table as loans carrying a zero yield. Three Months Ended December 31, 2022 2021 (Dollars in thousands) Average Outstanding Balance Interest Earned / Paid Yield / Rate (1) Average Outstanding Balance Interest Earned / Paid Yield / Rate (1) Interest-earning assets: Cash and fed funds sold $ 226,004 $ 1,716 3.01 % $ 594,614 $ 560 0.37 % Mortgage-backed securities 1,571,022 10,412 2.63 % 1,007,030 3,864 1.52 % Tax exempt investment securities 154,754 980 3.18 % 207,621 820 1.98 % Asset-backed securities 155,988 1,149 2.92 % 387,567 1,152 1.18 % Other investment securities 301,739 2,407 3.17 % 279,839 1,460 2.07 % Total investments 2,183,503 14,948 2.76 % 1,882,057 7,296 1.58 % Commercial finance 3,010,868 58,100 7.66 % 2,775,394 49,021 7.01 % Consumer finance 198,372 4,313 8.63 % 316,573 6,114 7.66 % Tax services 25,230 57 0.90 % 33,604 1,474 17.40 % Warehouse finance 290,454 5,926 8.09 % 443,506 6,901 6.17 % Community banking — — — % 137,898 1,525 4.39 % Total loans and leases (3) 3,524,924 68,396 7.70 % 3,706,975 65,035 6.96 % Total interest-earning assets 5,934,431 $ 85,060 5.70 % 6,183,646 $ 72,891 4.69 % Noninterest-earning assets 589,580 839,854 Total assets $ 6,524,011 $ 7,023,500 Interest-bearing liabilities: Interest-bearing checking $ 447 $ — 0.33 % $ 389 $ — 0.32 % Savings 62,607 6 0.04 % 80,765 5 0.03 % Money markets 138,872 78 0.22 % 75,664 52 0.27 % Time deposits 7,199 2 0.11 % 8,619 15 0.67 % Wholesale deposits 5,712 56 3.89 % 67,384 69 0.41 % Total interest-bearing deposits 214,837 142 0.26 % 232,821 141 0.24 % Overnight fed funds purchased 24,783 244 3.91 % 327 — 0.31 % Subordinated debentures 19,593 357 7.22 % 73,995 986 5.28 % Other borrowings 15,817 260 6.53 % 18,636 151 3.22 % Total borrowings 60,193 861 5.67 % 92,958 1,137 4.85 % Total interest-bearing liabilities 275,030 1,003 1.45 % 325,779 1,278 1.56 % Noninterest-bearing deposits 5,421,821 — — % 5,688,563 — — % Total deposits and interest-bearing liabilities 5,696,851 $ 1,003 0.07 % 6,014,342 $ 1,278 0.08 % Other noninterest-bearing liabilities 178,789 182,916 Total liabilities 5,875,640 6,197,258 Shareholders' equity 648,371 826,242 Total liabilities and shareholders' equity $ 6,524,011 $ 7,023,500 Net interest income and net interest rate spread including noninterest-bearing deposits $ 84,057 5.63 % $ 71,613 4.61 % Net interest margin 5.62 % 4.59 % Tax-equivalent effect 0.02 % 0.02 % Net interest margin, tax-equivalent (2) 5.64 % 4.61 % (1) Tax rate used to arrive at the TEY for the three months ended December 31, 2022 and 2021 was 21%. (2) Net interest margin expressed on a fully-taxable-equivalent basis ("net interest margin, tax-equivalent") is a non-GAAP financial measure. The tax-equivalent adjustment to net interest income recognizes the estimated income tax savings when comparing taxable and tax-exempt assets and adjusting for federal and state exemption of interest income. The Company believes that it is a standard practice in the banking industry to present net interest margin expressed on a fully taxable equivalent basis and, accordingly, believes the presentation of this non-GAAP financial measure may be useful for peer comparison purposes. (3) Included in the yield computation are net loan fees of $6.5 million and $8.2 million for the three months ended December 31, 2022 and 2021, respectively. 38 Table of Contents Provision for Credit Losses The Company recognized a provision for credit losses of $9.8 million for the quarter ended December 31, 2022, compared to $0.2 million of provision for credit losses expense for the comparable period in the prior fiscal year. T he increase in provision for credit losses during the current quarter compared to the prior year period was primarily driven by the release of provision for credit losses related to the community bank portfolio during the prior year period. Net charge-offs were $3.2 million for the quarter ended December 31, 2022, compared to $1.1 million for the quarter ended December 31, 2021. Net charge-offs attributable to the commercial finance, tax services, and consumer finance portfolios for the current quarter were $2.0 million, $1.0 million, and $0.2 million, respectively. Noninterest Income Fiscal 2023 first quarter noninterest income decreased to $65.8 million from $86.6 million for the same period of the prior year. The decrease was primarily attributable to the gain on sale of trademarks as the Company recognized a $10.0 million gain during the current quarter as compared to a $50.0 million gain during the same period of the prior year. The period over period decrease was partially offset by increases in card