COASTAL FINANCIAL CORP 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview We are a bank holding company that operates through our wholly owned subsidiaries, Coastal Community Bank (the “Bank”) and Arlington Olympic LLC. We are headquartered in Everett, Washington, which by population is the largest city in, and the county seat of, Snohomish County. We focus on providing a wide range of banking products and services to consumers and small to medium sized businesses in the broader Puget Sound region in the state of Washington. 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). The Bank also provides banking as a service (“BaaS”) that allows our broker-dealer and digital financial service providers to offer their customers banking services and expects to introduce a digital bank offering in collaboration with Google in 2021. As of September 30, 2020, we had total assets of $1.75 billion, total gross loans of $1.51 billion, total deposits of $1.36 billion and total shareholders’ equity of $135.2 million. The following discussion and analysis presents our financial condition and results of operations on a consolidated basis. However, because we conduct all of our material business operations through the Bank, the discussion and analysis relate to activities primarily conducted by the Bank. As a bank holding company that operates through one segment, community banking, we generate most of our revenue from interest on loans and investments. Our primary source of funding for our loans is commercial and retail deposits from our customer relationships. 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 interest rate of 0.35%. The PPPLF 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, 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. 28 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 PPP program closed to new loan applicants on August 8, 2020. We accepted and processed requests for existing and new customers for the duration of the program. Deferral on PPP payments was extended as we await final guidance on these loans; however, we have begun accepting applications from customers for loan forgiveness. 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 and continued through the third quarter and into fourth quarter of 2020. The Company carefully executed the plan with limited operational disruptions, with 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. To date we have: • 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 successful employment of remote work solutions for many employees. • Continued participation in the SBA PPP with funded loans outstanding of $452.8 million, as of September 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 October 31, 2020, $9.2 million, or 10 loans, remain on deferred or modified payment status. • Pledged 820 PPP loans, or $202.6 million as of September 30, 2020, which provides an additional source of funding for the PPP loans, through the PPPLF. The borrowings must be paid down as PPP loan amounts are forgiven or when the customers pay their loans 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. • 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 provides: o Gatherings of no more than 5 people outside one’s household per week o Travel to counties that are in other phases of reopening to participate in non-essential activities is not allowed o Opens certain businesses with social distancing and capacity restrictions • Refreshed and analyzed the Company's liquidity, funding and capital stress forecasts and risk assumptions. PPP Overview During the second and third quarters of 2020, 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 quarter ended September 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 ”. 29 The table below summarizes key information regarding the PPP loans as of the period indicated: Loan Size As of September 30, 2020 $0.00 - $50,000.00 $50,0000.01 - $150,000.00 $150,000.01 - $350,000.00 $350,000.01 - $2,000,000.00 > 2,000,000.01 Totals (Dollars in thousands; unaudited) Principal outstanding: Existing customer $ 11,232 $ 27,696 $ 29,806 $ 86,302 $ 52,299 $ 207,335 New customer 20,604 34,355 42,793 86,707 61,052 245,511 Total principal outstanding 31,836 62,051 72,599 173,009 113,351 452,846 Deferred fees outstanding (1,161 ) (2,116 ) (2,417 ) (3,375 ) (752 ) (9,821 ) Deferred costs outstanding 629 278 174 134 19 1,234 Net deferred fees $ (532 ) $ (1,838 ) $ (2,243 ) $ (3,241 ) $ (733 ) $ (8,587 ) Total principal, net of deferred fees $ 31,304 $ 60,213 $ 70,356 $ 169,768 $ 112,618 $ 444,259 Weighted average maturity (years) 2.21 1.75 1.63 1.63 1.64 1.69 Number of loans: Existing customer 498 307 129 108 13 1,055 New customer 1,107 386 193 119 19 1,824 Total loan count 1,605 693 322 227 32 2,879 Percent of total 55.7 % 24.1 % 11.2 % 7.9 % 1.1 % 100.0 % 30 Comparison of Operating Results for the Three Months Ended September 30, 2020 and September 30, 2019 Results of Operations Net Income Net income for the three months ended September 30, 2020, was $4.1 million, or $0.34 per diluted share, compared to $3.5 million, or $0.29 per diluted share, for the three months ended September 30, 2019. The increase in net income over the comparable period in the prior year was attributable to a $4.4 million increase in net interest income, largely related to increased interest earning assets, including PPP loans. Interest and fee income related to PPP loans totaled $3.6 million for the three months ended September 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 $1.6 million increase in the provision for loan losses, related to an increase in qualitative factors related to the change in the economic outlook caused by the COVID-19 pandemic along with the growth in the loan portfolio, and $1.9 million increase in noninterest expense, which includes $1.0 million more in salaries and employee benefits, $211,000 more in legal and professional fees, and $207,000 more in occupancy expenses. Salaries and employee benefits were increased largely as a result of hiring staff for our BaaS CCBX division, legal and professional expenses increased due to development of contracts for CCBX customers and because of reporting related legal and professional services. The increase in occupancy expense is related to a one-time $119,000 building operating expense and higher rent and depreciation expenses resulting from the opening of our Arlington branch in the second quarter of 2020 and our overall growth as a Company. Net Interest Income Net interest income for the three months ended September 30, 2020, was $15.1 million, compared to $10.7 million for the three months ended September 30, 2019, an increase of $4.4 million, or 40.7%. The increase in net interest income consisted of a $4.0 million, or 32.7%, increase in interest income coupled with a $330,000, or 20.3%, decrease in interest expense. The increase in interest income was primarily attributable to a $627.4 million, or 72.5%, increase in average loans outstanding for the three months ended September 30, 2020, compared to the prior year period, partially offset by a 1.03% 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 June 2019, totaling 2.25%, resulting in lower rates on our variable rate, new and renewing loans. In addition, for the quarter ended September 30, 2020 there was an average of $448.3 million in PPP loans, which have a 1.0% interest rate and an approximate yield of 3.16% after including the amortization of deferred fees and costs, which contributed to the decline in loan yield. Contractual loan yields approximated 3.61% for the quarter ended September 30, 2020 compared to 5.24% for the quarter ended September 30, 2019. Excluding PPP loans, the contractual loan yield approximated 4.69% for the three months ended September 30, 2020. A reconciliation of this non-GAAP measure is set forth in the section titled “ GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures. ” Although there are rate floors in place for $361.8 million, or 23.8%, 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 expect that the FOMC will maintain the Fed funds rate low for some time. 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-Bank PPP customers. During the quarter ended September 30, 2020, our focus continued to be on working with small businesses within our communities as business owners navigate through the uncertainty and change resulting from the COVID-19 pandemic. We experienced a significant increase in commercial and industrial SBA 7(a) loans during the second and into the third quarter of 2020, as small business owners applied for relief via the PPP as prescribed in the CARES Act. The PPP program closed to new loan applicants on August 8, 2020, and the Bank is no longer originating any PPP loans. The decrease in interest expense for the three months ended September 30, 2020 was the result of a 39 basis point decrease in cost of funds, bringing it to 0.33% as of September 30, 2020, compared to 0.72% at September 30, 2019. In addition to the aforementioned rate reductions by the FOMC, which ultimately resulted in a lowering of the interest rate paid on interest-bearing deposit accounts, we gained new customer relationships by making PPP loans to noncustomers and they continued to move their banking/deposit relationships to the Bank. These increases in noninterest bearing and low rate interest bearing deposits helped contribute to the improved cost of funds for the quarter ended September 30, 2020, as compared to the prior year period. The increase in borrowed funds is largely the result of utilizing the PPPLF to help fund PPP loans. The PPPLF extends low cost borrowing lines, 0.35% interest rate, to eligible financial institutions that originate PPP loans, taking the loans as collateral at face value. Borrowings are required to be paid down as the pledged PPP loans are paid down or forgiven. The average balance for the three months ended September 30, 2020 was $199.1 million, resulting in $176,000 in interest expense. 31 The average balance of interest-bearing deposits increased $1 95.1 million, or 35.1 %, compared to the prior year period, but the average rate paid on interest bearing deposits was 5 5 basis points less for the quarter ended September 30, 2020, compared to the quarter ended September 30, 2019. A s 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 1 64 basis points and NOW and money market accounts de creased 51 basis points for the three months ended September 30, 2020 . The average rate paid on BaaS-brokered deposits was higher in the three months ended September 30, 2019 as a result of a 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 31 basis points and for time deposits over $100,000 , the average rate decreased 66 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 September 30, 2020 is the result of the recent decreased Fed funds rates and management lowering rates on these accounts in response . We continue to evaluate rates and anticipate that additional rates reductions may occur in the fourth quarter . Many deposit rates were either lowered late in the first quarter or at the start of the second quarter, and some rates were further lowered at the start of the third quarter of 2020, so the impact of these reductions were largely seen in the quarter ended September 30, 2020 and the full impact will continue to be seen in future periods. The average balance of BaaS-brokered deposits was $ 21.7 million for the three mont hs ended September 30, 2020 , which was up $8.9 million from the prior year period. T he average balance of savings accounts grew $ 21.4 million, or 40.8 %, and the average balance of time deposits declined $ 29. 6 million , or 30.8 % , to $ 66 .0 million in the three months ended September 30, 2020 , compared to the three months ended September 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 three months ended September 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 3.62% and 3.41%, respectively, compared to 4.29% and 3.81%, respectively, for the three months ended September 30, 2019. 32 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. 