ConnectOne Bancorp, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations The purpose of this analysis is to provide the reader with information relevant to understanding and assessing the Company’s results of operations for the periods presented herein and financial condition as of September 30, 2021 and December 31, 2020. In order to fully understand this analysis, the reader is encouraged to review the consolidated financial statements and accompanying notes thereto appearing elsewhere in this report. Cautionary Statement Concerning Forward-Looking Statements This report includes forward-looking statements within the meaning of Sections 27A of the Securities Act of 1933, as amended, and 21E of the Securities Exchange Act of 1934, as amended, that involve inherent risks and uncertainties. This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of ConnectOne Bancorp Inc. and its subsidiaries, including statements preceded by, followed by or that include words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trend,” “objective,” “continue,” “remain,” “pattern” or similar expressions or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may” or similar expressions. There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements. Factors that might cause such a difference include, but are not limited to: (1) competitive pressures among depository institutions may increase significantly; (2) changes in the interest rate environment may reduce interest margins; (3) prepayment speeds, loan origination and sale volumes, charge-offs and loan loss provisions may vary substantially from period to period; (4) general economic conditions may be less favorable than expected; (5) political developments, sovereign debt problems, wars or other hostilities may disrupt or increase volatility in securities markets or other economic conditions; (6) legislative or regulatory changes or actions may adversely affect the businesses in which ConnectOne Bancorp is engaged; (7) changes and trends in the securities markets may adversely impact ConnectOne Bancorp; (8) a delayed or incomplete resolution of regulatory issues could adversely impact planning by ConnectOne Bancorp; (9) the impact on reputation risk created by the developments discussed above on such matters as business generation and retention, funding and liquidity could be significant; (10) the outcome of regulatory and legal investigations and proceedings may not be anticipated, and (11) the impact of the COVID-19 pandemic on our employees and operations, and those of our customers. Further information on other factors that could affect the financial results of ConnectOne Bancorp is included in Item 1a. of ConnectOne Bancorp’s Annual Report on Form 10-K as amended and updated in ConnectOne Bancorp’s other filings with the Securities and Exchange Commission. These documents are available free of charge at the Commission’s website at http://www.sec.gov and/or from ConnectOne Bancorp, Inc. Critical Accounting Policies and Estimates The accounting and reporting policies followed by ConnectOne Bancorp, Inc. and its subsidiaries (collectively, the “Company”) conform, in all material respects, to GAAP. In preparing the consolidated financial statements, management has made estimates, judgments and assumptions that affect the reported amounts of assets and liabilities as of the dates of the consolidated statements of condition and for the periods indicated in the consolidated statements of income. Actual results could differ significantly from those estimates. The Company’s accounting policies are fundamental to understanding Management’s Discussion and Analysis (“MD&A”) of financial condition and results of operations. The Company has identified the determination of the ACL, the other-than-temporary impairment evaluation of securities, the evaluation of the impairment of goodwill and the evaluation of deferred tax assets to be critical because management must make subjective and/or complex judgments about matters that are inherently uncertain and could be most subject to revision as new information becomes available. Additional information on these policies is provided below. Allowance for Credit Losses and Related Provision : The ACL represents management’s estimate of current expected credit losses considering available information relevant to assessing collectability of cash flows over the contractual term of the financial asset(s). Determining the amount of the ACL is considered a critical accounting estimate because it requires significant judgment and the use of estimates including reasonable and supportable forecasts that affect the collectability of the remaining cash flows over the contractual term of the financial assets. The evaluation of the adequacy of the ACL includes, among other factors, an analysis of historical loss rates by loan segment applied to current loan totals. However, actual credit losses may be higher or lower than historical trends, which vary. Actual losses on specified problem loans, which also are provided for in the evaluation, may vary from estimated loss percentages, which are established based upon a limited number of potential loss classifications. The ACL is established through a provision for credit losses charged to expense. Management believes that the current ACL will be adequate to absorb current expected credit losses on existing loans that may become uncollectible based on the evaluation of known and inherent risks in the loan portfolio. The evaluation takes into consideration such factors as changes in the nature and size of the portfolio, overall portfolio quality, and specific problem loans and current economic conditions which may affect the borrowers’ ability to pay. The evaluation also details historical losses by loan segment and the resulting credit loss rates which are projected for current loan total amounts. Loss estimates for specified problem loans are also detailed. All of the factors considered in the analysis of the adequacy of the ACL may be subject to change. To the extent actual outcomes differ from management estimates, additional provisions for credit losses may be required that could materially adversely impact earnings in future periods. Additional information can be found in Note 5 of the Notes to Consolidated Financial Statements. 