Capital Bancorp Inc 10-K

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis is intended as a review of significant factors affecting the Company’s financial condition and results of operations for the periods indicated. This discussion and analysis should be read in conjunction with the accompanying consolidated financial statements and the related notes. The discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under “Cautionary Note Regarding Forward-Looking Statements,” “Risk Factors” and elsewhere in this Form 10-K, may cause actual results to differ materially from those projected in the forward-looking statements. We assume no obligation to update any of these forward-looking statements Results of Operations for the Years Ended December 31, 2020 and 2019 Net Income The following table sets forth the principal components of net income for the periods indicated. Years Ended December 31, (in thousands) 2020 2019 % Change Interest income $ 97,251 $ 82,180 18.3 % Interest expense 13,182 15,842 (16.8) % Net interest income 84,069 66,338 26.7 % Provision for loan losses 11,242 2,791 302.8 % Net interest income after provision 72,827 63,547 14.6 % Noninterest income 61,061 25,692 137.7 % Noninterest expense 98,751 66,525 48.4 % Net income before income taxes 35,137 22,714 54.7 % Income tax expense 9,314 5,819 60.1 % Net income $ 25,823 $ 16,895 52.8 % Net income for the year ended December 31, 2020 was $25.8 million, an increase of $8.9 million, or 53%, from net income for the year ended December 31, 2019 of $16.9 million. The increase in net interest income was primarily due to the $150.6 million increase in average loans outstanding year over year. The increase in loan volume resulted in an increase of $10.9 million of loan interest income which includes $4.5 million from SBA-PPP loans. The increase in non-interest income is primarily due to credit card fees of $9.4 million and $24.7 million in mortgage banking revenue when comparing year over year. Net Interest Income and Net Margin Analysis Net interest income is the difference between interest income on earning assets and the cost of funds supporting those assets. Earning assets are composed primarily of loans, loans held for sale, investment securities, and interest bearing deposits with banks. The cost of funds represents interest expense on deposits, and borrowings, which consist of federal funds purchased, advances from the FHLB and subordinated notes. Noninterest bearing deposits and capital also provide sources of funding. We analyze our ability to maximize income generated from interest earning assets and control the interest expenses of our liabilities, measured as net interest income, through our net interest margin and net interest spread. Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. Net interest spread is the difference between average interest rates earned on interest earning assets and average interest rates paid on interest bearing 59 liabilities. Changes in market interest rates and the interest rates we earn on interest earning assets or pay on interest bearing liabilities, as well as in the volume and mix of interest earning assets, interest bearing and noninterest bearing liabilities and stockholders’ equity, are usually the largest drivers of periodic changes in net interest income, net interest margin and net interest spread. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in the Washington, D.C. and Baltimore metropolitan areas, as well as developments affecting the real estate, technology, government services, hospitality and tourism and financial services sectors within our target markets and throughout the Washington, D.C. and Baltimore metropolitan areas. Our ability to respond to changes in these factors by using effective asset-liability management techniques is critical to maintaining the stability of our net interest income and net interest margin as our primary sources of earnings. The table below presents the average balances and rates of the major categories of the Company’s assets and liabilities for the years ended December 31, 2020, 2019 and 2018. Included in the table is a measurement of interest rate spread and margin. Interest rate spread is the difference (expressed as a percentage) between the interest rate earned on earning assets less the interest expense on interest bearing liabilities. While the interest rate spread provides a quick comparison of earnings rates versus cost of funds, management believes that the net interest margin may provide a better measurement of performance. The net interest margin (as compared to the net interest spread) includes the effect of noninterest bearing sources in its calculation and is net interest income expressed as a percentage of average earning assets. As the table shows, the increase in net interest income in 2020 as compared to 2019 was primarily a function of an increase in of earning assets. 60 AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS Years Ended December 31, 2020 2019 2018 (in thousands) Average Outstanding Balance Interest Income/ Expense Average Yield/ Rate Average Outstanding Balance Interest Income/ Expense Average Yield/ Rate Average Outstanding Balance Interest Income/ Expense Average Yield/ Rate Assets Interest earning assets: Interest bearing deposits $ 112,249 $ 343 0.31 % $ 47,762 $ 832 1.74 % $ 41,858 $ 687 1.64 % Federal funds sold 3,128 4 0.12 % 2,733 50 1.83 % 1,537 27 1.76 % Investment securities 58,071 1,292 2.22 % 41,130 924 2.25 % 50,074 1,041 2.08 % Restricted investments 4,025 244 6.07 % 4,334 243 5.61 % 2,724 143 5.25 % Loans held for sale 84,928 2,610 3.07 % 44,483 2,899 6.52 % 17,715 1,569 8.86 % SBA-PPP loans receivable 157,630 4,479 2.84 % — — — — Portfolio Loans (1)(2) 1,215,049 88,279 7.27 % 1,064,421 77,232 7.26 % 921,823 65,660 7.12 % Total interest earning assets 1,635,080 97,251 5.95 % 1,204,863 82,180 6.82 % 1,035,731 69,127 6.67 % Noninterest earning assets 24,923 15,046 10,001 Total assets $ 1,660,003 $ 1,219,909 $ 1,045,732 Liabilities and Stockholders’ Equity Interest bearing liabilities: Interest bearing demand accounts $ 195,794 $ 656 0.34 % $ 109,977 $ 672 0.61 % $ 72,523 $ 210 0.29 % Savings 4,722 5 0.11 % 3,597 13 0.36 % 3,704 12 0.32 % Money market accounts 480,218 4,786 1.00 % 344,272 5,822 1.69 % 286,257 3,797 1.33 % Time deposits 297,997 6,077 2.04 % 302,149 7,182 2.38 % 326,827 5,773 1.77 % Borrowed funds 42,471 1,658 3.90 % 59,387 2,153 3.63 % 34,558 1,447 4.19 % Total interest bearing liabilities 1,021,202 13,182 1.29 % 819,382 15,842 1.93 % 723,869 11,239 1.56 % Noninterest bearing liabilities: Noninterest bearing liabilities 22,007 16,144 9,828 Noninterest bearing deposits 473,301 260,726 220,445 Stockholders’ equity 143,493 123,657 91,590 Total liabilities and stockholders’ equity $ 1,660,003 $ 1,219,909 $ 1,045,732 Net interest spread (3) 4.66 % 4.89 % 5.11 % Net interest income $ 84,069 $ 66,338 $ 57,888 Net interest margin (4) (5) 5.14 % 5.51 % 5.59 % _______________ (1) Includes nonaccrual loans. (2) Interest income includes amortization of deferred loan fees, net of deferred loan costs. (3) Net interest spread is the difference between interest rates earned on interest earning assets and interest rates paid on interest bearing liabilities. (4) Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. (5) For the twelve months ended December 31, 2020, SBA-PPP loans negatively impacted the margin by 25 basis points while credit card loans improved the margin by 136 basis points, taken together, the net impact was 125 basis points to the reported net interest margin. For the twelve months ended December 31, 2019 and December 31, 2018, credit card loans contributed 125 and 81 basis points of the reported net interest margin, respectively. 61 Rate/Volume Analysis of Net Interest Income The rate/volume table below presents the composition of the change in net interest income for the periods indicated, as allocated between the change in net interest income due to changes in the volume of average earning assets and interest bearing liabilities, and the changes in net interest income due to changes in interest rates. The increase in net interest income in 2020 relative to 2019 was primarily due to an increase in volume of interest earning assets, and particularly loans. