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 March 31, 2022 and December 31, 2021. 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 credit 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 such as the ongoing conflict between Ukraine and Russia, 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 allowance for credit losses, 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 allowance for credit losses (“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 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. 37 Table of Contents 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 10 of the Notes to Consolidated Financial Statements included in the Company’s Form 10-K for the year ended December 31, 2021 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 March 31, 2022, the Company has one deferred loan with a total outstanding loan balance of $0.5 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 June 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 June 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 March 31, 2022, PPP loans were $54.3 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 March 31, 2022. Should those circumstances change, the Company could be required to establish additional provisions for credit loss expense charged to earnings. As of March 31, 2022 remaining deferred and unrecognized PPP fees were $2.6 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. Operating Results Overview Net income available to common stockholders for the three months ended March 31, 2022 was $29.9 million compared to $33.0 million for the comparable three-month period ended March 31, 2021. The Company’s diluted earnings per share were $0.75 for the three months ended March 31, 2022 as compared with diluted earnings per share of $0.82 for the comparable three-month period ended March 31, 2021. The $3.1 million decrease in net income available to common stockholders and $0.07 decrease in diluted earnings per share versus the first quarter of 2021 were due to a $7.2 million increase to provision for credit losses, a $2.7 million increase in noninterest expenses, $1.5 million in preferred dividends, a $0.4 million decrease in noninterest income and a $0.5 million increase in income tax expenses, partially offset by a $9.2 million increase in net interest income. 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 (including interest earned tax-free loans and on obligations of state and local 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 March 31, 2022 increased by $9.2 million, or 15.0%, from the comparable three-month period ended March 31, 2021. The increase from the three months ended March 31, 2021 resulted primarily from a 10.1% increase in average loans and a 15 basis-point widening of the net interest margin to 3.71% from 3.56%. The widening of the net interest margin resulted from a 27 basis-point reduction in the cost of interest-bearing liabilities, partially offset by an 8 basis-point reduction in the yield on average interest-earning assets. 38 Table of Contents The following tables, “Average Statements of Condition with Interest and Average Rates”, present for the three months ended March 31, 2022 and 2021, 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 March 31, 2022 2021 Average Balance Interest Income/ Expense Average Rate (7) Average Balance Interest Income/ Expense Average Rate (7) (dollars in thousands) Interest-earning assets: Securities (1) (2) $ 545,203 $ 2,771 2.06 % $ 473,181 $ 2,058 1.76 % Total loans (2) (3) (4) 6,871,477 76,320 4.50 6,242,960 70,676 4.59 Federal funds sold and interest-bearing with banks 312,224 120 0.16 269,537 49 0.07 Restricted investment in bank stocks 24,977 214 3.47 22,822 256 4.55 Total interest-earning assets 7,753,881 79,425 4.15 7,008,500 73,039 4.23 Noninterest-earning assets: Allowance for credit losses (79,763 ) (81,549 ) Other noninterest-earning assets 589,264 573,083 Total assets $ 8,263,382 $ 7,500,034 Interest-bearing liabilities: Interest-bearing deposits: Time deposits $ 1,124,614 2,154 0.78 $ 1,422,295 2,434 0.69 Other interest-bearing deposits 3,851,558 2,856 0.30 3,225,751 5,151 0.65 Total interest-bearing deposits 4,976,172 5,010 0.41 4,648,046 7,585 0.66 Borrowings 404,907 1,377 1.38 375,511 1,674 1.81 Subordinated debentures 152,977 2,168 5.75 154,341 2,167 5.70 Finance lease 1,917 28 5.92 2,115 32 6.14 Total interest-bearing liabilities 5,535,973 8,583 0.63 5,180,013 11,458 0.90 Demand deposits 1,547,055 1,348,585 Other liabilities 48,386 43,340 Total noninterest-bearing liabilities 1,595,441 1,391,925 Stockholders’ equity 1,131,968 928,096 Total liabilities and stockholders’ equity $ 8,263,382 $ 7,500,034 Net interest income (tax-equivalent basis) 70,842 61,581 Net interest spread (5) 3.53 % 3.33 % Net interest margin (6) 3.71 % 3.56 % Tax-equivalent adjustment (484 ) (418 ) Net interest income $ 70,358 $ 61,163 (1) Average balances are based on amortized cost and include equity securities. (2) Interest income is presented on a tax-equivalent basis using 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. 