7 million and $ 25 5 ,000 for the three months ended September 30, 2020 and 2019 , respectively. A total of $2.4 million in PPP loan fees were recognized in the quarter ended September 30, 2020. Yield on loans receivable was 4.33% for the three months ended September 30, 2020, compared to 5.36% for the three months ended September 30, 2019. Excluding PPP loans, the yield on loans receivable was 4.78% for the three months ended September 30, 2020. A reconciliation of this non-GAAP measure is set forth in the section titled “ GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures. ” For the three months ended September 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 September 30, 2020 2019 Average Interest & Yield / Average Interest & Yield / (Dollars in thousands) Balance Dividends Cost (4) Balance Dividends Cost (4) Assets Interest earning assets: Interest earning deposits $ 137,568 $ 99 0.29 % $ 85,406 $ 486 2.26 % Investment securities, available for sale (1) 20,373 22 0.43 32,581 134 1.63 Investment securities, held to maturity (1) 3,509 5 0.57 4,393 34 3.07 Other investments 5,951 24 1.60 3,621 10 1.10 Loans receivable (2) 1,493,024 16,244 4.33 865,674 11,691 5.36 Total interest earning assets 1,660,425 16,394 3.93 991,675 12,355 4.94 Noninterest earning assets: Allowance for loan losses (15,711 ) (10,548 ) Other noninterest earning assets 60,160 50,842 Total assets $ 1,704,874 $ 1,031,969 Liabilities and Shareholders’ Equity Interest bearing liabilities: Interest bearing deposits $ 750,790 $ 880 0.47 % $ 555,665 $ 1,435 1.02 % PPPLF borrowings 199,076 176 0.35 - - 0.00 FHLB advances and other borrowings 24,999 71 1.13 539 3 2.21 Subordinated debt 9,987 148 5.90 9,973 148 5.89 Junior subordinated debentures 3,584 23 2.55 3,582 42 4.65 Total interest bearing liabilities 988,436 1,298 0.52 569,759 1,628 1.13 Noninterest bearing deposits 569,615 330,553 Other liabilities 12,781 12,756 Total shareholders' equity 134,042 118,901 Total liabilities and shareholders' equity $ 1,704,874 $ 1,031,969 Net interest income $ 15,096 $ 10,727 Interest rate spread 3.41 % 3.81 % Net interest margin (3) 3.62 % 4.29 % (1) 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. (2) Includes nonaccrual loans. (3) Net interest margin represents annualized net interest income divided by average total interest earning assets. (4) Yields and costs are annualized. 33 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. The table illustra tes the $6.8 million increase in loan interest income is attributed to an increase in loan volume. This increase is partially offset by a $2.2 million decrease in loan interest income due to lower interest rates, however that decrease is largely due to low rate PPP loans, which yielded approximately 3.16%, after including the amortization of the deferred fees and costs, for the three months ended September 30, 2020. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated to volume. Three Months Ended September 30, 2020 Compared to Three Months Ended September 30, 2019 Increase (Decrease) Due to Total Increase (Dollars in thousands) Volume Rate (Decrease) Interest income: Interest earning deposits $ 37 $ (424 ) $ (387 ) Investment securities, available for sale (13 ) (99 ) (112 ) Investment securities, held to maturity (1 ) (28 ) (29 ) Other Investments 9 5 14 Loans receivable 6,800 (2,247 ) 4,553 Total increase in interest income 6,832 (2,793 ) 4,039 Interest expense: Interest bearing deposits 227 (782 ) (555 ) PPPLF borrowings 176 - 176 FHLB advances and other borrowings 69 (1 ) 68 Subordinated debt - - - Junior subordinated debentures - (19 ) (19 ) Total increase in interest expense 472 (802 ) (330 ) Increase in net interest income $ 6,360 $ (1,991 ) $ 4,369 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 three months ended September 30, 2020 was $2.2 million, compared to $637,000 for the three months ended September 30, 2019. The allowance for loan losses as a percentage of loans was 1.13% at September 30, 2020, compared to 1.25% at September 30, 2019. For the three months ended September 30, 2020, there were $452.8 million in PPP loans included in our portfolio. These loans are 100% guaranteed by the SBA, therefore we have not allocated any portion of our allowance to these 100% guaranteed loans. The allowance for loan losses to loans receivable, excluding the guaranteed PPP loans, is 1.60%. 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 an increase in qualitative factors related to the change in economic outlook caused by the COVID-19 pandemic along with loan growth. 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 September 30, 2020, as demonstrated by the low level of charge-offs and nonperforming loan balance. Nonperforming loans increased $42,000 in the three months ended September 30, 2020, as compared to $4.4 million in the three months ended June 30, 2020. N onperforming assets to total assets was 0.26% at September 30, 2020 compared to 0.12% at September 30, 2019. For a description of the Company’s nonperforming assets see “—Financial Condition—Nonperforming Assets.” Pursuant to federal guidance, the Company deferred and/or modified payments on loans to assist customers financially during the COVID-19 pandemic and economic shutdown. The majority of those loans have successfully returned to active status. At September 30, 2020, the Company had 44 loans, or $52.5 million, that remained outstanding with deferred or modified payments, compared to $207.2 million, or 215 loans, as of June 30, 2020. All of the loans that have migrated to active status are current, with 128 loans or $93.1 million, successfully resuming payments and 65 loans or $76.0 million back on active status with an initial 34 payment due in the fourth quarter of 2020. In addition, $3.0 million of deferred and/or modified loans paid-in-full or closed as of September 30, 2020 . The purpose of this program was to provide cash flow relief for small businesses as they navigated through the uncertainty of the COVID-19 pandemic. We believe that the Company’s deferral program was successful as evidenced by customers’ ability to migrate from deferral to active status and resume making payments as planned. However, a s 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, political uncertainty, 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 three months ended September 30, 2020. Net charge-offs for the three months ended September 30, 2020 totaled $1,000, or 0.00% (annualized), of total average loans, as compared to $192,000, or 0.09% (annualized) of total average loans, for the three months ended September 30, 2019. The full extent of 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 loan losses. Noninterest Income Our primary sources of recurring noninterest income are deposit service charges and fees, BaaS fees, mortgage broker fees and loan referral fees. Noninterest income does not include loan origination fees including PPP loans fees, which to the extent they exceed the direct loan origination costs, are generally recognized over the life of the related loan as an adjustment to yield using the interest or similar method and recognized in interest and fees on loans as part of interest income. For the three months ended September 30, 2020, noninterest income totaled $1.9 million, a decrease of $146,000, or 7.0%, compared to $2.1 million for the three months ended September 30, 2019. The following table presents, for the periods indicated, the major categories of noninterest income: Three Months Ended September30, Increase Percent (Dollars in thousands) 2020 2019 (Decrease) Change Deposit service charges and fees $ 824 $ 795 $ 29 3.6 % BaaS fees 576 456 120 26.3 Loan referral fees 180 - 180 100.0 Mortgage broker fees 125 140 (15 ) (10.7 ) Gain on sales of loans, net 47 369 (322 ) (87.3 ) Gain on sale of securities, net - 171 (171 ) (100.0 ) Other 190 157 33 21.0 Total noninterest income $ 1,942 $ 2,088 $ (146 ) (7.0 )% 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 $824,000 for the three months ended September 30, 2020, an increase of $29,000, or 3.6%, from $795,000 over the same period in the prior year. The increase in deposit service charges and fees was primarily the result of $61,000 increase in point of sale fees partially offset by $32,000 less overdraft fee income in the quarter ended September 30, 2020 compared to the prior year period. BaaS Fees. Our CCBX division provides BaaS offerings that enable our broker dealer and digital financial service providers 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 September 30, 2020 was $576,000 compared to $456,000 for the three months ended September 30, 2019. The increase is the result of adding additional CCBX customers to active and implementation status. As of September 30, 2020, there were four active CCBX relationships, one in friends and family trials, four in onboarding/implementation, two signed letters of intent and a solid pipeline of potential new relationships. As more CCBX customers move to active status, we expect that BaaS fees will increase. 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 $180,000 in income from l oan referral fees for the three months 35 ended September 30, 2020 , compared to zero 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 , or recognize more or fewer, loan referral fees in some periods. Mortgage Broker Fees . We earn mortgage broker fees for residential real estate loans that we broker through mortgage lenders. Mortgage broker fees decreased $15,000 in the three months ended September 30, 2020 to $125,000, compared to $140,000 in the same period in 2019 as a result of lower demand; however, low mortgage rates continue to make homes more affordable and mortgage refinancing an attractive option. 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. Gain on sale of loans decreased $322,000, or 87.3%, to $47,000 for the three months ended September 30, 2020, compared to $369,000 for the same period in 2019 as a result of fewer SBA and USDA loans being originated and sold to the secondary market. Our focus on loans in the second and third quarter of 2020 was on PPP loans administered by the SBA. Gain on Sale of Securities, net . In the third quarter of 2019, we restructured our investment portfolio to improve the rate of return, interest rate and pricing risk on the portfolio. As a result of this restructuring we were able to recognize $171,000 in net gains on the securities sold during the three months ended September 30, 2019 while decreasing the overall weighted average maturity of the investment portfolio. No securities were sold in the three months ended September 30, 2020. Other. This category includes a variety of other income-producing activities, lease and sublease income, annuity broker fees, and SBA and USDA servicing fees. Other noninterest income increased $33,000 in the three months ended September 30, 2020, compared to the same period in 2019 primarily from higher SBA and USDA servicing fee 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 September 30, 2020, noninterest expense totaled $9.7 million, an increase of $1.9 million, or 24.8%, compared to $7.7 million for the three months ended September 30, 2019. The following table presents, for the periods indicated, the major categories of noninterest expense: Three Months Ended September 30, Increase Percent (Dollars in thousands) 2020 2019 (Decrease) Change Salaries and employee benefits $ 5,971 $ 4,971 $ 1,000 20.1 % Occupancy 1,091 884 207 23.4 Data processing 577 509 68 13.4 Legal and professional fees 381 170 211 124.1 Software licenses, maintenance and subscriptions 337 181 156 86.2 Excise taxes 291 184 107 58.2 Director and staff expenses 156 241 (85 ) (35.3 ) Federal Deposit Insurance Corporation (“FDIC”) assessments 148 (4 ) 152 3800.0 Business development 72 122 (50 ) (41.0 ) Marketing 52 98 (46 ) (46.9 ) Other 590 392 198 50.5 Total noninterest expense $ 9,666 $ 7,748 $ 1,918 24.8 % 36 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 $ 6.0 million for the three months ended September 30, 2020 , an increase of $ 1.0 million , or 20.1 %, compared to $ 5.0 million for the three months ended September 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 , including hiring staff for opening our Arlington branch in J une 20 20, as well as employing temporary help to assist with operations related to the PPP loans . A s our BaaS activities and customers grow , we expect to continue to add employees to support this line of business. As of September 30, 2020 , we had 2 34 full-time equivalent employees, compared to 1 92 at September 30, 2019 , a 2 2.0 % increase . Occupancy. Occupancy expenses were $1.1 million for the three months ended September 30, 2020, compared to $884,000 for the three months ended September 30, 2019. This category includes building, leasehold, furniture, fixtures and equipment depreciation totaling $345,000 and $301,000 for the three months ended September 30, 2020 and 2019, respectively. Occupancy expenses increased as a result of $119,000 in a one-time building operating expense, with the opening of our 15 th branch late in the second quarter of 2020 and as a result of the growth in CCBX. As we continue to grow, we expect occupancy expenses to increase. Data Processing. Data processing costs were $577,000 for the three months ended September 30, 2020, compared to $509,000 for the three months ended September 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 grow and 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 grows. Legal and Professional Fees. Legal and professional costs were $381,000 for the quarter ended September 30, 2020, compared to $170,000 for the quarter ended September 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. The increase in legal and professional expenses is associated with BaaS activities through CCBX operations and higher costs related to legal and accounting work related to reporting. 