46 Table of Contents Business Combinations : We account for business combinations under the acquisition method of accounting. Using this method, assets acquired, liabilities assumed and consideration paid are recorded at their estimated fair values as of the acquisition date. The application of this method of accounting requires the use of significant estimates and assumptions. The application of the acquisition method of accounting usually results in the recognition of goodwill and a core deposit intangible (if the acquiree has deposits). The amount of goodwill recorded represents the excess purchase price over the estimated fair value of the net assets acquired, including any identifiable intangibles, if applicable. Goodwill is not amortized for book purposes; however, it is reviewed at least annually for impairment and is usually not deductible for tax purposes. The assets acquired and liabilities assumed and consideration paid in the acquisition are recorded at their estimated fair values based on management’s best estimates using information available at the date of the acquisition and are subject to adjustment for up to one year after the closing date of the acquisition. Our estimates are based upon assumptions that we believe to be reasonable and the Company may use an outside service provider to assist with the valuations. Goodwill : The Company adopted the provisions of FASB ASC 350-10, which requires that goodwill be reported separate from other intangible assets in the Consolidated Statements of Condition and not be amortized but rather tested for impairment annually or more frequently if impairment indicators arise. The Company performs an annual goodwill impairment test in the fourth quarter of each year, or more often if events or circumstances warrant. We will continue to monitor and evaluate the impact of COVID-19 and its impact on our market capitalization, overall economic conditions and any other potential triggering events that may indicate an impairment of goodwill in the future. In the event we conclude that all or a portion of our goodwill is impaired, a non-cash charge for the amount of such impairment would be recorded to earnings. Such a charge would have no impact on tangible capital or our regulatory capital ratios. Income Taxes : The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could impact the Company’s consolidated financial condition or results of operations. Note 11 of the Notes to Consolidated Financial Statements included in the Company’s Form 10-K for the year ended December 31, 2020 includes additional discussion on the accounting for income taxes. Impact of COVID-19 COVID-19 continues to impact the Company’s operations and financial results, as well as those of our customers. In response to the COVID-19 pandemic, the Company continued to offer temporary relief to effected customers, deferring either their full loan payment, the principal component or the interest component of their loan payment for an initial period of time ranging from 30 to 120 days. As of September 30, 2021, the Company has 10 deferred loans with a total outstanding loan balance of $10.2 million. As provided for under the CARES Act, these short-term deferrals are not considered troubled debt restructurings, provided that the modification is related to COVID-19, executed on a loan that was not more than 30 days past due as of December 31, 2019 or the date of the deferral, and executed between March 1, 2020 and January 1, 2022, or the date that is 60 days after the termination date of the national emergency declared by the President on March 13, 2020, under the National Emergencies Act related to the outbreak of COVID-19. With the passage of the Paycheck Protection Program (“PPP”), administered by the Small Business Administration (“SBA”), the Company was an active participant in assisting its customers with applications for resources through the program. PPP loans originated prior to September 5, 2020 have a two-year term, which may be extended to five years with the consent of the Company, and those originated on or after September 5, 2020 have a five-year term, and the loans bear interest at 1%, along with an origination fee payable from the SBA to the Company. The Company believes that the majority of these loans will ultimately be forgiven by the SBA in accordance with the terms of the program. As of September 30, 2021, PPP loans were $177.8 million. It is the Company’s understanding that loans funded through the PPP program are fully guaranteed by the U.S. government and, as such, the Company has not included the PPP loans in calculation of the ACL as of September 30, 2021. Should those circumstances change, the Company could be required to establish additional provisions for credit loss expense charged to earnings. As of September 30, 2021, remaining deferred and unrecognized PPP fees were $6.0 million. We currently anticipate recognizing a majority of this balance by December 31, 2022, reflecting the expected timing of PPP loan forgiveness granted by the Small Business Administration. 47 Table of Contents Operating Results Overview Net income for the three months ended September 30, 2021 was $32.1 million, compared to $24.8 million for the three-month period ended September 30, 2020. The Company’s diluted earnings per share were $0.80 for the three months ended September 30, 2021, compared with diluted earnings per share of $0.62 for the three-month period ended September 30, 2020. The increase in net income and diluted earnings per share was attributable to an increase in net interest income of $7.7 million, a decrease in provision for credit losses of $3.9 million, and an increase in noninterest income of $0.5 million, partially offset by an increase in noninterest expenses of $1.7 million and an increase in income tax expense of $3.1 million. The decrease in provision for credit losses, to $1.1 million, was due to the impact of an improved economic outlook on the current expected credit losses (“CECL”) accounting standard, compared with a $5.0 million provision in the third quarter of 2020. Net income for the nine months ended September 30, 2021 was $97.3 million compared to $45.6 million for the comparable nine-month period ended September 30, 2020. The Company’s diluted earnings per share were $2.43 for the nine months ended September 30, 2021, compared with diluted earnings per share of $1.15 for the comparable nine-month period ended September 30, 2020. The increase in net income and diluted earnings per share were primarily