and deposit fee income, gain on sale of other, other income, and rental income. The increase in card and deposit fee income was primarily from servicing fee income on off-balance sheet deposits, which totaled $12.9 million during the fiscal 2023 first quarter , as compared to an insignificant amount for the fiscal quarter ended December 31, 2021 . Noninterest Expense Noninterest expense increased 27% to $105.1 million for the fiscal 2023 first quarter, from $82.4 million for the same quarter last year. The increase was primarily attributable to increases in card processing expense, compensation expense, legal and consulting expense, and operating lease equipment depreciation. The card processing expense increase was due to structured agreements with BaaS partners. The amount of expense paid under those agreements is based on an agreed upon rate index that varies depending on the deposit levels, floor rates, market conditions, and other performance conditions. Generally, this rate index averages between 50% to 85% of the EFFR and reprices immediately upon a change in the EFFR. Approximately 43% of the deposit portfolio was subject to these higher card processing expenses. For the fiscal quarter ended December 31, 2022, card processing expenses related to these structured agreements were $14.0 million, as compared to $0.1 million for the fiscal quarter ended December 31, 2021. Income Tax Expense The Company recorded an income tax expense of $6.6 million, representing an effective tax rate of 18.8%, for the fiscal 2023 first quarter, compared to income tax expense of $14.3 million, representing an effective tax rate of 18.9%, for the first quarter last year. The current quarter decrease in income tax expense was primarily due to decreased earnings. The Company originated $11.4 million in solar leases during the fiscal 2023 first quarter, resulting in $3.1 million in total net investment tax credits. During the first quarter of fiscal 2022, the Company originated $21.2 million in solar leases resulting in $5.7 million in total net investment tax credits. Investment tax credits related to solar leases are recognized ratably based on income throughout each fiscal year. The timing and impact of future solar tax credits are expected to vary from period to period, and the Company intends to undertake only those tax credit opportunities that meet the Company's underwriting and return criteria. Asset Quality Generally, when a loan or lease becomes delinquent 90 days or more or when the collection of principal or interest becomes doubtful, the Company will place the loan or lease on a nonaccrual status and, as a result, previously accrued interest income on the loan or lease is reversed against current income. The loan or lease will generally remain on a non-accrual status until six months of good payment history has been established or management believes the financial status of the borrower has been significantly restored. Certain relationships in the table below are over 90 days past due and still accruing. The Company considers these relationships as being in the process of collection. Insurance premium finance loans, consumer finance and tax services loans are generally not placed on nonaccrual status but are instead written off when the collection of principal and interest become doubtful. Loans and leases, or portions thereof, are charged-off when collection of principal becomes doubtful. Generally, this is associated with a delay or shortfall in payments of greater than 210 days for insurance premium finance, 180 days for tax and other specialty lending loans, 120 days for consumer credit products and 90 days for other loans. 39 Table of Contents Action is taken to charge off ERO loans if such loans have not been collected by the end of June and refund advance loans if such loans have not been collected by the end of the calendar year. Nonaccrual loans and troubled debt restructurings are generally considered impaired. The Company believes that the level of allowance for credit losses at December 31, 2022 was appropriate and reflected probable losses related to these loans and leases; however, there can be no assurance that all loans and leases will be fully collectible or that the present level of the allowance will be adequate in the future. See the section below titled “Allowance for Credit Losses” for further information. The table below sets forth the amounts and categories of the Company's nonperforming assets. (Dollars in thousands) December 31, 2022 September 30, 2022 Nonperforming Loans and Leases Nonaccruing loans and leases: Commercial finance $ 