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 $337,000 for the quarter ended September 30, 2020, compared to $181,000 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. Additionally, software related expenses are expected to continue to increase as we grow product lines and our CCBX division. Excise Taxes. Excise taxes were $291,000 for the three months ended September 30, 2020, compared to $184,000 for the three months ended September 30, 2019. Excise taxes are based on gross income of $18.4 million and $14.4 million for the three months ended September 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. In addition, the tax rate that is applied to our industry increased 25 basis points effective April 1, 2020, which contributed to the increase in excise tax. 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 $156,000 for the three months ended September 30, 2020, compared to $241,000 for the three months ended September 30, 2019, a decrease of 85,000 or 35.3%. 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 September 30, 2020 compared to quarter ended September 30, 2019. FDIC Assessments. FDIC assessments are assessed to fund the Deposit Insurance Fund (“DIF”) to insure and protect the depositors of insured banks and to resolve failed banks. The assessment rate is based on a number of factors and recalculated each quarter. FDIC assessments were $148,000 for the three months ended September 30, 2020, compared to $4,000 credit for the three months ended September 30, 2019, an increase of $152,000. The DIF’s reserve was in excess of the required ratio in 2019, resulting in a credit for the three months ended September 30, 2019 based on past activity and payments. The DIF reserve ratio is currently below the required ratio. Business Development. Business development costs were $72,000 for the three months ended September 30, 2020, compared to $122,000 for the three months ended September 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. Marketing. Marketing costs were $52,000 for the three months ended September 30, 2020, compared to $98,000 for the three months ended September 30, 2019. Marketing costs decreased year over year due to a conscious effort to reduce general advertising costs 37 during the COVID-19 pandemic. The bank is using more cost-effective advertising options ; however, we expect to see advertising expenses increase as we deploy more branding and targeted advertising. Other. 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 $590,000 for the three months ended September 30, 2020, compared to $392,000 for the three months ended September 30, 2019. The increase was largely due to a $191,000 increase in BaaS expenses and overall growth for the three months ended September 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 September 30, 2020, income tax expense totaled $1.1 million, compared to $919,000 for the three months ended September 30, 2019. Our effective tax rates for the three months ended September 30, 2020 and 2019 were 20.9% and 20.7%, respectively. 38 Comparison of Operating Results for the Nine months ended September 30, 2020 and September 30, 2019 Results of Operations Net Income Net income for the nine months ended September 30, 2020, was $10.5 million, or $0.86 per diluted share, compared to $9.6 million, or $0.79 per diluted share, for the nine months ended September 30, 2019. The increase in net income over the comparable period in the prior year was attributable to a $9.8 million increase in net interest income, largely related to organic loan growth combined with growth from PPP loans, partially offset by a $4.0 million increase in the provision for loan losses, related to an increase in qualitative factors related to the change in the economic outlook caused by the COVID-19 pandemic along with the growth in the loan portfolio, and $4.6 million increase in noninterest expense, which includes $2.8 million more in salaries and employee benefits and $306,000 more in legal and professional fees. Salaries and employee benefits were increased largely as a result of hiring staff for our BaaS CCBX division. Legal and professional fees increased due to BaaS activities through our CCBX division and as a result of higher costs related to legal and accounting work related to reporting. Net Interest Income Net interest income for the nine months ended September 30, 2020, was $40.5 million, compared to $30.7 million for the nine months ended September 30, 2019, an increase of $9.8 million, or 31.9%. The increase in net interest income consisted of $11.0 million, or 33.3%, in increased loan interest income. An increase in loan volume drove income up, despite a decrease in interest rates. Additionally, interest expense on deposits decreased $761,000, or 17.7%, and was partially offset by $375,000, or 64.4%, increase in interest on borrowed funds. The increase in interest income was primarily attributable to a $445.1 million, or 54.2%, increase in average loans outstanding for the nine months ended September 30, 2020, compared to the prior year period, partially offset by a 73 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 nine months ended September 30, 2020 there was an average of $261.9 million in PPP loans, which have a 1.0% interest rate and an approximate yield of 3.23% after including the amortization of deferred fees and costs. Contractual loan yields approximated 4.08% for the nine months ended September 30, 2020 compared to 5.23% for the nine months ended September 30, 2019. Excluding PPP loans, the contractual loan yield approximated 4.86%. A reconciliation of this non-GAAP measure is set forth in the section titled “ GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures. ” Although we have rate floors in place for $361.8 million, or 23.8%, 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 expect that the FOMC will maintain the Fed funds rate low for some time. We have continued to focus on our loan growth initiatives, but most recently much of our focus has been on working with small businesses within our communities, providing assistance as business owners navigate through the uncertainty and change resulting from the COVID-19 pandemic. We experienced a significant increase in commercial and industrial loans during the second and third quarters of 2020, as small business owners applied for financial assistance via the PPP through the SBA as prescribed in the CARES Act. The decrease in interest expense for the nine months ended September 30, 2020 was the result of a $761,000 decrease in interest expense on deposit accounts partially offset by a $375,000 increase in interest on borrowed funds. Cost of funds decreased 29 basis points to 0.45% as of September 30, 2020, compared to 0.74% at September 30, 2019. The increases in noninterest bearing and low rate interest bearing deposits helped contribute to the improved cost of funds for the nine months ended September 30, 2020, as compared to the prior year period. We gained new customer relationships by making PPP loans to noncustomers and they continued to move their banking/deposit relationships to the Bank. The increase in borrowed funds is largely the result of utilizing the PPPLF to help fund PPP loans as disbursements are withdrawn from deposit accounts. The PPPLF extends low cost borrowing lines, 0.35% interest rate, to eligible financial institutions that originate PPP loans, taking the loans as collateral at face value. Borrowings are required to be paid down as the pledged PPP loans are paid down or forgiven. The average balance for the nine months ended September 30, 2020 was $102.5 million, resulting in $269,000 in interest expense. The average balance of interest-bearing deposits increased $136.9 million, or 24.5%, compared to the prior year period, but the average rate paid on interest bearing deposits was 35 basis points less for the nine months ended September 30, 2020, compared to the nine months ended September 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 39 paid on BaaS-brokered deposits decreased 1.72% and NOW and money market accounts decreased 21 basis points for the nine months ended September 30, 2020. The average rate paid on BaaS-brokered deposits was higher in the nine months ended September 30, 2019 as a result of the temporary rate negotiated for 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 1 9 basis points and for time deposits over $100,000 the average rate decreased 36 basis points, as compared to the prior year period . The average rate paid on NOW, money market, and time deposit accounts in the nine months ended September 30, 2020 is the result of the recent decreased Fed funds rate and management lowering rates in response. We continue to evaluate rates and anticipate that additional rates reductions may occur in the fourth quarter. Many deposit rates were either lowered late in the first quarter or at the start of the second quarter of 2020, and some were further decreased at the start of the third quarter, so the impact of these reductions will continue to be seen in future periods. The average balance of NOW and money market accounts grew $ 1 55.5 million, or 41.4 %, in the nine months ended September 30, 2020 , compared to the nine months ended September 30, 2019 . The average balance of BaaS-brokered deposits was $2 1. 8 million for the nine months ended September 30, 2020, which was down $ 13.6 million , or 38.4 %, from the prior year period. The higher balance in the prior year period was the result of a temporary increase in BaaS deposits for that period , and a subsequent planned exit of balances . T he average balance of savings accounts grew $ 12.8 million, or 24.5 %, and the average balance of time deposits declined $ 17.8 million, or 18.5 % , to $ 78.2 million in the nine months ended September 30, 2020, compared to the nine months ended September 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 nine months ended September 30, 2020, net interest margin and net interest spread were 3.81% and 3.51%, respectively, compared to 4.22% and 3.76%, respectively, for the nine months ended September 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 $5.3 million and $920,000 for the nine months ended September 30, 2020 and 2019, respectively. The increase in loan fees for the nine months ended September 30, 2020 is due to the PPP loans. Yield on loans receivable was 4.65% for the nine months ended September 30, 2020, compared to 5.38% for the nine months ended September 30, 2019. Excluding PPP loans, the yield on loans receivable was 4.99% for the nine months ended September 30, 2020. A reconciliation of this non-GAAP measure is set forth in the section titled “ GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures. ” For the nine months ended September 30, 2020 and 2019, the amount of interest income not recognized on nonaccrual loans was not material. 