attributable to an increase in net interest income of $15.8 million, a decrease in provision for credit losses of $42.3 million, a decrease in noninterest expenses of $13.7 million and an increase in noninterest income of $1.0 million, partially offset by an increase in income tax expense of $21.1 million. The $6.3 million reversal of provision for loan losses was due to the impact of an improved economic outlook on the CECL accounting standard, compared with a $36.0 million provision in the nine months ended September 30, 2020, which reflected the impact of the pandemic estimated under the incurred loss method. Net Interest Income and Margin Net interest income is the difference between the interest earned on the portfolio of earning assets (principally loans and investments) and the interest paid for deposits and borrowings, which support these assets. Net interest income is presented on a tax-equivalent basis by adjusting tax-exempt income (primarily interest earned on obligations of state and political subdivisions) by the amount of income tax which would have been paid had the assets been invested in taxable issues. Net interest margin is defined as net interest income on a tax-equivalent basis as a percentage of total average interest-earning assets. Fully taxable equivalent net interest income for the three months ended September 30, 2021 increased by $7.8 million, or 12.7%, from the comparable three-month period ended September 30, 2020. The increase from the third quarter of 2020 resulted primarily from a 24 basis-point widening of the net interest margin to 3.73% from 3.49%, and an increase of 5.2% in average interest-earning assets. The widening of the net interest margin resulted from a 60 basis-point reduction in the cost of interest-bearing liabilities, partially offset by 24 basis-points reduction in the yield on average interest-earning assets. Fully taxable equivalent net interest income for the nine months ended September 30, 2021 increased by $15.8 million, or 8.8%, from the comparable nine-month period ended September 30, 2020, resulting from an increase in average interest-earning assets of 3.3%, largely due to PPP originations, and a 19 basis-point widening of the net interest margin to 3.63% from 3.44%. The widening of the net interest margin resulted from a 62 basis-point reduction in the cost of interest-bearing liabilities, partially offset by a 33 basis-point reduction in the yield on average interest-earning assets. 48 Table of Contents The following tables, “Average Statements of Condition with Interest and Average Rates”, present for the three and nine months ended September 30, 2021 and 2020, the Company’s average assets, liabilities and stockholders’ equity. The Company’s net interest income, net interest spread and net interest margin are also reflected. Average Statements of Condition with Interest and Average Rates Three Months Ended September 30, 2021 2020 Average Balance Interest Income/ Expense Average Rate (7) Average Balance Interest Income/ Expense Average Rate (7) (dollars in thousands) Interest-earning assets: Investment securities (1) (2) $ 459,559 $ 1,712 1.48 % $ 420,362 $ 2,176 2.06 % Total loans (2) (3) (4) 6,455,952 75,434 4.64 6,288,443 75,028 4.75 Federal funds sold and interest-bearing deposits with banks 387,155 151 0.15 227,617 47 0.08 Restricted investment in bank stocks 19,105 245 5.09 26,077 426 6.50 Total interest-earning assets 7,321,771 77,542 4.20 6,962,499 77,667 4.44 Allowance for credit losses (78,327) (69,381) Other noninterest-earning assets 594,553 580,884 Total assets $ 7,837,997 $ 7,474,002 Interest-bearing liabilities: Time deposits $ 1,252,818 $ 2,983 0.94 $ 1,728,129 $ 8,174 1.88 Other interest-bearing deposits 3,582,261 2,495 0.28 2,881,592 3,773 0.52 Total interest-bearing deposits 4,835,079 5,478 0.45 4,609,721 11,947 1.03 Borrowings 276,183 1,105 1.59 467,399 1,992 1.70 Subordinated debentures, net of capitalized costs 152,825 2,168 5.63 202,502 2,700 5.30 Capital lease obligation 2,018 30 5.90 2,211 33 5.94 Total interest-bearing liabilities 5,266,105 8,781 0.66 5,281,833 16,672 1.26 Noninterest-bearing demand deposits 1,495,456 1,253,235 Other liabilities 44,245 55,570 Total noninterest-bearing liabilities 1,539,701 1,308,805 Stockholders’ equity 1,032,191 883,364 Total liabilities and stockholders’ equity $ 7,837,997 $ 7,474,002 Net interest income (tax-equivalent basis) 68,761 61,005 Net interest spread (5) 3.54 % 3.18 % Net interest margin (6) 3.73 % 3.49 % Tax-equivalent adjustment (516) (456) Net interest income $ 68,245 $ 60,549 (1) Average balances are based on amortized cost and include equity securities. (2) Interest income is presented on a tax-equivalent basis using an assumed tax rate of 21%. (3) Includes loan fee income and accretion of purchase accounting adjustments. (4) Total loans include loans held-for-sale and nonaccrual loans. (5) Represents difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities and is presented on a tax- equivalent basis. (6) Represents net interest income on a tax-equivalent basis divided by average total interest-earning assets. (7) Rates are annualized. 49 Table of Contents Average Statements of Condition with Interest and Average Rates Nine Months Ended September 30, 2021 2020 Average Balance Interest Income/ Expense Average Rate (7) Average Balance Interest Income/ Expense Average Rate (7) (dollars in thousands) Interest-earning assets: Investment securities (1) (2) $ 459,017 $ 5,534 1.61 % $ 438,563 $ 7,802 2.38 % Total loans (2) (3) (4) 6,319,160 217,465 4.60 6,192,822 224,336 4.84 Federal funds sold and interest-bearing deposits with banks 332,290 285 0.11 244,539 625 0.34 Restricted investment in bank stocks 21,098 764 4.84 28,124 1,268 6.02 Total interest-earning assets 7,132,565 224,048 4.20 6,904,048 234,031 4.53 Allowance for credit losses (80,129) (54,009) Other noninterest-earning assets 585,043 571,628 Total assets $ 7,637,479 $ 7,421,667 Interest-bearing liabilities: Time deposits $ 1,332,587 $ 12,096 1.21 $ 1,864,835 $ 28,130 2.01 Other interest-bearing deposits 3,377,443 7,391 0.29 2,727,696 14,625 0.72 Total interest-bearing deposits 4,710,030 19,487 0.55 4,592,531 42,755 1.24 Borrowings 327,412 4,199 1.71 580,641 6,580 1.51 Subordinated debentures, net of capitalized costs 153,300 6,502 5.67 157,936 6,555 5.54 Capital lease obligation 2,066 93 6.02 2,257 101 5.98 Total interest-bearing liabilities 5,192,808 30,281 