25,077 $ 13,375 Total nonaccruing loans and leases 25,077 13,375 Accruing loans and leases delinquent 90 days or more: Commercial finance 13,281 4,142 Consumer finance 2,493 2,793 Tax services (1) — 8,873 Total accruing loans and leases delinquent 90 days or more 15,774 15,808 Total nonperforming loans and leases 40,851 29,183 Other Assets Nonperforming operating leases 4,188 1,736 Foreclosed and repossessed assets: Commercial finance — 1 Total foreclosed and repossessed assets — 1 Total other assets 4,188 1,737 Total nonperforming assets $ 45,039 $ 30,920 Total as a percentage of total assets 0.68 % 0.46 % (1) Certain tax services loans do not bear interest. The Company's nonperforming loans and leases at December 31, 2022 were $40.9 million, representing 1.16% of total gross loans and leases, compared to $29.2 million, or 0.82% of total gross loans and leases at September 30, 2022. The increase in the nonperforming assets as a percentage of total assets at December 31, 2022 compared to September 30, 2022, was driven by an increase in nonperforming loans in the commercial finance portfolio, primarily due to one lending relationship that moved to nonperforming during the period. The increase was partially offset by a decrease in nonperforming tax services loans due to seasonal timing. Classified Assets . Federal regulations provide for the classification of certain loans, leases, and other assets such as debt and equity securities considered by the Bank's primary regulator, the OCC, to be of lesser quality as “substandard,” “doubtful” or “loss,” with each such classification dependent on the facts and circumstances surrounding the assets in question. An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. “Substandard” assets include those characterized by the “distinct possibility” that the Bank will sustain “some loss” if the deficiencies are not corrected. Assets classified as “doubtful” have all of the weaknesses inherent in those classified “substandard,” with the added characteristic that the weaknesses present make “collection or liquidation in full,” on the basis of currently existing facts, conditions and values, “highly questionable and improbable.” Assets classified as “loss” are those considered “uncollectible” and of such minimal value that their continuance as assets without the establishment of a specific loss reserve is not warranted. 40 Table of Contents General allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When assets are classified as “loss,” the Bank is required either to establish a specific allowance for losses equal to 100% of that portion of the asset so classified or to charge off such amount. The Bank’s determinations as to the classification of its assets and the amount of its valuation allowances are subject to review by its regulatory authorities, which may order the establishment of additional general or specific loss allowances. On the basis of management’s review of its loans, leases, and other assets, at December 31, 2022, the Company had classified loans and leases of $199.4 million as substandard, $3.9 million as doubtful and none as loss. At September 30, 2022, the Company classified loans and leases of $203.7 million as substandard, $4.0 million as doubtful and none as loss. Allowance for Credit Losses . The ACL represents management’s estimate of current credit losses expected to be incurred by the loan and lease portfolio over the life of each financial asset as of the balance sheet date. The Company individually evaluates loans and leases that do not share similar risk characteristics with other financial assets, which generally means loans and leases identified as troubled debt restructurings or loans and leases on nonaccrual status. All other loans and leases are evaluated collectively for credit loss. A reserve for unfunded credit commitments such as letters of credit and binding unfunded loan commitments is recorded in other liabilities on the Condensed Consolidated Statements of Financial Condition. Individually evaluated loans and leases are a key component of the ACL. Generally, the Company measures credit loss on individually evaluated loans based on the fair value of the collateral less estimated selling costs, as the Company considers these financial assets to be collateral dependent. If an individually evaluated loan or lease is not collateral dependent, credit loss is measured at the present value of expected future cash flows discounted at the loan or lease initial effective interest rate. The Company's ACL totaled $52.6 million at December 31, 2022, an increase compared to $45.9 million at