40 Average balance sheets For the Nine Months Ended September 30, 2020 2019 Average Interest & Yield / Average Interest & Yield / (Dollars in thousands) Balance Dividends Cost (4) Balance Dividends Cost (4) Assets Interest earning assets: Interest earning deposits $ 122,941 $ 587 0.64 % $ 108,230 $ 1,946 2.40 % Investment securities, available for sale (1) 20,302 155 1.02 36,367 425 1.56 Investment securities, held to maturity (1) 3,950 44 1.49 2,516 56 2.98 Other Investments 5,435 129 3.17 3,479 99 3.80 Loans receivable (2) 1,265,705 44,025 4.65 820,560 33,027 5.38 Total interest earning assets 1,418,333 44,940 4.23 971,152 35,553 4.89 Noninterest earning assets: Allowance for loan losses (13,651 ) (10,068 ) Other noninterest earning assets 57,830 49,536 Total assets $ 1,462,512 $ 1,010,620 Liabilities and Shareholders’ Equity Interest bearing liabilities: Interest bearing deposits $ 696,051 $ 3,530 0.68 % $ 559,119 $ 4,291 1.03 % PPPLF borrowings 102,527 269 0.35 - - 0.00 FHLB advances and other borrowings 19,304 164 1.13 794 14 2.36 Subordinated debt 9,984 441 5.90 9,970 439 5.89 Junior subordinated debentures 3,583 83 3.09 3,582 129 4.81 Total interest bearing liabilities 831,449 4,487 0.72 573,465 4,873 1.14 Noninterest bearing deposits 488,296 309,270 Other liabilities 12,607 12,971 Total shareholders' equity 130,160 114,914 Total liabilities and shareholders' equity $ 1,462,512 $ 1,010,620 Net interest income $ 40,453 $ 30,680 Interest rate spread 3.51 % 3.76 % Net interest margin (3) 3.81 % 4.22 % (1) 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. (2) Includes nonaccrual loans. (3) Net interest margin represents annualized net interest income divided by average total interest earning assets. (4) Yields and costs are annualized. 41 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 . This table illustrates the $15.5 million increase in loan interest income as a result of increased loan volume was significantly more than the $4.5 million decrease in interest income due to lower interest rates on loans , resulting in an overall increase in loan interest income for the nine months ended September 30, 2020, compared to the n i ne months ended September 30, 2019. Similarly, the volume of interest bearing deposits has increased by $702,000 , but the reduced interest rate paid on interest bearing deposits resulted in an overall decrease in interest expense on interest bearing deposits for the nine months ended September 30, 2020, compared to the nine months ended September 30, 2019. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated to volume. Nine Months Ended September 30, 2020 Compared to Nine Months Ended September 30, 2019 Increase (Decrease) Due to Total Increase (Dollars in thousands) Volume Rate (Decrease) Interest income: Interest earning deposits $ 76 $ (1,435 ) $ (1,359 ) Investment securities, available for sale (122 ) (148 ) (270 ) Investment securities, held to maturity 16 (28 ) (12 ) Other Investments 47 (17 ) 30 Loans receivable 15,526 (4,528 ) 10,998 Total increase in interest income 15,543 (6,156 ) 9,387 Interest expense: Interest bearing deposits 702 (1,463 ) (761 ) PPPLF borrowings 269 - 269 FHLB advances 157 (7 ) 150 Subordinated debt 1 1 2 Junior subordinated debentures - (46 ) (46 ) Total increase in interest expense 1,129 (1,515 ) (386 ) Increase in net interest income $ 14,414 $ (4,641 ) $ 9,773 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 nine months ended September 30, 2020 was $5.7 million, compared to $1.7 million for the nine months ended September 30, 2019. The allowance for loan losses as a percentage of loans was 1.13% at September 30, 2020, compared to 1.25% at September 30, 2019. As of September 30, 2020, there were $452.8 million in PPP loans in our portfolio. These loans are 100% guaranteed by the SBA and we have not allocated any portion of our allowance to these 100% guaranteed loans. The allowance for loan losses to loans receivable, excluding the guaranteed PPP loans, is 1.60%. 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 an increase in qualitative factors related to the change in economic outlook caused by the COVID-19 pandemic along with loan growth. 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 modified payments in accordance with federal guidance on $52.5 million as of September 30, 2020, compared to $207.2 million as of June 30, 2020. Credit quality has remained stable through September 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 September 30, 2020 compared to 0.12% at September 30, 2019. For a description of the Company's nonperforming assets, see "—Financial Condition—Nonperforming Assets." Pursuant to federal guidance, the Company deferred and/or modified payments on loans to assist customers financially during the COVID-19 pandemic and economic shutdown. The majority of those loans have successfully returned to active status. At September 30, 2020, the Company had 44 loans, or $52.5 million, that remained outstanding with deferred or modified payments, compared to $207.2 million, or 215 loans, as of June 30, 2020. All of the loans that have migrated to active status are current, with 42 128 loans or $93.1 million, successfully resuming payments and 65 loans or $76.0 million back on active status with an initial payment due in the fourth quarter of 2020. In addition, $3.0 million of deferred and/or modified loans paid-in-full or closed as of September 30, 2020 . The purpose of this program was to provide cash flow relief for small businesses as they navigated through the uncertainty of the COVID-19 pandemic. We believe that the Company’s deferral program was successful as evidenced by customers ’ ability to migrate from deferral to active status and resume making payments as planned. However, a s 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 , political uncertainty, 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 nine months ended September 30, 2020. Net charge-offs for the nine months ended September 30, 2020 totaled $132,000, or 0.01% (annualized) of total average loans, as compared to $243,000, or 0.04% (annualized) of total average loans, for the nine months ended September 30, 2019. The full extent of 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, including PPP loan fees, which are generally recognized over the life of the related loan as an adjustment to yield using the interest or similar method and recognized in interest and fees on loans as part of interest income. For the nine months ended September 30, 2020, noninterest income totaled $6.1 million, a decrease of $71,000, or 1.1%, compared to $6.2 million for the nine months ended September 30, 2019. The following table presents, for the periods indicated, the major categories of noninterest income: Nine Months Ended September 30, Increase Percent (Dollars in thousands) 2020 2019 (Decrease) Change Deposit service charges and fees $ 2,224 $ 2,302 $ (78 ) (3.5 )% BaaS fees 1,630 1,404 226 16.1 Loan referral fees 1,303 1,106 197 17.8 Mortgage broker fees 439 336 103 30.7 Gain on sales of loans, net 47 490 (443 ) (90.4 ) Gain on sales of securities, net - 171 (171 ) (100.0 ) Other 490 395 95 24.1 Total noninterest income $ 6,133 $ 6,204 $ (71 ) (1.1 )% 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 $2.2 million for the nine months ended September 30, 2020, a decrease of $78,000, or 3.5%, from $2.3 million over the same period in the prior year. The decrease in deposit service charges and fees was primarily the result of $118,000 less overdraft fee income in the nine months ended September 30, 2020 compared to the prior year period 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. An increase in point-of-sale fees of $49,000 partially offset some of these reductions. BaaS Fees. Our CCBX division provides BaaS offerings that enable our broker dealer and digital financial service providers 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 nine months ended September 30, 2020 was $1.6 million compared to $1.4 million for the nine months ended September 30, 2019. The increase is the result of increased relationships with broker dealers and digital financial service providers. At September 30, 2020 there were four active CCBX relationships, one in friends and family trials, four in onboarding/implementation, two signed letters of intent and a solid pipeline of potential new relationships. As more CCBX customers move to active status, we expect that BaaS fees will increase. 43 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. 3 million in income from l oan referral fees for the nine months ended September 30, 2020 compared to $1.1 million for the nine months ended September 30, 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 more or fewer, loan referral fees in some periods. Mortgage Broker Fees . We earn mortgage broker fees for residential real estate loans that we broker through mortgage lenders. Mortgage broker fees increased $103,000 in the nine months ended September 30, 2020 to $439,000, compared to $336,000 in the same period in 2019 as a result of increased demand from lower interest rates on mortgages which continue to make homes more affordable and mortgage refinancing an attractive option. 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. Income from the sale of loans was $47,000 for the nine months ended September 30, 2020, compared to $490,000 for the nine months ended September 30, 2019, a decrease of $443,000 or 90.4%, as a result of fewer SBA and USDA loans being originated and sold to the secondary market. Gain on Sale of Securities, net. In the third quarter of 2019, we restructured our investment portfolio to improve the rate of return, interest rate and pricing risk on the portfolio. As a result of this restructuring we were able to recognize $171,000 in net gains on the securities sold during the nine months ended September 30, 2019 while decreasing the overall weighted average maturity of the investment portfolio. No securities were sold in the nine months ended September 30, 2020 . Other. This category includes a variety of other income-producing activities, annuity broker fees, and SBA and USDA servicing fees. Other noninterest income increased $95,000 in the nine months ended September 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 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 nine months ended September 30, 2020, noninterest expense totaled $27.6 million, an increase of $4.6 million, or 19.9%, compared to $23.1 million for the nine months ended September 30, 2019. The following table presents, for the periods indicated, the major categories of noninterest expense: Nine Months Ended September 30, Increase Percent (Dollars in thousands) 2020 2019 (Decrease) Change Salaries and employee benefits $ 16,869 $ 14,058 $ 2,811 20.0 % Occupancy 2,951 2,808 143 5.1 Data processing 1,749 1,537 212 13.8 Legal and professional fees 1,178 872 306 35.1 Software licenses, maintenance and subscriptions 919 501 418 83.4 Excise taxes 756 529 227 42.9 Director and staff expenses 613 698 (85 ) (12.2 ) FDIC assessments 292 205 87 42.4 Marketing 280 300 (20 ) (6.7 ) Business development 245 320 (75 ) (23.4 ) Other 1,778 1,225 553 45.1 Total noninterest expense $ 27,630 $ 23,053 $ 4,577 19.9 % 44 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 $ 1 6.9 million for the nine months ended September 30, 2020 , an increase of $ 2 .8 million , or 2 0.0 %, compared to $ 14.1 million for the nine months ended September 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 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. 4 million higher and lowered expense by that same amount, for the nine months ended September 30, 2020, compared to the nine months ended September 30, 2019. As our BaaS banking activities grow, we expect to continue to add employees to support this line of business. As of September 30, 2020 , we had 2 34 full-time equivalent employees, compared to 1 92 at September 30, 2019, a 22.0 % increase. Occupancy. Occupancy expenses were $3.0 million for the nine months ended September 30, 2020 compared to $2.8 million for the nine months ended September 30, 2019, an increase of $143,000 or 5.1%. This category includes building, leasehold, furniture, fixtures and equipment depreciation totaling $965,000 and $907,000 for the nine months ended September 30, 2020 and 2019, respectively. Occupancy expenses increased $143,000 year over year largely as the result of the opening of our 15 th branch late in the second quarter of 2020. As we continue to grow, we expect occupancy expenses to increase. Data Processing. Data processing costs were $1.7 million for the nine months ended September 30, 2020, compared to $1.5 million for the nine months ended September 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 $1.2 million for the nine months ended September 30, 2020 compared to $872,000 for the nine months ended September 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. 