What changed in this filing

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Item 2. Management’s Discussion and Analysis

2020-08-07 compared with 2020-05-08 · 663 added, 413 removed, 509 unchanged (68% of the section changed)

Management’s Discussion and Analysis o f Financial Condition and Results of Operations

Management’s Discussion and Analysis of Financial Condition and Results of Operations

We are a bank holding company that operates through our wholly owned subsidiary, Coastal Community Bank (the “Bank”).

2 unchanged sentences

We currently operate 15 full-service banking locations, 12 of which are located in Snohomish County, where we are the largest community bank by deposit market share, and three of which are located in neighboring counties (one in King County and two in Island County).

We plan to open our 15 th branch in Arlington, Washington during the second quarter 2020.

As of March 31, 2020, we had total assets of $1.18 billion, total gross loans of $1.01 billion, total deposits of $1.01 billion and total shareholders’ equity of $127.2 million.

We opened our 15 th branch in Arlington, Washington during the second quarter of 2020.

The Bank also provides banking as a service (“BaaS”) that allows our broker-dealer and digital financial service partners to offer their customers banking services.

As of June 30, 2020, we had total assets of $1.68 billion, total gross loans of $1.45 billion, total deposits of $1.31 billion and total shareholders’ equity of $131.0 million.

The following discussion and analysis presents our financial condition and results of operations on a consolidated basis.

3 unchanged sentences

We place secondary reliance on wholesale funding, primarily borrowings from the Federal Home Loan Bank (“FHLB”).

We are utilizing the Paycheck Protection Program Liquidity Facility (“PPPLF”), which provides an additional source of low cost funding for the PPP loans, with a contractual 0.35% interest rate.

The borrowings are collateralized by Paycheck Protection Program (“PPP”) loans and must be paid down as the PPP loans are forgiven or paid down by customers.

Less commonly used sources of funding include borrowings from the Federal Reserve System (“Federal Reserve”) discount window, draws on established federal funds lines from unaffiliated commercial banks, brokered funds, which allows us to obtain deposits from sources that do not have a relationship with the Bank and can be obtained through certificate of deposit listing services, via the internet or through other advertising methods, or a one-way buy through an insured cash sweep (“ICS”) account, which allows us to obtain funds from other institutions that have deposited funds through ICS.

Our largest expenses are salaries and related employee benefits, occupancy, interest on deposits and borrowings, data processing, and provision for loan losses.

Our largest expenses are salaries and related employee benefits, provision for loan losses, interest on deposits and borrowings, occupancy and data processing.

Our principal lending products are commercial real estate loans, commercial and industrial loans, residential real estate loans, construction, land and land development loans, and to a lesser extent consumer loans.

The Company's Preparations and Responses to Pandemic

Coronavirus Aid, Relief, and Economic Security (“CARES”) Act

On March 27, 2020, the CARES Act was enacted, providing wide ranging economic relief for individuals and businesses impacted by the COVID-19 pandemic.

Among other things, the statute created the PPP, which is a stimulus response to the potential economic impacts of COVID-19, and its purpose is to provide forgivable loans to smaller businesses that use the proceeds of the loans for payroll and certain other qualifying expenses.

The Small Business Administration ("SBA") manages and backs the PPP.

If a loan is fully forgiven, the SBA will repay the lending bank in full.

If a loan is partially forgiven or not forgiven at all, a bank must look to the borrower for repayment of unforgiven principal and interest.

If the borrower defaults, the loan is guaranteed by the SBA.

The Company's Preparations and Responses to COVID-19 Pandemic

As part of its ongoing risk preparation and mitigation efforts, the Company had developed a detailed plan and action measures related to a possible pandemic scenario.

This pandemic plan was implemented on March 12, 2020.

Subsequently, the Company initiated a series of measures to limit operational disruptions, support customer needs and to ensure the continued safety of employees, customers and vendors.

This pandemic plan was implemented on March 12, 2020 and continued through the second quarter and into third quarter of 2020.

The Company carefully executed the plan with limited operational disruptions, attention to ensure continued customer support, and with the utmost care to safeguard employees, customers and vendors.

Management continues to monitor and, when appropriate, make changes to our planned response.

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Continued to serve customers through drive throughs, call center, mobile banking, online banking and ATMs, and closed branches except for drive throughs and appointments.

Dispersed workforce throughout facilities in order to maximize social distancing protocols, including remote work solutions for many employees.

Subsequent to quarter end March 31, 2020, funded Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”) loan approval requests for 1,874 borrowers and $393.4 million, impacting over 35,325 employees in our communities.

Actively engaged borrowers and other businesses in discussion to identify short-term cash flow and other financial needs, and restructuring payments on existing loans to alleviate financial hardship per regulatory guidance.

As of May 6, 2020 payments have been deferred on over 215 loans representing $196.1 million.

Pledged 327 PPP loans, or $111.1 million as of May 6, 2020, which provides an additional source of funding for the PPP loans, through the Paycheck Protection Program Liquidity Facility (“PPPLF”).

Dispersed workforce throughout facilities in order to maximize social distancing protocols, including successful employment of remote work solutions for many employees.

Continued participation in the SBA PPP with funded loans outstanding of $438.1 million, for 2,526 borrowers, impacting nearly 40,000 employees in our communities, as of June 30, 2020.

Actively engaged borrowers and other businesses in discussion to identify short-term cash flow and other financial needs, and restructured payments on existing loans to alleviate financial hardship per regulatory guidance.

As of June 30, 2020, payments have been deferred on 215 loans representing $207.2 million.

Pledged 711 PPP loans, or $190.2 million as of June 30, 2020, which provides an additional source of funding for the PPP loans, through the PPPLF.

The borrowings must be paid down as they are forgiven or when the customers pay the loan down.

PPPLF is a low cost source of funding and liquidity for PPP loans, with an interest rate of 0.35%, and favorable capital treatment.

Enhanced credit monitoring on loan segments that have been most impacted by COVID-19, monitoring and tracking loan payment deferrals and customer liquidity.

Reviewed loans impacted by the temporary halting of non-essential construction projects resulting from the stay at home order issued by the Governor of Washington, working with contractors and extending the construction period as appropriate to compensate for the work shutdown.

Reviewed loans impacted by the temporary halting of non-essential construction projects resulting from the stay-at-home order issued by the Governor of Washington, working with borrowers and extending the construction period as appropriate to compensate for the work shutdown.

The majority of Washington State, and Snohomish County in particular, was under a stay-at-home order for much of the second quarter of 2020.

Majority of Washington State, including Snohomish County, migrated to Phase 2 in early June, after spending most of the second quarter of 2020 in Phase 1 of Washington State’s 4 phase approach to re-opening businesses.

We anticipate remaining in Phase 2 for the foreseeable future.

Phase 2 allows:

Gatherings of no more than 5 people outside one’s household per week

Limited non-essential travel in proximity of one’s home

Opens certain businesses with social distancing and capacity restrictions

Refreshed and analyzed the Company's liquidity, funding and capital stress forecasts and risk assumptions.

Comparison of Operating Results for the Three Months Ended March 31, 2020 and March 31, 2019

The Company’s first quarter 2019 results were impacted by a temporary, atypically large balance held in a deposit account by a Banking as a Service (“BaaS”) client, which is not expected to occur again.

The deposits came through a BaaS relationship and not from the end customer so they are classified as brokered deposits in accordance with regulatory guidance.

The increase of BaaS -brokered deposits during the quarter ended March 31, 2019 most significantly affected the following balance s heet items:

cash and cash equivalents, total assets, deposits, and total liabilities.

Cost of deposits, cost of funds, net interest margin, and net income were the most significantly impacted income statement items due to the temporary increase in BaaS -br okered deposits .

These BaaS -brokered d eposits stabilized in the third quarter 2019 to a more normalized balance and remained that way through March of 2020 .

Comparison of Operating Results for the Three Months Ended June 30 , 2020 and June 30 , 201 9

During the quarter ended June 30, 2020, significant focus was placed on helping the small businesses in our communities through the PPP.

These loans have had a significant impact on our financial statements for the current quarter ended June 30, 2020 and will continue to impact our results in the future.

Throughout this discussion, we will address the impact of these loans, including borrowings received through PPPLF to help fund these loans and to aid in liquidity, increased customer deposit accounts from unused disbursements, and earnings and expenses related to these activities.

Any estimated adjusted ratios that exclude the impact of this activity are non- U.S.

generally accepted accounting principles (“GAAP”) measures.

For more information about non-GAAP financial measures, see the non-GAAP disclosure “ GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures ”.

The table below summarizes key information regarding the PPP loans as of the period indicated:

As of June 30, 2020

$150,000.01 -

$350,000.01 -

$2,000,000.00

> 2,000,000.01

(Dollars in thousands;

Principal outstanding:

Existing customer

Total principal outstanding

Deferred fees outstanding

Deferred costs outstanding

Net deferred fees

Total principal, net of deferred fees

Weighted average maturity (years)

Number of loans:

Existing customer

Total loan count

Results of Operations

Net income for the three months ended March 31, 2020, was $2.7 million, or $0.22 per diluted share, compared to $2.8 million, or $0.23 per diluted share, for the three months ended March 31, 2019.

The decrease in net income over the comparable period in the prior year was attributable to a $1.0 million increase in the provision for loan losses, related to the growth in the loan portfolio along with an increase in qualitative factors related to the change in the economic outlook caused by the COVID-19 pandemic, and $1.4 million increase in noninterest expense, which includes $1.1 million more in salaries and employee benefits.

These are partially offset by $1.6 million increase in net interest income, primarily arising from increased interest earning assets from our loan growth initiatives, as well as increases in noninterest income of $420,000 in loan referral fees, and $133,000 in BaaS fees.

BaaS is a line of business t hat enable our broker dealer and digital financial service partners to offer their customers banking services.

Net income for the three months ended June 30, 2020, was $3.7 million, or $0.30 per diluted share, compared to $3.3 million, or $0.27 per diluted share, for the three months ended June 30, 2019.

The increase in net income over the comparable period in the prior year was attributable to a $3.8 million increase in net interest income, largely related to PPP loans.

Interest and fee income related to PPP loans totaled $2.8 million for the three months ended June 30, 2020.

Net deferred fees on PPP loans will be earned over the life of the loan, as a yield adjustment.

Forgiveness of principal, early paydowns and payoffs on PPP loans will increase interest income earned in those periods.

The increase in net interest income was partially offset by a $1.4 million increase in the provision for loan losses, related to the growth in the loan portfolio along with an increase in qualitative factors related to the change in the economic outlook caused by the COVID-19 pandemic, and $1.3 million increase in noninterest expense, which includes $686,000 more in salaries and employee benefits, $181,000 more in legal and professional fees and $122,000 more in data processing expenses.

Salaries and employee benefits were increased largely as a result of hiring staff for our BaaS CCBX division and legal and professional expenses were increased due to development of contracts for CCBX customers and because of reporting related legal and professional services.

Data processing costs grow as we add new products, customers and branches.

Additionally, CCBX data processing expenses are included in this category and are expected to increase incrementally as the CCBX division develops.

Net Interest Income

Net interest income for the three months ended March 31, 2020, was $11.4 million, compared to $9.8 million for the three months ended March 31, 2019, an increase of $1.6 million, or 16.4%.

The increase in net interest income consisted of a $1.7 million, or 15.1%, increase in interest income partially offset by a $129,000, or 7.9%, increase in interest expense.

The increase from prior quarter one year ago is related to increased interest income resulting from our loan growth, partially offset by increased interest expense due to growth in interest bearing deposits and a decrease in rates on existing loans that are tied to indexes, including, among others, Wall Street Journal Prime, FHLB term advance rates and LIBOR .

The growth in interest income was primarily attributable to a $184.2 million, or 23.6%, increase in average loans outstanding for the three months ended March 31, 2020, compared to the prior year period, partially offset by $30.1 million less in interest earning deposits and a 15 basis point decrease in average yield on loans.

The decrease in loan yields, as compared to the prior year period, was the result of the Federal Open Market Committee (“FOMC”) lowering rates five times since July 2019, resulting in lower rates on new and renewing loans as well as loans tied to indexes.

Contractual loan yields approximated 5.08% for the quarter ended March 31, 2020 compared to 5.22% for the quarter ended March 31, 2019.

Net interest income for the three months ended June 30, 2020, was $14.0 million, compared to $10.2 million for the three months ended June 30, 2019, an increase of $3.8 million, or 37.4%.

The increase in net interest income consisted of a $3.6 million, or 30.7%, increase in interest income coupled with a $185,000, or 11.4%, decrease in interest expense.

The increase in interest income was primarily attributable to a $ 522.3 million, or 64.3 %, increase in average loans outstanding for the three months ended June 30, 2020 , compared to the prior year period , partially offset by an 82-basis point decrease in yield on loans.

The decrease in loan yields , as compared to the prior year period , was the result of the Federal Open Market Committee (“FOMC”) lowering the Fed funds rate five times since Ju ne 2019, totaling 2.

25 % , resulting in lower rates on new and renewing loans as well as loans tied to indexes.

In addition, for the quarter ended June 30, 2020 there was an average of $335.2 million in PPP loans, which have a 1.0% interest rate and an approximate yield of 3.31% after the amortization of deferred fees and costs .

Contractu al loan yields approximated 3.91 % for the quarter ended June 30, 2020 compared to 5.

2 3 % f or the quarter ended June 30, 2019 .

Although we have rate floors in place for $ 349.1 million, or 23.9 %, in existing loans, the rate reductions by the FOMC have had a corresponding impact on loan yields and subsequently the net interest margin in future periods.

We have continued to focus on our loan growth initiatives, including the deepening of relationships with existing customers and developing new loan and deposit relationships with new customers.

We have experienced a significant increase in commercial and industrial SBA 7(a) loans during the second quarter 2020, as small business owners apply for relief via the PPP as prescribed in the CARES Act.

We primarily focus on organically growing loans through our existing lenders and by acquiring new lenders or teams to assist to grow our loan portfolio .

The increase in interest expense for the three months ended March 31, 2020 was primarily related to $57.0 million, or 10.0%, increase in average interest bearing deposits, compared to the prior year period.

