Citizens Community Bancorp Inc. 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS Certain matters discussed in this report contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 and the Company intends that these forward-looking statements be covered by the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. These statements may be identified by the use of forward-looking words or phrases such as “anticipate,” “believe,” “could,” “expect,” “estimates,” “intend,” “may,” “preliminary,” “planned,” “potential,” “should,” “will,” “would,” or the negative of those terms or other words of similar meaning. Similarly, statements that describe the Company’s future plans, objectives or goals are also forward-looking statements. Such forward-looking statements are inherently subject to many uncertainties in the Company’s operations and business environment. Factors that could affect actual results or outcomes include the matters described under the caption “Risk Factors” in Item 1A of our annual report on Form 10-K for the year ended December 31, 2022, filed with the SEC on March 7, 2023 (“2022 10-K”), the matters described in “Risk Factors” in Item 1A for the quarter ended March 31, 2023 and in Item 1A of this Form 10-Q, and the following: • conditions in the financial markets and economic conditions generally; • reputational risk, new legislation, regulations or policy changes as a result of recent volatility in the banking sector; • adverse impacts to the Company or Bank arising from the COVID-19 pandemic; • acts of terrorism and political or military actions by the United States or other governments; • the possibility of a deterioration in the residential real estate markets; • interest rate risk; • lending risk; • higher lending risks associated with our commercial and agricultural banking activities; • the sufficiency of the allowance for credit losses; • changes in the fair value or ratings downgrades of our securities; • competitive pressures among depository and other financial institutions; • disintermediation risk; • our ability to maintain our reputation; • our ability to maintain or increase our market share; • our ability to realize the benefits of net deferred tax assets; • our inability to obtain needed liquidity; • our ability to raise capital needed to fund growth or meet regulatory requirements; • our ability to attract and retain key personnel; • our ability to keep pace with technological change; • prevalence of fraud and other financial crimes; • cybersecurity risks; • the possibility that our internal controls and procedures could fail or be circumvented; • our ability to successfully execute our acquisition growth strategy; • risks posed by acquisitions and other expansion opportunities, including difficulties and delays in integrating the acquired business operations or fully realizing the cost savings and other benefits; • restrictions on our ability to pay dividends; • the potential volatility of our stock price; • accounting standards for credit losses; • legislative or regulatory changes or actions, or significant litigation, adversely affecting the Company or Bank; • public company reporting obligations; • changes in federal or state tax laws; and • changes in accounting principles, policies or guidelines and their impact on financial performance. Stockholders, potential investors, and other readers are urged to consider these factors carefully in evaluating the forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements made herein are only made as of the date of this filing and the Company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances occurring after the date of this report. 59 GENERAL The following discussion sets forth management’s discussion and analysis of our consolidated financial condition as of June 30, 2023, and our consolidated results of operations for the three and six months ended June 30, 2023, compared to the same periods in the prior fiscal year for the three and six months ended June 30, 2022. This discussion should be read in conjunction with the interim consolidated financial statements and the condensed notes thereto included with this report and with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the financial statements and notes related thereto included in our 2022 10-K. Unless otherwise stated, all monetary amounts in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, other than share, per share and capital ratio amounts, are stated in thousands. CRITICAL ACCOUNTING ESTIMATES Our consolidated financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amount of assets, liabilities, revenue, expenses, and their related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends, and other factors that our management believes to be