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 $919,000 for the quarter ended September 30, 2020, compared to $501,000 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 $756,000 for the nine months ended September 30, 2020, compared to $529,000 for the nine months ended September 30, 2019. Excise taxes are based on gross income of $51.1 million and $41.8 million for the nine months ended September 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. In addition, the tax rate that is applied to our industry increased 25 basis points effective April 1, 2020, which contributed to the increase in excise taxes. 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 $613,000 for the nine months ended September 30, 2020 and $698,000 for the nine months ended September 30, 2019, a decrease of $85,000. The decrease is the result of decreased expenses related to employee travel expenses as a result of restrictions related to COVID-19 partially offset by increased training expenses in the nine months ended September 30, 2020, compared to the nine months ended September 30, 2019. FDIC Assessments. FDIC assessments are assessed to fund the DIF to insure and protect the depositors of insured banks and to resolve failed banks. The assessment rate is based on a number of factors and is recalculated each quarter. FDIC assessments were $292,000 for the nine months ended September 30, 2020, compared to $205,000 for the nine months ended September 30, 2019, an increase of $87,000. The DIF’s reserve was in excess of the required ratio in 2019, resulting in a credit for the third quarter of 2019, reducing the amount assessed. Marketing. Marketing costs were $280,000 for the nine months ended September 30, 2020, compared to $300,000 for the nine months ended September 30, 2019. Marketing costs decreased year over year due to a conscious effort to reduce general advertising costs during the COVID-19 pandemic. The bank is using more cost-effective advertising options; however, we expect to see advertising expenses increase as we deploy more branding and targeted advertising. Business Development. Business development costs were $245,000 for the nine months ended September 30, 2020, compared to $320,000 for the nine months ended September 30, 2019. Business development costs include sponsorships and other activities to 45 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 . Other. 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 expenses were $1.8 million for the nine months ended September 30, 2020, compared to $1.2 million for the nine months ended September 30, 2019. The increase was largely due to a $108,000 increase in bank examination fees, $56,000 increase in telephone costs, $47,000 increase in service charges from banks, $42,000 increase in operational losses, $32,000 increase in donations and overall increases resulting from growth for the nine months ended September 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 nine months ended September 30, 2020, income tax expense totaled $2.8 million, compared to $2.5 million for the nine months ended September 30, 2019. Our effective tax rates for the nine months ended September 30, 2020 and 2019, was 20.9% and 20.8%, respectively. 46 Financial Condition The Company’s total assets increased $621.1 million, or 55.0%, to $1.75 billion at September 30, 2020 from $1.13 billion at December 31, 2019. The increase is primarily the result of $570.3 million in gross loan growth during the nine months ended September 30, 2020. Included in the loan growth is $452.8 million in PPP loans. These PPP loans are 100% guaranteed by the SBA and have a rate of 1.0%, an approximate yield of 3.23%. Interest earning deposits with other banks also increased $56.8 million, compared to September 30, 2019. Loan Portfolio The quarter ended September 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 $5.7 million during the nine months ended September 30, 2020, as a result of an increase in qualitative factors related to uncertainties in the economic outlook from the COVID-19 pandemic and loan growth. As a preferred SBA lender, we worked diligently with the SBA in the second quarter and third quarters of 2020 to offer assistance to small businesses as provided in the CARES Act, which significantly increased our loan totals. 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 September 30, 2020, we have $52.5 million in deferred or modified payments, pursuant to federal guidance, representing 44 loans. During the quarter ended September 30, 2020, there were an additional 7 loans, or $10.2 million, that were granted deferred or modified payments and 169 loans, representing $161.9 million, that moved back to active status from deferral status. In total, we have deferred or modified payments on 245 loans, or $224.6 million. As of September 30, 2020, $93.1 million, or 128 loans, have successfully resumed payments as scheduled, $76.0 million, or 65 loans, have moved to active status and have a payment due in the fourth quarter of 2020, $3.0 million, or 8 loans, have closed and paid-in-full, leaving $52.5 million, or 44 loans, on deferral. All of the loans on deferred or modified status as of September 30, 2020 are scheduled to return to active status in the fourth quarter of 2020. The graph below illustrates the status of all the loans that were part of the COVID-19 deferral program: 47 The graph below indicates the percentage of loans that remain on a COVID-19 deferral. This illustration is based on total loans outstanding as of as of September 30, 2020. Remaining deferrals by industry as of September 30, 2020: As a result of proactively reaching out to customers to offer deferment to help reduce cash flow pressure we did not see material downgrades in credit during the nine months ended September 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. A substantial portion of our loan portfolio consists of commercial real estate loans and commercial and industrial loans in the Puget Sound region. Our loan portfolio represents the highest yielding component of our earning assets. As of September 30, 2020, gross loans totaled $1.51 billion, an increase of $570.3 million, or 60.7%, compared to December 31, 2019. The increase was largely due to our efforts to provide community assistance through the PPP loans, which resulted in $452.8 million in PPP loans as of September 30, 2020, coupled with an additional $117.5 million in loan growth. 48 Loans as a percentage of deposits were 1 1 1.0 % as of September 30, 2020 , compared to 9 7.0 % 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 September 30, 2020 As of December 31, 2019 (Dollars in thousands) Amount Percent Amount Percent Commercial and industrial loans: PPP loans $ 452,846 29.8 % $ - 0.0 % All other commercial & industrial loans 136,358 8.9 111,401 11.8 Total commercial and industrial loans: 589,204 38.7 111,401 11.8 Real estate loans: Construction, land and land development 100,955 6.6 97,034 10.3 Residential real estate 121,147 8.0 115,011 12.2 Commercial real estate 705,186 46.4 613,398 65.2 Consumer and other loans 3,927 0.3 4,214 0.5 Gross loans receivable 1,520,419 100.0 % 941,058 100.0 % Net deferred origination fees - PPP loans (8,586 ) - Net deferred origination fees - all other loans (2,444 ) (1,955 ) Loans receivable $ 1,509,389 $ 939,103 Commercial and Industrial Loans. Commercial and industrial loans increased $477.8 million, or 428.9%, to $589.2 million as of September 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. These loans are primarily made based on the borrower’s ability to service the debt from income. 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. Included in this balance is $ 43.8 million in capital call lines resulting from relationships with our BaaS customers as of September 30, 2020. Our work with the SBA to help small businesses as provided in the CARES Act resulted in $452.8 million in PPP loans, with $8.6 million in net unearned deferred fees, which are included in commercial and industrial loans. This includes 2,879 loans, helping over 40,600 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 received approximately $14.5 million in loan fees from the SBA for originating and servicing the PPP loans, net of fees paid to agents. These SBA 7(a) loans allowed small business owners to apply for financial relief under the PPP. This program allowed 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. PPP loans have a maximum maturity of five years; however, the majority of our PPP loans are two 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. We accepted and processed requests through the duration of the program, which ended on August 8, 2020. 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 have 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. In October 2020, we started to receive some forgiveness payments from the SBA. It is still uncertain how quickly the SBA will be processing forgiveness requests, but we anticipate that forgiveness of PPP loans will begin in fourth quarter 2020, and the pace of forgiveness will increase in the first half of 2021. The initial payment deferral period on PPP loans was extended and 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 $91.8 million, or 15.0%, to $705.2 million as of September 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. The real estate securing our existing commercial real estate loans includes a wide variety of property types, such as manufacturing and processing facilities, business parks, warehouses, retail centers, 49 convenience stores, hotels and motels, office buildings, mixed-use residential and commercial, and other properties. We originate both fixed- and adjustable-rate loans with terms up to 20 years. Fixed-rate loans typically amortize over a 10-to-25 year period with balloon payments at the end of five to ten years. 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 September 30, 2020 , approximately 39.3 % of the commercial real estate loan portfolio consisted of fixed rate loans. Commercial real estate loans represented 46. 4 % of our loan portfolio at September 30, 2020 and are historically our largest source of revenue. The addition of the $ 452.8 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. 1 % 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 $3.9 million, or 4.0%, to $101.0 million as of September 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 $76.3 million at September 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 full extent of the short-term and long-term effects of the COVID-19 pandemic remain to be seen. We anticipate that as projects continue we will see drawdowns on the available commitments. Residential Real Estate Loans. Our residential loans increased $6.1 million, or 5.3%, from $115.0 million at December 31, 2019 to $121.1 million at September 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 September 30, 2020, the balance of our ARM portfolio loans was $14.0 million, compared to $11.7 million at December 31, 2019. 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 to earn a higher interest rate. 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 September 30, 2020, we held $17.9 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. We have a defined set of credit guidelines that we use when evaluating these loans. 