The increase was partially offset by a six-basis point decrease in the cost of funds to 0.70% for the quarter ended March 31, 2020 compared to 0.76% for the quarter ended March 31, 2019.

The average rate paid on BaaS-brokered deposits decreased 1.29% compared to the prior year period, and NOW and money market accounts increased 28 basis points for the three months ended March 31, 2020.

The average rate paid on BaaS-brokered deposits was higher in the three months ended March 31, 2019 as a result of the temporary increase in BaaS-brokered deposits for that period.

The average rate paid on NOW and money market accounts in the quarter ended March 31, 2020 is the result of the recent decreased FOMC rates, compounded by continued market pressure for higher rates, which in turn resulted in lowered rates on these accounts;

however, the impact of such rate decreases will be reflected in future periods, starting with second quarter 2020.

The average balance of NOW and money market accounts grew $117.9 million, or 33.8%, in the three months ended March 31, 2020.

The average balance of BaaS-brokered deposits was $21.8 million for the three months ended March 31, 2020, which was down $52.3 million for the prior year period.

The average balance of savings accounts grew $1.5 million, or 2.8%, and the average balance of time deposits declined $10.1 million, or 10.7%, to $84.7 million in the three months ended March 31, 2020, in an intentional effort to focus on more on core deposit growth.

We have continued to focus on our loan growth initiatives, including the deepening of relationships with existing customers and developing new loan and deposit relationships with new customers and non- B ank PPP customers .

During the quarter ended June 30, 2020 , our focus was on working with small busin esses within our communities with PPP loan requests.

W e have experienced a significant increase in commercial and industrial SBA 7(a) loans during the second quarter 2020, as small business owners apply for relief via the PPP as prescribed in the CARES Act.

The decrease in interest expense for the three months ended June 30, 2020 was the result of a 33 basis point decrease in cost of funds, bringing it to 0.41% as of June 30, 2020, compared to 0.74% at June 30, 2019.

Much of the funding from the PPP loans was deposited into core deposit accounts, including noninterest bearing accounts, until customers use the funds, which helped contribute to the improved cost of funds for the quarter ended June 30, 2020, as compared to the prior year period.

The average balance of interest-bearing deposits increased $157.9 million, or 28.7%, compared to the prior year period, but the average rate paid on interest bearing deposits was 41 basis points less for the quarter ended June 30, 2020, compared to the quarter ended June 30, 2019.

As previously mentioned, the Fed funds rate reductions by the FOMC have impacted the rates that are paid on interest bearing accounts and management lowered deposit rates in response to these rate reductions.

The average rate paid on BaaS-brokered deposits decreased 195 basis points and NOW and money market accounts decreased 33 basis points for the three months ended June 30, 2020.

The average rate paid on BaaS-brokered deposits was higher in the three months ended June 30, 2019 as a result of the temporary negotiated rate for that period.

The average rate paid on time deposits also decreased.

For time deposits less than $100,000, the rate decreased 20 basis points and for time deposits over $100,000, the average rate decreased 43 basis points, as compared to the prior year period.

The average rate paid on NOW, money market, and time deposit accounts in the quarter ended June 30, 2020 is the result of the recent decreased Fed funds rates and management lowering rates in response, which resulted in management lowering rates on these accounts.

Many deposit rates were either lowered late in the first quarter or at the start of the second quarter of 2020, so the impact of these reductions will continue to be seen in future periods.

The average balance of NOW and money market accounts grew $154.1 million, or 30.8%, in the three months ended June 30, 2020.

The average balance of BaaS-brokered deposits was $22.1 million for the three months ended June 30, 2020, which was up $1.9 million from the prior year period.

The average balance of savings accounts grew $15.5 million, or 25.5%, and the average balance of time deposits declined $13.6 million, or 16.0%, to $84.0 million in the three months ended June 30, 2020, compared to the three months ended June 30, 2019, in an intentional effort to focus more on core deposit growth.

We do not regularly advertise time deposit rates or money market rates, although we occasionally advertise promotional rates in targeted portions of our market area.

Our branch managers, business development officers, and lenders collaborate to provide consistent and coordinated customer service and to seek deposits from new and existing customers.

For the thre e months ended March 31, 2020 , net interest margin (annualized net interest income divided by average total interest earning assets) and net interest spread (average yield on total interest earning assets minus average cost of total interest bearing liabilities) were 4.15 % and 3.

70 %, respectively, compared to 4.13% and 3.

6 9 % , respectively, for the three months ended March 31, 2019 .

For the three months ended June 30, 2020, net interest margin (annualized net interest income divided by average total interest earning assets) and net interest spread (average yield on total interest earning assets minus average cost of total interest bearing liabilities) were 3.78% and 3.49%, respectively, compared to 4.24% and 3.77%, respectively, for the three months ended June 30, 2019.

The following table presents an analysis of the average balances of net interest income, net interest spread and net interest margin for the periods indicated.

Loan fees included in interest income totaled $429,000 and $350,000 for the three months ended March 31, 2020 and 2019, respectively.

For the three months ended March 31, 2020 and 2019, the amount of interest income not recognized on nonaccrual loans was not material.

Loan fees included in interest income totaled $ 2.2 million and $ 3 1 5 ,000 for the three months ended June 30, 2020 and 2019 , respectively.

The increase in loan fees for the quarter ended June 30, 2020 is due to the PPP loans.

For the three months ended June 30, 2020 and 2019 , the amount of interest income not recognized on nonaccrual loans was not material.

Average Balance Sheets

For the Three Months Ended March 31,

For the Three Months Ended June 30,

(Dollars in thousands)

12 unchanged sentences

Interest bearing deposits

PPPLF borrowings

FHLB advances and other borrowings

13 unchanged sentences

Yields and costs are annualized.

The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest earning assets and inter est bearing liabilities and distinguishes between the changes attributable to changes in volume and changes attributable to changes in interest rates.

The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest earning assets and interest bearing liabilities and distinguishes between the changes attributable to changes in volume and changes attributable to changes in interest rates.

For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated to volume.

Three Months Ended March 31, 2020

Three Months Ended March 31, 2019

Three Months Ended June 30, 2020

Three Months Ended June 30, 2019

Increase (Decrease)

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Interest bearing deposits

PPPLF borrowings

FHLB advances and other borrowings

6 unchanged sentences

For a description of the factors taken into account by our management in determining the allowance for loan losses see “—Financial Condition—Allowance for Loan Losses.”

The provision for loan losses for the three months ended March 31, 2020 was $1.6 million, compared to $540,000 for the three months ended March 31, 2019.

The allowance for loan losses as a percentage of loans was 1.29% at March 31, 2020, compared to 1.25% at March 31, 2019.

The provision for loan losses for the three months ended June 30, 2020 was $1.9 million, compared to $547,000 for the three months ended June 30, 2019.

The allowance for loan losses as a percentage of loans was 1.03% at June 30, 2020, compared to 1.24% at June 30, 2019.

For the three months ended June 30, 2020, there were $438.1 million in PPP loans included in our portfolio.

These loans are 100% guaranteed by the SBA.

The allowance for loan losses to loans receivable, excluding the guaranteed PPP loans, is 1.46%.

A reconciliation of this non-GAAP measure is set forth in the section titled “ GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.

” The provision for loan losses was increased due to loan growth and along with an increase in qualitative factors related to the change in economic outlook caused by the COVID-19 pandemic.

We are not required to implement the provisions of the Current Expected Credit Loss (“CECL”) accounting standard until January 1, 2023, therefore we are continuing to account for the allowance for loan losses under the incurred loss model.

Credit quality has remained stable through March 31, 2020, as demonstrated by the low level of charge-offs and declining nonperforming loan balance.

N onperforming assets to total assets was 0.06% at March 31, 2020 compared to 0.12% at March 31, 2019.

Net charge-offs for the three months ended March 31, 2020 totaled $123,000, or 0.05% (annualized) of total average loans, as compared to net recoveries of $32,000, or 0.02% (annualized) of total average loans, for the three months ended March 31, 2019.

The immediate and long-term economic impact of the COVID-19 pandemic is unknown;

however, we remain diligent in our efforts to communicate and work with borrowers to help mitigate potential credit deterioration.

Credit quality has remained stable through June 30, 2020, as demonstrated by the low level of charge-offs and nonperforming loan balance.

N onperforming assets to total assets was 0.26% at June 30, 2020 compared to 0.16% at June 30, 2019.

For a description of the Company’s nonperforming assets see “—Financial Condition—Nonperforming Assets.”

Net charge-offs for the three months ended June 30, 2020 totaled $8,000, or 0.00% (annualized), of total average loans, as compared to $19,000, or 0.01% (annualized) of total average loans, for the three months ended June 30, 2019.

The short-term and long-term economic impact of the COVID-19 pandemic is unknown;

however, we remain diligent in our efforts to communicate and proactively work with borrowers to help mitigate potential credit deterioration.

Noninterest Income

Our primary sources of recurring noninterest income are loan referral fees, deposit service charges and fees, BaaS fees and mortgage broker fees.

Noninterest income does not include 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 or similiar method.

For the three months ended March 31, 2020, noninterest income totaled $2.7 million, an increase of $687,000, or 34.6%, compared to $2.0 million for the three months ended March 31, 2019.

Our primary sources of recurring noninterest income are deposit service charges and fees, BaaS fees, mortgage broker fees and loan referral fees.

For the three months ended June 30, 2020 , noninterest income totaled $ 1.5 million, a de crease of $ 6 12 ,000, or 28.7 %, compared to $ 2.

1 million for the three months ended June 30, 2019 .

The following table presents, for the periods indicated, the major categories of noninterest income:

Ended March 31,

Ended June 30,

(Dollars in thousands)

Loan referral fees

Deposit service charges and fees

1 unchanged sentence

Mortgage broker fees

Sublease and lease income

Loan referral fees

Gain on sales of loans, net

Total noninterest income

Deposit Service Charges and Fees.

Deposit service charges and fees include service charges on accounts, point-of-sale fees, merchant services fees and overdraft fees.

Together they constitute one of the largest components of our noninterest income.

Deposit service charges were $677,000 for the three months ended June 30, 2020, a decrease of $104,000, or 13.3%, from $781,000 over the same period in the prior year.

The decrease in deposit service charges and fees was primarily the result of $57,000 less overdraft fee income in the quarter ended June 30, 2020 compared to the prior year period, combined with $17,000 less in point of sale fees, $16,000 less in merchant services revenue and $12,000 less in ATM income, all of which could be attributed to the stay-at-home order in place for Washington State during part of the second quarter, and overall reduced activity as a result of COVID-19 restrictions, stimulus payments distributed to tax payers and increased unemployment benefits.

Our CCBX division provides BaaS offerings that enable our broker dealer and digital financial service partners to offer their customers banking services.

In exchange for providing these services, we earn fixed fees, volume-based fees and reimbursement of costs depending on the contract.

BaaS fee income for the three months ended June 30, 2020 was $475,000 compared to $502,000 for the three months ended June 30, 2019.

The decrease is the result of slower implementation times with new BaaS partners and modifications to fee arrangements with existing customers which reduced noninterest income in the quarter ended June 30, 2020 in exchange for increased fees in the future.

The decision to trade current revenue for ongoing future revenue was made to benefit the Company in the long term.

As of June 30, 2020, there were three active CCBX partners, two in friends and family trials, two in onboarding/implementation, three signed letters of intent and a solid pipeline.

As partnerships move to active status it is expected that BaaS fees will increase.

Mortgage Broker Fees .

We earn mortgage broker fees for residential real estate loans that we broker through mortgage lenders.

Mortgage broker fees increased $41,000 in the three months ended June 30, 2020 to $152,000, compared to $111,000 in the same period in 2019 as a result of increased demand from lower interest rates on mortgages.

Loan Referral Fees .

2 unchanged sentences

By facilitating interest rate swaps to our clients, we are able to provide them with a long-term, fixed interest rate without assuming the interest rate risk.

We had $1.1 million in income from l oan referral fees for the three months ended March 31, 2020, compared to $633,000 in the same period in the prior year.

We had $70,000 in income from l oan referral fees for the three months ended June 30, 2020, compared to $473,000 in the same period in the prior year.

Interest rate volatility, swap rates, and the timing of loan closings all impact the demand for long-term fixed rate swaps.

The recognition of loan referral fees fluctuates in response to these market conditions and as a result we may not recognize any loan referral fees in some periods.

The recognition of loan referral fees fluctuates in response to these market conditions and as a result we may not recognize any, or recognize fewer, loan referral fees in some periods.

Gain on Sales of Loans, net .

Gain on sales of loans occurs when we sell in the secondary market the guaranteed portion (generally 75% of the principal balance) of the SBA and U.S.

Department of Agriculture (“USDA”) loans that we originate.

This activity fluctuates based on SBA and USDA loan activity.

We did not sell the guaranteed portion of any SBA or USDA loans in the three months ended June 30, 2020, therefore our income decreased $132,000 from the three months ended June 30, 2019.

This category includes a variety of other income-producing activities, annuity broker fees, and SBA and USDA servicing fees.

Other noninterest income increased $13,000 in the three months ended June 30, 2020, compared to the same period in 2019 primarily from higher lease and sublease income.

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 expense, data processing expense, legal and professional fees, director and staff expense and software licenses, maintenance and subscriptions.

For the three months ended June 30, 2020, noninterest expense totaled $8.9 million, an increase of $1.3 million, or 17.0%, compared to $7.6 million for the three months ended June 30, 2019.

The following table presents, for the periods indicated, the major categories of noninterest expense:

Ended June 30,

(Dollars in thousands)

Salaries and employee benefits

Data processing

Legal and professional fees

Software licenses, maintenance and subscriptions

Director and staff expenses

FDIC assessments

Business development

Total noninterest expense

Salaries and Employee Benefits.

Salaries and employee benefits are the largest component of noninterest expense and include payroll expense, incentive compensation costs, benefit plans, health insurance and payroll taxes.

Salaries and employee benefits were $5.2 million for the three months ended June 30, 2020, an increase of $686,000, or 15.1%, compared to $4.5 million for the three months ended June 30, 2019.