0.78 5,333,365 55,991 1.40 Noninterest-bearing demand deposits 1,426,121 1,162,340 Other liabilities 47,417 53,788 Total noninterest-bearing liabilities 1,473,538 1,216,129 Stockholders’ equity 971,133 872,173 Total liabilities and stockholders’ equity $ 7,637,479 $ 7,421,667 Net interest income (tax-equivalent basis) 193,767 178,040 Net interest spread (5) 3.42 % 3.13 % Net interest margin (6) 3.63 % 3.44 % Tax-equivalent adjustment (1,350) (1,419) Net interest income $ 192,417 $ 176,621 (1) Average balances are based on amortized cost and include equity securities. (2) Interest income is presented on a tax-equivalent basis using an assumed tax rate of 21%. (3) Includes loan fee income and accretion of purchase accounting adjustments. (4) Total loans include loans held-for-sale and nonaccrual loans. (5) Represents difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities and is presented on a tax- equivalent basis. (6) Represents net interest income on a tax-equivalent basis divided by average total interest-earning assets. (7) Rates are annualized. 50 Table of Contents Noninterest Income Noninterest income totaled $4.0 million for the three months ended September 30, 2021, compared with $3.5 million for the comparable three-month period ended September 30, 2020. The increase of $0.5 million in noninterest income when compared to the third quarter of 2020 was attributable to increases in sale of loans held-for-sale of $0.5 million and deposit, loan and other income of $0.4 million, partially offset by a decrease in BOLI of $0.3 million and a net loss on equity securities of $0.1 million. Noninterest income totaled $11.9 million for the nine months ended September 30, 2021, compared with $11.0 million for the comparable nine-month period ended September 30, 2020. Included in noninterest income for the nine months ended September 30, 2021 and September 30, 2020 were $0.9 million and $2.3 million, respectively, of PPP loan referral fee income generated by BoeFly. Also included in noninterest income for the nine months ended September 30, 2021 was $0.7 million on a gain on sale of branches and a $0.2 million gain on sale/redemption of investment securities. Excluding these items, noninterest income increased by $1.8 million when compared to the comparable nine-month period ended September 30, 2020. The increase was primarily attributable to an increase in net gains on sale of loans held-for-sale of $1.4 million and an increase in deposit, loan and other income of $1.0 million, partially offset by decreases in BOLI income of $0.2 million and an increase in net losses on equity securities of $0.5 million. Noninterest Expenses Noninterest expenses totaled $28.2 million for the three months ended September 30, 2021, compared with $26.5 million for the comparable three-month period ended September 30, 2020. Noninterest expenses increased $1.7 million when compared to the comparable three-month period ended September 30, 2020. The increase was primarily attributable to increases in salaries and employee benefits of $1.6 million, other expenses of $1.2 million, professional and consulting expenses of $0.3 million, marketing and advertising $0.1 million and data processing expenses of $0.1 million, partially offset by decreases in occupancy and equipment expenses of $0.9 million, FDIC insurance expense of $0.6 million and amortization of core deposit intangibles of $0.1 million. Noninterest expenses totaled $80.9 million for the nine months ended September 30, 2021, compared with $94.6 million for the comparable nine-month period ended September 30, 2020. Included in noninterest expenses for the nine months ended September 30, 2020 were $14.6 million in merger and restructuring expenses and $2.3 million in expenses related to the BoeFly acquisition. Excluding these items, noninterest expenses increased $3.3 million when compared to the comparable nine-month period ended September 30, 2020. The increase was primarily attributable to increases in salaries and employee benefits of $3.5 million, other expenses of $1.5 million, professional and consulting expenses of $1.1 million and data processing expenses of $0.2 million, partially offset by decreases in occupancy and equipment expense of $1.3 million, FDIC insurance expense of $1.0 million, amortization of core deposit intangibles of $0.4 million and marketing and advertising expense of $0.1 million. Income Taxes Income tax expense was $10.9 million for the three months ended September 30, 2021, compared to $7.8 million for the comparable three-month period ended September 30, 2020. The increase in income tax expense was the result of higher income before taxes. The effective tax rate for the three months ended September 30, 2021 and September 30, 2020 was 25.3% and 23.9%, respectively. The higher effective tax rate during the third quarter 2021 when compared to the third quarter of 2020 resulted from a lower proportion of income from non-taxable sources. Income tax expense was $32.4 million for the nine months ended September 30, 2021, compared to $11.3 million for comparable nine-month period ended September 30, 2020. The increase in income tax expense was the result of higher income before taxes. The effective tax rate for the nine months ended September 30, 2021 was 25.0% versus 19.9% for the prior-year period. The higher effective tax rate during the third quarter of 2021 when compared to the third quarter of 2020 resulted from a lower proportion of income from non-taxable sources. 