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 properties and to business owners to secure their business loans. As of September 30, 2020, residential real estate loans made to investors and business owners totaled $75.6 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. Consumer and other loans totaled $3.9 million as of September 30, 2020, decreasing $287,000 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. Industry Exposure and Categories of Loans We have a diversified loan portfolio, representing a wide variety of industries. Three of our largest categories of our loans are commercial real estate, commercial and industrial, and construction, land and land development loans. Together they represent $942.5 million in outstanding loan balances, or 88.3% of total gross loans outstanding, excluding PPP loans of $452.8 million. When combined with $232.4 million in unused commitments the total of these three categories is $1.17 billion, or 89.0% of total outstanding loans and loan commitments. Commercial Real Estate Loans. Commercial real estate represents the largest segment of our loans, comprising 66.1% of our total balance of outstanding loans, excluding PPP loans, as of September 30, 2020. Unused commitments to extend credit represents an 50 additional $15.6 million, the combined total exposure in commercial real estate loans represents $720.8 million, or 54.6 % 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 September 30, 2020: (Dollars in thousands, unaudited) Outstanding Balance Available Loan Commitments Total Exposure % of Total Loans (Outstanding Balance & Available Commitment) Average Loan Balance Number of Loans Hotel/Motel $ 111,316 $ 986 $ 112,302 8.5 % $ 4,281 26 Apartments 92,556 3,159 95,715 7.3 1,402 66 Retail 73,247 55 73,302 5.6 927 79 Office 76,151 3,012 79,163 6.0 810 94 Mixed use 68,011 4,428 72,439 5.5 791 86 Convenience Store 69,725 - 69,725 5.3 1,835 38 Warehouse 62,611 14 62,625 4.7 1,181 53 Manufacturing 35,810 500 36,310 2.8 995 36 Mini Storage 33,169 857 34,026 2.6 3,317 10 Groups < 2.0% of total 82,590 2,593 85,183 6.5 1,073 77 Total $ 705,186 $ 15,604 $ 720,790 54.6 % $ 1,248 565 Commercial and Industrial Loans. Commercial and industrial loans comprise 12.8% of our total balance of outstanding loans, excluding PPP loans, as of September 30, 2020. Unused commitments to extend credit represents an additional $140.5 million, the combined total exposure in commercial and industrial loans represents $276.9 million, or 21.0% 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 September 30, 2020: (Dollars in thousands, unaudited) Outstanding Balance Available Loan Commitments Total Exposure % of Total Loans (Outstanding Balance & Available Commitment) Average Loan Balance Number of Loans Capital Call Lines $ 43,776 $ 79,238 $ 123,014 9.3 % $ 1,122 39 Construction/Contractor Services 14,052 22,916 36,968 2.8 96 146 Financial Institutions 15,400 - 15,400 1.2 3,850 4 Family and Social Services 9,994 5,247 15,241 1.2 769 13 Manufacturing 8,293 6,172 14,465 1.1 151 55 Medical / Dental / Other Care 13,584 483 14,067 1.1 203 67 Groups < 1.0% of total 31,259 26,480 57,739 4.4 101 311 Total $ 136,358 $ 140,536 $ 276,894 21.0 % $ 215 635 51 Construction, Land and Land Development Loans. Construction, land and land development loans comprise 9.5% of our total balance of outstanding loans, excluding PPP loans, as of September 30, 2020. Unused commitments to extend credit represents an additional $76.3 million, the combined total exposure in construction, land and land development loans represents $177.3 million, or 13.4% of our total outstanding loans and loan commitments , excluding PPP loans. The following table details our concentration for our construction, land and land development loan portfolio as of September 30, 2020: (Dollars in thousands, unaudited) Outstanding Balance Available Loan Commitments Total Exposure % of Total Loans (Outstanding Balance & Available Commitment) Average Loan Balance Number of Loans Commercial construction $ 46,674 $ 53,820 $ 100,494 7.6 % $ 2,223 21 Residential construction 24,149 14,493 38,642 2.9 894 27 Developed land loans 13,097 236 13,333 1.0 409 32 Undeveloped land loans 9,726 332 10,058 0.8 486 20 Land development 7,309 7,423 14,732 1.1 731 10 Total $ 100,955 $ 76,304 $ 177,259 13.4 % $ 918 110 Nonperforming Assets Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by applicable regulations. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. In general, we place loans on nonaccrual status when they become 90 days past due. We also place loans on nonaccrual status if they are less than 90 days past due if the collection of principal or interest is in doubt. We are not required to report as nonperforming a loan for which we have allowed the borrower to defer payment on a short term basis because of financial pressure related to COVID-19. When loans are placed on nonaccrual status, all unpaid accrued interest is reversed from income and all interest accruals are stopped. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal balance. Loans are returned to accrual status if we believe that all remaining principal and interest is fully collectible and there has been at least six months of sustained repayment performance since the loan was placed on nonaccrual status. We define nonperforming loans as loans on nonaccrual status and accruing loans 90 days or more past due. Nonperforming assets also include other real estate owned and repossessed assets. We believe our lending practices and active approach to managing nonperforming assets has resulted in sound asset quality and timely resolution of problem assets. We have procedures in place to assist us in maintaining the overall credit quality of our loan portfolio. We have established underwriting guidelines, concentration limits and we also monitor our delinquency levels for any negative or adverse trends. We actively manage problem assets to reduce our risk for loss. We had $4.5 million in nonperforming assets, as of September 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 September 30, 2020 and December 31, 2019. Our nonperforming loans to loans receivable ratio was 0.30% at September 30, 2020, compared to 0.11% at December 31, 2019. Construction, land and land development loans totaled $3.3 million, representing one loan that was added in the second quarter of 2020. Commercial and industrial nonaccrual loans totaled $625,000 at September 30, 2020 and consisted of three lending relationships. Commercial real estate loans totaled $405,000, representing one loan, which was added during the second quarter of 2020. During the third quarter of 2020, one loan for $117,000 in residential real estate moved to nonperforming status. The addition of this loan to nonperforming status in the third quarter was partially offset by 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 full extent of 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. 52 The following table presents information regarding nonperforming assets at the dates indicated: As of As of September 30, December 31, (Dollars in thousands) 2020 2019 Nonaccrual loans: Commercial and industrial loans $ 625 $ 965 Real estate loans: Construction, land and land development 3,269 - Residential real estate 178 65 Commercial real estate 405 - Total nonaccrual loans 4,477 1,030 Accruing loans past due 90 days or more: Total accruing loans past due 90 days or more - - Total nonperforming loans 4,477 1,030 Real estate owned - - Repossessed assets - - Troubled debt restructurings, accruing - - Total nonperforming assets $ 4,477 $ 1,030 Total nonperforming loans to loans receivable 0.30 % 0.11 % Total nonperforming assets to total assets 0.26 % 0.09 % Allowance for Loan Losses We maintain an allowance for loan losses that represents management’s best estimate of the loan losses and risks inherent in our loan portfolio. The amount of the allowance for loan losses should not be interpreted as an indication that charge-offs in future periods will necessarily occur in those amounts. In determining the allowance for loan losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of the allowance for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of our loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, and current economic factors. In connection with our allowance for loan loss review, we consider risk elements applicable to particular loan types or categories in assessing the quality of individual loans. Some of the risk elements we consider include: • for commercial and industrial loans, the debt service coverage ratio (income from the business in excess of operating expenses compared to loan repayment requirements), the operating results of the commercial, professional or agricultural enterprise, the borrower’s business, professional and financial ability and expertise, the specific risks and volatility of income and operating results typical for businesses in that category and the value, nature and marketability of collateral; • for commercial real estate loans, the debt service coverage ratio, operating results of the owner in the case of owner-occupied properties, the loan-to-value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type; • 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; and • 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 ratio. As of September 30, 2020, the allowance for loan losses totaled $17.0 million, or 1.13% of total loans. As of December 31, 2019, the allowance for loan losses totaled $11.5 million, or 1.22% of total loans. Included in total loans is $452.8 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 1.60%. 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 September 30, 2020 increased by $5.6 million, or 48.6%, compared to December 31, 2019, due to an increase in our qualitative factors primarily related to the current economic environment from the COVID-19 pandemic on our loan portfolio and loan growth. 53 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 and for the Three As of and for the Nine Months Ended Months Ended September 30, September 30, (Dollars in thousands) 2020 2019 2020 2019 Allowance at beginning of period $ 14,847 $ 10,443 $ 11,470 $ 9,407 Provision for loan losses 2,200 637 5,708 1,724 Charge-offs: Commercial and industrial loans - 118 130 125 Real estate loans: Residential real estate loans - 75 - 75 Commercial real estate - - - 29 Consumer and other 2 3 9 23 Total charge-offs 2 196 139 252 Recoveries: Commercial and industrial loans - 2 5 4 Consumer and other 1 2 2 5 Total recoveries 1 4 7 9 Net charge-offs 1 192 132 243 Allowance at end of period $ 17,046 $ 10,888 $ 17,046 $ 10,888 Allowance to nonperforming loans 380.75 % 837.54 % 380.75 % 837.54 % Allowance to loans receivable 1.13 % 1.25 % 1.13 % 1.25 % Net charge-offs to average loans (1) 0.00 % 0.09 % 0.01 % 0.04 % (1) Ratios for the three and nine months ended September 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 nine months ended September 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 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 recover from this uncertain and trying time. Securities 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 September 30, 2020, 83.9% of our investment portfolio consisted of U.S. Treasury securities. The remainder of our securities portfolio was invested in U.S. Government agency securities, U.S. A gency collateralized mortgage obligations and U.S. Agency residential mortgage-backed securities, and municipal bonds. 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 September 30, 2020, our loan-to-deposit ratio was 111.0%, 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. 54 As of September 30, 2020 , the carrying amount of our investment securities totaled $ 2 3.8 million, a de crease of $ 8. 9 million , or 2 7 . 3 %, compared to $ 3 2 . 7 million as of December 31, 2019 . The decrease in the securities portfolio was due to maturities and principal paydowns . Our investment portfolio consists of securities classified as available for sale and, to a lesser amount, held to maturity. The carrying values of our investment securities classified as available for sale are adjusted for unrealized gain or loss, and any gain or loss is reported on an after-tax basis as a component of other comprehensive income in shareholders’ equity. The following table summarizes the amortized cost and estimated fair value of our investment securities as of the dates shown: As of As of September 30, 2020 December 31, 2019 Amortized Fair Amortized Fair (Dollars in thousands) Cost Value Cost Value Securities available-for-sale: U.S. Treasury securities $ 19,996 $ 20,041 $ 24,988 $ 24,945 U.S. Government securities - - 3,000 2,999 U.S. Agency collateralized mortgage obligations 108 113 129 129 U.S. Agency residential mortgage-backed securities 11 11 27 27 Municipal bonds 255 263 257 260 Total available-for-sale securities 20,370 20,428 28,401 28,360 Securities held-to-maturity: U.S. Agency residential mortgage-backed securities 3,354 3,470 4,350 4,329 Total held-to-maturity securities 3,354 3,470 4,350 4,329 Total investment securities $ 23,724 $ 23,898 $ 32,751 $ 32,689 Deposits We offer a variety of deposit products that have a wide range of interest rates and terms, including demand, savings, money market and time accounts as well as BaaS-brokered deposits. In addition, we recently added reciprocal deposits to our product offering. This enables us to extend FDIC insurance to customers that have balances in excess of the FDIC insurance limit. This service trades our customers’ 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 September 30, 2020 were $1.36 billion, an increase of $392.1 million, or 40.5%, compared to $968.0 million as of December 31, 2019. The increase was largely in core deposits, which increased $407.7 million to $1.27 billion from $862.5 million at December 31, 2019. The increase in core deposits is primarily the result of expanding and growing banking relationships with new customers, including deposit relationships from PPP loans made to noncustomers moving their banking relationship to the Bank. 