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been proportionately allocated to both volume and rate. ANALYSIS OF CHANGES IN NET INTEREST INCOME Year Ended December 31, 2020 Year Ended December 31, 2019 Compared to the Compared to the Year Ended December 31, 2019 Year Ended December 31, 2018 Change Due To Interest Variance Change Due To Interest Variance (In thousands) Volume Rate Volume Rate Interest Income: Interest bearing deposits $ (1,253) $ 765 $ (488) $ 101 $ 44 $ 145 Federal funds sold 8 (55) (47) 22 1 23 Investment securities 377 (9) 368 (213) 96 (117) Restricted investments (8) 9 1 90 10 100 Loans held for sale (691) 402 (289) 1,612 (282) 1,330 SBA-PPP loans 4,479 — 4,479 — — — Portfolio loans 10,944 103 11,047 10,326 1,245 11,571 Total interest income 13,856 1,215 15,071 11,938 1,114 13,052 Interest Expense: Interest bearing demand accounts (38) 22 (16) 147 315 462 Savings 6 (14) (8) — 1 1 Money market accounts 25,897 (26,933) (1,036) 859 1,166 2,025 Time deposits (97) (1,008) (1,105) (394) 1,802 1,408 Borrowed funds (677) 183 (494) 868 (162) 706 Total interest expense 25,091 (27,750) (2,659) 1,480 3,122 4,602 Net interest income $ (11,235) $ 28,965 $ 17,730 $ 10,458 $ (2,008) $ 8,450 Net interest income increased by $17.7 million to $84.1 million for the year ended December 31, 2020 compared to 2019, primarily as a result of 35.7% growth in average earning assets. For the twelve months ended December 31, 2020, our average interest-earning assets increased by $430.2 million, compared to the prior year. In addition to the average earning asset growth in 2020, the average rate on interest bearing liabilities decreased by 64 basis points to 1.29%. Net interest margin decreased 37 basis points to 5.14% for the twelve months ended December 31, 2020 from 5.51% for the twelve months ended 2019. The Company’s average portfolio loan yield slightly decreased in 2020 to 7.27% as compared to 7.26% in 2019. The Company believes its net interest margin remains favorable as compared to its peer banking companies. Average total interest earning assets were $1.6 billion for the year ended December 31, 2020 compared with $1.2 billion for the year ended December 31, 2019. The yield on those interest earning assets decreased 87 basis points to 5.95% for 2020 compared to 6.82% for 2019. The increase in the average balance of interest earning assets for the year ended December 31, 2020 compared to December 31, 2019, was driven by $64.5 million growth in the average balances of 62 interest earning deposits, as well as growth in investment securities of $16.9 million, loans held for sale of $40.4 million, SBA-PPP loans of $157.6 million and portfolio loans of $150.6 million. Average interest bearing liabilities increased by $201.8 million to $1.0 billion for the year ended December 31, 2020 from $819.4 million for the year ended December 31, 2019. The increase was due to an increase in the average balance of interest bearing demand accounts of $85.8 million, or 78.0%, an increase in money market accounts of $135.9 million, or 39.5% and a decrease in the average balance of borrowed funds of $16.9 million, or 28.5%. compared to the year ended December 31, 2019 balances. Deposits are the primary funding source for the Company. The average interest rate paid on interest bearing liabilities decreased to 1.29% for 2020 compared to 1.93% for 2019. While the average interest rate paid on interest bearing deposits decreased 27 basis points, the average interest rate paid on borrowed funds increased by 27 basis points. For the year ended December 31, 2020, the Company’s net interest margin was 5.14% and net interest spread was 4.66% compared to 5.51% and 4.89% for 2019. Provision for Loan Losses The provision for loan losses represents the amount of expense charged to current earnings to fund the allowance for loan losses. The amount of the allowance for loan losses is based on many factors which reflect management’s assessment of the risk in the loan portfolio. Those factors include historical losses, economic conditions and trends, the value and adequacy of collateral, volume and mix of the portfolio, performance of the portfolio, and internal loan processes of the Company and Bank. For a detailed description of the factors taken into account by our management in determining the allowance for loan losses see “Financial Condition— Allowance for Loan Losses.” For the year ended December 31, 2020, the Company recorded a provision for loan losses of $11.2 million, compared to $2.8 million for the previous year. The increase in the provision for 2020 compared to 2019 was primarily due to the uncertainty surrounding the deterioration of the macro-economic environment related to the COVID-19 pandemic. Year over year our allowance for loan losses as a percent of total portfolio loans increased to 1.78% at December 31, 2020 from 1.14% at December 31, 2019. Net charge-offs for 2020 amounted to $1.1 million, representing 0.09% of average loans, compared to $799 thousand for 2019. Included in the net charge-offs for 2020 were $296 thousand for construction loans, $233 thousand for commercial loans and $588 thousand for credit cards. The credit card portfolio charge-offs represented 54.7% and 55.4% of total charge-offs, respectively, for the periods presented. The maintenance of a high quality loan portfolio, with an adequate allowance for possible credit losses, will continue to be a primary management objective for the Company. Noninterest Income Our primary sources of recurring noninterest income are service charges on deposit accounts, credit card fees, such as interchange fees and statement fees, and gain on sale of residential mortgage loans and other mortgage banking revenue. Noninterest income does not include (i) loan origination fees to the extent they exceed the direct loan origination costs, which are generally recognized over the life of the related loan as an adjustment to yield using the interest method or (ii) annual, renewal and late fees related to our credit card portfolio, which are generally recognized over the twelve month life of the related loan as an adjustment to yield using the interest method. 63 The following table presents, for the periods indicated, the major categories of noninterest income: NONINTEREST INCOME Years Ended December 31, (in thousands) 2020 2019 % Change Noninterest income: Service charges on deposit accounts $ 520 $ 542 (4.1) % Credit card fees 16,966 7,602 123.2 % Mortgage banking revenue 40,649 15,955 154.8 % Gain on sale of investment securities available for sale 20 26 (23.1) % Other fees and charges 2,906 1,567 85.4 % Total noninterest income $ 61,061 $ 25,692 137.7 % Noninterest income for the the year ended December 31, 2020 was $61.1 million, a $35.4 million or 137.7% increase compared to noninterest income of $25.7 million for the year ended December 31, 2019. This increase is largely due to increases in credit card fees and mortgage banking revenue. Credit card fees increased $9.4 million, or 123.2%, for the year ended December 31, 2020 to $17.0 million compared to $7.6 million for 2019 . This increase was primarily due to an increase in outstanding card accounts to 568 thousand at December 31, 2020, compared to 223 thousand at December 31, 2019, an increase of 345 thousand accounts, or 154.4%. Mortgage banking revenue increased $24.7 million, or 154.8%, during 2020 to $40.6 million compared to 2019 revenue of $16.0 million, primarily as a result of an increase in mortgage origination volume driven by the favorable mortgage refinancing market in 2020. Year over year mortgage originations increased to $1.3 billion from prior year originations of $593.2 million, a 120.7% increase. Mortgage loans sold are subject to repurchase in circumstances where documentation is deficient or the underlying loan becomes delinquent or pays off within a specified period following loan funding and sale. The Bank considers these potential recourse provisions to be a risk and has established a reserve under generally accepted accounting principles for possible repurchases. The reserve increased to $1.2 million at December 31, 2020, compared to $576 thousand for the same period in 2019 primarily due to the increase in volume. The Bank does not originate “sub-prime” loans and has no exposure to this market segment Noninterest Expense Generally, noninterest expense is composed of all employee expenses and costs associated with operating our facilities, obtaining and retaining customer relationships and providing bank services. The largest component of noninterest expense is salaries and employee benefits. Noninterest expense also includes operational expenses, such as occupancy and equipment expenses, professional fees, advertising expenses, loan processing expenses and other general and administrative expenses, including FDIC assessments, communications, travel, meals, training, supplies and postage. 