relevant at the time our consolidated financial statements are prepared. Some of these estimates are more critical than others. In addition to the policies included in Note 1, “Nature of Business and Summary of Significant Accounting Policies,” to the Consolidated Financial Statements included as an exhibit in our annual report on our 2022 10-K, our critical accounting estimates are as follows: Allowance for Credit Losses We adopted ASU 2016-13, Financial Instruments-Credit Losses (Topic 326), “Measurement of Credit Losses on Financial Instruments” through a cumulative-effect adjustment on January 1, 2023. We have selected a loss estimation methodology, utilizing a third-party model. See also Notes 1 and 3 to the unaudited consolidated financial statements for further discussion of our adoption of ASU 2016-13. Allowance for Credit Losses – Held-to-Maturity Securities. Currently, all of the Company’s held-to-maturity securities are backed by governments or government agencies, for which the risk of credit loss is minimal. Accordingly, the Company does not record an allowance for credit losses on held-to-maturity securities. Allowance for Credit Losses - Loans - We maintain an allowance for credit losses to absorb probable and inherent losses in our loan portfolio. The allowance is based on ongoing, quarterly assessments of the estimated lifetime losses in our loan portfolio. In evaluating the level of the allowance for loan loss, we consider the types of loans and the amount of loans in our loan portfolio, historical loss experience, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, prevailing economic conditions and other relevant factors determined by management. We follow all applicable regulatory guidance, including the “Interagency Policy Statement on Allowances for Credit losses,” issued by the Office of the Comptroller of the Currency, Department of the Treasury, Federal Deposit Insurance Corporation, and National Credit Union Administration. We believe that the Bank’s Allowance for Credit Losses Policy conforms to all applicable regulatory requirements. However, based on periodic examinations by regulators, the amount of the allowance for credit losses recorded during a particular period may be adjusted. Our determination of the allowance for credit losses - loans is based on (1) an individual allowance for specifically identified and evaluated loans that management has determined have unique risk characteristics. For these loans the estimated loss is based on likelihood of default, payment history, and net realizable value of underlying collateral. Specific allocations for collateral dependent loans are based on the fair value of the underlying collateral relative to the amortized cost of the loans. For loans that are not collateral dependent, the specific allocation is based on the present value of expected future cash flows discounted at the loan’s original effective interest rate through the repayment period; and (2) a collective allowance for loans not specifically identified in (1) above. The allowance for these loans is estimated by pooling loans with a similar risk profile and calculating a collective loss rate using the pool’s risk drivers, historical loss experience, and reasonable and supportable future economic forecasts to project lifetime losses. This collectively estimated loss is adjusted for qualitative factors. Assessing the allowance for credit losses - loans is inherently subjective as it requires making material estimates, including the amount, and timing of future cash flows expected to be received on impaired loans, any of which estimates may be susceptible to significant change. In our opinion, the allowance, when taken as a whole, reflects estimated probable loan losses in our loan portfolio. Allowance for Credit Losses – Unfunded Commitments. The Company estimates expected credit losses over the contractual period for which the Company is exposed to credit risk, via a contractual obligation to extend credit, unless the 60 obligation is unconditionally cancellable by the Company. The allowance for credit losses - unfunded commitments on off-balance sheet exposures is included in other liabilities on the consolidated balance sheet. Goodwill. We account for goodwill and other intangible assets in accordance with ASC Topic 350, “Intangibles - Goodwill and Other.” The Company records the excess of the cost of acquired entities over the fair value of identifiable tangible and intangible assets acquired, less liabilities assumed, as goodwill. The Company amortizes acquired intangible assets with definite useful economic lives over their useful economic lives utilizing the straight-line method. On a periodic basis, management assesses whether events or changes in circumstances