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 September 30, 2020 were $570.7 million, an increase of $199.4 million, or 53.7%, compared to $371.2 million as of December 31, 2019. The increase is primarily the result of expanding and growing banking relationships with new customers, including deposit relationships from PPP loans made to noncustomers, who moved their banking relationship to the Bank. Noninterest bearing deposits represent 42.0% and 38.4% of total deposits for September 30, 2020 and December 31, 2019, respectively. Total interest bearing account balances, excluding time deposits, as of September 30, 2020 were $724.5 million, an increase of $209.6 million, or 40.7%, from $514.9 million as of December 31, 2019. Included in interest bearing account balances is $24.9 million in BaaS-brokered deposits, an increase of $1.3 million from December 31, 2019. Also included in interest bearing deposits is $9.7 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. 55 Total time deposit balances as of September 30, 2020 were $ 64.9 million, a de crease of $ 17.0 million, or 20.7 % , from $ 81.9 million as of December 31, 2019 . The de crease 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. As of As of September 30, 2020 December 31, 2019 Percent of Percent of (Dollars in thousands) Amount Total Deposits Amount Total Deposits Demand, noninterest bearing $ 570,664 42.0 % $ 371,243 38.4 % NOW and money market 624,891 45.9 437,908 45.2 Savings 74,694 5.5 53,365 5.5 Total core deposits 1,270,249 93.4 862,516 89.1 BaaS-brokered deposits 24,870 1.8 23,586 2.4 Time deposits less than $100,000 19,341 1.4 21,108 2.3 Time deposits $100,000 and over 45,551 3.3 60,749 6.3 Total $ 1,360,011 100.0 % $ 967,959 100.0 % The following table sets forth the Company’s time deposits of $100,000 or more by time remaining until maturity as of the dates indicated: (Dollars in thousands) As of September 30, 2020 As of December 31, 2019 Maturity Period: Three months or less $ 12,864 $ 12,562 Over three through six months 10,848 20,940 Over six through twelve months 14,487 7,007 Over twelve months 7,352 20,240 Total $ 45,551 $ 60,749 Weighted average maturity (in years) 0.70 0.73 Average deposits for the three and nine months ended September 30, 2020 were $1.32 billion and $1.18 billion, respectively, an increase of 49.0% and 36.4%, respectively , compared to the three and nine months ended September 30, 2019. The increase in average deposits was primarily due to an increase in core deposits, both in noninterest bearing deposits and in low rate interest bearing deposits. Included in this increase is deposit relationships gained from PPP loans made to noncustomers that moved their banking/deposit relationship to the Bank. We expect deposit to grow with continued growth in our primary market areas, 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. The average rate paid on total deposits was 0.27% and 0.40%, respectively, for the three and nine months ended September 30, 2020, compared to 0.64% and 0.66%, for the three and nine months ended September 30, 2019, respectively. The average rate paid on BaaS-brokered deposits decreased 1.64% and 1.72% for the three and nine months ended September 30, 2020, respectively, compared to the prior year periods, and NOW and money market accounts decreased 51 basis points and 21 basis points, for the three and nine months ended September 30, 2020, respectively. The average rate paid on NOW and money market accounts in the three and nine months ended September 30, 2020 is the result of the decreased Fed funds rates since June 2019; 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. 56 The following table presents the average balances and average rates paid on deposits for the periods indicated: For the Three Months Ended September 30, For the Nine Months Ended September 30, 2020 2019 2020 2019 (Dollars in thousands) Average Balance Average Rate Average Balance Average Rate Average Balance Average Rate Average Balance Average Rate Demand, noninterest bearing $ 569,615 0.00 % $ 330,553 0.00 % $ 488,296 0.00 % $ 309,270 0.00 % NOW and money market 589,209 0.45 394,939 0.96 530,761 0.66 375,267 0.87 Savings 73,928 0.05 52,511 0.05 65,247 0.05 52,401 0.06 BaaS-brokered deposits 21,653 0.35 12,787 1.99 21,849 0.59 35,494 2.32 Time deposits less than $100,000 19,274 0.99 24,126 1.30 20,181 1.13 25,221 1.31 Time deposits $100,000 and over 46,726 1.17 71,302 1.84 58,013 1.45 70,736 1.81 Total deposits $ 1,320,405 0.27 % $ 886,218 0.64 % $ 1,184,347 0.40 % $ 868,389 0.66 % The ratio of average noninterest bearing deposits to average total deposits for the three and nine months ended September 30, 2020 was 43.1% and 41.2%, respectively, compared to 37.3% and 35.6% for the three and nine months ended September 30, 2019, respectively. Borrowings 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. Federal Reserve Bank Line of Credit. 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 September 30, 2020, and December 31, 2019, total borrowing capacity of $20.8 and $21.4 million, respectively, was available under this arrangement. As of September 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 provided 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 September 30, 2020, there was $202.6 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 Nine Months Ended Months Ended September 30, September 30, (Dollars in thousands) 2020 2019 2020 2019 Maximum amount outstanding at any month-end during period: PPPLF Advances $ 202,595 $ - $ 202,595 $ - Average outstanding balance during period: PPPLF Advances $ 199,076 $ - $ 102,527 $ - Weighted average interest rate during period: PPPLF Advances 0.35 % 0.00 % 0.35 % 0.00 % Balance outstanding at end of period: PPPLF Advances $ 202,595 $ - $ 202,595 $ - Weighted average interest rate at end of period: PPPLF Advances 0.35 % 0.00 % 0.35 % 0.00 % 57 Federal Home Loan Bank Advances. The FHLB allows us to borrow against our line of credit, which is collateralized by certain loans. As of September 30, 2020, and December 31, 2019, we had borrowing capacity of $92.7 million and $84.9 million, respectively, under this arrangement. As of September 30, 2020, we borrowed a total of $25.0 million in FHLB long term advances. This includes $10.0 million for a 2.50-year remaining term and $15.0 million advance with a 4.50-year remaining term. FHLB advances totaled $25.0 million as of September 30, 2020 and $10.0 million as of December 31, 2019. There was $67.7 million and $74.9 million borrowing capacity remaining as of September 30, 2020, and December 31, 2019, respectively. Although there are no immediate plans to borrow additional funds, additional borrowing capacity of $67.7 million was available under this arrangement as of September 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 Nine Months Ended Months Ended September 30, September 30, (Dollars in thousands) 2020 2019 2020 2019 Maximum amount outstanding at any month-end during period: FHLB Advances $ - $ 20,000 $ - $ 20,000 Average outstanding balance during period: FHLB Advances $ - $ 870 $ 89 $ 740 Weighted average interest rate during period: FHLB Advances 0.00 % 2.35 % 1.84 % 2.46 % Balance outstanding at end of period: FHLB Advances $ - $ 20,000 $ - $ 20,000 Weighted average interest rate at end of period: FHLB Advances 0.00 % 2.39 % 0.00 % 2.09 % The table below provides details on the FHLB long term borrowings for the periods indicated: As of and For the Three As of and For the Nine Months Ended Months Ended September 30, September 30, (Dollars in thousands) 2020 2019 2020 2019 Maximum amount outstanding at any month-end during period: FHLB Advances $ 24,999 $ - $ 24,999 $ - Average outstanding balance during period: FHLB Advances $ 24,999 $ - $ 19,160 $ - Weighted average interest rate during period: FHLB Advances 1.13 % 0.00 % 1.13 % 0.00 % Balance outstanding at end of period: FHLB Advances $ 24,999 $ - $ 24,999 $ - Weighted average interest rate at end of period: FHLB Advances 1.13 % 0.00 % 1.13 % 0.00 % Junior Subordinated Debentures. In 2004, we issued $3.6 million in junior subordinated debentures to Coastal (WA) Statutory Trust I (the “Trust”), of which we own all of the outstanding common securities. The Trust used the proceeds from the issuance of its underlying common securities and preferred securities to purchase the debentures issued by the Company. These debentures are the Trust’s only assets and the interest payments from the debentures finance the distributions paid on the preferred securities. The debentures bear interest at a rate per annum equal to the 3-month LIBOR plus 2.10%. The effective rate as of September 30, 2020, and December 31, 2019, was 2.35 % 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. During any such extension period, distributions on the Trust’s preferred securities will also be deferred, and our ability to pay dividends on our common stock will be restricted. 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 58 ex ceptions, the redemption price with respect to any Trust securities called for redemption and amounts due if the Trust is liquidated or terminated. Subordinated Debt . In 2016, the Company issued a subordinated note to a commercial bank in the amount of $10.0 million. 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. We may redeem the subordinated note, in whole or in part, without premium or penalty after July 29, 2021, subject to any required regulatory approvals. Liquidity and Capital Resources Liquidity Management Liquidity refers to our capacity to meet our cash obligations at a reasonable cost. Our cash obligations require us to have cash flow that is adequate to fund loan growth and maintain on-balance sheet liquidity while meeting present and future obligations of deposit withdrawals, borrowing maturities and other contractual cash obligations. In managing our cash flows, management regularly confronts situations that can give rise to increased liquidity risk. These include funding mismatches, market constraints in accessing sources of funds and the ability to convert assets into cash. Changes in economic conditions or exposure to credit, market, and operational, legal and reputational risks also could affect the Bank’s liquidity risk profile and are considered in the assessment of liquidity management. 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 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. Critical elements of our liquidity risk management include: effective corporate governance consisting of oversight by the board of directors and active involvement by management; appropriate strategies, policies, procedures, and limits used to manage and mitigate liquidity risk; comprehensive liquidity risk measurement and monitoring systems that are commensurate with the complexity of our business activities; active management of intraday liquidity and collateral; an appropriately diverse mix of existing and potential future funding sources; adequate levels of highly liquid marketable securities free of legal, regulatory, or operational impediments, that can be used to meet liquidity needs in stressful situations; contingency funding policies and plans that sufficiently address potential adverse liquidity events and emergency cash flow requirements; and internal controls and internal audit processes sufficient to determine the adequacy of the Bank’s liquidity risk management process. Our liquidity position is supported by management of our liquid assets and liabilities and access to alternative sources of funds. Our liquidity requirements are met primarily through our deposits, FHLB advances and the principal and interest payments we receive on loans and investment securities. Cash on hand, cash at third-party banks, investments available-for-sale and maturing or prepaying balances in our investment and loan portfolios are our most liquid assets. Other sources of liquidity that are routinely available to us include funds from retail, commercial, and BaaS deposits, advances from the FHLB and proceeds from the sale of loans. 