September 30, 2022. The increase in the ACL at December 31, 2022, when compared to September 30, 2022, was primarily due to a $4.7 million increase in the commercial finance portfolio, a $1.4 million increase in the consumer finance portfolio and a $0.6 million increase in the seasonal tax services loan portfolio. The following table presents the Company's ACL as a percentage of its total loans and leases. As of the Period Ended December 31, 2022 September 30, 2022 June 30, 2022 March 31, 2022 December 31, 2021 Commercial finance 1.62 % 1.46 % 1.56 % 1.66 % 2.04 % Consumer finance 1.54 % 0.86 % 2.44 % 3.18 % 2.70 % Tax services 2.01 % 0.05 % 54.29 % 35.76 % 1.60 % Warehouse finance 0.10 % 0.10 % 0.10 % 0.10 % 0.10 % Total loans and leases 1.50 % 1.30 % 2.04 % 2.38 % 1.84 % Total loans and leases excluding tax services 1.50 % 1.30 % 1.44 % 1.59 % 1.84 % The Company's ACL as a percentage of total loans and leases increased to 1.50% at December 31, 2022 from 1.30% at September 30, 2022. The increase in the total loans and leases coverage ratio was primarily driven by the commercial and consumer finance portfolios. The increase in the commercial finance coverage ratio was primarily due to a specific reserve on an individually evaluated loan relationship while the increase in consumer finance was related to seasonal activity. The Company expects to continue to diligently monitor the ACL and adjust as necessary in future periods to maintain an appropriate and supportable level. 41 Table of Contents CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company’s financial statements are prepared in accordance with GAAP. The financial information contained within these financial statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. Management has identified its critical accounting policies, which are those policies that, in management's view, are most important in the portrayal of our financial condition and results of operations. These policies involve complex and subjective decisions and assessments. Some of these estimates may be uncertain at the time they are made, could change from period to period, and could have a material impact on the financial statements. A discussion of the Company’s critical accounting policies and estimates can be found in the Company's Annual Report on Form 10-K for the year ended September 30, 2022. There were no significant changes to these critical accounting policies and estimates during the first three months of fiscal 2023. LIQUIDITY AND CAPITAL RESOURCES The Company’s primary sources of funds are deposits, derived principally through its BaaS business line, borrowings, principal and interest payments on loans and leases and mortgage-backed securities, and maturing investment securities. In addition, the Company utilizes wholesale deposit sources to provide temporary funding when necessary or when favorable terms are available. While scheduled loan repayments and maturing investments are relatively predictable, deposit flows and early loan repayments are influenced by the level of interest rates, general economic conditions and competition. The Company uses its capital resources principally to meet ongoing commitments to fund maturing certificates of deposit and loan commitments, to maintain liquidity, and to meet operating expenses. At December 31, 2022, the Company had unfunded loan and lease commitments of $1.24 billion. Management believes that loan repayment and other sources of funds will be adequate to meet its foreseeable short- and long-term liquidity needs. As U.S. banking organizations, the Company and the Bank are required to comply with the regulatory capital rules adopted by the Federal Reserve and the OCC (the "Capital Rules") that became effective on January 1, 2015, subject to phase-in periods for certain requirements and other provisions of the Capital Rules. Under the Capital Rules and the regulatory framework for prompt corrective action, the Company and Bank must meet specific capital guidelines that involve quantitative measures of the Company’s and Bank’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s and Bank’s capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings and other factors. The Capital Rules require the Company and the Bank to maintain minimum ratios (set forth in the table below) of total risk-based capital and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and a leverage ratio consisting of Tier 1 capital (as defined) to average assets (as defined). At December 31, 2022, both the Company and the Bank exceeded federal regulatory minimum capital requirements to be classified