indicate that the carrying amounts of the intangible assets may be impaired. The Company does not amortize goodwill, but reviews goodwill for impairment at a reporting unit level on an annual basis, or when events or changes in circumstances indicate that the carrying amounts may be impaired. A reporting unit is defined as any distinct, separately identifiable component of the Company’s one operating segment for which complete, discrete financial information is available and reviewed regularly by the segment’s management. The Company has one reporting unit as of June 30, 2023, which is related to its banking activities. The Company performed the required goodwill impairment test and determined that goodwill was not impaired as of December 31, 2022. The Company has monitored events and conditions since December 31, 2022, and has determined that no triggering event has occurred that would require goodwill to be tested for impairment. Fair Value Measurements and Valuation Methodologies. We apply various valuation methodologies to assets and liabilities which often involve a significant degree of judgment, particularly when liquid markets do not exist for the particular items being valued. Quoted market prices are referred to when estimating fair values for certain assets, such as most investment securities. However, for those items for which an observable liquid market does not exist, management utilizes significant estimates and assumptions to value such items. Examples of these items include loans, deposits, borrowings, goodwill, core deposit intangible assets, other assets and liabilities obtained or assumed in business combinations, and certain other financial instruments. These valuations require the use of various assumptions, including, among others, discount rates, rates of return on assets, repayment rates, cash flows, default rates, and liquidation values. The use of different assumptions could produce significantly different results, which could have material positive or negative effects on the Company’s results of operations, financial condition, or disclosures of fair value information. In addition to valuation, the Company must assess whether there are any declines in value below the carrying value of assets that should be considered other than temporary or otherwise require an adjustment in carrying value and recognition of a loss in the consolidated statement of operations. Examples include but are not limited to: loans, investment securities, goodwill, core deposit intangible assets and deferred tax assets, among others. Specific assumptions, estimates and judgments utilized by management are discussed in detail herein in management’s discussion and analysis of the Company’s balance sheet and statement of operations and in notes 1, 2, 3, 4 and 10 of Condensed Notes to Consolidated Financial Statements. Income Taxes. Amounts provided for income tax expenses are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws. The amounts provided for income taxes are also impacted by the Company’s investment in a New Markets Tax Credit. With the adoption of ASU 2023-02 on January 1, 2023, amortization of the investment will now be recognized in the period of and proportional to recognition of the related tax credit and included in provision for income taxes. Deferred income tax assets and liabilities, which arise principally from temporary differences between the amounts reported in the financial statements and the tax basis of certain assets and liabilities, are included in the amounts provided for income taxes. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income and tax planning strategies which will create taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and if necessary, tax planning strategies in making this assessment. The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and application of specific provisions of federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management’s current assessment, the impact of which could be material to our consolidated results of operations and reported earnings. We believe that the deferred tax assets and liabilities are adequate and properly recorded in the accompanying consolidated financial statements. As of June 30, 2023, management does not believe a valuation allowance related to the realizability of its deferred tax assets is necessary. 