39 Table of Contents Noninterest Income Noninterest income totaled $3.1 million for the three months ended March 31, 2022, compared with $3.4 million for the three months ended March 31, 2021. Included in noninterest income were net losses on equity securities of $0.6 million and $0.2 million for the three months ended March 31, 2022 and three months ended 2021, respectively, and a $0.7 million gain on the sale of branches in the first quarter 2021. Excluding the aforementioned items, noninterest income was $3.7 million and $2.9 million for the three months ended March 31, 2022 and three-month period ended March 31, 2021, respectively. The $0.7 million increase in noninterest income excluding the items discussed above for the three months ended March 31, 2022 versus the comparable three-month period ended March 31, 2021 was primarily due to increases in deposit, loan and other income of $0.4 million, BoeFly income of $0.2 million and BOLI income of $0.1 million. Noninterest Expenses Noninterest expenses totaled $29.2 million for the three months ended March 31, 2022, compared to $26.5 million for the three months ended March 31, 2021. The increase in noninterest expenses of $2.7 million from the comparable three-month period ended period March 31, 2021 was primarily attributable to increases in salaries and employee benefits of $3.1 million, a $0.7 million increase acquisition expenses related to BoeFly and increases in other expenses of $0.6 million, and information technology and communications of $0.3 million, partially offset by decreases in occupancy and equipment expenses of $1.5 million, which included a $0.9 million favorable dissolution of a merger lease obligation, FDIC insurance of $0.3 million and professional and consulting of $0.2 million. The increase in salaries and employee benefits from the prior year quarter was attributable to new hires, a seasonal increase in payroll taxes, as well as higher incentive-based, stock compensation expense. Income Taxes Income tax expense was $11.4 million for the three months ended March 31, 2022, compared to $10.9 million for the three months ended March 31, 2021. The effective tax rate for the three months ended March 31, 2022 and March 31, 2021 was 26.6% and 24.8%, respectively. The effective tax rate for the first quarter of 2022 was higher compared to March 31, 2021 due to different proportions of income from non-taxable sources. 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. March 31, 2022 December 31, 2021 Amount Increase/ Amount % Amount % (Decrease) (dollars in thousands) Commercial (1) $ 1,278,477 18.3 % $ 1,299,428 19.0 % $ (20,951 ) Commercial real estate 4,919,093 70.4 4,741,590 69.3 177,503 Commercial construction 539,058 7.7 540,178 7.9 (1,120 ) Residential real estate 250,205 3.5 255,269 3.7 (5,064 ) Consumer 1,140 0.1 1,886 0.1 (746 ) Gross loans $ 6,987,973 100.0 % $ 6,838,351 100.0 % $ 149,622 As of March 31, 2022, gross loans totaled $7.0 billion, an increase of $149.6 million, or 2.2%, as compared to December 31, 2021. Net loan growth was attributable to organic loan originations. (1 ) Included in commercial loans as of March 31, 2022 and December 31, 2021 are PPP loans of $54.3 million and $93.1 million, respectively. 40 Table of Contents Allowance for Credit Losses and Related Provision As of March 31, 2022, the Company’s allowance for credit losses for loans was $80.1 million, an increase of $1.3 million from $78.8 million December 31, 2021. The allowance for credit losses for loans as of December 31, 2021 included a $6.6 million increase that was related to the “Day 1” CECL adjustment resulting from adopting CECL as of January 1, 2021. Excluding that increase, the allowance for credit losses for loans increased by $7.8 million. The increase was primarily attributable to an increase in provision for credit losses for loans of $6.6 million and a decrease of $2.1 million in charge-offs, partially offset by a decrease of $0.4 million in recoveries. The provision for (reversal of) credit losses was $1.5 million for the three months ended March 31, 2022 and $(5.8) million for the three months ended March 31, 2021. The provision for credit losses during the three months ended March 31, 2022 reflected strong organic loan growth and stabilizing macroeconomic forecasts. The reversal of provision for credit losses during the three months ended March 31, 2021 was the result of an improved macroeconomic forecast when compared to January 1, 2021, the date of CECL implementation. There were $0.2 million net charge-offs for the three months ended March 31, 2022, compared with $0.1 million in net recoveries for the three months ended March 31, 2021. The ACL as a percentage of loans receivable amounted to 1.15% as of both March 31, 2022 and December 31, 2021. Excluding the impact of PPP loans in the calculation of the ACL as a percentage of loans receivable, the ratio increases to 1.16% as of March 31, 2022, compared to 1.17% as of December 31, 2021. PPP loans do not have allowance for credit losses attributable to them, as they are fully guaranteed by the SBA. The level of the allowance for the respective periods of 2022 and 2021 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 March 31, 2022 is adequate to cover 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. Changes in the ACL are presented in the following table for the periods