51 Table of Contents Financial Condition Loan Portfolio The following table sets forth the composition of our loan portfolio, excluding loans held-for-sale and unearned net origination fees and costs, by loan segment at the periods indicated. September 30, 2021 December 31, 2020 Amount Increase/ Amount % Amount % (Decrease) (dollars in thousands) Commercial (1) $ 1,325,488 20.1 % $ 1,521,967 24.4 % $ (196,479) Commercial real estate 4,436,626 67.3 3,783,550 60.6 653,076 Commercial construction 552,896 8.4 617,747 9.8 (64,851) Residential real estate 270,793 4.1 322,564 5.1 (51,771) Consumer 2,093 0.1 1,853 0.1 240 Gross loans $ 6,587,896 100.0 % $ 6,247,681 100.0 % $ 340,215 (1)       Included in commercial loans as of September 30, 2021 and December 31, 2020 were PPP loans of $177.8 million and $397.5 million, respectively. As of September 30, 2021, gross loans totaled $6.6 billion, an increase of $340.2 million, or 5.4%, as compared to December 31, 2020. Net loan growth was primarily attributable to increases in the commercial real estate segment of $653.1 million, offset by decreases in the commercial segment of $196.5 million, which primarily resulted from PPP loan forgiveness, decreases in commercial construction of $64.9 million and decreases in residential real estate of $51.8 million. Allowance for Credit Losses and Related Provision As of January 1, 2021, the Company adopted the CECL accounting standard. As of September 30, 2021, the Company’s ACL for loans was $78.0 million, a decrease of $1.2 million from $79.2 million December 31, 2020. The decrease was attributable to a release of credit losses of approximately $6.0 million, net charge-offs of $1.8 million, partially offset by a provision of $6.6 million resulting from the “Day 1” effect of the adoption of the CECL accounting. The provision for (reversal of) credit losses, which includes provision for unfunded commitments, for the three and nine months ended September 30, 2021 was $1.1 million and $(6.3) million, respectively, compared to $5.0 million and $36.0 million, for the three and nine months ended September 30, 2020, respectively. The decrease in provision for credit losses was the result of an improved macroeconomic outlook as of September 30, 2021 when compared to January 1, 2021, the day the Company adopted CECL. The prior year provision in the three and nine months ended September 30, 2020, was primarily due to the significant economic slowdown due to the COVID-19 pandemic. There were $1.6 million and $1.8 million in net loan charge-offs during the three and nine months ended September 30, 2021, compared with $(0.5) million and $-0- in net loan recoveries during the three and nine months ended September 30, 2020, respectively. The current quarter included a $1.4 million charge-off of a commercial real estate loan that previously had a specific credit reserve. The ACL as a percentage of loans receivable was to 1.19% as of September 30, 2021 compared to 1.27% as of December 31, 2020. Excluding the impact of PPP loans in the calculation of the ACL as a percentage of loans receivable, the ratio is 1.22% as of September 30, 2021, compared to 1.36% as of December 31, 2020. PPP loans do not have allowance for credit losses attributable to them, as they are assumed to be fully guaranteed by the SBA. The level of the ACL for the respective periods of 2021 and allowance for loan losses for 2020 reflects the credit quality within the loan portfolio, loan growth, the changing composition of the commercial and residential real estate loan portfolios and other related factors. In management’s view, the level of the ACL as of September 30, 2021 is adequate to cover expected credit losses inherent in the loan portfolio. Management’s judgment regarding the adequacy of the allowance constitutes a “Forward-Looking Statement” under the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from management’s analysis, based principally upon the factors considered by management in establishing the allowance. 52 Table of Contents Changes in the ACL are presented in the following table for the periods indicated. Three Months Ended September 30, 2021 2020 (1) (dollars in thousands) Average loans receivable at end of period $ 6,449,726 $ 6,277,671 Analysis of the ACL: Balance – beginning of period $ 78,684 $ 68,724 Charge-offs: Commercial (254) (48) Commercial real estate (1,473) - Residential real estate - (209) Total charge-offs (1,727) (257) Recoveries: Commercial 1 - Commercial real estate 85 800 Residential real estate 20 Consumer 7 - Total recoveries 113 800 Net loan (charge-offs) recoveries (1,614) 543 Provision for credit losses (loans) 916 5,000 Balance - end of period $ 77,986 $ 74,267 Ratio of annualized net charge-offs during the period to average loans receivable during the period 0.10 % (0.03) % Loans receivable $ 6,576,439 $ 6,251,051 ACL as a percentage of loans receivable 1.19 % 1.19 % Nine Months Ended September 30, 2021 2020 (1) (dollars in thousands) Average loans receivable at end of period $ 6,314,433 $ 6,192,822 Analysis of the ACL: Balance - beginning of quarter $ 79,226 $ 38,293 CECL Day 1 Adjustment 6,557 - Balance – January 1, 2021 (as adjusted) 85,783 38,293 Charge-offs: Commercial (304) (552) Commercial real estate (1,628) - Residential real estate (7) (278) Consumer - (3) Total charge-offs (1,939) (833) Recoveries: Commercial 74 2 Commercial real estate 85 802 Residential real estate 20 - Consumer 9 3 Total recoveries 188 807 Net loan charge-offs (1,751) (26) (Reversal of) provision for credit losses (loans) (6,046) 36,000 Balance - end of period $ 77,986 $ 74,267 Ratio of annualized net charge-offs during the period to average loans receivable during the period 0.04 % 0.00 % Loans receivable $ 6,576,439 $ 6,251,051 ACL as a percentage of loans receivable 1.19 % 1.19 % (1) The ACL for the prior periods was calculated based on the incurred loan loss model. 53 Table of Contents Asset Quality The Company manages asset quality and credit risk by maintaining diversification in its loan portfolio and through review processes that include analysis of credit requests and ongoing examination of outstanding loans, delinquencies, and potential problem loans, with particular attention to portfolio dynamics and mix. The Company strives to identify loans experiencing difficulty early enough to correct the problems, to record charge-offs promptly based on realistic assessments of current collateral values and cash flows, and to maintain an adequate allowance for loan losses at all times. It is generally the Company’s policy to discontinue interest accruals once a loan is past due as to interest or principal payments for a period of ninety days. When a loan is placed on nonaccrual status, interest accruals cease and uncollected accrued interest is reversed and charged against current income. Payments received on nonaccrual loans are generally applied against principal. A loan may be restored to an accruing basis when all past due amounts have been collected. Loans past due 90 days or more which are both well-secured and in the process of collection may remain on an accrual basis. Nonperforming assets include nonaccrual loans and other real estate owned. Nonaccrual loans represent loans on which interest accruals have been suspended. In general, it is the policy of management to consider the charge-off of