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 low cost funding, at a 0.35% interest rate, and favorable capital treatment for the PPP loans. We have pledged 820 of these loans, or $202.6 million, as of September 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. The Company is a corporation separate and apart from our Bank and, therefore, must provide for its own liquidity, including liquidity required to meet its debt service requirements on its subordinated note and junior subordinated debentures. The Company’s main source of cash flow has been through equity and debt offerings. 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 $5.6 million at September 30, 2020. The Company uses approximately $1.3 million for debt servicing and operating purposes each year, leaving about $3.0 million for other purposes after deducting $2.6 million to cover operating purposes for the next two years. In addition, the Bank can declare and pay dividends to the Company to meet the Company’s debt and operating expenses. There are statutory and regulatory limitations that affect the ability of the Bank to pay dividends to the Company. 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. Both of these minimum liquidity levels are on-balance sheet sources. Per policy and the Bank’s liquidity contingency plan, in event of a liquidity emergency the Bank can utilize wholesale funds in an amount up to 30% of 59 ass ets. 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 Capital management consists of providing equity and other instruments that qualify as regulatory capital to support current and future operations. Banking regulators view capital levels as important indicators of an institution’s financial soundness. As a general matter, FDIC-insured depository institutions and their holding companies are required to maintain minimum capital levels relative to the amount and types of assets they hold. We are subject to regulatory capital requirements at the bank level. The Company will become subject to regulatory capital requirements once its consolidated assets exceed $3.0 billion. 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. 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 September 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. 60 The following table presents the Company’s and the Bank’s regulatory capital ratios as of the dates presented, as well as the regulatory capital ratios that are required by Federal Reserve regulations to maintain “well-capitalized” status: Actual Minimum Required for Capital Adequacy Purposes Required to be Well Capitalized Under the Prompt Corrective Action Provisions Amount Ratio Amount Ratio Amount Ratio (dollars in thousands) September 30, 2020 Leverage Capital (to average assets) Company $ 138,531 9.20 % $ 60,226 4.00 % $ 75,282 5.00 % Bank Only 141,866 9.43 % 60,199 4.00 % 75,249 5.00 % Common Equity Tier I risk-based capital ratio (to risk-weighted assets) Company 135,031 12.14 % 50,066 4.50 % 72,317 6.50 % Bank Only 141,866 12.66 % 50,418 4.50 % 72,826 6.50 % Tier I Capital (to risk-weighted assets) Company 138,531 12.45 % 66,754 6.00 % 89,006 8.00 % Bank Only 141,866 12.66 % 67,224 6.00 % 89,632 8.00 % Total Capital (to risk-weighted assets) Company 162,581 14.61 % 89,006 8.00 % 111,257 10.00 % Bank Only 155,916 13.92 % 89,632 8.00 % 112,040 10.00 % December 31, 2019 Leverage Capital (to average assets) Company $ 127,524 11.64 % $ 43,806 4.00 % $ 54,758 5.00 % Bank Only 122,904 11.22 % 43,801 4.00 % 54,751 5.00 % Common Equity Tier I risk-based capital ratio (to risk-weighted assets) Company 124,024 12.78 % 43,659 4.50 % 63,064 6.50 % Bank Only 122,904 12.43 % 44,504 4.50 % 64,283 6.50 % Tier I Capital (to risk-weighted assets) Company 127,524 13.14 % 58,213 6.00 % 77,617 8.00 % Bank Only 122,904 12.43 % 58,338 6.00 % 79,118 8.00 % Total Capital (to risk-weighted assets) Company 149,416 15.40 % 77,617 8.00 % 97,021 10.00 % Bank Only 134,796 13.63 % 79,118 8.00 % 98,897 10.00 % 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 September 30, 2020. Payments Due by Period Less than 1 to 3 4 to 5 More than (Dollars in thousands) Total 1 Year Years Years 5 Years Time Deposits $ 64,892 $ 52,266 $ 10,544 $ 2,082 $ - Paycheck Protection Program Liquidity Facility 202,595 - 202,595 - - FHLB advances 24,999 - 10,000 14,999 - Subordinated note 10,000 - 3,500 4,000 2,500 Junior subordinated debentures 3,609 - - - 3,609 Deferred compensation plans 1,329 175 350 350 454 Operating leases 8,885 1,259 2,521 1,716 3,389 For a discussion of our borrowings, see “—Financial Condition—Borrowings” in this section. 61 We believe that we will be able to meet our contractual obligations as they come due. Adequate cash levels are expected through profitability, repayments from loans and securities, deposit gathering activity, access to borrowing sources and periodic loan sales. Off-Balance Sheet Items In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and standby and commercial letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in our consolidated balance sheets. Our commitments associated with outstanding commitments to extend credit and standby and commercial letters of credit are summarized below. Since commitments associated with commitments to extend credit and letters of credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements. As of As of September 30, December 31, (Dollars in thousands) 2020 2019 Commitments to extend credit: Commercial and industrial loans $ 140,536 $ 66,563 Construction – commercial real estate loans 58,170 42,371 Construction – residential real estate loans 18,134 21,361 Residential real estate loans 19,096 9,888 Commercial real estate loans 15,604 19,082 Other 1,064 1,181 Total commitments to extend credit $ 252,604 $ 160,446 Standby letters of credit $ 1,540 $ 2,250 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn upon, the total commitment amounts disclosed above do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by us, upon extension of credit, is based on management’s credit evaluation of the customer. Standby and commercial letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. In the event of nonperformance by the customer, we have rights to the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and/or marketable securities. Our credit risk associated with issuing letters of credit is essentially the same as the risk involved in extending loan facilities to our customers. 62 Critical Accounting Policies Our accounting policies are integral to understanding our results of operations. Our accounting policies are described in greater detail in “Note 1 - Description of Business and Summary of Significant Accounting Policies” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies” of our Form 10-K. We have procedures and processes in place to facilitate making these judgments. Actual results in these areas could differ from management’s estimates. There have been no significant changes concerning our critical accounting policies as described in our Form 10-K. Selected Financial Data 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 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 Nine Months Ended (unaudited) September 30, 2020 June 30, 2020 March 31, 2020 December 31, 2019 September 30, 2019 September 30, 2020 September 30, 2019 Return on average assets (1) 0.95 % 0.96 % 0.96 % 1.31 % 1.35 % 0.96 % 1.27 % Return on average equity (1) 12.14 % 11.37 % 8.66 % 11.66 % 11.72 % 10.73 % 11.16 % Pre-tax, pre-provision return on average assets (1)(2) 1.72 % 1.72 % 1.77 % 1.95 % 1.95 % 1.73 % 1.83 % Yield on earnings assets (1) 3.93 % 4.16 % 4.79 % 4.90 % 4.94 % 4.23 % 4.89 % Yield on loans receivable (1) 4.33 % 4.57 % 5.25 % 5.36 % 5.36 % 4.65 % 5.38 % Yield on loans receivable, as adjusted (1)(2) 4.78 % 4.94 % n/a n/a n/a 4.99 % n/a Contractual yield on loans receivable, excluding earned fees (1) 3.61 % 3.91 % 5.08 % 5.15 % 5.24 % 4.08 % 5.23 % Contractual yield on loans receivable, excluding earned fees, as adjusted (1)(2) 4.69 % 4.84 % n/a n/a n/a 4.86 % n/a Cost of funds (1) 0.33 % 0.41 % 0.70 % 0.70 % 0.72 % 0.45 % 0.74 % Cost of deposits (1) 0.27 % 0.35 % 0.64 % 0.63 % 0.64 % 0.40 % 0.66 % Net interest margin (1) 3.62 % 3.78 % 4.15 % 4.26 % 4.29 % 3.81 % 4.22 % Noninterest expense to average assets (1) 2.26 % 2.34 % 3.18 % 2.90 % 2.98 % 2.52 % 3.05 % Efficiency ratio 56.73 % 57.66 % 64.26 % 59.86 % 60.46 % 59.31 % 62.50 % Loans receivable to deposits 110.98 % 110.77 % 100.01 % 97.02 % 94.78 % 110.98 % 94.78 % (1) Annualized calculations shown for quarterly and nine month periods presented. (2) A reconciliation of the non-GAAP measures are set forth in “GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures”. GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures 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 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. 63 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. The most directly comparable GAAP measure is net income. Pre-tax, pre-provision return on average assets is a non-GAAP measure that excludes the impact of provision for loan losses and provision for income taxes from return on average assets. The most directly comparable GAAP measure is return on average assets. Reconciliations of the GAAP and non-GAAP measures are presented below. As of and for the Three Months Ended As of and for the Nine Months Ended (Dollars in thousands, unaudited) September 30, 2020 June 30, 2020 March 31, 2020 December 31, 2019 September 30, 2019 September 30, 2020 September 30, 2019 Pre-tax, pre-provision net income and pre-tax, pre-provision return on average assets: Total average assets $ 1,704,874 $ 1,538,546 $ 1,141,453 $ 1,095,343 $ 1,031,969 $ 1,462,512 $ 1,010,620 Total net income 4,090 3,671 2,724 3,608 3,511 10,485 9,593 Plus: provision for loan losses 2,200 1,930 1,578 820 637 5,708 1,724 Plus: provision for income taxes 1,082 967 714 947 919 2,763 2,514 Pre-tax, pre-provision net income $ 7,372 $ 6,568 $ 5,016 $ 5,375 $ 5,067 $ 18,956 $ 13,831 Return on average assets 0.95 % 0.96 % 0.96 % 1.31 % 1.35 % 0.96 % 1.27 % Pre-tax, pre-provision return on average assets: 1.72 % 1.72 % 1.77 % 1.95 % 1.95 % 1.73 % 1.83 % 64 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. These measures include the following: 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 As of and for the Three Months Ended Nine Months Ended (Dollars in thousands, unaudited) September 30, 2020 September 30, 2020 Adjusted allowance for loan losses to loans receivable: Total loans, net of deferred fees $ 1,509,389 $ 1,509,389 Less: PPP loans (452,846 ) (452,846 ) Less: net deferred fees on PPP loans 8,586 8,586 Adjusted loans, net of deferred fees $ 1,065,129 $ 1,065,129 Allowance for loan losses $ (17,046 ) $ (17,046 ) Allowance for loan losses to loans receivable 1.13 % 1.13 % Adjusted allowance for loan losses to loans receivable 1.60 % 1.60 % Adjusted yield on loans receivable: Total average loans receivable $ 1,493,024 $ 1,265,705 Less: average PPP loans (448,313 ) (261,854 ) Plus: average deferred fees on PPP loans 9,599 6,112 Adjusted total average loans receivable $ 1,054,310 $ 1,009,964 Interest income on loans $ 16,244 $ 44,025 Less: interest and fee income on PPP loans (3,566 ) (6,325 ) Adjusted interest income on loans $ 12,678 $ 37,700 Yield on loans receivable 4.33 % 4.65 % Adjusted yield on loans receivable: 4.78 % 4.99 % Adjusted contractual yield on loans receivable, excluding earned fees and interest on PPP loans: Total average loans receivable $ 1,493,024 $ 1,265,705 Less: average PPP loans (448,313 ) (261,854 ) Plus: average deferred fees on PPP loans $ 9,599 $ 6,112 Adjusted total average loans receivable, excluding earned fees $ 1,054,310 $ 1,009,964 Interest and earned fee income on loans $ 16,244 $ 44,025 Less: earned fee income on loans $ (2,693 ) $ (5,303 ) Less: interest income on PPP loans (1,129 ) (1,966 ) Adjusted interest income on loans $ 12,422 $ 36,756 Contractual yield on loans receivable, excluding earned fees 3.61 % 4.08 % Adjusted contractual yield on loans receivable, excluding earned fees and interest on PPP loans: 4.69 % 4.86 % 65