indicated. Three Months Ended March 31, 2022 2021 (dollars in thousands) Average loans receivable at end of period $ 6,871,095 $ 6,238,723 Analysis of the ACL: Balance - beginning of quarter $ 78,773 $ 79,226 CECL Day 1 Adjustment - 6,557 Balance – beginning of quarter (as adjusted) 78,773 85,783 Charge-offs: Commercial (274 ) - Total charge-offs (274 ) - Recoveries: Commercial 1 60 Consumer 31 1 Total recoveries 32 61 Net (charge-offs) recoveries (242 ) 61 Provision for (reversal of) credit losses (loans) 1,539 (5,276 ) Balance - end of period $ 80,070 $ 80,568 Ratio of annualized net charge-offs during the period to average loans receivable during the period 0.01 % 0.00 % Loans receivable $ 6,979,595 $ 6,277,191 ACL as a percentage of loans receivable 1.15 % 1.28 % 41 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 credit 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: March 31, 2022 December 31, 2021 (dollars in thousands) Nonaccrual loans $ 59,403 $ 61,700 OREO 316 - Total nonperforming assets (1) $ 59,719 $ 61,700 Performing TDRs $ 47,441 $ 43,587 Loans 90 days or greater past due and still accruing (non PCD) $ - $ - Loans 90 days or greater past due and still accruing (PCD) $ 12,380 $ 13,531 (1) Nonperforming assets are defined as nonaccrual loans and OREO. Nonaccrual loans to total loans receivable 0.85 % 0.90 % Nonperforming assets to total assets 0.72 % 0.76 % Nonperforming assets, performing TDRs, and loans 90 days or greater past due and still accruing to loans receivable 1.71 % 1.74 % 42 Table of Contents Investment Securities As of March 31, 2022, 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 quarter ended March 31, 2022, average securities increased $65.1 million to approximately $545.2 million, or 7.0% of average total interest-earning assets, from approximately $480.1 million, or 6.4% of average interest-earning assets, compared to December 31, 2021. As of March 31, 2022, net unrealized losses on securities available-for-sale, which are carried as a component of accumulated other comprehensive loss and included in stockholders’ equity, net of tax, amounted to $23.0 million as compared with net unrealized losses of $0.5 million as of December 31, 2021. The increase in unrealized losses 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 allowance for credit losses for available-for-sale as of March 31, 2022. 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 simulation and economic value of equity (“EVE”) models to measure the potential impact to the Bank of future changes in interest rates. As of March 31, 2022 and December 31, 2021, 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 March 31, 2022, 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 3.60%, while a 100 basis-point instantaneous decrease in interest rates would decrease net interest income by 6.28%. As of December 31, 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 3.35%, while a 100 basis-point instantaneous decrease in interest rates would decrease net interest income by 5.64%. Based on our model, which was run as of March 31, 2022, 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 9.20%, while a 100 basis-point instantaneous decrease in interest rates would decrease net interest income by 10.89%. As of December 31, 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 9.77%, while a 100 basis-point instantaneous decrease in interest rates would decrease net interest income by 10.41%. 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 March 31, 2022, would increase by 0.65% with an instantaneous rate shock of up 200 basis points, and decline by 6.89% with an instantaneous rate shock of down 100 basis points. Our EVE as of December 31, 2021, would increase by 0.24% with an instantaneous rate shock of up 200 basis points, and decline by 5.20% 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 March 31, 2022. Interest Rates Estimated Estimated Change in EVE Interest Rates Estimated Estimated Change in NII (basis points) EVE Amount % (basis points) NII Amount % +300 $ 1,144,436 $ (10,469 ) (0.72 ) +300 $ 305,198 $ 15,172 5.23 +200 1,464,299 9,394 0.65 +200 300,455 10,429 3.60 +100 1,471,303 16,398 1.13 +100 295,712 5,686 1.96 0 1,454,905 - - 0 290,026 - - -100 1,354,701 (100,204 ) (6.89 ) -100 271,825 (18,201 ) (6.28 ) 43 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 March 31, 2022, 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 March 31, 2022, liquid assets (cash and due from banks, interest-bearing deposits with banks and unencumbered investment securities) were $742.8 million, which represented 9.1% of total assets and 10.9% of total deposits and borrowings, compared to $742.1 million as of December 31, 2021, which represented 9.1% 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 March 31, 2022, had the ability to borrow $1.9 billion. In addition, as of March 31, 2022, the Bank had in place borrowing capacity of $25 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 $1.8 million. As of March 31, 2022, the Bank had aggregate available and unused credit of approximately $1.0 billion, which represents the aforementioned facilities totaling $1.9 billion net of $0.9 billion in outstanding borrowings and letters of credit. As of March 31, 2022, outstanding commitments for the Bank to extend credit were approximately $1.2 billion. Cash and cash equivalents totaled $311.5 million as of March 31, 2022, increasing by $46.0 million from $265.5 million as of December 31, 2021. Operating activities provided $45.8 million in net cash. Investing activities used $160.2 million in net cash, primarily reflecting an increase in loans. Financing activities provided $160.4 million in net cash, primarily reflecting an increase in deposits, partially offset by net repayment of FHLB borrowings of $56 million. 