61 STATEMENT OF OPERATIONS ANALYSIS Net Interest Income. Net interest income represents the difference between the dollar amount of interest earned on interest-bearing assets and the dollar amount of interest paid on interest-bearing liabilities. The interest income and expense of financial institutions (including those of the Bank) are significantly affected by general economic conditions, competition, policies of regulatory authorities and other factors. Interest rate spread and net interest margin are used to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on interest earning assets and the rate paid for interest-bearing liabilities that fund those assets. Net interest margin is expressed as the percentage of net interest income to average interest earning assets. Net interest margin currently exceeds interest rate spread because non-interest-bearing sources of funds (“net free funds”), principally demand deposits and stockholders’ equity, also support interest earning assets. The narrative below discusses net interest income, interest rate spread, and net interest margin for the three and six-month periods ended June 30, 2023, and June 30, 2022, respectively. Net interest income was $11.7 million and $24.5 million for the three and six months ended June 30, 2023, respectively, compared to $14.3 million and $27.4 million for the three and six months ended June 30, 2022, respectively. Net interest income for the three months ended June 30, 2023, decreased from the same period one year ago due to: 1) higher deposit and borrowing balances and costs and 2) a $0.5 million reduction in the accretion on purchased loans. This was partially offset by: 1) positive loan volume variance due to growth in loans outstanding and 2) increases in loan and investment yields due to both contractual repricing and higher coupons on new loans and investments in excess of portfolio yield. The net interest margin for the three-month period ended June 30, 2023, was 2.72%, compared to 3.46% for the three-month period ended June 30, 2022. The net interest margin decrease was due to: 1) higher deposit costs due to strategic increases in deposit rates to maintain a strong deposit base and customers moving from lower cost savings and money market accounts to higher yielding certificate accounts; 2) the impact of higher short-term interest rates which increased FHLB advance and other borrowing costs; and 3) a 13-basis point decrease in accretion on purchased loans. This was partially offset by increases in loan and investment yields due to contractual repricing and rates on new loans and investments exceeding the portfolio as a whole. Net interest income for the six months ended June 30, 2023, decreased from the same period one year ago due to: 1) higher deposit and borrowing balances and related costs; 2) $0.8 million reduction in the accretion on purchased loans; and 3) $0.3 million of lower SBA PPP accretion, as the last SBA PPP loan was repaid in second quarter 2022. This was partially offset by: 1) positive loan volume variance due to growth in loans outstanding and 2) increases in loan and investment yields due to both contractual repricing and higher coupons on new loans and investments in excess of portfolio yield. The net interest margin for the six-month period ended June 30, 2023, was 2.88%, compared to 3.35% for the six-month period ended June 30, 2022. The net interest margin decrease was due to: 1) higher deposit and FHLB borrowing costs; 2) an 8- basis point decrease in accretion on purchased loans; 3) a 3-basis point decrease on SBA PPP accretion; and 4) the impact of additional interest expense of the subordinated debt issued in March 2022. These decreases were partially offset by increases in loan and investment yields due to both contractual repricing and higher coupons on new loans and investments in excess of portfolio yield. 62 Average Balances, Net Interest Income, Yields Earned and Rates Paid. The following net interest income analysis table presents interest income from average interest earning assets, expressed in dollars and yields, and interest expense on average interest-bearing liabilities, expressed in dollars and rates on a tax equivalent basis. Shown below is the weighted average tax equivalent yield on interest earning assets, rates paid on interest-bearing liabilities and the resultant spread at or during the three-month and six-month periods ended June 30, 2023 and June 30, 2022. Non-accruing loans have been included in the table as loans carrying a zero yield. NET INTEREST INCOME ANALYSIS ON A TAX EQUIVALENT BASIS (Dollar amounts in thousands) Three months ended June 30, 2023 compared to the three months ended June 30, 2022: Three months ended June 30, 2023 Three months ended June 30, 2022 Average Balance Interest Income/ Expense Average Yield/ Rate (1) Average Balance Interest Income/ Expense Average Yield/ Rate (1) Average interest earning assets: Cash and cash equivalents $ 24,779 $ 327 5.29 % $ 25,195 $ 43 0.68 % Loans 1,414,925 17,960 5.09 % 1,328,661 14,893 4.50 % Interest-bearing deposits 5 — — % 1,509 8 2.13 % Investment securities (1) 264,579 2,210 3.34 % 285,332 