64 The following table presents, for the periods indicated, the major categories of noninterest expense: NONINTEREST EXPENSE Years Ended December 31, (in thousands) 2020 2019 % Change Noninterest expense: Salaries and employee benefits $ 44,359 $ 32,586 36.1 % Occupancy and equipment 5,170 4,360 18.6 % Professional fees 4,900 2,871 70.7 % Data processing 26,917 15,512 73.5 % Advertising 2,530 2,066 22.5 % Loan processing 3,811 1,894 101.2 % Other real estate expense, net 69 122 (43.4) % Other operating 10,995 7,114 54.6 % Total noninterest expense $ 98,751 $ 66,525 48.4 % Noninterest expense was $98.8 million for the year ended December 31, 2020, an increase of $32.2 million, or 48.4%, compared to $66.5 million for 2019. The increase was driven primarily by increases in salaries and benefits, which includes commissions paid on mortgage originations. In 2020, as a result of robust mortgage originations, commissions were $10.9 million, compared to $5.4 million in 2019. The increase in professional fees resulted primarily from increased consultant and other outside services. Data processing increased primarily due to the increase in loan and credit card volume. Other operating expenses increased primarily a result of increases in marketing, credit expense and credit card related expenses. Income Tax Expense The amount of income tax expense we incur is influenced by our pre-tax income and our other nondeductible expenses. Deferred tax assets and liabilities are reflected at current income tax rates in effect for the period in which the deferred tax assets and liabilities are expected to be realized or settled. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense was $9.3 million for 2020 compared to $5.8 million for 2019. Our effective tax rates for those periods were 26.5% and 25.6%, respectively. Financial Condition Total assets at December 31, 2020 were $1.88 billion, a 31.5% increase as compared to $1.4 billion at December 31, 2019. Total portfolio loans (excluding mortgage loans held for sale) were $1.3 billion at December 31, 2020, an 11.7% increase as compared to $1.1 billion at December 31, 2019. Loans held for sale amounted to $107.2 million at December 31, 2020 as compared to $71.0 million for the same period in 2019, a 50.9% increase year over year. Total borrowed funds at December 31, 2020, were $36.0 million compared to $47.6 million at December 31, 2019. In 2020, in an effort to reduce funding costs, manage liquidity and mitigate interest rate risk, the Company acquired a long term $22 million FHLB Fixed Rate Advance to pay off the FHLB Fixed Rate Principal Reducing long term debt incurred in 2019. As of December 31, 2020, $22.0 million of the advance remains outstanding. 65 Deposits were $1.7 billion at December 31, 2020, an increase of $426.7 million, a 34.8% as compared to $1.2 billion at December 31, 2019. The growth in the portfolio was primarily due to an increase in the non-interest bearing demand account category. The Company continues to execute on its strategic initiative to improve the deposit portfolio mix by reducing reliance on wholesale time deposits. Accordingly, wholesale time deposits decreased by $59.3 million or 35.5% to $107.7 million at December 31, 2020, from $167.0 million at December 31, 2019. Stockholders’ equity increased $26.0 million, or 19%, to $159.3 million at December 31, 2020, compared to $133.3 million at December 31, 2019. The increase was primarily attributable to 2020 earnings of $25.8 million and proceeds from exercise of stock options of $0.8 million. Shares repurchased and retired in 2020 as part of the Company’s stock repurchase program totaled 304,114 shares at a weighted average price of $10.81 for a total cost of $3.3 million including commissions. As of December 31, 2020, the Bank’s capital ratios continued to exceed the regulatory requirements for a “well capitalized” institution. Interest Bearing Deposits at Other Financial Institutions As of December 31, 2020, interest bearing deposits at the Federal Reserve Bank of Richmond increased by $23.6 million, or 23.1%, to $126.1 million from a balance of $102.4 million at December 31, 2019. Securities The Company uses its securities portfolio to provide a source of liquidity, provide an appropriate return on funds invested, manage interest rate risk, meet collateral requirements and meet regulatory capital requirements. Management classifies investment securities as either held to maturity or available for sale based on our intentions and the Company’s ability to hold such securities until maturity. In determining such classifications, securities that management has the positive intent and the Company has the ability to hold until maturity are classified as held to maturity and carried at amortized cost. All other securities are designated as available for sale and carried at estimated fair value with unrealized gains and losses included in stockholders’ equity on an after-tax basis. For the years presented, all securities were classified as available for sale. Our investment portfolio totaled $99.8 million at December 31, 2020, a 64.0% increase from $60.8 million at December 31, 2019. To supplement interest income earned on our loan portfolio, the Company invests in high quality mortgage-backed securities, government agency bonds, asset-backed securities and high quality municipal and corporate bonds. 66 The following tables summarize the contractual maturities and weighted-average yields of investment securities at December 31, 2020 and the amortized cost and carrying value of those securities as of the indicated dates. INVESTMENT PORTFOLIO One Year or Less More Than One Year Through Five Years More Than Five Years Through 10 Years More Than 10 Years Total At December 31, 2020 Book Value Weighted Average Yield Book Value Weighted Average Yield Book Value Weighted Average Yield Book Value Weighted Average Yield Book Value Fair Value Weighted Average Yield (dollars in thousands) Securities Available for Sale: Asset-backed securities $ — — % $ — — % $ — — % $ 10,839 1.10 % $ 10,839 $ 10,881 1.10 % Municipal — — % — — % — — % 10,836 1.94 % 10,836 10,927 1.94 % Corporate bonds — — % — — % 5,500 5.13 % 259 3.29 % 5,759 5,767 4.83 % Mortgage-backed securities — — % 996 1.66 % 15,026 2.14 % 53,994 1.73 % 70,016 72,212 1.82 % Total $ — — % $ 996 1.66 % $ 20,526 2.94 % $ 75,928 1.68 % $ 97,450 $ 99,787 1.93 % December 31, 2020 2019 2018 Book Value Fair Value Book Value Fair Value Book Value Fair Value (in thousands) Securities Available for Sale: U.S. government-sponsored agencies $ — $ — $ 1,000 $ 999 $ 17,496 $ 17,360 Asset-backed securities 10,839 10,881 — — — — Municipal 10,836 10,927 515 528 517 501 Corporate bonds 5,759 5,767 2,542 2,565 2,908 2,885 Mortgage-backed securities 70,016 72,212 56,754 56,736 26,836 26,186 Total $ 97,450 $ 99,787 $ 60,811 $ 60,828 $ 47,757 $ 46,932 Portfolio Loans Our primary source of income is derived from interest earned on loans. Our loan portfolio consists of loans secured by real estate, commercial business loans and credit card loans, substantially all of which are secured by corresponding deposits at the Bank and, to a very limited extent, other consumer loans. Our loan customers primarily consist of small- to medium-sized businesses, professionals, real estate investors, small residential builders and individuals. Our owner-occupied and investment commercial real estate loans, residential construction loans and commercial business loans provide us with higher risk-adjusted returns, shorter maturities and more sensitivity to interest rate fluctuations, and are complemented by our relatively lower risk residential real estate loans to individuals. Our credit card portfolio supplements our traditional lending products with enhanced yields. Outside of credit cards, our lending activities are principally directed to our market area consisting of the Washington, D.C. and Baltimore metropolitan areas. 