The increase was primarily due to continued hiring staff for our BaaS CCBX division and additional staff for our ongoing banking related growth initiatives, as well as employing temporary help to assist with operations related to the PPP loans.

The increase in expense was reduced as a result of an increase in deferred loan costs recorded as salary offsets, largely from originating PPP loans, which was $1.2 million higher and lowered expense by that same amount, for the quarter ended June 30, 2020, compared to the quarter ended June 30, 2019.

As our BaaS banking activities grow, we expect to continue to add employees to support this line of business.

As of June 30, 2020, we had 220 full-time equivalent employees, compared to 187 at June 30, 2019, a 17.6% increase.

Occupancy Expenses.

Occupancy expenses were $933,000 for the three months ended June 30, 2020, compared to $930,000 for the three months ended June 30, 2019.

This category includes building, leasehold, furniture, fixtures and equipment depreciation totaling $311,000 and $301,000 for the three months ended June 30, 2020 and 2019, respectively.

Occupancy expenses remained relatively flat year over year, but with the opening of our 15 th branch late in the second quarter of 2020, and as we continue to grow, we expect occupancy expenses to increase.

Data Processing.

Data processing costs were $621,000 for the three months ended June 30, 2020, compared to $499,000 for the three months ended June 30, 2019.

Data processing costs include all of our customer transaction processing and data storage, computer processing, and network costs.

Data processing costs grow as we add new products, customers and branches.

Additionally, CCBX data processing expenses are included in this category and are expected to increase incrementally as the CCBX division expands.

Legal and Professional Fees.

Legal and professional costs were $474,000 for the quarter ended June 30, 2020, compared to $293,000 for the quarter ended June 30, 2019.

Legal and professional costs fluctuate with the development of contracts for CCBX customers and are also impacted by our reporting cycle and timing of legal and professional services.

Software Licenses, Maintenance and Subscriptions.

Software licenses, maintenance and subscriptions includes expenses related to obtaining and maintaining software required for various functions throughout the Company.

Software licenses, maintenance and subscriptions were $311,000 for the quarter ended June 30, 2020, compared to $172,000 for the prior year period.

Late in 2019, we changed how we were expensing these costs, consolidating all related expenses to one category, which contributed to the increase over

the prior year period.

Software related expenses is expected to continue to increase as we grow product lines and expand our CCBX division.

Excise Taxes.

Excise taxes were $262,000 for the three months ended June 30, 2020, compared to $180,000 for the three months ended June 30, 2019.

Excise taxes are based on gross income of $16.9 million and $13.9 million for the three months ended June 30, 2020 and 2019, respectively.

Gross income is reduced by certain allowed deductions to arrive at the taxable base;

however, as gross income increases, so does the excise tax expense.

Director and Staff Expenses.

Director and staff expenses includes compensation for director service, continuing education for employees and other director and staff related expenses.

Director and staff expenses were $187,000 for the three months ended June 30, 2020, compared to $217,000 for the three months ended June 30, 2019, a decrease of $30,000 or 13.8%.

Decreased expenses related to employee travel as a result of restrictions related to the COVID-19 pandemic contributed to the decrease in the quarter ended June 30, 2020 compared to quarter ended June 30, 2019.

Marketing costs were $116,000 for the three months ended June 30, 2020, compared to $108,000 for the three months June 30, 2019.

Marketing costs were relatively flat year over year;

however, as we continue to offer new products and services and grow our brand, we would expect marketing costs to increase.

Business Development.

Business development costs were $48,000 for the three months ended June 30, 2020, compared to $96,000 for the three months ended June 30, 2019.

Business development costs include sponsorships and other activities to cultivate business and community development.

As expected, these expenses were reduced as a result of restrictions on in person meetings and business related activities due to the COVID-19 pandemic.

This category includes dues and memberships, office supplies, mail services, telephone, examination fees, internal loan expenses, services charges from banks, operational losses, directors and officer’s insurance, donations, provision for unfunded commitments, and miscellaneous other expenses.

Other noninterest expense was $704,000 for the three months ended June 30, 2020, compared to $485,000 for the three months ended June 30, 2019.

The increase was largely due to a $39,000 increase in the reserve for unfunded commitments, $40,000 increase in bank examination fees, $23,000 increase in FRB and bank service changes, and overall growth for the three months ended June 30, 2020, as compared to the same period last year.

Income Tax Expense

The amount of income tax expense we incur is impacted by the amounts of our pre-tax income, tax-exempt income and 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.

As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

Valuation allowances are established when necessary to reduce our deferred tax assets to the amount expected to be realized.

For the three months ended June 30, 2020, income tax expense totaled $967,000, compared to $854,000 for the three months ended June 30, 2019.

Our effective tax rates for the three months ended June 30, 2020 and 2019 were 20.8% and 20.7%, respectively.

Comparison of Operating Results for the Six Months Ended June 30, 2020 and June 30, 2019

Results of Operations

Net income for the six months ended June 30, 2020, was $6.4 million, or $0.52 per diluted share, compared to $6.1 million, or $0.50 per diluted share, for the six months ended June 30, 2019.

The increase in net income over the comparable period in the prior year was attributable to a $5.4 million increase in net interest income, largely related to organic loan growth combined with growth from PPP loans, partially offset by a $2.4 million increase in the provision for loan losses, related to the growth in the loan portfolio along with an increase in qualitative factors related to the change in the economic outlook caused by the COVID-19 pandemic, and $2.7 million increase in noninterest expense, which includes $1.8 million more in salaries and employee benefits and $144,000 more in data processing expenses.

Salaries and employee benefits were increased largely as a result of hiring staff for our BaaS CCBX division.

Data processing costs grow as we add new products, customers and branches.

Additionally, CCBX data processing expenses are included in this category and are expected to increase incrementally as the CCBX division develops.

Net Interest Income

Net interest income for the six months ended June 30, 2020, was $25.4 million, compared to $20.0 million for the six months ended June 30, 2019, an increase of $5.4 million, or 27.1%.

The increase in net interest income consisted of a $6.4 million, or 30.2%, in increased loan interest income as a result of higher volume and $206,000, or 7.2%, less in interest expense on deposits, partially offset by $150,000, or 38.6%, increase in interest on borrowed funds.

The increase in interest income was primarily attributable to a $353.2 million, or 44.3%, increase in average loans outstanding for the six months ended June 30, 2020, compared to the prior year period, partially offset by a 54 basis point decrease in yield on loans.

The decrease in loan yields, as compared to the prior year period, was the result of the FOMC lowering rates five times since June 2019, totaling 2.25%, which resulted in lower rates on new and renewing loans as well as loans tied to indexes.

In addition, for the six months ended June 30, 2020 there was an average of $167.6 million in PPP loans, which have a 1.0% interest rate and an approximate yield of 3.31% after the amortization of deferred fees and costs.

Contractual loan yields approximated 4.40% for the six months ended June 30, 2020 compared to 5.23% for the six months ended June 30, 2019.

Although we have rate floors in place for $349.1 million, or 23.9%, in existing loans, the rate reductions by the FOMC have had a corresponding impact on loan yields and subsequently the net interest margin in future periods.

We have continued to focus on our loan growth initiatives, but most recently our focus has been on working with small businesses within our communities, providing assistance to existing and new customers, through PPP loans.

We have experienced a significant increase in commercial and industrial loans, as small business owners apply for financial assistance via the PPP through the SBA as prescribed in the CARES Act.

The slight decrease in interest expense for the six months ended June 30, 2020 was the result of a $206,000 decrease in interest expense on deposit accounts partially offset by a $150,000 increase in interest on borrowed funds.

Cost of funds decreased 21 basis points to 0.54% as of June 30, 2020, compared to 0.75% at June 30, 2019.

Much of the funding from the PPP loans was deposited into core deposit accounts, including noninterest bearing accounts, until customers use the funds, which contributed to the improved cost of funds for the six months ended June 30, 2020, as compared to the prior year period.

The average balance of interest-bearing deposits increased $107.5 million, or 19.2%, compared to the prior year period, but the average rate paid on interest bearing deposits was 23 basis points less for the six months ended June 30, 2020, compared to the six months ended June 30, 2019.

As previously discussed, the Fed funds rate reductions by the FOMC have impacted the rates that are paid on interest bearing accounts and management lowered deposit rates in response to these rate reductions.

The average rate paid on BaaS-brokered deposits decreased 165 basis points and NOW and money market accounts decreased four basis points for the six months ended June 30, 2020.

The average rate paid on BaaS-brokered deposits was higher in the six months ended June 30, 2019 as a result of the temporary increase in BaaS-brokered deposits for that period.

The average rate paid on time deposits also decreased.

For time deposits less than $100,000 the rate decreased 12 basis points and for time deposits over $100,000 the average rate decreased 24 basis points, as compared to the prior year period.

The average rate paid on NOW, money market, and time deposit accounts in the six months ended June 30, 2020 is the result of the recent decreased Fed funds rates, which resulted in management lowering rates on these accounts.

Many deposit rates were either lowered late in the first quarter or at the start of the second quarter of 2020, so the impact of these reductions will continue to be seen in future periods.

The average balance of NOW and money market accounts grew $135.9 million, or 37.2%, in the six months ended June 30, 2020, compared to the six months ended June 30, 2019.

The average balance of BaaS-brokered deposits was $21.9 million for the six months ended June 30, 2020, which was down $25.1 million, or

53.3%, from the prior year period.

The higher balance in the prior year period was the result of temporary increase in BaaS deposits for that period , and a subsequent planned exit of balances .

T he average balance of savings accounts grew $ 8.5 million, or 16.3 %, and the average balance of time deposits declined $1 1.9 million, or 12.3 % , to $84.

4 million in the six months ended June 30, 2020, compared to the six months ended June 30, 2019, in an intentional effort to focus on more on core deposit growth .

We do not regularly advertise time deposit rates or money market rates, although we occasionally advertise promotional rates in targeted portions of our market area.

Our branch managers, business development officers, and lenders collaborate to provide consistent and coordinated customer service and to seek deposits from new and existing customers.

For the six months ended June 30, 2020, net interest margin and net interest spread were 3.93% and 3.58%, respectively, compared to 4.19% and 3.73%, respectively, for the six months ended June 30, 2019.

The following table presents an analysis of the average balances of net interest income, net interest spread and net interest margin for the periods indicated.

Loan fees included in interest income totaled $2.6 million and $666,000 for the six months ended June 30, 2020 and 2019, respectively.

The increase in loan fees for the six months ended June 30, 2020 is due to the PPP loans.

For the six months ended June 30, 2020 and 2019, the amount of interest income not recognized on nonaccrual loans was not material.

Average Balance Sheets

For the Six Months Ended June 30,

(Dollars in thousands)

Interest earning assets:

Interest earning deposits

Investment securities, available for sale (1)

Investment securities, held to maturity (1)

Other Investments

Loans receivable (2)

Total interest earning assets

Noninterest earning assets:

Allowance for loan losses

Other noninterest earning assets

Liabilities and Shareholders’ Equity

Interest bearing liabilities:

Interest bearing deposits

PPPLF borrowings

FHLB advances and other borrowings

Subordinated debt

Junior subordinated debentures

Total interest bearing liabilities

Noninterest bearing deposits

Other liabilities

Total shareholders' equity

Total liabilities and shareholders' equity

Net interest income

Interest rate spread

Net interest margin (3)

For presentation in this table, average balances and the corresponding average rates for investment securities are based upon historical cost, adjusted for amortization of premiums and accretion of discounts.

Includes nonaccrual loans.

Net interest margin represents annualized net interest income divided by average total interest earning assets.

Yields and costs are annualized.

The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest earning assets and interest bearing liabilities and distinguishes between the changes attributable to changes in volume and changes attributable to changes in interest rates.

For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated to volume.

Six Months Ended June 30, 2020

Six Months Ended June 30, 2019

Increase (Decrease)

Total Increase

(Dollars in thousands)

Interest income:

Interest earning deposits

Investment securities, available for sale

Investment securities, held to maturity

Other Investments

Loans receivable

Total increase in interest income

Interest expense:

Interest bearing deposits

PPPLF borrowings

FHLB advances

Subordinated debt

Junior subordinated debentures

Total increase in interest expense

Increase in net interest income

Provision for Loan Losses

The provision for loan losses is an expense we incur to maintain an allowance for loan losses at a level that management deems appropriate to absorb inherent losses on existing loans.

For a description of the factors taken into account by our management in determining the allowance for loan losses see “—Financial Condition—Allowance for Loan Losses.”

The provision for loan losses for the six months ended June 30, 2020 was $3.5 million, compared to $1.1 million for the six months ended June 30, 2019.

The allowance for loan losses as a percentage of loans was 1.03% at June 30, 2020, compared to 1.24% at June 30, 2019.

For the six months ended June 30, 2020, there were $438.1 million in PPP loans in our portfolio.

These loans are 100% guaranteed by the SBA.

The allowance for loan losses to loans receivable, excluding the guaranteed PPP loans, is 1.46%.

A reconciliation of this non-GAAP measure is set forth in the section titled “ GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.

” The provision for loan losses was increased due to loan growth and along with an increase in qualitative factors related to the change in economic outlook caused by the COVID-19 pandemic.

We are not required to implement the provisions of the CECL accounting standard until January 1, 2023, therefore we are continuing to account for the allowance for loan losses under the incurred loss model.

We are working with customers impacted by COVID-19 and have deferred or restructured payments in accordance with federal guidance on $207.2 million as of June 30, 2020.

Credit quality has remained stable through June 30, 2020, as demonstrated by the low level of charge-offs and nonperforming loan balance.

N onperforming assets to total assets was 0.26% at June 30, 2020 compared to 0.16% at June 30, 2019.

For a description of the Company's nonperforming assets, see "—Financial Condition—Nonperforming Assets."

As of June 30, 2020, there were $207.2 million, or 215 customers, on deferred payments, with $7.2 million, or 24 customers, moving to active status during the month of June 2020.

Of the customers moving to active status from deferrals, all were able to successfully resume making payments.

As additional loans migrate to active status, we anticipate that there will be borrowers that are unable to resume making payments as planned.