uncollectible amounts of loans at the point they become past due 90 days. Performing troubled debt restructured loans represent loans to borrowers experiencing financial difficulties on which a concession was granted, such as a reduction in interest rate below the current market rate for new debt with similar risks or modified repayment terms and are performing under the restructured terms. The following table sets forth, as of the dates indicated, the amount of the Company’s nonaccrual loans, other real estate owned (“OREO”), performing troubled debt restructurings (“TDRs”) and loans past due 90 days or greater and still accruing: September 30, 2021 December 31, 2020 (dollars in thousands) Nonaccrual loans $ 65,959 $ 61,696 OREO - - Total nonperforming assets (1) $ 65,959 $ 61,696 Performing TDRs $ 41,256 $ 23,655 Loans 90 days or greater past due and still accruing (non PCD) $ - $ - Loans 90 days or greater past due and still accruing (PCD) $ 14,683 $ 12,821 (1) Nonperforming assets are defined as nonaccrual loans and OREO. Nonaccrual loans to total loans receivable 1.00 % 0.99 % Nonperforming assets to total assets 0.83 0.82 Nonperforming assets, performing TDRs, and loans 90 days or greater past due and still accruing to loans receivable 1.85 1.57 During the nine months ended September 30, 2021, the Bank designated approximately $40.7 million as TDRs. The increase in that designation was mainly attributable to maturity extensions and interest rate reductions in the commercial real estate segment. The majority of these loans were previously on deferment, and were subsequently designated TDRs once the deferral periods ended. 54 Table of Contents Investment Securities As of September 30, 2021, the principal components of the securities portfolio were federal agency obligations, mortgage-backed securities, obligations of U.S. states and political subdivisions, corporate bonds and notes, asset-backed securities and equity securities. For the three months ended September 30, 2021, average securities increased by $39.2 million to approximately $459.6 million, or 6.3% of average total interest-earning assets, from approximately $420.4 million, or 6.0% of average interest-earning assets, for the comparable period in 2020. As of September 30, 2021, net unrealized gains on securities available-for-sale, which are carried as a component of accumulated other comprehensive income and included in stockholders’ equity, net of tax, amounted to $1.5 million as compared with net unrealized gains of $7.9 million as of December 31, 2020. The decrease in unrealized gains is predominately attributable to changes in market conditions and interest rates. Unrealized losses have not been recognized into income because the issuers are of high credit quality, we do not intend to sell, and it is likely that we will not be required to sell the securities prior to their anticipated recovery. The decline in fair value is largely due to changes in interest rates and other market conditions. The issuers continue to make timely principal and interest payments on the securities. Any impairment that has not been recorded through an allowance for credit losses is recognized in other comprehensive income, net of applicable taxes. The Company did not record an ACL for available-for-sale as of September 30, 2021. Interest Rate Sensitivity Analysis The principal objective of our asset and liability management function is to evaluate the interest-rate risk included in certain balance sheet accounts; determine the level of risk appropriate given our business focus, operating environment, and capital and liquidity requirements; establish prudent asset concentration guidelines; and manage the risk consistent with Board approved guidelines. We seek to reduce the vulnerability of our operations to changes in interest rates, and actions in this regard are taken under the guidance of the Bank’s Asset Liability Committee (the “ALCO”). The ALCO generally reviews our liquidity, cash flow needs, maturities of investments, deposits and borrowings, and current market conditions and interest rates. We currently utilize net interest income (“NII”) simulation and economic value of equity (“EVE”) models to measure the potential impact to the Bank of future changes in interest rates. As of September 30, 2021 and December 31, 2020, the results of the models were within guidelines prescribed by our Board of Directors. If model results were to fall outside prescribed ranges, action, including additional monitoring and reporting to the Board, would be required by the ALCO and the Bank’s management. The net interest income simulation model attempts to measure the change in net interest income over the next one-year period, and over the next three-year period on a cumulative basis, assuming certain changes in the general level of interest rates. Based on our model, which was run as of September 30, 2021, we estimated that over the next one-year period a 200 basis-point instantaneous increase in the general level of interest rates would increase our net interest income by 3.23%, while a 100 basis-point instantaneous decrease in interest rates would decrease net interest income by 5.80%. As of December 31, 2020, we estimated that over the next one-year period a 200 basis-point instantaneous increase in the general level of interest rates would increase our net interest income by 0.70%, while a 100 basis-point instantaneous decrease in interest rates would decrease net interest income by 5.18%. Based on our model, which was run as of September 30, 2021, we estimated that over the next three years, on a cumulative basis, a 200 basis-point instantaneous increase in the general level of interest rates would increase our net interest income by 9.39%, while a 100 basis-point instantaneous decrease in interest rates would decrease net interest income by 10.72%. As of December 31, 2020, we estimated that over the next three years, on a cumulative basis, a 200 basis-point instantaneous increase in the general level of interest rates would increase our net interest income by 3.89%, while a 100 basis-point instantaneous decrease in interest rates would decrease net interest income by 8.56%. An EVE analysis is also used to dynamically model the present value of asset and liability cash flows with instantaneous rate shocks of up 200 basis points and down 100 basis points. The economic value of equity is likely to be different as