67 The following table summarizes our portfolio loans by type of loan as of the dates indicated: COMPOSITION OF PORTFOLIO LOANS December 31, 2020 2019 2018 2017 2016 (in thousands) Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent Real estate: Residential $ 437,860 33 % $ 427,926 36 % $ 407,844 41 % $ 342,684 39 % 286,332 37 % Commercial 392,550 30 % 348,091 30 278,691 28 259,853 29 234,869 31 Construction 224,904 17 % 198,702 17 157,586 16 144,932 16 144,932 18 Commercial 157,127 12 % 151,109 13 122,264 12 108,982 12 87,563 11 Credit card 102,186 8 % 45,526 4 34,673 3 31,507 4 20,446 3 Other consumer 1,649 0 % 1,285 — 1,202 — 1,053 — 1,157 — Total gross loans 1,316,276 100 % 1,172,639 100 % 1,002,260 100 % 889,011 100 % 764,907 100 % Unearned income (774) (2,404) (1,992) (1,591) (1,477) Total portfolio loans, net of unearned income 1,315,502 1,170,235 1,000,268 887,420 763,430 Allowance for loan losses (23,434) (13,301) (11,308) (10,033) (8,597) Total portfolio loans, net $ 1,292,068 $ 1,156,934 $ 988,960 $ 877,387 $ 754,832,503 Residential Real Estate Loans . We offer one-to-four family mortgage loans primarily on owner-occupied primary residences and, to a lesser extent, investor owned residences. Residential loans are originated through our commercial sales teams and our Capital Bank Home Loan division. Our residential loans also include home equity lines of credit. Our owner-occupied residential real estate loans usually have fixed rates for five to seven years and adjust on an annual basis after the initial term based on a typical maturity of 30 years. Our investor residential real estate loans are generally based on 25-year terms with a balloon payment due after five years. In general, the required minimum debt service coverage ratio is 1.15. Residential real estate loans have represented a stable and growing portion of our loan portfolio. The Company intends to continue to emphasize residential real estate lending. Commercial Real Estate Loans . The Company originates both owner-occupied and non-owner-occupied commercial real estate loans. These loans may be adversely affected by conditions in the real estate markets or in the general economy. Commercial loans that are secured by owner-occupied commercial real estate and primarily collateralized by operating cash flows are also included in this category of loans. As of December 31, 2020, the Company had approximately $200.3 million of owner-occupied commercial real estate loans, representing approximately 15.2% of our total portfolio. Commercial real estate loan terms are generally extended for 10 years or less and amortize generally over 25 years or less. The interest rates on our commercial real estate loans generally have an initial fixed rate terms that adjust typically at 5 years. Origination fees are routinely charged for our services. The Company generally requires personal guarantees from the principal owners of the business, supported by a review of the principal owners’ personal financial statements and global debt service obligations. The properties securing the portfolio are diverse in terms of type. This diversity helps reduce the exposure to adverse economic events that affect any single industry. Construction Loans . Our construction loans are offered within our Washington, D.C. and Baltimore, Maryland metropolitan operating areas to builders primarily for the construction of single-family homes, condominium and townhouse conversions or renovations and, to a lesser extent, to individuals. Our construction loans typically have terms of 12 to 18 months with the goal of transitioning the borrowers to permanent financing or re-underwriting and selling into the secondary market through Capital Bank Home Loan. According to our underwriting standards, the ratio of loan principal to collateral value, as established by an independent appraisal, cannot exceed 75% for investor-owned and 80% for owner-occupied properties. We conduct semi-annual stress testing of our construction loan portfolio and closely monitor underlying real estate conditions as well as our borrower’s trends of sales valuations as 68 compared to underwriting valuations as part of our ongoing risk management efforts. Borrowers’ progress is closely monitored during the course of construction buildout and our original underwriting guidelines for construction milestones and completion timelines are followed. Commercial Business Loans . In addition to our other loan products, the Company provides general commercial loans, including commercial lines of credit, working capital loans, term loans, equipment financing, letters of credit and other loan products, primarily in our target markets, and underwritten based on each borrower’s ability to service debt from income. These loans are primarily made based on the identified cash flows of the borrower and secondarily, on the underlying collateral provided by the borrower. Most commercial business loans are secured by a lien on general business assets including, among other things, available real estate, accounts receivable, promissory notes, inventory and equipment, and we generally obtain a personal guaranty from the borrower or other principal. Credit Cards . Through our OpenSky® credit card division, the Company provides credit cards on a nationwide basis to under-banked populations and those looking to rebuild their credit scores through a fully digital and mobile platform. Substantially all of the lines of credit are secured by a noninterest bearing demand account at the Bank in an amount equal to the full credit limit of the credit card. In addition, using our proprietary scoring model, which considers credit score and repayment history (typically a minimum of six months of on-time repayments, but ultimately determined on a case-by-case basis), the Bank offers certain customers an unsecured line in excess of their secured line of credit. Other Consumer Loans . To a very limited extent and typically as an accommodation to existing customers, we offer personal consumer loans such as term loans, car loans or boat loans. The repayment of loans is a source of additional liquidity for us. The following table details maturities and sensitivity to interest rate changes for our loan portfolio at December 31, 2020: PORTFOLIO LOAN MATURITY AND SENSITIVITY TO CHANGES IN INTEREST RATES As of December 31, 2020 (in thousands) Due in One Year or Less Due in One to Five Years Due After Five Years Total Real estate: Residential $ 100,897 $ 164,118 $ 172,845 $ 437,860 Commercial 55,026 193,777 143,747 392,550 Construction 198,529 26,375 — 224,904 Commercial 72,882 50,254 33,991 157,127 Credit card 102,186 — — 102,186 Other consumer 1,297 192 160 1,649 Total portfolio loans $ 530,817 $ 434,716 $ 350,743 $ 1,316,276 Amounts with fixed rates $ 169,762 $ 313,101 $ 99,261 $ 582,124 Amounts with floating rates $ 361,054 $ 121,616 $ 251,482 $ 734,152 Nonperforming Assets Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. In general, we place loans on nonaccrual status when they become 90 days past due. We also place loans on nonaccrual status if they are less than 90 days past due if the collection of principal or interest is in doubt. When interest accrual is discontinued, all unpaid accrued 69 interest is reversed from income. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are, in management’s opinion, reasonably assured. Any loan which the Bank deems to be uncollectible, in whole or in part, is charged off to the extent of the anticipated loss. Consumer credit card balances are moved into the charge off queue after they become more than 90 days past due and are charged off not later than 120 days after they become past due. Loans that are past due for 180 days or more are charged off unless the loan is well secured and in the process of collection. The Company believes its disciplined lending approach and focused management of nonperforming assets has resulted in sound asset quality and timely resolution of problem assets. There are several procedures in place to assist the Company in maintaining the overall quality of our loan portfolio. The Company has established underwriting guidelines to be followed by our bankers, and monitor our delinquency levels for any negative or adverse trends. There can be no assurance, however, that our loan portfolio will not become subject to increasing pressures from deteriorating borrower credit. Nonperforming loans were $9.2 million at December 31, 2020 and $4.7 million December 31, 2019. Nonperforming loans were 0.61% and 0.40% of total portfolio loans at the respective year ends. Foreclosed real estate increased to $3.3 million as of December 31, 2020 compared to $2.4 million, for the same period of 2019. The foreclosure of a construction loan with an outstanding balance of $2.1 million was the primary reason for the increase. The property is currently being marketed. As of December 31, 2020, we had $230 thousand of accruing loans past due 90 days. These loans were past due as a result of maturity date, not payment issues. Total nonperforming assets were $12.6 million at December 31, 2020 compared to $7.1 million at December 31, 2019, or 0.67% and 0.50%, respectively, of corresponding total assets. Of the $12.6 million in total nonperforming assets, nonperforming loans represented $9.2 million and other real estate owned totaled $3.3 million. Nonperforming loans included five restructured loans totaling $440 thousand. The following table presents information regarding nonperforming assets at the dates indicated: NONPERFORMING ASSETS December 31, (in thousands) 2020 2019 2018 2017 2016 Nonaccrual loans Real Estate: Residential $ 3,581 $ 2,193 $ 2,207 1,828 $ 1,822 Commercial 2,358 1,433 1,486 1,648 1,193 Construction 1,886 — — 499 — Commercial 1,182 474 749 1,067 750 Accruing loans 90 or more days past due 230 620 237 365 753 Total nonperforming loans 9,237 4,720 4,679 5,407 4,518 Other real estate owned 3,326 2,384 142 93 90 Total nonperforming assets $ 12,563 $ 7,104 $ 4,821 $ 5,500 $ 4,608 Restructured loans-nonaccrual $ 440 $ 459 $ 284 $ 592 $ 941 Restructured loans-accruing $ — $ — $ — 3,219 $ — Nonperforming loans to total loans 0.61 % 0.40 % 0.47 % 0.61 % 0.59 % Nonperforming assets to total assets 0.67 % 0.50 % 0.44 % 0.54 % 0.51 % 70 Potential Problem Loans From a credit risk standpoint, we grade watchlist and problem loans into one of five categories: pass/watch, special mention, substandard, doubtful or loss. The classifications of loans reflect a judgment about the risks of default and loss associated with the loan. Credits ratings are reviewed regularly. Ratings are adjusted regularly to reflect the degree of risk and loss that our management believes to be appropriate for each credit. Our methodology is structured so that specific reserve allocations are increased in accordance with deterioration in credit quality (and a corresponding increase in risk and loss) or decreased in accordance with improvement in credit quality (and a corresponding decrease in risk and loss). Our lending policy requires the routine monitoring of weekly past due reports, daily overdraft reports, monthly maturing loans, monthly risk rating reports and internal loan review reports. The lending and credit management of the Bank meet several times a week to review loans rated pass/watch. The focus of each meeting is to identify and promptly determine any necessary required action with this loan population, which consists of loans that, although considered satisfactory and performing to terms, may exhibit special risk features that warrant management’s attention. Loans that are deemed special mention, substandard, doubtful or loss are listed in the Bank’s Problem Loan Status Report. The Problem Loan Status Report provides a detailed summary of the borrower and guarantor status, loan accrual status, collateral evaluation and includes a description of the planned collection and administration program designed to mitigate the Bank’s risk of loss and remove the loan from problem status. The Special Asset Committee reviews the Problem Loan Status Report on a quarterly basis for borrowers with an overall loan exposure in excess of $250,000. The Bank uses the following definitions for watch list risk ratings: • Pass/Watch. Borrowers who are considered satisfactory and performing to terms, however exhibiting special risk features such as declining earnings, strained cash flow, increasing leverage, and/or weakening fundamentals that indicate above average risk. • Special Mention. A special mention loan has potential weaknesses deserving of management’s attention. If uncorrected, such weaknesses may result in deterioration of the repayment prospects for the asset or in our credit position at some future date. • Substandard. A substandard loan is inadequately protected by the current financial condition and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that we will sustain some loss if deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets that are classified as substandard. • Doubtful. A doubtful loan has all weaknesses inherent in one classified as substandard, with the added characteristic that weaknesses make collection or liquidation in full, on the basis of existing facts, conditions, and values, highly questionable and improbable. The probability of loss is extremely high, but certain important and reasonably specific factors that may work to the advantage and strengthening of the asset exist. Therefore, its classification as an estimated loss is deferred until a more precise status may be determined by management. Pending factors include proposed merger, acquisition or liquidation procedures, capital injection, perfecting liens on additional collateral and refinancing plans. • Loss. Credits rated as loss are charged-off. We have no expectation of the recovery of any payments in respect of credits rated as loss. 71 Loans not meeting the criteria above are considered to be pass-rated loans. The following tables present the portfolio loan balances by category as well as risk rating. No assets were classified as loss during the periods presented. PORTFOLIO LOAN CLASSIFICATION (in thousands) Pass (1) Special Mention Substandard Doubtful Total December 31, 2020 Real estate: Residential $ 428,260 $ 5,150 $ 4,450 $ — $ 437,860 Commercial 383,311 6,881 2,358 — 392,550 Construction 220,057 1,112 3,735 — 224,904 Commercial 145,365 9,766 1,996 — 157,127 Credit card (2) 102,186 — — — 102,186 Other consumer 1,649 — — — 1,649 Total $ 1,280,828 $ 22,909 $ 12,539 $ — $ 1,316,276 December 31, 2019 Real estate: Residential $ 425,661 $ — $ 2,265 $ — $ 427,926 Commercial 340,313 6,345 1,433 — 348,091 Construction 198,702 — — — 198,702 Commercial 145,178 4,505 1,426 — 151,109 Credit card (2) 45,526 — — — 45,526 Other consumer 1,285 — — — 1,285 Total $ 1,156,665 $ 10,850 $ 5,124 $ — $ 1,172,639 _______________ (1) Category includes loans graded exceptional, very good, satisfactory and pass/watch. (2) Credit cards are evaluated by past due not risk rating. At December 31, 2020, the recorded investment in impaired loans was $9.2 million, $391 thousand of which required a specific reserve of $253 thousand compared to a recorded investment in impaired loans of $4.1 million including $273 thousand requiring a specific reserve of $119 thousand at December 31, 2019. Of the $9.2 million of impaired loans, $3.7 million was related to one loan relationship. Impaired loans also include certain loans that have been modified as troubled debt restructurings (“TDRs”). At December 31, 2020, the Company had five loans amounting to $440 thousand that were considered to be TDRs, compared to five loans amounting to $459 thousand at December 31, 2019. Allowance for Loan Losses We maintain an allowance for loan losses that represents management’s best estimate of the loan losses and risks inherent in our loan portfolio. The amount of the allowance for loan losses should not be interpreted as an indication that charge-offs in future periods will necessarily occur in those amounts, or at all. In determining the 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 the allowance for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of our 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. 