There is uncertainty surrounding the economy, the continuation of unemployment benefits, stimulus payments and the continued restrictions on businesses, all of which lead to uncertainty with our customers and their ability to remain current on their financial obligations.

These factors all contributed to the additional reserve to loan losses that was made in the six months ended June 30, 2020.

Net charge-offs for the six months ended June 30, 2020 totaled $131,000, or 0.02% (annualized) of total average loans, as compared to $51,000, or 0.01% (annualized) of total average loans, for the six months ended June 30, 2019.

The short-term and long-term

economic impact of the COVID-19 pandemic is unknown;

however, we remain diligent in our efforts to communicate and proactively work with borrowers to help mitigate potential credit deterioration and future losses.

Noninterest Income

Our primary sources of recurring noninterest income are deposit service charges and fees, loan referral fees, BaaS fees, and mortgage broker fees.

Noninterest income does not include loan origination fees, which are generally recognized over the life of the related loan as an adjustment to yield using the interest or similar method.

For the six months ended June 30, 2020, noninterest income totaled $4.2 million, a decrease of $75,000, or 1.8%, compared to $4.1 million for the six months ended June 30, 2019.

The following table presents, for the periods indicated, the major categories of noninterest income:

Ended June 30,

(Dollars in thousands)

Deposit service charges and fees

Loan referral fees

BaaS service fees

Mortgage broker fees

Gain on sales of loans, net

Total noninterest income

Deposit Service Charges and Fees.

Deposit service charges and fees include service charges on accounts, point-of-sale fees, merchant services fees and overdraft fees.

Together they constitute one of the largest components of our noninterest income.

Deposit service charges were $723,000 for the three months ended March 31, 2020, a decrease of $3,000, or 0.4%, from $726,000 over the same period in the prior year.

The decrease in deposit service charges and fees was primarily the result of $29,000 less overdraft fee income in the quarter ended March 31, 2020 compared to the prior year period.

Deposit service charges were $1.4 million for the six months ended June 30, 2020, a decrease of $107,000, or 7.1%, from $1.5 million over the same period in the prior year.

The decrease in deposit service charges and fees was primarily the result of $86,000 less overdraft fee income in the six months ended June 30, 2020 compared to the prior year period, combined with $12,000 less in point of sale fees, $11,000 less in merchant services revenue and $8,000 less in ATM income, all of which may be attributed to the stay-at-home order in place for Washington State during part of the first half of 2020, and overall reduced activity as a result of COVID-19 restrictions, stimulus payments distributed to tax payers and increased unemployment benefits.

Loan Referral Fees .

We earn loan referral fees when we originate a variable rate loan and the borrower enters into an interest rate swap agreement with a third party to fix the interest rate for an extended period, usually 20 or 25 years.

We recognize the loan referral fee for arranging the interest rate swap.

By facilitating interest rate swaps to our clients, we are able to provide them with a long-term, fixed interest rate without assuming the interest rate risk.

We had $1.1 million in income from l oan referral fees for the six months ended June 30, 2020 and 2019.

Interest rate volatility, swap rates, and the timing of loan closings all impact the demand for long-term fixed rate swaps.

The recognition of loan referral fees fluctuates in response to these market conditions and as a result we may not recognize any, or recognize fewer, loan referral fees in some periods.

Our CCBX division provides BaaS offerings that enable our broker dealer and digital financial service partners to offer their customers banking services.

In exchange for providing these services, we earn fixed fees, volume-based fees and reimbursement of costs depending on the contract.

BaaS fee income for the three months ended March 31, 2020 was $579,000 compared to $446,000 for the three months ended March 31, 2019.

The increase is the result of growth in the number of BaaS partnerships.

BaaS fee income for the six months ended June 30, 2020 was $1.1 million compared to $948,000 for the six months ended June 30, 2019.

The increase is the result of increased partnerships with broker dealers and digital financial service partners.

At June 30, 2020 there were three active CCBX partners, two in friends and family trials, two in onboarding/implementation, three signed letters of intent and a solid pipeline.

Gain on Sales of Loans, net .

Gain on sales of loans occurs when we sell in the secondary market the guaranteed portion (generally 75% of the principal balance) of the SBA and USDA loans that we originate.

This activity fluctuates based on SBA and USDA loan activity.

We did not sell the guaranteed portion of any SBA or USDA loans in the six months ended June 30, 2020, therefore our income decreased $121,000 from the six months ended June 30, 2019.

Mortgage Broker Fees .

We earn mortgage broker fees for residential real estate loans that we broker through mortgage lenders.

Mortgage broker fees increased $77,000 in the three months ended March 31, 2020 to $162,000, compared to $85,000 in the same period in 2019 as a result of increased demand from lower interest rates on mortgages.

This category includes a variety of other income-producing activities, annuity broker fees, and SBA and U.S.

Department of Agriculture (“USDA”) servicing fees.

Other noninterest income increased $40,000 in the three months ended March 31, 2020, compared to the same period in 2019 primarily as a result of higher SBA and USDA servicing fees.

Mortgage broker fees increased $118,000 in the six months ended June 30, 2020 to $314,000, compared to $196,000 in the same period in 2019 as a result of increased demand from lower interest rates on mortgages.

This category includes a variety of other income-producing activities, annuity broker fees, and SBA and USDA servicing fees.

Other noninterest income increased $62,000 in the six months ended June 30, 2020, compared to the same period in 2019 primarily as a result of higher SBA and USDA servicing fees and higher lease and sublease income.

Noninterest Expense

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For the three months ended March 31, 2020, noninterest expense totaled $9.0 million, an increase of $1.4 million, or 17.7%, compared to $7.7 million for the three months ended March 31, 2019.

For the six months ended June 30, 2020, noninterest expense totaled $18.0 million, an increase of $2.7 million, or 17.4%, compared to $15.3 million for the six months ended June 30, 2019.

The following table presents, for the periods indicated, the major categories of noninterest expense:

Ended March 31,

Ended June 30,

(Dollars in thousands)

2 unchanged sentences

Legal and professional fees

Director and staff expenses

Software licenses, maintenance and subscriptions

Director and staff expenses

Business development

3 unchanged sentences

Salaries and employee benefits are the largest component of noninterest expense and include payroll expense, incentive compensation costs, benefit plans, health insurance and payroll taxes.

Salaries and employee benefits were $5.7 million for the three months ended March 31, 2020, an increase of $1.1 million, or 24.7%, compared to $4.6 million for the three months ended March 31, 2019.

The increase was primarily due to hiring staff for our BaaS CCBX division and additional staff for our ongoing banking related growth initiatives.

Salaries and employee benefits were $10.9 million for the six months ended June 30, 2020, an increase of $1.8 million, or 19.9%, compared to $9.1 million for the six months ended June 30, 2019.

The increase in expense would have been greater if not for an increase in deferred loan costs recorded as salary offsets, largely from originating PPP loans, which was $1.2 million higher and lowered expense by that same amount, for the six months ended June 30, 2020, compared to the six months ended June 30, 2019.

As our BaaS banking activities grow, we expect to continue to add employees to support this line of business.

As of March 31, 2020, we had 208 full-time equivalent employees, compared to 179 at March 31, 2019, a 16.2% increase.

As of June 30, 2020, we had 220 full-time equivalent employees, compared to 187 at June 30, 2019, a 17.6% increase.

Occupancy Expenses.

Occupancy expenses were $927,000 for the three months ended March 31, 2020, compared to $994,000 for the three months ended March 31, 2019.

This category includes building, leasehold, furniture, fixtures and equipment depreciation totaling $309,000 and $304,000 for the three months ended March 31, 2020 and 2019, respectively.

The decrease of 6.7% in occupancy expenses for the three months ended March 31, 2020, compared to the same period in the prior year, was largely due to a decrease in maintenance and repair costs and lower utilities expense.

Occupancy expenses were $1.9 million for the six months ended June 30, 2020 and 2019.

This category includes building, leasehold, furniture, fixtures and equipment depreciation totaling $620,000 and $606,000 for the six months ended June 30, 2020 and 2019, respectively.

Data Processing.

Data processing costs were $551,000 for the three months ended March 31, 2020, compared to $529,000 for the three months ended March 31, 2019.

Data processing costs were $ 1.2 million for the six months ended June 30, 2020, compared to $ 1.0 million for the six months ended June 30, 2019 .

Data processing costs include all of our customer transaction processing and data storage , computer processing, and network costs.

Data processing costs grow as we add new products, customers and branches.

Additionally, CCBX data processing expenses are included in this category and are expected to increase incrementally as the CCBX division expands .

Legal and Professional Fees.

Legal and professional costs were $323,000 for the quarter ended March 31, 2020 compared to $409,000 for the quarter ended March 31, 2019.

Legal and professional costs were $797,000 for the six months ended June 30, 2020 compared to $702,000 for the six months ended June 30, 2019.

Legal and professional costs fluctuate with the development of contracts for CCBX customers and are also impacted by our reporting cycle and timing of legal services.

Director and Staff Expenses.

Director and staff expenses includes compensation for director service, continuing education for employees and other director and staff related expenses.

Director and staff expenses were $270,000 for the three months ended March 31, 2020 compared to $240,000 for the three months ended March 31, 2019, an increase of $30,000 or 12.5%.

Increased expenses related to staff training combined with the addition of one director to the Board of Directors of the Company in May of 2019 contributed to the increase in the quarter ended March 31, 2020 compared to quarter ended March 31, 2019.

Software Licenses, Maintenance and Subscriptions.

Software licenses, maintenance and subscriptions includes expenses related to obtaining and maintaining software required for various functions throughout the Company.

Software licenses, maintenance and subscriptions were $241,000 for the quarter ended March 31, 2020, compared to $86,000 for the prior year period.

Software licenses, maintenance and subscriptions were $582,000 for the quarter ended June 30, 2020, compared to $320,000 for the prior year period.

Late in 2019, we changed how we were expensing these costs, consolidating all related expenses to one category, which contributed to the increase over the prior year period.

1 unchanged sentence

Excise Taxes.

Excise taxes were $203,000 for the three months ended March 31, 2020 compared to $165,000 for the three months ended March 31, 2019.

Excise taxes are based on gross income of $15.8 million and $13.4 million for the three months ended March 31, 2020 and 2019, respectively.

Excise taxes were $465,000 for the six months ended June 30, 2020, compared to $345,000 for the six months ended June 30, 2019.

Excise taxes are based on gross income of $32.7 million and $27.3 million for the six months ended June 30, 2020 and 2019, respectively.

Gross income is reduced by certain allowed deductions to arrive at the taxable base;

however, as gross income increases, so does the excise tax expense.

Director and Staff Expenses.

Director and staff expenses includes compensation for director service, continuing education for employees and other director and staff related expenses.

Director and staff expenses were $457,000 for the six months ended June 30, 2020 and 2019.

Increased director fees from adding an additional director in May of 2019 and higher employee training costs were offset by decreased expenses related to employee travel expenses as a result of restrictions related to COVID-19 in the six months ended June 30, 2020, compared to quarter ended June 30, 2019.

Marketing costs were $228,000 for the six months ended June 30, 2020, compared to $202,000 for the six months ended June 30, 2019.

Marketing costs were relatively flat year over year;

however, as we continue to offer new products and services and grow our brand, we expect marketing costs to increase.

Business Development.

Business development costs were $12 5 ,000 for the three months ended March 31, 2020 compared to $ 102 ,000 for the three months ended March 31, 2019 .

Business development costs were $173,000 for the six months ended June 30, 2020, compared to $198,000 for the six months ended June 30, 2019.

Business development costs include sponsorships and other activities to cultivate business and community development.

As expected, these expenses increase as the Bank grows.

As expected, these expenses were reduced as a result of restrictions on in person meetings and business related activities due to the COVID-19 pandemic.

Other noninterest expense was $514,000 for the three months ended March 31, 2020, compared to $410,000 for the three months ended March 31, 2019.

The increase was largely due to a $49,000 increase in bank examination fees and overall growth for the three months ended March 31, 2020 as compared to the same period last year.

Other noninterest expenses were $1.2 million for the six months ended June 30, 2020, compared to $833,000 for the six months ended June 30, 2019.

The increase was largely due to a $90,000 increase in bank examination fees and overall growth for the six months ended June 30, 2020, as compared to the same period last year.

Income Tax Expense

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Valuation allowances are established when necessary to reduce our deferred tax assets to the amount expected to be realized.

For the three months ended March 31, 2020, income tax expense totaled $714,000, compared to $741,000 for the three months ended March 31, 2019.

Our effective tax rates for the three months ended March 31, 2020 and 2019, were 20.8% and 20.9%, respectively.

For the six months ended June 30, 2020, income tax expense totaled $1.7 million, compared to $1.6 million for the six months ended June 30, 2019.

Our effective tax rates for the six months ended June 30, 2020 and 2019 was 20.8%.

Financial Condition

The Company’s total assets increased $55.5 million, or 4.9%, to $1.18 billion at March 31, 2020 from $1.13 billion at December 31, 2019.

The increase is primarily the result of $66.1 million in gross loan growth during the three months ended March 31, 2020.

This increase was partially offset by a decrease of $13.0 million in investment securities resulting from maturities and principal paydowns.

The Company’s total assets increased $550.4 million, or 48.8%, to $1.68 billion at June 30, 2020 from $1.13 billion at December 31, 2019.

The increase is primarily the result of $508.0 million in gross loan growth during the six months ended June 30, 2020.

Included in the loan growth is $438.1 million in PPP loans.

These PPP loans are 100% guaranteed by the SBA and have a rate of 1.0%, an approximate yield of 3.31%.

Interest earning deposits with other banks also increased $36.4 million, compared to June 30, 2019.

Loan Portfolio

The quarter ended March 31, 2020 closed amid an unprecedented global COVID-19 pandemic that is impacting the economic health of our community and nation.

The provision for loan losses allowances was $1.6 million during the quarter ended March 31, 2020, as a result of loan growth and an increase in qualitative factors related to the economic outlook.