44 Table of Contents Deposits Total deposits increased by $227.5 million, or 3.6%, to $6.6 billion as of March 31, 2022 from December 31, 2021. The increase was primarily due to increases in demand, interest-bearing and NOW, savings, and demand, noninterest bearing deposits, partially offset by a decrease in time deposits. The following table sets forth the composition of our deposit base by the periods indicated. March 31, 2022 December 31, 2021 Amount Increase/ Amount % Amount % (Decrease) (dollars in thousands) Demand, noninterest-bearing $ 1,631,292 24.9 % $ 1,617,049 25.5 % $ 14,243 Demand, interest-bearing and NOW 3,403,099 51.9 3,127,350 49.4 % 275,749 Savings 460,200 7.0 438,445 6.9 % 21,755 Time 1,065,814 16.2 1,150,109 18.2 % (84,295 ) Total deposits $ 6,560,405 100.0 % $ 6,332,953 100.0 % $ 227,452 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 March 31, 2022 was 3.15%. During June 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, June 15, 2025 or the date of earlier redemption, payable semi-annually in arrears on June 15 and December 15 of each year, commencing December 15, 2020. From and including June 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. 45 Table of Contents Stockholders’ Equity The Company’s stockholders’ equity was $1.1 billion as of March 31, 2022, an increase of $14.3 million from December 31, 2021. The increase in stockholders’ equity was primarily attributable to retained earnings, in addition to an increase in additional paid-in capital, partially offset by a decrease in accumulated other comprehensive income, reflecting the after-tax decline in the fair value of investment securities net of unrealized hedge gains recorded in other assets, and an increase in treasury stock. As of March 31, 2022, the Company’s tangible common equity ratio and tangible book value per share were 9.99% and $20.51, respectively. As of December 31, 2021, the tangible common equity ratio and tangible book value per share were 10.06% and $20.12, respectively. Total goodwill and other intangible assets were approximately $216.9 million and $217.4 million, as of March 31, 2022 and December 31, 2021, respectively. The following table shows the reconciliation of common equity to tangible common equity and the tangible common equity ratio. March 31, December 31, 2022 2021 (dollars in thousands, except for share and per share data) Common equity $ 1,027,592 $ 1,013,285 Less: intangible assets (216,936 ) (217,369 ) Tangible common stockholders’ equity $ 810,656 $ 795,916 Total assets $ 8,334,301 $ 8,129,480 Less: intangible assets (216,936 ) (217,369 ) Tangible assets $ 8,117,365 $ 7,912,111 Common stock outstanding at period end 39,518,411 39,568,090 Tangible common equity ratio (1) 9.99 % 10.06 % Book value per common share $ 26.00 $ 25.61 Less: intangible assets 5.49 5.49 Tangible book value per common share $ 20.51 $ 20.12 (1) Tangible common equity ratio is a non-GAAP measure. 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. 46 Table of Contents The following is a summary of regulatory capital amounts and ratios as of March 31, 2022 for the Company and the Bank, compared with minimum capital adequacy requirements and the regulatory requirements for classification as a well-capitalized depository institution (for the Bank). ConnectOne Bancorp, Inc. For Capital Adequacy Purposes To Be Well-Capitalized Under Prompt Corrective Action Provisions The Company Amount Ratio Amount Ratio Amount Ratio As of March 31, 2022 (dollars in thousands) Tier 1 leverage capital $ 931,398 11.57 % $ 322,078 4.00 % $ N/A N/A CET I risk-based ratio 815,316 10.69 343,288 4.50 N/A N/A Tier 1 risk-based capital 931,398 12.21 457,717 6.00 N/A N/A Total risk-based capital 1,161,468 15.23 610,289 8.00 N/A N/A N/A - not applicable ConnectOne Bank For Capital Adequacy Purposes To Be Well-Capitalized Under Prompt Corrective Action Provisions The Bank Amount Ratio Amount Ratio Amount Ratio As of March 31, 2022 (dollars in thousands) Tier 1 leverage capital $ 918,787 11.41 % $ 322,041 4.00 % 402,552 5.00 % CET I risk-based ratio 918,787 12.04 343,279 4.50 495,847 6.50 Tier 1 risk-based capital 918,787 12.04 457,705 6.00 610,273 8.00 Total risk-based capital 1,031,107 13.52 610,273 8.00 762,841 10.00 As of March 31, 2022, both the Company and Bank satisfy the capital conservation buffer requirements applicable to them. The lowest ratio at the Company is the CET I Risk Based Ratio which was 3.69% above the minimum buffer ratio and, at the Bank, the lowest ratio was the Total Risk Based Capital Ratio which was 3.02% above the minimum buffer ratio. 47 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. 48 Table of Contents