72 The following table presents a summary of changes in the allowance for loan losses for the periods and dates indicated: ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES For the Years Ended December 31, (in thousands) 2020 2019 2018 2017 2016 Allowance for loan losses at beginning of period $ 13,301 $ 11,308 $ 10,033 $ 8,597 $ 6,573 Charge-offs: Real estate: Residential — (40) (121) (190) (42) Commercial — — (22) (312) (62) Construction (296) — — — — Commercial (233) (331) (147) (25) (1,765) Credit card (637) (461) (806) (1,124) (640) Other consumer — — — — — Total charge-offs (1,166) (832) (1,096) (1,651) (2,509) Recoveries: Real estate: Residential — — 3 — 7 Commercial — 13 152 115 89 Construction 7 — — — — Commercial — 2 34 3 8 Credit card 50 19 42 314 138 Other consumer — — — — — Total recoveries 57 34 231 432 242 Net charge-offs (1,109) (798) (865) (1,219) (2,267) Provision for loan losses 11,242 2,791 2,140 2,655 4,291 Allowance for loan losses at period end (1) $ 23,434 $ 13,301 $ 11,308 $ 10,033 $ 8,597 Allowance for loan losses to period end portfolio loans (1) 1.78 % 1.14 % 1.13 % 1.13 % 1.13 % Net charge-offs to average portfolio loans 0.09 % 0.08 % 0.09 % 0.15 % 0.33 % _______________ (1) Allowance calculation excludes SBA-PPP loans. Our allowance for loan losses at December 31, 2020 and December 31, 2019 was $23.4 million and $13.3 million, respectively, or 1.78% and 1.14% of portfolio loans for each respective period end. The allowance for loan losses at December 31, 2020 included specific reserves of $253 thousand set aside for impaired loans. Our charge-offs for the year ended December 31, 2020 were $1.2 million and were partially offset by recoveries of $57 thousand. The allowance for loan losses at December 31, 2019 included specific reserves of $119 thousand set aside for impaired loans. Our charge-offs for the year ended December 31, 2019 were $0.8 million and were partially offset by recoveries of $34 thousand. Total charge-offs for the years ended December 31, 2020 and 2019 were primarily due to credit card charge-offs resulting from growth in our credit card portfolio and certain charges in excess of credit limits. Additionally in 2019, there was a charge-off of a commercial and industrial loan in the amount of $233 thousand. As the loan portfolio and allowance for loan losses review processes continue to evolve, there may be changes to elements of the allowance and this may have an effect on the overall level of the allowance maintained. Historically, the Bank has enjoyed a high quality loan portfolio with relatively low levels of net charge-offs and low delinquency rates. The maintenance of a high quality portfolio will continue to be a high priority for both management and the Board of Directors. 73 Management, being aware of the significant loan growth experienced by the Company, is intent on maintaining a strong credit review function and risk rating process. The Company has an experienced Credit Administration function, which provides independent analysis of credit requests and the management of problem credits. The Credit Department has developed and implemented analytical procedures for evaluating credit requests, has refined the Company’s risk rating system, and continues to adapt and enhance the monitoring of the loan portfolio. The loan portfolio analysis process is intended to contribute to the identification of weaknesses before they become more severe. Although we believe we have established our allowance for loan losses in accordance with GAAP and that the allowance for loan losses was adequate to provide for known and inherent losses in the portfolio at all times shown above, future provisions for loan losses will be subject to ongoing evaluations of the risks in our loan portfolio. The following table sets forth activity in the allowance for loan losses for the past five years for the categories and certain other information as of the dates indicated. The total allowance is available to absorb losses from any loan category. ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES December 31, 2020 2019 2018 2017 2016 (in thousands) Amount Percent (1) Amount Percent (1) Amount Percent (1) Amount Percent (1) Amount Percent (1) Real estate: Residential $ 7,153 31 % $ 4,135 31 % $ 3,541 30 % $ 3,137 31 % $ 2,664 30 % Commercial 6,786 29 3,572 27 3,003 27 2,860 29 2,682 31 Construction 4,595 20 2,668 20 2,093 19 1,646 16 1,591 19 Commercial 2,417 10 1,548 12 1,578 14 1,497 15 1,174 14 Credit card 2,462 10 1,368 10 1,084 10 885 9 477 6 Other consumer 21 — 10 — 9 — 8 — 9 — Total allowance for loan losses $ 23,434 100 % $ 13,301 100 % $ 11,308 100 % $ 10,033 100 % $ 8,597 100 % _______________ (1) Loan category as a percentage of total portfolio loans which excludes SBA-PPP loans. Deposits Deposits are the major source of funding for the Company. We offer a variety of deposit products including interest bearing demand, savings, money market and time accounts all of which we actively market at competitive pricing. We generate deposits from our customers on a relationship basis and through the efforts of our commercial lending officers and our business banking officers. Year over year, deposits increased 34.8% with the largest increase occurring in non-interest bearing demand accounts. The Company continues to execute on its strategic initiative to improve the deposit portfolio mix by reducing reliance on wholesale time deposits. This is evident in the reduction in our wholesale time deposit portfolio of $59.3 million or 35.5%, to $107.7 million at December 31, 2020, from $167.0 million, or 13.6% at December 31, 2019. Our credit card customers are also a significant source of low cost deposits. As of December 31, 2020, our credit card customers accounted for $192.5 million, or 31.6%, of our total noninterest bearing deposit balances. We supplement our deposits with wholesale funding sources such as brokered deposits as needed. At December 31, 2020, interest bearing deposits were $1.0 billion, an increase of $109.9 million, or 11.8%, compared to $933.6 million at December 31, 2019. This increase was primarily due to the Company’s continued effort to improve the deposit mix by reducing reliance on wholesale time deposits. 74 During the same period, money market balances increased to $447.1 million, an $18.0 million or 4.2% change from the prior year’s balance of $429.1 million. In order to fund the loan growth of the Bank, we built upon our prior success of focusing our strategic efforts to grow core deposits through an expanded deposits sales force, incentives to our commercial loan team and increased marketing efforts. The average rate paid on interest bearing demand deposits decreased 27 basis points to 0.34% at December 31, 2020 from 0.61% for the same period in 2019. Rates paid on certificates of deposit and money market decreased 34 and 69 basis points, respectively, for the period presented. The decrease in the average rates was primarily due to decreases in market interest rates resulting from prolonged low level of the federal funds rate during 2020. The following table presents the average balances and average rates paid on deposits for the periods indicated: COMPOSITION OF DEPOSITS December 31, 2020 2019 2018 (in thousands) Average Balance Average Rate Average Balance Average Rate Average Balance Average Rate Interest bearing demand accounts $ 195,794 0.34 % $ 109,977 0.61 % $ 72,523 0.29 % Money market accounts 480,218 1.00 % 344,272 1.69 % 286,257 1.33 % Savings accounts 4,722 0.11 % 3,597 0.36 % 3,704 0.32 % Certificates of deposit 297,997 2.04 % 302,149 2.38 % 326,827 1.77 % Total interest bearing deposits 978,731 1.18 % 759,995 1.80 % 689,311 1.42 % Noninterest bearing demand accounts 473,301 260,726 220,445 Total deposits $ 1,452,032 0.79 % $ 1,020,721 1.34 % $ 909,756 1.08 % The following table presents the maturities of our certificates of deposit as of December 31, 2020. MATURITIES OF CERTIFICATES OF DEPOSIT (in thousands) Three Months or Less Over Three Through Six Months Over Six Through Twelve Months Over Twelve Months Total $100,000 or more $ 51,471 $ 46,704 $ 109,164 $ 91,516 $ 298,855 Less than $100,000 4,842 6,717 18,724 5,428 35,711 Total $ 56,313 $ 53,421 $ 127,888 $ 96,944 $ 334,566 Borrowings We utilize short-term and long-term borrowings to supplement deposits to fund our lending and investment activities, each of which is discussed below. FHLB Advances . The FHLB allows us to borrow up to 25% of our assets on a blanket floating lien status collateralized by certain securities and loans. As of December 31, 2020, approximately $222.0 million in real estate loans and $1.2 million in investment securities were pledged as collateral for our FHLB borrowings. We utilize these borrowings to meet liquidity needs and to fund certain fixed rate loans in our portfolio. As