As a preferred SBA lender, we are working diligently with the SBA to offer assistance to small businesses as provided in the recently passed Coronavirus Aid, Relief and Economic Security Act (“CARES Act”).

These SBA loans are discussed further under the Commercial and Industrial loans section below.

We are also in contact with borrowers with existing loans that have been impacted by COVID-19.

We expect to continue to restructure payments for our loan customers during this uncertain time to help alleviate financial hardships and are deferring payments on over 215 loans as of May 6, 2020.

These loans include 87 commercial real estate loans representing $132.1 million;

72 commercial and industrial loans representing $22.1 million;

11 construction, land and land development loans representing $23.5 million;

and 43 residential real estate loans representing $18.4 million.

In accordance with GAAP and interagency guidance issued on March 22, 2020, short-term modifications, made on a good faith basis in response to COVID-19 to borrowers that were current prior to any relief, are not classified as troubled debt restructurings.

As part of the stay at home order issued by the Governor of Washington in March 2020, non-essential construction projects have been temporarily halted which will likely have an impact on future draws on unfunded commitments.

The Bank is working with our contractors and extending the construction period as appropriate to compensate for the work shutdown.

The quarter ended June 30, 2020 closed with the global COVID-19 pandemic continuing to impact the economic health of our community and nation.

The provision for loan losses allowances was $3.5 million during the six months ended June 30, 2020, as a result of loan growth and an increase in qualitative factors related to the economic outlook.

As a preferred SBA lender, we worked diligently with the SBA to offer assistance to small businesses as provided in the CARES Act.

These SBA loans are discussed further in this section under “Commercial and Industrial Loans”.

As part of our ongoing commitment to our customers, we have been proactive in contacting customers impacted by the stay-at-home order in Washington State, temporary business closures, or that have otherwise been impacted by the COVID-19 pandemic and responses thereto.

In addition to the PPP loans we made to assist customers, as of June 30, 2020, we have $207.2 million in deferred or restructured payments, pursuant to federal guidance, representing 215 loans.

Of the 215 loans that remain on deferral, 92 loans, or $77.1 million, received a loan extension as part of the deferral and restructuring process.

During the quarter ended June 30, 2020, there were 24 loans, representing $7.2 million, that moved back to active status from deferral status, with all of them successfully resuming payments.

The charts below show more detail regarding the payment modifications and deferrals.

The graphs below indicate the percentage of loans that were granted a deferral related to the COVID-19 pandemic.

This illustration is based on total loans outstanding as of March 31, 2020 to approximate the impact to our portfolio, pre-COVID-19;

also presented is deferred loans compared to total loans outstanding as of June 30, 2020.

Deferrals remaining as of June 30, 2020:

Remaining deferrals by industry as of Ju ne 30 , 2020:

As a result of proactively reaching out to customers to offer deferment to help reduce cash flow pressure through the stay-at-home order, we did not see material downgrades in credit during the six months ended June 30, 2020.

We will continue to be diligent in monitoring credit and changes in the economy, keeping the lines of communication open with our customers, but the full impact of these challenging economic times on our financial condition and liquidity remains to be seen at this time.

In accordance with GAAP and interagency guidance issued on March 22, 2020, short-term modifications, made on a good faith basis in response to the COVID-19 pandemic to borrowers that were current prior to any relief, are not classified as troubled debt restructurings.

Our primary source of income is derived through interest earned on loans.

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Our loan portfolio represents the highest yielding component of our earning assets.

As of March 31, 2020, gross loans totaled $1.01 billion, an increase of $66.1 million, or 7.0%, compared to December 31, 2019.

The increase was primarily due to our efforts to increase income by building a diversified loan portfolio while maintaining strong credit quality.

Loans as a percentage of deposits were 100.0% as of March 31, 2020, compared to 97.0% as of December 31, 2019.

As of June 30, 2020, gross loans totaled $1.45 billion, an increase of $508.0 million, or 54.1%, compared to December 31, 2019.

The increase was largely due to our efforts to provide community assistance through the PPP loans, which resulted in $438.1 million in PPP loans as of June 30, 2020.

Loans as a percentage of deposits were 110.8% as of June 30, 2020, compared to 97.0% as of December 31, 2019.

We are focused on serving our communities and markets by growing loans and funding those loans with customer deposits.

The increase in the loan to deposit ratio is largely due to the large volume of PPP loans.

The following table summarizes our loan portfolio by type of loan as of the dates indicated:

As of March 31, 2020

As of June 30, 2020

As of December 31, 2019

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Commercial and industrial loans:

All other commercial & industrial loans

Total commercial and industrial loans:

Real estate loans:

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Gross loans receivable

Net deferred origination fees

Net deferred origination fees - PPP loans

Net deferred origination fees - all other loans

Loans receivable

Commercial and Industrial Loans.

Commercial and industrial loans increased $11.3 million, or 10.1%, to $122.7 million as of March 31, 2020, from $111.4 million as of December 31, 2019.

Commercial and industrial loans increased $440.1 million, or 395.1%, to $551.6 million as of June 30, 2020, from $111.4 million as of December 31, 2019.

Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and effectively.

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Most commercial and industrial loans are secured by the assets being financed or other business assets, such as accounts receivable, inventory or equipment, and we generally obtain personal guarantees on these loans.

We are working with the SBA to help small businesses as provided in the recently passed CARES Act.

We expect to see an increase in commercial and industrial SBA 7(a) loans in the second quarter 2020, as small business owners apply for financial relief under the PPP.

Included in this balance is $12.0 million in capital call lines resulting from relationships with our BaaS partners as of June 30, 2020.

We are working with the SBA to help small businesses as provided in the CARES Act.

Included in commercial and industrial loans are $438.1 million in PPP loans, with $10.6 million in net deferred fees.

This includes 2,526 current loans, helping nearly 40,000 employees in our communities.

We were able to provide loans to our existing customers and also provide assistance to new customers, by taking a proactive approach and reaching out to the communities we serve to offer aid through the PPP.

We have or will receive approximately $13.9 million in loan fees from the SBA for originating and servicing the PPP loans.

These SBA 7(a) loans allow small business owners to apply for financial relief under the PPP.

This program allows business owners that are impacted by the COVID-19 pandemic to apply for and receive financial relief to help pay for employee wages and certain other expenses.

These short-term loans bear a 1% interest rate and may be forgiven by the government if certain criteria are met.

As of May 6, 2020, we have successfully funded 1,874 loan applications representing $393.4 million in resources to businesses in our community through PPP loans.

All PPP activity has occurred subsequent to March 31, 2020.

These short-term loans, two to five years, bear a 1.0% interest rate and may be forgiven by the government if certain criteria are met.

These fees are or will be recognized in interest income over the life of the loans;

however, if loans are forgiven or paid off remaining deferred fees will be recognized in the period the forgiveness or payoff occurs.

These fees are recognized as interest income and will provide a source of income to the Company as we navigate through these changes in our business and economy, so we may continue to provide financial services to our customers and communities.

On July 4, 2020, the President signed legislation extending the June 30, 2020 deadline to August 8, 2020, and we will accept and process requests for the duration of the program.

We have begun accepting applications from customers for loan forgiveness;

however, we are awaiting further guidance and cannot approve an application or submit it to the SBA until the specific criteria has been disclosed.

In order to obtain loan forgiveness, a PPP borrower must submit a forgiveness application to us, which we must review and forward to the SBA.

It is still uncertain what the final criteria will be, but we anticipate that the third quarter of 2020 will be busy as we migrate through this next stage of the PPP loans.

Customers with two-year loans can work with their lender to extend to a five year maturity, which we anticipate could be a good option for customers that are not eligible for forgiveness.

Commercial Real Estate Loans.

Commercial real estate loans increased $30.1 million, or 4.9%, to $643.5 million as of March 31, 2020, from $613.4 million as of December 31, 2019.

Included in this increase is $11.5 million in capital call lines resulting from relationships with our BaaS clients.

Commercial real estate loans increased $64.9 million, or 10.6%, to $678.3 million as of June 30, 2020, from $613.4 million as of December 31, 2019.

We make commercial mortgage loans collateralized by owner-occupied and non-owner-occupied real estate, as well as multi-family residential loans.

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Adjustable-rate loans are generally based on the prime rate and adjust with the prime rate or are based on term equivalent FHLB rates.

At March 31, 2020, approximately 37.9% of the commercial real estate loan portfolio consisted of fixed rate loans.

Commercial real estate loans represented 63.9% of our loan portfolio at March 31, 2020 and are our largest source of revenue.

The Bank actively seeks commercial real estate loans in our markets and our lenders are experienced in originating and competing for these loans.

Our credit administration team has substantial experience in underwriting, managing, monitoring and working out commercial real estate loans.

At June 30, 2020, approximately 43.1% of the commercial real estate loan portfolio consisted of fixed rate loans.

Commercial real estate loans represented 46.5% of our loan portfolio at June 30, 2020 and are historically our largest source of revenue.

The addition of the $438.1 million in PPP loans as commercial and industrial loans has significantly impacted the composition of our loan portfolio;

without the PPP loans, commercial real estate loans would represent

approximately 66.4% of the loan portfolio, which is more in line with what it has been historically.

The Bank actively seek s commercial real estate loans in our markets and our lenders are experienced in originating and competing for these loans.

Our credit administration team has substantial experience in underwriting, managing , monitoring and working out commercial real estate loans , and remains diligent in communicat ing and proactively work ing with borrowers to help mitigate potential credit deterioration .

Construction, Land and Land Development Loans.

Construction, land and land development loans increased $22.6 million, or 23.3%, to $119.7 million as of March 31, 2020, from $97.0 million as of December 31, 2019.

We saw favorable economic conditions for building in our market area in the first quarter of 2020.

We have a number of construction loans that have been approved, primarily for commercial projects, where the contractor/developer has not requested the funds, resulting in our unfunded construction and development commitments increasing to $72.9 million at March 31, 2020, from $63.7 million at December 31, 2019.

Although we have seen a strong commercial and residential real estate market in the Puget Sound region thus far in 2020, the immediate and long-term effects of the COVID-19 pandemic remain to be seen.

The Bank is working with our contractors and extending the construction period as appropriate to compensate for the work shutdown.

Construction, land and land development loans increased $5.4 million, or 5.6%, to $102.4 million as of June 30, 2020, from $97.0 million as of December 31, 2019.

We have a number of construction loans that have been approved, primarily for commercial projects, where the borrower has not requested the funds, resulting in our unfunded construction and development commitments increasing to $77.5 million at June 30, 2020, from $63.7 million at December 31, 2019.

Although we have seen a strong commercial and residential real estate market in the Puget Sound region thus far in 2020, the short-term and long-term effects of the COVID-19 pandemic remain to be seen.

As part of the stay-at-home order issued by the Governor of Washington in March 2020, non-essential construction projects were temporarily halted.

The Bank worked with our contractors and extended the construction period as appropriate to compensate for the work shutdown.

As projects start or resume, we expect that more of the available commitments will be utilized.

Residential Real Estate Loans.

Our residential loans increased $2.8 million, or 2.4%, from $115.0 million at December 31, 2019 to $117.8 million at March 31, 2020.

Our residential loans increased $7.9 million, or 6.9%, from $115.0 million at December 31, 2019 to $122.9 million at June 30, 2020.

We originate one-to-four adjustable-rate mortgage (“ARM”), loans for our portfolio and operate as a mortgage broker for mortgage lenders we have agreements with for customers who want a 15-year to 30-year, fixed-rate mortgage loan.

As of March 31, 2020, the balance of our ARM portfolio loans was $14.0 million, compared to $11.7 million at December 31,

Our ARM loans typically do not meet the guidelines for sale in the secondary market due to characteristics of the property, the loan terms or exceptions from agency underwriting guidelines, which enables us t o earn a higher interest rate.

As of June 30, 2020, the balance of our ARM portfolio loans was $14.3 million, compared to $11.7 million at December 31, 2019.

We also purchase residential mortgages originated by other financial institutions to hold for investment with the intent to diversify our residential mortgage loan portfolio, meet certain regulatory requirements and increase our interest income.

As of March 31, 2020 , we held $26.6 million in purchased residential real estate mortgage loans , compared to $28.6 million at December 31, 2019 .

As of June 30, 2020, we held $24.7 million in purchased residential real estate mortgage loans, compared to $28.6 million at December 31, 2019.

These loans purchased typically have a fixed rate with a term of 15 to 30 years and are collateralized by one-to-four family residential real estate.

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Although purchased loans were originated and underwritten by another institution, our mortgage, credit, and compliance departments conduct an independent review of each underlying loan that includes re-underwriting each of these loans to our credit and compliance standards.

We also make one-to-four family loans to investors to finance their rental properti es and to business owners to secure their business loans .

As of March 31, 2020 , residential real estate loans made to investors and business owners totaled $ 63.2 million .

We also make one-to-four family loans to investors to finance their rental properties and to business owners to secure their business loans.

As of June 30, 2020, residential real estate loans made to investors and business owners totaled $72.8 million .

Like our commercial real estate loans, our residential real estate loans are secured by real estate, the value of which may fluctuate significantly over a short period of time as a result of market conditions in the area in which the real estate is located.

Adverse developments affecting real estate values in our market areas could therefore increase the credit risk associated with these loans, impair the value of property pledged as collateral on loans, and affect our ability to sell the collateral upon foreclosure without a loss or additional losses.

Consumer and Other Loans.

Consumer and other loans totaled $3.7 million as of March 31, 2020, decreasing $519,000 from $4.2 million at December 31, 2019.

Consumer and Other.

Consumer and other loans totaled $4.7 million as of June 30, 2020, increasing $521,000 from $4.2 million at December 31, 2019.

Our consumer and other loans are comprised of personal lines of credit, automobile, boat, and recreational vehicle loans, and secured term loans.

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We have a diversified loan portfolio, representing a wide variety of industries.

The three largest categories of loans are commercial real estate, commercial and industrial, and construction, land and land development loans.

Together they represent $885.8 million in outstanding loan balances or 88.0% of total gross loans outstanding.

Three of our largest categories of loans are commercial real estate, commercial and industrial, and construction, land and land development loans.