1,593 2.23 % Other investments 17,491 280 6.42 % 14,969 166 4.45 % Total interest earning assets (1) $ 1,721,779 $ 20,777 4.84 % $ 1,655,666 $ 16,703 4.05 % Average interest-bearing liabilities: Savings accounts $ 209,277 $ 393 0.75 % $ 241,245 $ 131 0.22 % Demand deposits 366,037 1,752 1.92 % 410,468 257 0.25 % Money market 299,201 1,774 2.38 % 323,907 277 0.34 % CD’s 293,262 2,243 3.07 % 159,578 320 0.80 % Total deposits $ 1,167,777 $ 6,162 2.12 % $ 1,135,198 $ 985 0.35 % FHLB Advances and other borrowings 238,776 2,929 4.92 % 186,050 1,451 3.13 % Total interest-bearing liabilities $ 1,406,553 $ 9,091 2.59 % $ 1,321,248 $ 2,436 0.74 % Net interest income $ 11,686 $ 14,267 Interest rate spread 2.25 % 3.31 % Net interest margin (1) 2.72 % 3.46 % Average interest earning assets to average interest-bearing liabilities 1.22 1.25 (1) Fully taxable equivalent (FTE). The average yield on tax exempt securities is computed on a tax equivalent basis using a tax rate of 21.0% for the quarters ended June 30, 2023, and June 30, 2022. The FTE adjustment to net interest income included in the rate calculations totaled $0 and $0 thousand for the three months ended June 30, 2023, and June 30, 2022, respectively. 63 NET INTEREST INCOME ANALYSIS ON A TAX EQUIVALENT BASIS (Dollar amounts in thousands) Six months ended June 30, 2023 compared to the six months ended June 30, 2022: Six months ended June 30, 2023 Six months ended June 30, 2022 Average Balance Interest Income/ Expense Average Yield/ Rate (1) Average Balance Interest Income/ Expense Average Yield/ Rate (1) Average interest earning assets: Cash and cash equivalents $ 17,931 $ 467 5.25 % $ 30,174 $ 56 0.37 % Loans 1,412,870 35,086 5.01 % 1,316,469 28,660 4.39 % Interest-bearing deposits 126 1 1.6 % 1,510 15 2.00 % Investment securities (1) 266,224 4,385 3.32 % 286,789 3,009 2.10 % Other investments 16,923 511 6.09 % 15,112 339 4.52 % Total interest earning assets (1) $ 1,714,074 $ 40,450 4.76 % $ 1,650,054 $ 32,079 3.92 % Average interest bearing liabilities: Savings accounts $ 213,106 $ 776 0.73 % $ 237,464 $ 231 0.20 % Demand deposits 378,450 3,183 1.7 % 410,678 470 0.23 % Money market 299,393 2,870 1.93 % 311,524 492 0.32 % CD’s 270,819 3,681 2.74 % 174,300 860 0.99 % Total deposits $ 1,161,768 $ 10,510 1.82 % $ 1,133,966 $ 2,053 0.37 % FHLB Advances and other borrowings 229,825 5,459 4.79 % 176,139 2,592 2.97 % Total interest bearing liabilities $ 1,391,593 $ 15,969 2.31 % $ 1,310,105 $ 4,645 0.71 % Net interest income $ 24,481 $ 27,434 Interest rate spread 2.45 % 3.21 % Net interest margin (1) 2.88 % 3.35 % Average interest earning assets to average interest bearing liabilities 1.23 1.26 (1) Fully taxable equivalent (FTE). The average yield on tax exempt securities is computed on a tax equivalent basis using a tax rate of 21.0% for the six months ended June 30, 2023 and June 30, 2022. The FTE adjustment to net interest income included in the rate calculations totaled $0 and $1 thousand for the six-month periods ended June 30, 2023 and June 30, 2022, respectively. 64 Rate/Volume Analysis. The following tables present the dollar amount of changes in interest income and interest expense for the components of interest earning assets and interest-bearing liabilities that are presented in the preceding table. For each category of interest earning assets and interest-bearing liabilities, information is provided on changes attributable to: 1) changes in volume, which are changes in the average outstanding balances multiplied by the prior period rate (i.e., holding the initial rate constant) and 2) changes in rate, which are changes in average interest rates multiplied by the prior period volume (i.e., holding the initial balance constant). Rate changes have been discussed previously in the net interest income section above. For the three and six months ended June 30, 2023, compared to the same period in 2022, the loan volume increased due to strong organic growth. The increase in certificate volumes is due to CD growth, with some of this growth moving from money market accounts. Investment securities volume decreases for the three and six months ended June 30, 2023, compared to the three and six months ended June 30, 2022, are primarily due to: 1) principal repayments and sales, net of purchases and 2) unrealized losses in the available for sale securities portfolio. RATE / VOLUME ANALYSIS (Dollar amounts in thousands) Three months ended June 30, 2023 compared to the three months ended June 30, 2022. Increase (decrease) due to Volume Rate Net Interest income: Cash and cash equivalents $ (1) $ 285 $ 284 Loans 1,007 2,060 3,067 Interest-bearing deposits (8) — (8) Investment securities (123) 740 617 Other investments 31 83 114 Total interest earning assets 906 3,168 