of December 31, 2020, we had $22.0 million in outstanding advances and $201.2 million in available borrowing capacity from the FHLB. 75 The following table sets forth certain information on our FHLB borrowings during the periods presented: FHLB ADVANCES Years Ended December 31, (in thousands) 2020 2019 2018 Amount outstanding at period-end $ 22,000 $ 32,222 $ 2,000 Weighted average interest rate at period-end 0.93 % 2.40 % 4.26 % Maximum month-end balance during the period $ 31,111 $ 34,444 $ 17,000 Average balance outstanding during the period $ 25,917 $ 43,472 $ 8,101 Weighted average interest rate during the period 2.15 % 2.47 % 2.83 % Other borrowed funds . The Company has also issued junior subordinated debentures and other subordinated notes. At December 31, 2020, these other borrowings amounted to $14.0 million. At December 31, 2020, our junior subordinated debentures amounted to $2.1 million. The junior subordinated debentures were issued in June of 2006, mature on June 15, 2036, and may be redeemed prior to that date under certain circumstances. The principal amount of the debentures has not changed since issuance, and they accrue interest at a floating rate equal to the three-month LIBOR plus 1.87%. On November 30, 2020, the Company issued $10.0 million in subordinated notes due in 2030 to replace the outstanding higher yielding $13.5 million, reducing interest expense. The notes have a ten year term and have a fixed rated of 5.00% for the first five years; thereafter, the rate resets quarterly to a benchmark rate plus 490 basis points. The notes may be redeemed, in part or whole, upon the occurrence of certain events. Federal Reserve Bank of Richmond . The Federal Reserve Bank of Richmond has an available borrower in custody arrangement which allows us to borrow on a collateralized basis. The Company’s borrowing capacity under the Federal Reserve’s discount window program was $15.6 million as of December 31, 2020. Certain commercial loans are pledged under this arrangement. We maintain this borrowing arrangement to meet liquidity needs pursuant to our contingency funding plan. No advances were outstanding under this facility as of December 31, 2020. The Company also has lines of credit of $76.0 million available with other correspondent banks at December 31, 2020, as well as access to certificate of deposit funding through a financial network which the Bank strives to limit to 15% of the Bank’s assets. There were no outstanding balances on the lines of credit from correspondent banks at December 31, 2020. Liquidity Liquidity is defined as the Bank’s capacity to meet its cash and collateral obligations at a reasonable cost. Maintaining an adequate level of liquidity depends on the Bank’s ability to meet both expected and unexpected cash flows and collateral needs efficiently without adversely affecting either daily operations or the financial condition of the Bank. Liquidity risk is the risk that we will be unable to meet our obligations as they become due because of an inability to liquidate assets or obtain adequate funding. The Bank’s obligations, and the funding sources used to meet them, depend significantly on our business mix, balance sheet structure and the cash flow profiles of our on- and off-balance sheet obligations. In managing our cash flows, management regularly confronts situations that can give rise to increased liquidity risk. These include funding mismatches, market constraints on the ability to convert assets into cash or in accessing sources of funds (i.e., market liquidity) and contingent liquidity events. Changes in 76 economic conditions or exposure to credit, market, operating, legal and reputational risks also could affect the Bank’s liquidity risk profile and are considered in the assessment of liquidity and asset/liability management. Management has established a comprehensive management process for identifying, measuring, monitoring and controlling liquidity risk. Because of its critical importance to the viability of the Bank, liquidity risk management is integrated into our risk management processes. Critical elements of our liquidity risk management include: corporate governance consisting of oversight by the board of directors and active involvement by management; the application of strategies, policies, procedures, and limits used to manage and mitigate liquidity risk; liquidity risk measurement and monitoring systems (including assessments of the current and prospective cash flows or sources and uses of funds) that are commensurate with the complexity and business activities of the Bank; active management of intraday liquidity and collateral; an appropriately diverse mix of existing and potential future funding sources; adequate levels of highly liquid marketable securities free of legal, regulatory or operational impediments, that can be used to meet liquidity needs in stressful situations; comprehensive contingency funding plans that are believed to be adequate to address potential adverse liquidity events and emergency cash flow requirements; and internal controls and internal audit processes that are believed to be appropriate to assure the adequacy of the institution’s liquidity risk management process. We expect funds to be available from a number of basic banking activity sources, including the core deposit base, the repayment and maturity of loans and investment security cash flows. Other potential funding sources include brokered certificates of deposit, deposit listing services, CDARS, borrowings from the FHLB and other lines of credit. We had outstanding borrowings of $2.0 million with the Federal Reserve Bank of Richmond at December 31, 2020 as participation with the Paycheck Protection Program Liquidity Facility (“PPPLF”). The PPPLF extended credit to eligible financial institutions that originated SBA-PPP loans, using the loans as collateral. We have an available borrower custody arrangement with the Federal Reserve Bank of Richmond which allows us to borrow on an eligible collateralized basis. As of December 31, 2020, we had $201.2 million of available borrowing capacity from the FHLB, $15.6 million of available borrowing capacity from the Federal Reserve Bank of Richmond and available lines of credit of $76.0 million with other correspondent banks. Cash and cash equivalents were $146.9 million million at December 31, 2020 and $114.8 million at December 31, 2019. Accordingly, our liquidity resources were at sufficient levels to fund loans and meet other cash needs as necessary. Capital Resources Stockholders’ equity increased $26.0 million for the year ended December 31, 2020 largely due to net income of $25.8 million for the year. Stock options exercised, shares issued as compensation, shares sold and stock-based compensation increased common stock and additional paid-in capital aggregately by $1.8 million. These increases were offset by the repurchase of 304,114 shares aggregating $3.7 million during 2020, and net unrealized gains on available for sale securities and cash flow hedging derivative of $1.7 million. The Company uses several indicators of capital strength. The most commonly used measure is average common equity to average assets (computed as average equity divided by average total assets), which was 8.64% at December 31, 2020 and 10.14% at December 31, 2019. The following table shows the return on average assets (computed as net income divided by average total assets), return on average equity (computed as net income divided by average equity) and average equity to average assets ratios for the years ended December 31, 2020 and 2019. 