Together they represent $894.2 million in outstanding loan balances, or 87.5%, of total gross loans outstanding, excluding PPP loans of $438.1 million.

When combined with $189.9 million in unused commitments the total of these three categories is $1.08 billion, or 87.9%, of total outstanding loans and loan commitments.

Commercial Real Estate Loans.

Commercial real estate represents the largest segment of our loans, comprising 63.9% of our total balance of outstanding loans as of March 31, 2020.

Unused commitments to extend credit represents an additional $11.3 million, the combined total exposure in commercial real estate loans represents $654.7 million or 55.2% of our total outstanding loans and loan commitments.

The following table summarizes our concentration by industry for our commercial real estate loan portfolio as of March 31, 2020:

Commercial real estate represents the largest segment of our loans, comprising 66.4% of our total balance of outstanding loans, excluding PPP loans, as of June 30, 2020.

Unused commitments to extend credit represents an additional $13.5 million, the combined total exposure in commercial real estate loans represents $691.9 million, or 56.1%, of our total outstanding loans and loan commitments, excluding PPP loans.

The following table summarizes our concentration by industry for our commercial real estate loan portfolio as of June 30, 2020:

(Dollars in thousands)

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Number of Loans

Convenience stores

Convenience Store

Manufacturing

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Commercial and Industrial Loans.

Commercial and industrial loans comprise 12.2% of our total balance of o utstanding loans as of March 31, 2020.

Unused commitments to extend credit represents an additional $74.9 million, the combined total exposure in commercial and industrial loans represents $197.6 million or 16.7% of our total outstanding loans and loan co mmitments.

The following table summarizes our concentration by industry for our commercial and industrial loan portfolio as of March 31, 2020:

Commercial and industrial loans comprise 11.1% of our total balance of outstanding loans, excluding PPP loans, as of June 30, 2020.

Unused commitments to extend credit represents an additional $99.2 million, the combined total exposure in commercial and industrial loans represents $212.7 million, or 17.2%, of our total outstanding loans and loan commitments, excluding PPP loans.

The following table summarizes our concentration by industry for our commercial and industrial loan portfolio as of June 30, 2020:

(Dollars in thousands)

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Number of Loans

Construction/contractor services

Capital Call Lines

Construction/Contractor

Manufacturing

Medical / Dental / Other Care

Financial Institutions

Medical / Dental /

Family and Social Services

Financial Institutions

Groups < 1.0% of total

Construction, Land and Land Development Loans.

Construction, land and land development loans comprise 11.9% of our total balance of outstanding loans as of March 31, 2020.

Construction, land and land development loans comprise 10.0% of our total balance of outstanding loans, excluding PPP loans, as of June 30, 2020.

Unused commitments to extend credit represents an additional $77.5 million, the combined total exposure in construction, land and land development loans represents $180.0 million , or 14.6% , of our total outstanding loans and loan commitments.

The following table details our concentration for our construction, land and land development loan portfolio as of March 31, 2020:

The following table details our concentration for our construction, land and land development loan portfolio as of June 30, 2020:

(Dollars in thousands)

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We actively manage problem assets to reduce our risk for loss.

We had $763,000 in nonperforming assets, as of March 31, 2020, compared to $1.0 million as of December 31, 2019.

There were no loans more than 90 days past due and still accruing interest as of March 31, 2020 and December 31, 2019.

Credit quality has remained stable in 2020 thus far as demonstrated by the low level of charge-offs and declining nonperforming loan balance.

The immediate and long-term economic impact of the COVID-19 pandemic is unknown;

however, we remain diligent in our efforts to communicate and work with borrowers to help mitigate potential credit deterioration.

We had $4.4 million in nonperforming assets, as of June 30, 2020, compared to $1.0 million as of December 31, 2019.

There were no loans more than 90 days past due and still accruing interest as of June 30, 2020 and December 31, 2019.

Our nonperforming loans to loans receivable ratio was 0.31% at June 30, 2020, compared to 0.11% at December 31, 2019.

Commercial and industrial nonaccrual loans totaled $689,000 at June 30, 2020 and consisted of three lending relationships.

During the second quarter of 2020, there was $11,000 in charge-offs on one nonperforming loan.

Two loans moved to nonperforming status during the second quarter, which included $3.3 million in construction, land and land development loans and $413,000 in commercial real estate loans.

The addition of these loans to nonperforming status in the second quarter was partially offset by the aforementioned charge-off and principal reductions and resulted in an overall increase in our ratios of nonperforming loans and nonperforming assets to total assets compared to December 31, 2019.

Credit quality has remained stable in 2020 thus far as demonstrated by the low level of charge-offs and nonperforming loan balance.

The short-term and long-term economic impact of the COVID-19 pandemic is unknown;

however, we remain diligent in our efforts to communicate and proactively work with borrowers to help mitigate potential credit deterioration.

Credit administration is closely analyzing higher risk segments within the loan portfolio, monitoring and tracking loan payment deferrals and customer liquidity, and providing timely reporting to management and the board of directors.

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Real estate loans:

Construction, land and land development

Residential real estate

Commercial real estate

Total nonaccrual loans

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for residential real estate loans, the borrower’s ability to repay the loan, including a consideration of the debt-to-income ratio and employment and income stability, the loan-to-value ratio, and the age, condition and marketability of the collateral;

for construction, land and land development loans, the perceived market feasibility of the project including the ability to sell developed lots or improvements constructed for resale or the ability to lease property constructed for lease, the quality and nature of contracts for presale or prelease, if any, experience and ability of the developer and loan-to-value rat io.

As of March 31, 2020, the allowance for loan losses totaled $12.9 million, or 1.29% of total loans.

As of June 30, 2020, the allowance for loan losses totaled $14.8 million, or 1.03% of total loans.

As of December 31, 2019, the allowance for loan losses totaled $11.5 million, or 1.22% of total loans.

Our allowance for loan losses as of March 31, 2020, increased by $1.5 million, or 12.7%, compared to December 31, 2019, due to growth in our loan portfolio along with an increase in our qualitative factors primarily related to uncertainties in the economic outlook from the COVID-19 pandemic on our loan portfolio.

The following table presents, as of and for the periods indicated, an analysis of the allowance for loan losses and other related data:

Included in total loans is $438.1 million in PPP loans which are 100% guaranteed by the SBA.

The allowance for loan losses to loans receivable, excluding the guaranteed PPP loans, is approximately 1.46%.

A reconciliation of this non-GAAP measure is set forth in the section titled “ GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures.

” Our allowance for loan losses as of June 30, 2020 increased by $3.4 million, or 29.4%, compared to December 31, 2019, due to growth in our loan portfolio along with an increase in our qualitative factors primarily related to the current economic environment from the COVID-19 pandemic on our loan portfolio.

The following table present s , as of and for the periods indicated, an analysis of the allowance for loan losses and other related data:

As of or for the Three

As of or for the Six

(Dollars in thousands)

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Real estate loans:

Residential real estate loans

Commercial real estate

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Commercial and industrial loans

Consumer and other

Total recoveries

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Net charge-offs to average loans (1)

(1) Ratios for the three months ended March 31, 2020 and 2019, are annualized.

Although we believe that we have established our allowance for loan losses in accordance with U.S.

Generally Accepted Accounting Principles (“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.

In anticipation of the potential economic effects of the COVID-19 pandemic on our loan portfolio, we increased our provision during the quarter ended March 31, 2020.

If Washington State remains under a stay at home order for a long period of time, preventing businesses and consumers from conducting business, the state and Puget Sound region may experience an economic downturn, and our asset quality could deteriorate, which may require material additional provisions for loan losses.

We remain focused on working with the communities we serve, offering payment deferrals and other resources available under the CARES Act to provide financial assistance to businesses and consumers until they are able to re-open and recover from this uncertain and trying time.

(1) Ratios for the three and six months ended June 30, 2020 and 2019 are annualized.

Although we believe that 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.

As a result of the COVID-19 pandemic and the subsequent impact to the economy, we increased our provision during the six months ended June 30, 2020.

If the COVID-19 pandemic worsens or continues indefinitely, preventing businesses and consumers from conducting business, the state and Puget Sound region may experience a continued economic downturn, and our asset quality could deteriorate, which may require material additional provisions for loan losses.

We use our securities portfolio primarily as a source of liquidity and collateral that can be readily sold or pledged for public deposits or other business purposes.

At March 31, 2020, 76.2% of our investment portfolio consisted of U.S.

At June 30, 2020, 82.4% of our investment portfolio consisted of U.S.

Treasury securities.

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Because we target a loan-to-deposit ratio in the range of 90% to 100%, we prioritize liquidity over the earnings of our securities portfolio.

At March 31, 2020, our loan-to-deposit ratio was 100.0%.

At June 30, 2020, our loan-to-deposit ratio was 110.8%, which is elevated as a result of the PPP loans.

Our securities portfolio represented less than 2% of assets.

To the extent our securities represent more than 5% of assets, absent an immediate need for liquidity, we anticipate investing excess funds to provide a higher return.

As of March 31, 2020 , the carrying amount of our investment securities totaled $ 19.

8 million, a de crease of $ 1 3.0 million , or 39 .6 %, compared to $ 3 2 .7 million as of December 31, 2019 .

As of June 30, 2020, the carrying amount of our investment securities totaled $24.3 million, a decrease of $8.4 million, or 25.7%, compared to $32.7 million as of December 31, 2019.

The decrease in the securities portfolio was due to maturities and principal paydowns.

We do not expect to purchase securities to replace these decreases, except as needed for pledging purposes.

We purchased short-term six-month U.S.

Treasury Securities during the quarter ended June 30, 2020, for pledging purposes.

We do not expect to purchase securities to replace decreases, except as needed for pledging purposes.

Our investment portfolio consists of securities classified as available for sale and, to a lesser amount, held to maturity.

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The following table summarizes the amortized cost and estimated fair value of our investment securities as of the dates shown:

March 31, 2020

June 30, 2020

December 31, 2019

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This enables us to extend Federal Deposit Insurance Corporation (“FDIC”) insurance to customers that have balances in excess of the FDIC insurance limit.

This service trades our customer’s funds as CDs in increments under the FDIC insured amount to other participating financial institutions and in exchange we receive CD investments from participating financial institutions in a reciprocal agreement.

This service trades our customer’s funds as CDs or interest bearing demand deposits in increments under the FDIC insured amount to other participating financial institutions and in exchange we receive CD or interest bearing demand investments from participating financial institutions in a reciprocal agreement.

We rely primarily on competitive pricing policies, convenient locations, electronic delivery channels (Internet and mobile), and personalized service to attract new deposits and retain existing deposits.

Total deposits as of March 31, 2020 were $1.01 billion, an increase of $37.1 million, or 3.8%, compared to $968.0 million as of December 31, 2019.

The increase was largely in core deposits, which increased $29.9 million to $892.4 million from $862.5 million at December 31, 2019.

Total deposits as of June 30, 2020 were $1.31 billion, an increase of $338.5 million, or 35.0%, compared to $968.0 million as of December 31, 2019.

The increase was largely in core deposits, which increased $349.7 million to $1.21 billion from $862.5 million at December 31, 2019.

A portion of the funds from PPP loans were deposited directly into existing or new deposit accounts, thus elevating those deposit account balances until such time that the funds were, or are, used.

We expect our deposit totals to decline as customers use the funds obtained through the PPP loans.

We define core deposits as all deposits except time deposits and BaaS-brokered deposits.

We focus on growing core deposits and our branch managers, business development officers, treasury service personnel and lenders work together to grow deposits from existing and new customers.

Noninterest bearing deposits as of March 31, 2020 were $345.5 million, a decrease of $25.7 million, or 6.9%, compared to $371.2 million as of December 31, 2019.

The $25.7 million decrease partially resulted from a $10.2 million estate distribution and a $8.5 million reclassification to interest bearing deposits from a BaaS customer which we expect to eventually transfer back to noninterest bearing.

These deposits represent 34.4% and 38.4% of total deposits for March 31, 2020 and December 31, 2019, respectively.

Total interest bearing account balances, excluding time deposits, as of March 31, 2020 were $570.8 million, an increase of $55.9 million, or 10.9%, from $514.9 million as of December 31, 2019.

Included in interest bearing account balances is $23.9 million in BaaS-brokered deposits, an increase of $318,000 from December 31, 2019.

Also included in interest bearing deposits is $638,000 in reciprocal deposits.

In 2019 we introduced reciprocal deposits as a product available for time deposit customers and beginning this year we are offering an interest bearing demand reciprocal deposit product.

Total time deposit balances as of March 31, 2020 were $88.8 million, an increase of $6.9 million, or 8.4%, from $81.9 million as of December 31, 2019.

The increase is the result of $10.9 million in reciprocal deposits, which are included in time deposits.

s een competitors continue to offer higher rates on time deposits , and we have not globally matched their rates in response as we have been able to grow and retain less costly core deposits.

Funds from PPP loans were frequently deposited directly into existing or new customer accounts during the quarter ended June 30, 2020.

This includes approximately 842 new deposit relationships that were established as a result of funding PPP loans for business owners in the communities we serve.

The time and effort spent working with these new customers throughout the PPP process has resulted in increased deposits and new relationships that the Company will work to grow and retain into the future.

Noninterest bearing deposits as of June 30, 2020 were $563.8 million, an increase of $192.5 million, or 51.9%, compared to $371.2 million as of December 31, 2019.

The increase is largely attributed to the aforementioned PPP funds being deposited and held in customer accounts until the funds are used.

Noninterest bearing deposits represent 43.2% and 38.4% of total deposits for June 30, 2020 and December 31, 2019, respectively.

Total interest bearing account balances, excluding time deposits, as of June 30, 2020 were $674.9 million, an increase of $160.1 million, or 31.1%, from $514.9 million as of December 31, 2019.

Included in interest bearing account balances is $26.5 million in BaaS-brokered deposits, an increase of $2.9 million from December 31, 2019.

Also included in interest bearing deposits is $4.4 million in reciprocal deposits.

In 2019 we introduced reciprocal deposits as a product available for time deposit customers and beginning in 2020 we added an interest bearing demand reciprocal deposit product.