as well-capitalized under the prompt corrective action requirements. The Company and the Bank took the AOCI opt-out election; under the rule, non-advanced approach banking organizations were given a one-time option to exclude certain AOCI components. The tables below include certain non-GAAP financial measures that are used by investors, analysts and bank regulatory agencies to assess the capital position of financial services companies. Management reviews these measures along with other measures of capital as part of its financial analyses and has included this non-GAAP financial information, and corresponding reconciliation to total equity. The decrease in Tier 1 leverage capital ratio for the period is the result of higher quarterly average assets related to its seasonal tax business. Regulatory Capital is not affected by the unrealized loss on AOCI. The securities portfolio is made up of nearly all amortizing securities that should provide consistent cash flow and is not expected to require sales to realize the losses to fund future loan growth. 42 Table of Contents At December 31, 2022 Company Bank Minimum to be Adequately Capitalized Under Prompt Corrective Action Provisions Minimum to be Well Capitalized Under Prompt Corrective Action Provisions Tier 1 leverage capital ratio 8.37 % 8.68 % 4.00 % 5.00 % Common equity Tier 1 capital ratio 12.31 13.09 4.50 6.50 Tier 1 capital ratio 12.63 13.09 6.00 8.00 Total capital ratio 14.29 14.29 8.00 10.00 The following table provides a reconciliation of the amounts included in the table above for the Company. (Dollars in thousands) Standardized Approach (1) December 31, 2022 Total stockholders' equity $ 659,133 Adjustments: LESS: Goodwill, net of associated deferred tax liabilities 298,788 LESS: Certain other intangible assets 25,053 LESS: Net deferred tax assets from operating loss and tax credit carry-forwards 16,641 LESS: Net unrealized gains (losses) on available for sale securities (200,597) LESS: Noncontrolling interest (207) ADD: Adoption of Accounting Standards Update 2016-13 2,017 Common Equity Tier 1 (1) 521,472 Long-term borrowings and other instruments qualifying as Tier 1 13,661 Tier 1 minority interest not included in common equity Tier 1 capital (138) Total Tier 1 capital 534,995 Allowance for credit losses 50,853 Subordinated debentures, net of issuance costs 19,521 Total capital $ 650,369 (1) Capital ratios were determined using the Basel III capital rules that became effective on January 1, 2015. Basel III revised the definition of capital, increased minimum capital ratios, and introduced a minimum common equity tier 1 capital ratio; those changes were fully phased in through the end of 2021. The following table provides a reconciliation of tangible common equity and tangible common equity excluding AOCI, each of which is used in calculating tangible book value data, to total stockholders' equity. Each of tangible common equity and tangible common equity excluding AOCI is a non-GAAP financial measure that is commonly used within the banking industry. (Dollars in thousands) At December 31, 2022 Total stockholders' equity $ 659,133 LESS: Goodwill 309,505 LESS: Intangible assets 24,433 Tangible common equity 325,195 LESS: AOCI (201,690) Tangible common equity excluding AOCI $ 526,885 Since January 1, 2016, the Company and the Bank have been required to maintain a capital conservation buffer above the minimum risk-based capital requirements in order to avoid certain limitations on capital distributions, stock repurchases and discretionary bonus payments to executive officers. The capital conservation buffer is exclusively composed of Common Equity Tier 1 capital, and it applies to each of the three risk-based capital ratios but not the leverage ratio. The required Common Equity Tier 1 risk-based, Tier 1 risk-based and total risk-based capital ratios with the buffer are currently 7.0%, 8.5% and 10.5%, respectively. 43 Table of Contents Based on current and expected continued profitability and subject to continued access to capital markets, we believe that the Company and the Bank will continue to meet the capital conservation buffer of 2.5% in addition to required minimum capital ratios. CONTRACTUAL OBLIGATIONS See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Contractual Obligations " in the Company’s Annual Report on Form 10-K for its fiscal year ended September 30, 2022 for a summary of our contractual obligations as of September 30, 2022. There were no material changes outside the ordinary course of our business in contractual obligations from September 30, 2022 through December 31, 2022.