interest rates change. Our EVE as of September 30, 2021, would decline by 0.61% with an instantaneous rate shock of up 200 basis points, and decrease by 1.30% with an instantaneous rate shock of down 100 basis points. Our EVE as of December 31, 2020, would decline by 7.76% with an instantaneous rate shock of up 200 basis points, and increase by 5.70% with an instantaneous rate shock of down 100 basis points. The following table illustrates the most recent results for EVE and one-year NII sensitivity as of September 30, 2021. Interest Rates Estimated Estimated Change in EVE Interest Rates Estimated Estimated Change in NII (basis points) EVE Amount % (basis points) NII Amount % +300 $1,083,143 $(24,967) (2.25) +300 $264,965 $11,837 4.68 +200 1,101,319 (6,791) (0.61) +200 261,300 8,172 3.23 +100 1,107,326 (784) (0.07) +100 257,096 3,968 1.57 0 1,108,110 - - - 253,128 - - -100 1,093,701 (14,409) (1.30) -100 238,450 (14,678) (5.80) 55 Table of Contents Estimates of Fair Value The estimation of fair value is significant to a number of the Company’s assets, including loans held-for-sale and securities available-for-sale. These are all recorded at either fair value or the lower of cost or fair value. Fair values are volatile and may be influenced by a number of factors. Circumstances that could cause estimates of the fair value of certain assets and liabilities to change include a change in prepayment speeds, discount rates, or market interest rates. Fair values for most available-for-sale securities are based on quoted market prices. If quoted market prices are not available, fair values are based on judgments regarding future expected loss experience, current economic condition risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature, involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Impact of Inflation and Changing Prices The consolidated financial statements and notes thereto presented elsewhere herein have been prepared in accordance with GAAP, which requires the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of operations; unlike most industrial companies, nearly all of the Company’s assets and liabilities are monetary. As a result, interest rates have a greater impact on performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services. Liquidity Liquidity is a measure of a bank’s ability to fund loans, withdrawals or maturities of deposits, and other cash outflows in a cost-effective manner. Our principal sources of funds are deposits, scheduled amortization and prepayments of loan principal, maturities of investment securities, and funds provided by operations. While scheduled loan payments and maturing investments are relatively predictable sources of funds, deposit flow and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. As of September 30, 2021, the amount of liquid assets remained at a level management deemed adequate to ensure that, on a short and long-term basis, contractual liabilities, depositors’ withdrawal requirements, and other operational and client credit needs could be satisfied. As of September 30, 2021, liquid assets (cash and due from banks, interest-bearing deposits with banks and unencumbered investment securities) were $800.4 million, which represented 10.1% of total assets and 12.0% of total deposits and borrowings, compared to $697.4 million as of December 31, 2020, which represented 9.2% of total assets and 10.9% of total deposits and borrowings. The Bank is a member of the Federal Home Loan Bank of New York and, based on available qualified collateral as of September 30, 2021, had the ability to borrow $2.0 billion. In addition, as of September 30, 2021, the Bank had in place borrowing capacity of $25.0 million through correspondent banks. The Bank also has a credit facility established with the Federal Reserve Bank of New York for direct discount window borrowings with capacity based on pledged collateral of $3.1 million. As of September 30, 2021, the Bank had aggregate available and unused credit of approximately $1.2 billion, which represents the aforementioned facilities totaling $2.0 billion net of $760.3 million in outstanding borrowings and letters of credit. As of September 30, 2021, outstanding commitments for the Bank to extend credit were approximately $1.2 billion. Cash and cash equivalents totaled $413.2 million as of September 30, 2021, increasing by $109.4 million from $303.8 million as of December 31, 2020. Operating activities provided $154.6 million in net cash. Investing activities used $352.7 million in net cash, primarily reflecting an increase in loans. Financing activities provided $307.5 million in net cash, primarily reflecting a net increase in deposits of $440.9 million, net proceeds raised from the issuance of preferred stock of $110.9 million and a decrease in net borrowings of $172.7 million. 56 Table of Contents Deposits The following table sets forth the composition of our deposit base by the periods indicated. September 30, 2021 December 31, 2020 Amount Increase/ (Decrease) Amount % Amount % 2021 vs. 2020 (dollars in thousands) Demand, noninterest-bearing $ 1,500,754 23.5 % $ 1,339,108 22.5 % $ 161,646 Demand, interest-bearing 3,264,966 51.0 2,861,820 48.0 403,146 Savings 410,707 6.4 294,163 4.9 116,544 Time 1,221,911 19.1 1,464,133 24.6 (242,222) Total deposits $ 6,398,338 100.0 % $ 5,959,224 100.0 % $ 439,114 Subordinated Debentures During December 2003, Center Bancorp Statutory Trust II, a statutory business trust and wholly-owned subsidiary of the Parent Corporation issued $5.0 million of MMCapS capital securities to investors due on January 23, 2034. The trust loaned the proceeds of this offering to the Company and received in exchange $5.2 million of the Parent Corporation’s subordinated debentures. The subordinated debentures are redeemable in whole or part prior to maturity. The floating interest rate on the subordinated debentures is three-month LIBOR plus 2.85% and re-prices quarterly. The rate as of September 30, 2021 was 2.98%. During September 2020, the Parent Corporation issued $75 million in aggregate principal amount of fixed-to-floating rate subordinated notes (the “2020 Notes”). The 2020 Notes bear interest at 5.75% annually from, and including, the date of initial issuance to, but excluding, September 15, 2025 or the date of earlier redemption, payable semi-annually in arrears on September 15 and December 15 of each year, commencing December 15, 