Total time deposit balances as of June 30, 2020 were $67.7 million, a decrease of $14.2 million, or 17.3%, from $81.9 million as of December 31, 2019.

The decrease is a conscious effort to not replace maturing time deposits, but rather to grow and retain less

expensive core deposits .

We have s een competitors continue to offer higher rates on time deposits , and we have not globally matched their rates in response as we have been able to grow and retain less costly core deposits.

The following table sets forth deposit balances at the dates indicated.

March 31, 2020

June 30, 2020

December 31, 2019

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Weighted average maturity (in years)

Average deposits for the three months ended March 31, 2020 were $981.0 million, compared to $859.1 million for the three months ended March 31, 2019.

Average deposits for the three and six months ended June 30, 2020 were $1.25 billion and $1.12 billion, respectively, an increase of 45.5% and 29.8%, respectively , compared to the three and six months ended June 30, 2019.

The increase in average deposits was primarily due to an increase in core deposits, both in noninterest bearing deposits and in interest bearing deposits.

Included in this increase is funds from PPP loan disbursements which were primarily deposited and held in customer accounts until they used the funds.

Continued growth in our primary market areas and the increase in commercial lending relationships for which we also seek deposit balances and the results of business development efforts by our business development officers, branch managers and lenders continue to contribute to deposit growth.

The average rate paid on total deposits was 0.64% and 0.68%, respectively, for the three months ended March 31, 2020 and March 31, 2019, respectively.

The average rate paid on BaaS-brokered deposits decreased 1.29% for the three months ended March 31, 2020, compared to the prior year period, and NOW and money market accounts increased 28 basis points.

however, the impact of such rate decreases will be reflected in future periods, starting with second quarter 2020.

The average rate paid on total deposits was 0.35% and 0.48%, respectively, for the three and six months ended June 30, 2020, compared to 0.66% and 0.67%, for the three and six months ended June 30, 2019, respectively.

The average rate paid on BaaS-brokered deposits decreased 1.95% and 1.65% for the three and six months ended June 30, 2020, respectively, compared to the prior year periods, and NOW and money market accounts decreased 34 basis points and four basis points, for the three and six months ended June 30, 2020, respectively.

The average rate paid on NOW and money market accounts in the three and six months ended June 30, 2020 is the result of the recent decreased Fed funds rates and the impact of these rate decreases will continue to be reflected in future periods.

Any further changes to the Fed funds rate along with competition are expected to continue to impact future cost of deposits and our pricing strategies.

The following table presents the average balances and average rates paid on deposits for the periods indicated:

For the Three Months Ended March 31,

For the Three Months Ended June 30,

For the Six Months Ended June 30,

(Dollars in thousands)

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Total deposits

The ratio of average noninterest bearing deposits to average total deposits for the three months ended March 31, 2020 was 36.0%, compared to 33.5% for the three months ended March 31, 2019.

The ratio of average noninterest bearing deposits to average total deposits for the three and six months ended June 30, 2020 was 43.3% and 40.1%, respectively, compared to 35.9% and 34.7% for the three and six months ended June 30, 2019, respectively.

We have the ability to utilize short-term to long-term borrowings to supplement deposits to fund our lending and investment activities, each of which is discussed below.

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The Federal Reserve allows us to borrow against our line of credit through a borrower in custody agreement utilizing the discount window, which is collateralized by certain loans.

As of March 31, 2020 and December 31, 2019, total borrowing capacity of $21.4 million was available under this arrangement.

As of March 31, 2020 and December 31, 2019, Federal Reserve advances totaled zero.

As of June 30, 2020, and December 31, 2019, total borrowing capacity of $19.5 and $21.4 million, respectively, was available under this arrangement.

As of June 30, 2020, and December 31, 2019, Federal Reserve advances totaled zero.

Paycheck Protection Program Liquidity Facility.

To bolster the effectiveness of the SBA’s PPP loan program, the Federal Reserve is supplying liquidity to participating financial institutions through term financing backed by PPP loans to small businesses.

The PPP provides loans to small businesses so that they can keep their employees on the payroll and pay for other allowed expenses.

If the borrowers meet certain criteria, the loan may be forgiven.

The PPPLF extends credit to eligible financial institutions that originate PPP loans, taking the loans as collateral at face value.

The interest rate is 0.35% and as PPP loans are paid down, the borrowing line must also be paid down.

As of June 30, 2020, there was $190.2 million outstanding in PPPLF advances.

This is a new borrowing arrangement that has favorable capital treatment and is specific to the PPP loan program, and therefore there was no balance at December 31, 2019.

The table below provides details on PPPLF borrowings for the periods indicated:

As of and For the Three

As of and For the Six

(Dollars in thousands)

Maximum amount outstanding at any month-end

during period:

PPPLF Advances

Average outstanding balance during period:

PPPLF Advances

Weighted average interest rate during period:

PPPLF Advances

Balance outstanding at end of period:

PPPLF Advances

Weighted average interest rate at end of period:

PPPLF Advances

Federal Home Loan Bank Advances.

The FHLB allows us to borrow against our line of credit, which is collateralized by certain loans.

As of March 31, 2020 and December 31, 2019, we had borrowing capacity of $88.1 million and $84.9 million, respectively, under this arrangement.

On March 4, 2020 we borrowed a total of $25.0 million in FHLB long term advances.

This includes $10.0 million for a three-year term and $15.0 million for a five-year term.

FHLB advances totaled $25.0 million as of March 31, 2020 and $10.0 million as of December 31, 2019.

There was $63.1 million and $74.9 million borrowing capacity remaining as of March 31, 2020, and December 31, 2019, respectively.

As of June 30, 2020, and December 31, 2019, we had borrowing capacity of $88.7 million and $84.9 million, respectively, under this arrangement.

As of June 30, 2020, we borrowed a total of $25.0 million in FHLB long term advances.

This includes $10.0 million for a 2.75-year remaining term and $15.0 million advance with a 4.75-year remaining term.

FHLB advances totaled $25.0 million as of June 30, 2020 and $10.0 million as of December 31, 2019.

There was $63.7 million and $74.9 million borrowing capacity remaining as of June 30, 2020, and December 31, 2019, respectively.

Although there are no immediate plans to borrow additional funds, additional borrowing capacity of $63.7 million was available under this arrangement as of June 30, 2020.

The table below provides details on FHLB short term borrowings for the periods indicated:

As of and for the Three

As of and for the Six

(Dollars in thousands)

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As of and For the Three

As of and For the Six

(Dollars in thousands)

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The debentures bear interest at a rate per annum equal to the 3-month LIBOR plus 2.10%.

The effective rate as of March 31, 2020, and December 31, 2019, was 2.84 % and 3.99%, respectively.

The effective rate as of June 30, 2020, and December 31, 2019, was 2.41 % and 3.99%, respectively.

We generally have the right to defer payment of interest on the debentures at any time or from time to time for a period not exceeding five years provided that no extension period may extend beyond the stated maturity of the debentures.

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The Trust’s preferred securities are mandatorily redeemable upon maturity of the debentures, or upon earlier redemption as provided in the indenture, subject to Federal Reserve approval.

If the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.

We unconditionally guarantee payment of accrued and unpaid distributions required to be paid on the Trust securities subject to certain exceptions, the redemption price with respect to any Trust securities called for redemption and amounts due if the Trust is liquidated or terminated.

debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.

We unconditionally guarantee payment of accrued and unpaid distributions required to be paid on the Trust s ecurities subject to certain exceptions, the redemption price with respect to any Trust securities called for redemption and amounts due if the Trust is liquidated or terminated.

Subordinated Debt .

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The note matures on August 1, 2026, and bears interest at the rate of 5.65% per year for five years and, thereafter, at a rate equal to The Wall Street Journal prime rate plus 2.50%.

The five-year 5.65% interest period ends on August 1, 2021.

Principal payments of $500,000 per quarter commence November 1, 2021.

8 unchanged sentences

We continually monitor our liquidity position to ensure that our assets and liabilities are managed in a manner to meet all reasonably foreseeable short-term, long-term and strategic liquidity demands.

Management has established a com prehensive process for identifying, measuring, monitoring and controlling liquidity risk.

Management has established a comprehensive process for identifying, measuring, monitoring and controlling liquidity risk.

Because of its critical importance to the viability of the Bank, liquidity risk management is fully integrated into our risk management processes.

13 unchanged sentences

Less commonly used sources of funding include borrowings from the Federal Reserve discount window, draws on established federal funds lines from unaffiliated commercial banks, brokered funds, a one-way buy through an ICS account, and the issuance of debt or equity securities.

We are also participating in the PPPLF, which provides an additional source of funding for the PPP loans.

We have pledged 327 of these loans, or $111.1 million as of May 6, 2020.

We are also participating in the PPPLF, which provides an additional source of low cost funding, at a 0.35% interest rate, and favorable capital treatment for the PPP loans.

We have pledged 711 of these loans, or $190.2 million, as of June 30, 2020.

Under the terms of the agreement, the borrowings will be paid down as the loans are forgiven or paid down by the customer.

We also added a new liquidity source that would be classified as brokered deposits, but do not anticipate using it very often.

We believe we have ample liquidity resources to fund future growth and meet other cash needs as necessary and are closely monitoring liquidity in this uncertain economic environment.

2 unchanged sentences

The Company has consistently retained a portion of the funds from equity and debt offerings so that is has sufficient funds for its operating and debt costs for the next few years.

The Company down-streamed $7.5 million in capital to the Bank during the first quarter of 2020, bringing the Company’s cash holding to $6.1 million at March 31, 2020.

The Company down-streamed $7.5 million in capital to the Bank during the first quarter of 2020, bringing the Company’s cash holding to $5.8 million at June 30, 2020.

The Company uses approximately $1.3 million for debt servicing and operating purposes each year, leaving about $3.2 million for other purposes after deducting $2.6 million to cover operating purposes for the next two years.

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We believe that these limitations will not impact the ability of the Bank to pay dividends to the Company to meet ongoing operating needs.

For contingency purposes, the Company maintains a minimum level of cash to fund one year’s projected operating cash flow needs and the Bank established a minimum liquidity ratio of 5% of assets.

For contingency purposes, the Company maintains a minimum level of cash to fund one year’s projected operating cash flow needs and the Bank established a minimum

liquidity ratio of 5 % of assets.

Both of these minimum liquidity levels are on-balance sheet sources.

1 unchanged sentence

Since the Bank uses only a small portion of its borrowing or wholesale funding capacity, the Bank has access to funds if needed in a liquidity emergency.

Any P PPLF borrowings are excluded from the 30% of assets wholesale ratio as these funds are for a specific purpose and have favorable regulatory treatment.

Capital Adequacy

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Currently, the Federal Reserve assesses the capital position of the Company by reviewing its debt-to-equity ratio and assessing the Company's capacity to serve as a source of strength to the Bank.

As of March 31 , 2020 and December 31, 2019 , the Bank was in compliance with all applicable regulatory capital requirements, and the Bank was classified as “well capitalized” for purposes of the Federal Reserve’s 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 ea rnings.

During the first quarter of 2020, the Company contributed $7.5 million in capital to the Bank due to the volatile economic environment.

No additional contributions have been made;

however, the Company could downstream additional funds to the Bank in the future, if necessary.

As of June 30, 2020, and December 31, 2019, the Bank was in compliance with all applicable regulatory capital requirements, and the Bank was classified as “well capitalized” for purposes of the Federal Reserve’s 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 expect to monitor and control our growth in order to remain in compliance with all regulatory capital standards applicable to us.

6 unchanged sentences

(dollars in thousands)

March 31, 2020

June 30, 2020

Leverage Capital (to average assets)

10 unchanged sentences

Contractual Obligations

The following table summarizes contractual obligations and other commitments to make future payments (other than non-time deposit obligations), which consist of future cash payments associated with our contractual obligations, as of March 31, 2020.

Payments Due by Period

1 unchanged sentence

Time Deposits

Paycheck Protection Program Liquidity Facility

FHLB advances

38 unchanged sentences

The following table shows the Company’s key performance ratios for the periods indicated.

The table also includes ratios that were adjusted by removing the impact of the BaaS-brokered deposits to the quarters ended June 30, 2019 and March 31, 2019.

The BaaS-brokered deposits normalized at the end of the second quarter of 2019, therefore no adjustment was made to the loans receivable to deposits ratio as of June 30, 2019 and no adjustments were made to the performance ratios that are calculated using an average balance since the quarter ended June 30, 2019 .

These adjusted ratios are non-GAAP measures.

The table also includes ratios that were adjusted by removing the impact of the PPP loans on loans receivable related measures.

The adjusted ratios are non-GAAP measures.

For more information about non-GAAP financial measures, see “ GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures ” section that follows.

Three months ended

Six months ended

December 31, 2019

September 30, 2019

Return on average assets (1)

Return on average assets, as adjusted (1,2)

Return on average equity (1)

Pre-tax, pre-provision return on average assets (1,3)

Pre-tax, pre-provision return

on average assets (1)(2)

Yield on earnings assets (1)

Yield on loans receivable (1)

Loan yield excluding fees (1)

Yield on loans receivable,

as adjusted (1)(2)

Contractual yield on loans

receivable, excluding earned

Contractual yield on loans

receivable, excluding earned

fees, as adjusted (1)(2)

Cost of funds (1)

Cost of funds, as adjusted (1,4)

Cost of deposits (1)

Cost of deposits, as adjusted (1,5)

Net interest margin (1)

Net interest margin, as adjusted (1,6)

Noninterest expense to average assets (1)

Noninterest expense to average assets, as adjusted (1,7)

Noninterest expense to average

Efficiency ratio

Loans receivable to deposits

Loans receivable to deposits, as adjusted (8)

(1) Annualized calculations shown for quarterly periods presented.

(2) For quarters ended June 30, 2019 and March 31, 2019, adjusted return on average assets is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS deposits on balance sheet.

The most directly comparable GAAP measure is return on average assets.

See our reconciliation of non-GAAP financial measures to their most directly comparable GAAP financial measures in Item 2.

Management's Discussion and Analysis of Financial Condition and Operations under the caption “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures”.