4,074 Interest expense: Savings accounts (20) 282 262 Demand deposits (31) 1,526 1,495 Money market accounts (23) 1,520 1,497 CD’s 373 1,550 1,923 Total deposits 299 4,878 5,177 FHLB Advances and other borrowings 477 1,001 1,478 Total interest bearing liabilities 776 5,879 6,655 Net interest income $ 130 $ (2,711) $ (2,581) 65 Six months ended June 30, 2023 compared to the six months ended June 30, 2022. Increase (decrease) due to Volume Rate Net Interest income: Cash and cash equivalents $ (37) $ 448 $ 411 Loans 2,195 4,231 6,426 Interest-bearing deposits (11) (3) (14) Investment securities (229) 1,605 1,376 Other investments 44 128 172 Total interest earning assets 1,962 6,409 8,371 Interest expense: Savings accounts (26) 571 545 Demand deposits (40) 2,753 2,713 Money market accounts (20) 2,398 2,378 CD’s 617 2,204 2,821 Total deposits 531 7,926 8,457 FHLB Advances and other borrowings 924 1,943 2,867 Total interest bearing liabilities 1,455 9,869 11,324 Net interest income $ 507 $ (3,460) $ (2,953) Provision for Credit Losses. We determine our provision for credit losses (“provision”) based on our desire to provide an adequate Allowance for Credit Losses (“ACL”) - Loans to reflect estimated lifetime losses in our loan portfolio and ACL - Unfunded commitments to reflect estimated losses on our unfunded commitments to lend. We use a third-party model to collectively evaluate and estimate the ACL on loans and unfunded commitments on a pooled basis. The model pools loans and commitments with similar characteristics and calculates an estimated loss rate for the pool based on identified risk drivers. These risk drivers vary with loan type. Projections about future economic conditions and the effect they could have on future losses are inherent in the model. Loans with uniquely identified circumstances and risks are individually evaluated. Lifetime losses on these loans are estimated based on the loans’ individual characteristics. Total provision for credit losses for the three months ended June 30, 2023, was $0.45 million, compared to $0.40 million for the three months ended June 30, 2022. The total provision for credit losses for the 6-month period ending June 30, 2023 was $0.5 million, compared to $0.4 million for the same period in the prior year. The current year’s provision is primarily the result of growth in the loan portfolio, partially offset by minimal net recoveries of $0.03 million and reductions in reserves on individually evaluated loans. Based on loan growth and changes in economic conditions, the provision would have been $1.4 million in the second quarter of 2023. This was offset by a reduction in specific reserves of $0.95 million with reduction approximately evenly split between payoffs of nonaccrual loans and improvement in the collateral position on substandard and nonaccruals. Continued improving economic conditions in our markets, as evidenced by unemployment rates below the national average in our two largest population centers, have resulted in improving overall economic trends for businesses, with the impact of higher interest rates and the impact of an inverted yield forecast in our third-party model of economic condition to result in economic slowdown. Note that in discussing ACL allocations, the entire ACL balance is available for any loan that, in management’s judgment, should be charged off. Management believes that the provision recorded for the current year’s three and six-month periods is adequate in view of the present condition of our loan portfolio and the sufficiency of collateral supporting our non-performing loans. We continually monitor non-performing loan relationships and will adjust our provision, as necessary, if changing facts and circumstances require a change in the ACL. In addition, a decline in the quality of our loan portfolio as a result of general economic conditions, factors affecting particular borrowers or our market areas, or otherwise, could all affect the adequacy of our ACL. If there are significant charge-offs against the ACL, or we otherwise determine that the ACL is inadequate, we will need to record an additional provision in the future. 