2020. From and including September 15, 2025 through maturity or earlier redemption, the interest rate shall reset quarterly to an interest rate per annum equal to a benchmark rate, which is expected to be Three-Month Term SOFR (as defined in the Second Supplemental Indenture), plus 560.5 basis points, payable quarterly in arrears on March 15, June 15, September 15 and December 15 of each year, commencing on September 15, 2025. Notwithstanding the foregoing, if the benchmark rate is less than zero, then the benchmark rate shall be deemed to be zero. During January 2018, the Parent Corporation issued $75 million in aggregate principal amount of fixed-to-floating rate subordinated notes (the “2018 Notes”) to certain accredited investors. The net proceeds from the sale of the 2018 Notes were used for general corporate purposes, which included the Parent Corporation contributing $65 million of the net proceeds to the Bank in the form of debt and common equity in the first quarter of 2018. The 2018 Notes are non-callable for five years, have a stated maturity of February 1, 2028 and bear interest at a fixed rate of 5.20% per year, from and including January 17, 2018 to, but excluding February 1, 2023. From and including February 1, 2023 to, but excluding the maturity date, or early redemption date, the interest rate will reset quarterly to a level equal to the then current three-month LIBOR rate plus 284 basis points. During September 2015, the Parent Corporation issued $50 million in aggregate principal amount of fixed-to-floating rate subordinated notes (the “2015 Notes”). As of December 31, 2020, the 2015 Notes had a stated maturity of July 1, 2025, and bore interest until the maturity date or early redemption date at a variable rate equal to the then current three-month LIBOR rate plus 393 basis points. As of December 31, 2020, the variable interest rate was 4.16% and all costs related to 2015 issuance have been amortized. The 2015 Notes were redeemed in full on January 1, 2021. 57 Table of Contents Stockholders’ Equity The Company’s stockholders’ equity was $1.1 billion as of September 30, 2021, an increase of $183.1 million from December 31, 2020. In August 2021, the Company raised $110.9 million, net of estimated issuance expenses, from the issuance of $115 million in 5.25% fixed rate, non-cumulative, perpetual preferred stock. This issuance is primarily reason for the overall increase in stockholders’ equity, coupled with increases in retained earnings of $82.0 million and additional paid-in capital of $2.0 million, partially offset by a decrease in accumulated other comprehensive income of $3.8 million and an increase in treasury stock of $8.0 million. As of September 30, 2021, the Company’s tangible common equity ratio and tangible book value per share were 9.95% and $19.43, respectively. As of December 31, 2020, the tangible common equity ratio and tangible book value per share were 9.50% and $17.49, respectively. Total goodwill and other intangible assets were approximately $217.9 million as of September 30, 2021 and $219.3 million as of December 31, 2020. September 30, December 31, 2021 2020 (dollars in thousands, except for share and per share data) Common equity $ 987,506 $ 915,310 Less: intangible assets 217,852 219,349 Tangible common stockholders’ equity $ 769,654 $ 695,961 Total assets $ 7,949,514 $ 7,547,339 Less: intangible assets 217,852 219,349 Tangible assets $ 7,731,662 $ 7,327,990 Common stock outstanding as of period end 39,602,199 39,785,398 Tangible common equity ratio (1) 9.95 % 9.50 % Book value per common share $ 24.94 $ 23.01 Less: intangible assets 5.51 5.52 Tangible book value per common share $ 19.43 $ 17.49 (1) Tangible common equity ratio is a non-GAAP measure. 58 Table of Contents Regulatory Capital and Capital Adequacy The maintenance of a solid capital foundation is a primary goal for the Company. Accordingly, capital plans, stock repurchases and dividend policies are monitored on an ongoing basis. The Company’s objective with respect to the capital planning process is to effectively balance the retention of capital to support future growth with the goal of providing stockholders with an attractive long-term return on their investment. The Company and the Bank are subject to regulatory guidelines establishing minimum capital standards that involve quantitative measures of assets, and certain off-balance sheet items, as risk-adjusted assets under regulatory accounting practices. The following is a summary of regulatory capital amounts and ratios as of September 30, 2021 for the Company and the Bank, compared with minimum capital adequacy requirements and the regulatory requirements for classification as a well-capitalized depository institution. ConnectOne Bancorp, Inc. For Capital Adequacy Purposes To Be Well-Capitalized Under Prompt Corrective Action Provisions As of September 30, 2021 Amount Ratio Amount Ratio Amount Ratio (dollars in thousands) Tier 1 leverage capital $ 882,884 11.60 % $ 304,431 4.00 % N/A N/A CET I risk-based ratio 766,802 10.73 321,617 4.50 N/A N/A Tier 1 risk-based capital 882,884 12.35 428,823 6.00 N/A N/A Total risk-based capital 1,110,870 15.54 571,764 8.00 N/A N/A ConnectOne Bank For Capital Adequacy Purposes To Be Well-Capitalized Under Prompt Corrective Action Provisions As of September 30, 2021 Amount Ratio Amount Ratio Amount Ratio (dollars in thousands) Tier 1 leverage capital $ 862,103 11.33 % $ 304,414 4.00 % $ 380,517 5.00 % CET I risk-based ratio 862,103 12.06 321,610 4.50 464,548 6.50 Tier 1 risk-based capital 862,103 12.06 428,814 6.00 571,752 8.00 Total risk-based capital 972,339 13.61 571,752 8.00 714,689 10.00 N/A - not applicable As of September 30, 2021, both the Company and Bank satisfy the capital conservation buffer requirements applicable to them. The lowest ratio as measured against the capital conservation buffers, at the Company was the CET1 Risk Based Ratio, which was 3.73% above the minimum buffer ratio, and, at the Bank was the Total Risk Based Capital Ratio, which was 3.11% above the minimum buffer ratio. 59 Table of Contents Item 3. Qualitative and Quantitative Disclosures about Market Risks Market Risk Interest rate risk management is our primary market risk. See "Item 2- Management's Discussion and Analysis of Financial Condition and Results of Operations - Interest Rate Sensitivity Analysis" herein for a discussion of our management of our interest rate risk.