(3) Pre-tax, pre-provision return on average assets is a non-GAAP measure that excludes the impact of provision for loan losses and income tax expense from return on average assets.

The most directly comparable GAAP measure is return on average assets.

See our reconciliation of non-GAAP financial measures to their most directly comparable GAAP financial measures in Item 2.

Management's Discussion and Analysis of Financial Condition and Operations under the caption “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures”.

(4) For quarters ended June 30, 2019 and March 31, 2019, adjusted cost of funds is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS deposits on balance sheet.

The most directly comparable GAAP measure is cost of funds.

See our reconciliation of non-GAAP financial measures to their most directly comparable GAAP financial measures in Item 2.

Management's Discussion and Analysis of Financial Condition and Operations under the caption “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures”.

(5) For quarters ended June 30, 2019 and March 31, 2019, adjusted cost of deposits is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS deposits on balance sheet.

The most directly comparable GAAP measure is cost of deposits.

See our reconciliation of non- GAAP financial measures to their most directly comparable GAAP financial measures in Item 2.

Management's Discussion and Analysis of Financial Condition and Operations under the caption “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures ” .

(6) For quarters ended June 30, 2019 and March 31, 2019, adjusted net interest margin is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS deposits on balance sheet.

The most directly comparable GAAP measure is net interest margin.

See our reconciliation of non-GAAP financial measures to their most directly comparable GAAP financial measures in Item 2.

Management's Discussion and Analysis of Financial Condition and Operations under the caption “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures”.

(7) For quarters ended June 30, 2019 and March 31, 2019, adjusted noninterest expense to average assets is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS deposits on balance sheet.

The most directly comparable GAAP measure is noninterest expense to average assets.

See our reconciliation of non-GAAP financial measures to their most directly comparable GAAP financial measures in Item 2.

Management's Discussion and Analysis of Financial Condition and Operations under the caption “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures”.

(8) For quarter ended March 31, 2019, adjusted loans receivable to deposits is a non-GAAP measure that excludes BaaS-brokered deposits on balance sheet.

The most directly comparable GAAP measure is loans receivable to deposits.

See our reconciliation of non-GAAP financial measures to their most directly comparable GAAP financial measures in Item 2.

Management's Discussion and Analysis of Financial Condition and Operations under the caption “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures”.

(1) Annualized calculations shown for quarterly and six month periods presented.

(2) A reconciliation of the non-GAAP measures are set forth in the section " GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures ."

GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures

Some of the financial measures included in this report are not measures of financial performance recognized by GAAP.

Our management uses the non-GAAP financial measures set forth below in its analysis of our performance.

We believe that these non-GAAP financial measures provide information that is important to investors and that is useful in understanding our results of operations.

The following non-GAAP measures are presented to illustrate the impact of provision for loan losses and provision for income taxes on net income and return on average assets.

The Company uses certain non-GAAP financial measures to provide meaningful supplemental information regarding the Company’s operational performance and to enhance investors’ overall understanding of such financial performance.

However, these non-GAAP financial measures are supplemental and are not a substitute for an analysis based on GAAP measures.

As other companies may use different calculations for these measures, this presentation may not be comparable to other similarly titled measures by other companies.

As other companies may use different calculations for these adjusted measures, this presentation may not be comparable to other similarly titled adjusted measures reported by other companies.

We believe these non-GAAP measures are useful to investors in evaluating our performance and in demonstrating resources available with and without provision for loan losses and income taxes.

The following non-GAAP measures are presented to illustrate the impact of provision for loan losses and provision for income taxes on net income and return on average assets.

Pre- tax, pre- provision net income is a non-GAAP measure that excludes the impact of provision for loan losses and provision for income taxes from net income.

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Reconciliations of the GAAP and non-GAAP measures are presented below.

As of and for the Three Months Ended

(Dollars in thousands)

As of and for the

Three Months Ended

As of and for the

Six Months Ended

(Dollars in thousands, unaudited)

September 30,

Pre-tax, pre-provision return on average assets:

Pre-tax, pre-provision net income and pre-tax, pre-provision return on average assets:

Total average assets

1 unchanged sentence

provision for loan losses

provision for income taxes

Total pre-tax, pre-provision net income

Pre-tax, pre-provision return on average assets

provision for income

Pre-tax, pre-provision net

Return on average assets

Pre-tax, pre-provision return

on average assets:

The following non-GAAP financial measures are presented to illustrate and identify the impact of PPP loans on loans receivable related measures.

By removing these significant items and showing what the results would have been without them, we are providing investors with the information to better compare results with periods that did not have these significant items.

We believe that these non-GAAP financial measures provide information that is important to investors and that is useful in understanding our results of operations.

The following non-GAAP financial measures are presented to illustrate and identify the impact of temporary high rate BaaS deposits on the balance sheet.

By removing these temporary deposits to show what the results would have been without them we are providing the investors with the information to better compare results with periods that did not have these temporary deposits.

However, these non-GAAP financial measures are supplemental and are not a substitute for an analysis based on GAAP measures.

As other companies may use different calculations for these measures, this presentation may not be comparable to other similarly titled measures by other companies.

These measures include the following:

“Adjusted return on average assets” is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS-brokered deposits on the balance sheet.

The most directly comparable GAAP measure is return on average assets.

“Adjusted cost of funds” is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS-brokered deposits on the balance sheet.

The most directly comparable GAAP measure is cost of funds.

“ Adjusted c ost of deposits” is a non-GAAP measure that exc ludes the temporary impact of holding high rate BaaS-brokered deposits on the balance sheet.

The most directly comparable GAAP measure is cost of deposits.

“Adjusted net interest margin” is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS-brokered deposits on the balance sheet.

The most directly comparable GAAP measure is net interest margin.

“Adjusted noninterest expense to average assets” is a non-GAAP measure that excludes the temporary impact of holding high rate BaaS-brokered deposits on the balance sheet.

The most directly comparable GAAP measure is noninterest expense to average assets.

“Adjusted loans receivable to deposits” is a non-GAAP measure that excludes BaaS-brokered deposits on the balance sheet.

The most directly comparable GAAP measure is loans receivable to deposits.

The Company also presented comparable earnings and financial information using GAAP financial measures.

Reconciliations of the GAAP and non-G AAP measures are presented in the following tabl e :

As of and for the Three Months Ended

(Dollars in thousands)

Adjusted allowance for loan losses to loans receivable is a non-GAAP measure that excludes the impact of PPP loans on balance sheet.

The most directly comparable GAAP measure is allowance for loan losses to loans receivable.

Adjusted yield on loans receivable is a non-GAAP measure that excludes the impact of PPP loans on balance sheet.

The most directly comparable GAAP measure is yield on loans.

Adjusted contractual yield on loans receivable, excluding earned fees is a non-GAAP measure that excludes the impact of PPP loans on balance sheet.

The most directly comparable GAAP measure is contractual yield on loans, excluding fees.

Reconciliations of the GAAP and non-GAAP measures are presented in the following table:

As of and for the

Three Months Ended

Six Months Ended

(Dollars in thousands, unaudited)

June 30, 2020

March 31, 2019

Adjusted return on average assets:

Total average assets

average BaaS-brokered deposits

Adjusted total average deposits and borrowings

Total net income

fees earned on servicing BaaS-brokered deposits

Adjusted net income

Adjusted return on average assets:

Adjusted cost of funds:

Total average deposits and borrowings

average BaaS-brokered deposits

Adjusted total average deposits and borrowings

Total interest expense

interest expense on BaaS-brokered deposits

Adjusted interest expense

Adjusted cost of funds:

Adjusted cost of deposits:

Total average deposits

average BaaS-brokered deposits

Adjusted total average deposits

Interest expense on deposits

interest expense on BaaS-brokered deposits

Adjusted interest expense on interest bearing deposits

Adjusted cost of deposits:

Adjusted net interest margin:

Total average interest earning assets

average BaaS-brokered deposits held in cash

Adjusted total average interest earning assets

Total net interest income

interest income earned BaaS-brokered deposits held in cash

interest expense on BaaS-brokered deposits

Adjusted net interest income

Adjusted net interest margin:

Adjusted noninterest expense to average assets:

Total average assets

average BaaS-brokered deposits

Adjusted total average assets

Total noninterest expense

Adjusted noninterest expense to average assets:

As of and for the Three Months Ended

(Dollars in thousands)

June 30, 2020

March 31, 2019

Adjusted loans receivable to deposits (1):

Total loans receivable

Total deposits

BaaS-brokered deposits

Total deposits, less BaaS-brokered deposits

Adjusted loans receivable to deposits:

(1) Adjusted loans receivable to deposits is only presented for periods that include atypically large BaaS-brokered deposits as of the end of the period presented.

Quantitative and Qualitat ive Disclosure about Market Risk

Quantitative and Qualitative Disclosures about Market Risk

As a financial institution, our primary component of market risk is interest rate volatility.

Our asset liability and funds management policy provides management with the guidelines for effective funds management, and we have established a measurement system for monitoring our net interest rate sensitivity position.

We have historically managed our sensitivity position within our established guidelines.

Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of our assets and liabilities, and the market value of all interest earning assets and interest bearing liabilities, other than those which have a short term to maturity.

Interest rate risk is the potential for economic losses due to future interest rate changes.

These economic losses can be reflected as a loss of future net interest income and/or a decrease in current fair market values.

Our objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income.

We manage our exposure to interest rates by structuring our balance sheet in the ordinary course of business.

We do not enter into instruments such as leveraged derivatives, financial options, financial future contracts or forward delivery contracts for the purpose of reducing interest rate risk.

Based upon the nature of our operations, we are not subject to foreign exchange or commodity price risk.

We do not own any trading assets.

Our exposure to interest rate risk is managed by the Asset Liability Committee (ALCO), of the Bank and reviewed by the Asset Liability and Investment Committee of our board of directors in accordance with policies approved by our board of directors.

ALCO formulates strategies based on appropriate levels of interest rate risk.

In determining the appropriate level of interest rate risk, ALCO considers the impact on earnings and capital on the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors.

ALCO meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings.

Additionally, ALCO reviews liquidity, cash flows, maturities of deposits and consumer and commercial deposit activity.

Management employs various methodologies to manage interest rate risk including an analysis of relationships between interest earning assets and interest bearing liabilities and interest rate simulations using a model.

The Asset Liability and Investment Committee of our board of directors meets quarterly to review the Bank’s interest rate risk profile, liquidity position, including contingent liquidity, and investment portfolio.

We use interest rate risk simulation models to test interest rate sensitivity of net interest income and fair value of equity, and the impact of changes in interest rates on other financial metrics.

Contractual maturities and re-pricing opportunities of loans are incorporated in the model, as are prepayment assumptions, maturity data and call options within the investment portfolio.

Average life of non-maturity deposit accounts are based on historical decay rates and assumptions and are incorporated into the model.

The assumptions used are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income.

Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.

On a quarterly basis, we run multiple simulations under two different premises of which one is a static balance sheet and the other is a dynamic growth balance sheet.

The static balance sheet approach produces results that show the interest risk currently inherent in our balance sheet at that point in time.

The dynamic balance sheet includes our projected growth levels going forward and produces results that shows how net income, net interest income, and interest risk change based on our projected growth.

These simulations test the impact on net interest income and fair value of equity from changes in market interest rates under various scenarios.

Under the static and dynamic approaches, rates are shocked instantaneously and ramped over a 12-month horizon assuming parallel yield curve shifts.

Parallel shock scenarios assume instantaneous parallel movements in the yield curve compared to a flat yield curve scenario.

Non-parallel simulations are also conducted and involve analysis of interest income and expense under various changes in the shape of the yield curve including a forward curve, flat curve, steepening curve, and an inverted curve.

Our internal policy regarding internal rate risk simulations currently specifies that for instantaneous parallel shifts of the yield curve, estimated net income at risk for the subsequent one- and two-year period should not decline by more than 10% for a 100 basis point shift, 15% for a 200 basis point shift, 20% for a 300 basis point shift, and 25% for a 400 basis point shift.

The following tables summarize the simulated change in net interest income over a 12-month horizon as of the dates indicated:

Estimated Increase (Decrease) in

Net Interest Income

Change in Market Interest Rates

Twelve Month Projection

March 31, 2020

Twelve Month Projection

December 31, 2019

Static Balance Sheet and Rate Shifts

+400 basis points

+300 basis points

+200 basis points

+100 basis points

-100 basis points

-200 basis points

-300 basis points

Dynamic Balance Sheet and Rate Shifts

+400 basis points

+300 basis points

+200 basis points

+100 basis points

-100 basis points

-200 basis points

-300 basis points

The results illustrate that the Bank is asset sensitive and generally performs better in an increasing interest rate environment.

The results are primarily due to behavior of demand, money market and savings deposits during such rate fluctuations.

We have found that, historically, interest rates on these deposits change more slowly than changes in the discount and federal funds rates.

This assumption is incorporated into the simulation model.

The assumptions incorporated into the model are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income.

Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions, the shape of the interest yield curve, and the application and timing of various strategies.

Impact of Inflation

Our consolidated financial statements and related notes to those financial statements 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.

Adjusted allowance for loan losses to loans receivable:

Total loans, net of deferred fees

net deferred fees on PPP loans

Adjusted loans, net of deferred fees

Allowance for loan losses

Allowance for loan losses to loans receivable

Adjusted allowance for loan losses to loans receivable

Adjusted yield on loans receivable:

Total average loans receivable

average PPP loans

average deferred fees on PPP loans

Adjusted total average loans receivable

Interest income on loans

interest and fee income on PPP loans

Adjusted interest income on loans

Yield on loans receivable

Adjusted yield on loans receivable:

Adjusted contractual yield on loans receivable, excluding earned fees:

Total average loans receivable

average PPP loans

average deferred fees on PPP loans

Adjusted total average loans receivable, excluding earned fees

Interest and earned fee income on loans

earned fee income on loans

interest income on PPP loans

Adjusted interest income on loans

Contractual yield on loans receivable, excluding earned fees

Adjusted contractual yield on loans receivable, excluding earned fees:

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What changed 10-Q

Item 2. Management’s Discussion and Analysis