77 December 31, 2020 December 31, 2019 Return on Average Assets 1.56 % 1.38 % Return on Average Equity 18.00 % 13.66 % Average Equity to Average Assets 8.64 % 10.14 % The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can precipitate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum ratios of common equity Tier 1, Tier 1, and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1250%. The Bank is also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio. In July 2013, federal bank regulatory agencies issued a final rule that revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by Basel III and certain provisions of the Dodd-Frank Act. The final rule applies to all depository institutions and bank holding companies and savings and loan holding companies with total consolidated assets of more than $1 billion. The Bank was required to implement the new Basel III capital standards (subject to the phase-in for certain parts of the new rules) as of January 1, 2015. In August of 2018 the Regulatory Relief Act directed the Federal Reserve Board to revise the Small BHC Policy Statement to raise the total consolidated asset limit in the Small BHC Policy Statement from $1 billion to $3 billion. The Company is currently exempt from the consolidated capital requirements. The ability of the Company to continue to grow is dependent on its earnings and those of the Bank, the ability to obtain additional funds for contribution to the Bank’s capital, through additional borrowings, through the sale of additional common stock or preferred stock, or through the issuance of additional qualifying capital instruments, such as subordinated debt. The capital levels required to be maintained by the Company and Bank may be impacted as a result of the Bank’s concentrations in commercial real estate loans. See “Regulation” at page 18 and “Risk Factors” at page 33. As of December 31, 2020, the Bank was in compliance with all applicable regulatory capital requirements to which it was subject and was classified as “well capitalized” for purposes of the prompt corrective action regulations. As we deploy our capital and continue to grow our operations, our regulatory capital levels may decrease depending on our level of earnings. However, we intend to monitor and control our growth in order to remain in compliance with all regulatory capital standards applicable to us. 78 The following table presents the regulatory capital ratios for the Company (as if such requirements applied to the Company) and the Bank as of the dates indicated. (dollars in thousands) Actual Minimum Capital Adequacy To Be Well Capitalized Full Phase In of Basel III December 31, 2020 Amount Ratio Amount Ratio Amount Ratio Amount Ratio The Company Tier 1 leverage ratio (to average assets) $ 159,656 8.78 % $ 72,770 4.00 % N/A N/A $ 90,962 5.00 % Tier 1 capital (to risk-weighted assets) 159,656 13.10 % 73,100 6.00 % N/A N/A 97,467 8.00 % Common equity tier 1 capital ratio (to risk-weighted assets) 157,594 12.94 % 54,825 4.50 % N/A N/A 79,192 6.50 % Total capital ratio (to risk-weighted assets) 185,008 15.19 % 97,467 8.00 % N/A N/A 121,834 10.00 % The Bank Tier 1 leverage ratio (to average assets) $ 135,527 7.44 % $ 72,770 4.00 % $ 90,962 5.00 % $ 90,962 5.00 % Tier 1 capital (to risk-weighted assets) 135,527 12.06 % 71,731 6.00 % 95,642 8.00 % 95,642 8.00 % Common equity tier 1 capital ratio (to risk-weighted assets) 135,527 12.06 % 53,798 4.50 % 77,709 6.50 % 77,709 6.50 % Total capital ratio (to risk-weighted assets) 150,593 13.40 % 95,642 8.00 % 119,552 10.00 % 119,552 10.00 % December 31, 2019 The Company Tier 1 leverage ratio (to average assets) $ 135,380 9.96 % $ 54,397 4.00 % N/A N/A $ 67,996 5.00 % Tier 1 capital (to risk-weighted assets) 135,380 12.31 % 66,011 6.00 % N/A N/A 88,015 8.00 % Common equity tier 1 capital ratio (to risk-weighted assets) 133,318 12.12 % 49,508 4.50 % N/A N/A 71,512 6.50 % Total capital ratio (to risk-weighted assets) 149,142 13.56 % 88,015 8.00 % N/A N/A 110,018 10.00 % The Bank Tier 1 leverage ratio (to average assets) $ 114,613 8.65 % $ 53,005 4.00 % $ 66,256 5.00 % $ 66,256 5.00 % Tier 1 capital (to risk-weighted assets) 114,613 10.73 % 64,093 6.00 % 85,458 8.00 % 85,458 8.00 % Common equity tier 1 capital ratio (to risk-weighted assets) 114,613 10.73 % 48,070 4.50 % 69,435 6.50 % 69,435 6.50 % Total capital ratio (to risk-weighted assets) 127,976 11.98 % 85,458 8.00 % 106,822 10.00 % 106,822 10.00 % 79 Contractual Obligations We have contractual obligations to make future payments on debt and lease agreements. While our liquidity monitoring and management consider both present and future demands for and sources of liquidity, the following table of contractual commitments focuses only on future obligations and summarizes our contractual obligations as of December 31, 2020. CONTRACTUAL OBLIGATIONS As of December 31, 2020 (in thousands) Due in One Year or Less Due After One Through Three Years Due After Three Through Five Years Due After 5 Years Total FRB Borrowings $ — $ 1,954 $ — $ — $ 1,954 FHLB advances — — 22,000 — 22,000 Certificates of deposit $100,000 or more 207,339 90,872 644 — 298,855 Certificates of deposit less than $100,000 30,284 4,952 445 30 35,711 Lease payments 1,408 1,800 420 — 3,628 Subordinated debt — — — 12,062 12,062 Total $ 239,031 $ 99,578 $ 23,509 $ 12,092 $ 374,210 Off-Balance Sheet Items In the normal course of business, we enter into various transactions that, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and issue letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in our consolidated balance sheets. Our exposure to credit loss is represented by the contractual amounts of these commitments. The same credit policies and procedures are used in making these commitments as for on-balance sheet instruments. We are not aware of any accounting loss to be incurred by funding these commitments; however, we maintain an allowance for off-balance sheet credit risk which is recorded in other liabilities on the consolidated balance sheet. Our commitments associated with outstanding letters of credit and commitments to extend credit expiring by period as of the date indicated are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements. CREDIT EXTENSION COMMITMENTS December 31, (in thousands) 2020 2019 Unfunded lines of credit $ 331,576 $ 260,573 Commitments to originate residential loans held for sale 11,444 2,646 Letters of credit 5,102 5,305 Total credit extension commitments $ 348,122 $ 268,524 Unfunded lines of credit represent unused credit facilities to our current borrowers. Lines of credit generally have variable interest rates. Letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. In the event of nonperformance by the customer in accordance with the terms of the agreement with the third party, we would be required to fund the commitment. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, we would be 80 entitled to seek recovery from the customer from the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and/or marketable securities. Our policies generally require that letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements. The credit risk associated with issuing letters of credit is substantially the same as the risk involved in extending loan facilities to our customers. We minimize our exposure to loss under letters of credit and credit commitments by subjecting them to the same credit approval and monitoring procedures as we do for on-balance sheet instruments. The effect on our revenue, expenses, cash flows and liquidity of the unused portions of these lines of credit commitments cannot be precisely predicted because there is no guarantee that the lines of credit will be used. Commitments to extend credit are agreements to lend funds to a customer, as long as there is no violation of any condition established in the contract, for a specific purpose. Commitments generally have variable interest rates, fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn, the total commitment amounts disclosed above do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by us, upon extension of credit is based on management’s credit evaluation of the customer. We enter into forward commitments for the delivery of mortgage loans in our current pipeline. Interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from our commitments to fund the loans. These commitments to fund mortgage loans, to be sold into the secondary market, (interest rate lock commitments) and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. Impact of Inflation Our consolidated financial statements and related notes included elsewhere in this report have been prepared in accordance with GAAP. GAAP requires the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative value of money over time due to inflation or recession. Unlike many industrial companies, substantially all of our assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Interest rates may not necessarily move in the same direction or in the same magnitude as the prices of goods and services. However, other operating expenses do reflect general levels of inflation. 81