66 Non-interest Income . The following table reflects the various components of non-interest income for the three and six- month periods ended June 30, 2023 and 2022, respectively. Three months ended June 30, Six months ended June 30, 2023 2022 % Change 2023 2022 % Change Non-interest Income: Service charges on deposit accounts $ 488 $ 482 1.24 % $ 973 $ 970 0.31 % Interchange income 591 614 (3.75) % 1,142 1,163 (1.81) % Loan servicing income 499 600 (16.83) % 1,068 1,301 (17.91) % Gain on sale of loans 904 414 118.36 % 1,202 1,136 5.81 % Loan fees and service charges 88 141 (37.59) % 168 233 (27.90) % Net gains (losses) on investment securities 10 (75) N/M 66 (112) N/M Other 333 196 69.90 % 586 394 48.73 % Total non-interest income $ 2,913 $ 2,372 22.81 % $ 5,205 $ 5,085 2.36 % Loan servicing income decreased due to reduced capitalization of mortgage servicing rights resulting from lower mortgage loan origination volume in both the three and six-month periods ended June 30, 2023, compared to the same prior year periods, along with lower mortgage servicing income due to servicing a smaller portfolio. Gain on sale of loans increased in the current three-month period ended June 30, 2023, compared to the three months ended June 30, 2022, due to increased SBA gains, modestly offset by lower mortgage gains. For the six months ended June 30, 2023, compared June 30, 2022, increased SBA gains more that offset lower mortgage gains. Loan fees and services charges are lower for the three and six-month periods ended June 30, 2023, compared to the same periods in 2022 due to lower customer activity . The change in net gains (losses) on investment securities between the three and six months ended June 30, 2023, and the three and six months ended June 30, 2022, is primarily due to the change in valuations of equity securities and a small gain on the sale of available for sale securities in the second quarter of 2023 . 67 Non-interest Expense. The following table reflects the various components of non-interest expense for the three and six-month periods ended June 30, 2023 and 2022, respectively. Three months ended June 30, Six months ended June 30, 2023 2022 % Change 2023 2022 % Change Non-interest Expense: Compensation and related benefits $ 5,336 $ 5,589 (4.53) % $ 10,674 $ 10,987 (2.85) % Occupancy 1,359 1,343 1.19 % 2,782 2,708 2.73 % Data processing 1,444 1,415 2.05 % 2,904 2,716 6.92 % Amortization of intangible assets 193 399 (51.63) % 397 798 (50.25) % Mortgage servicing rights expense, net 148 195 (24.10) % 306 (132) (331.82) % Advertising, marketing and public relations 151 250 (39.60) % 287 462 (37.88) % FDIC premium assessment 203 118 72.03 % 404 233 73.39 % Professional services 306 368 (16.85) % 811 770 5.32 % Gains on repossessed assets, net (9) (2) (350.00) % (38) (9) (322.22) % New market tax credit depletion — 162 N/M — 325 N/M Other 715 625 14.40 % 1,440 1,272 13.21 % Total non-interest expense $ 9,846 $ 10,462 (5.89) % $ 19,967 $ 20,130 (0.81) % Non-interest expense (annualized) / Average assets 2.14 % 2.38 % (9.96) % 2.20 % 2.31 % (5.98) % Amortization of intangible assets for three and six months ended June 30, 2023, decreased from the same prior year periods, as intangible assets related to certain acquisitions have been fully amortized. Mortgage servicing rights expense, net decreased for the three months ended June 30, 2023, compared to the comparable prior year period due to lower forecasted prepayments and the impact of a lower balance of loans serviced for others. Amortization expense increased for the six-month period ended June 30, 2023 due to the impact of a $566 thousand of impairment reversal recorded in the comparable prior year period, partially offset by lower amortization due to lower forecasted prepayments and the impact of a lower balance of loans serviced for others. Advertising, marketing and public relations expense decreased for the three and six months ended June 30, 2023, compared to the prior year periods, as the timing of related spending is expected to be more heavily weighted more toward the last half of 2023 such that 2023 and 2022 yearly expenses are expected to be approximately equal . The FDIC insurance premium increased for the three and six-month period ended June 30, 2023, from the comparable prior year period due to an increase in the FDIC assessment rate. This was partially offset by the favorable impact of increased bank capital ratios, largely due to both a $15 million capital injection following the Company’s subordinated debt issuance in March of 2022, and the impact of growth in the Bank’s retained earnings. Professional services costs decreased during the three months ended June 30, 2023, from the comparable prior year period due to a decrease in the use of outside professionals as projects needing outside professionals decreased. For the six-month period ended June 30, 2023, professional services costs increased due to slightly higher professional services costs in the first quarter of 2023 compared to first quarter 2022, partially offset by the second quarter decrease in 2023. In the first quarter of 2022, the Bank invested $4.1 million in a New Market Tax Credit. Based on the applicable accounting guidance at the time of investment, the related non-tax-deductible asset depletion would have occurred over a 5-year period in lockstep with the recognition of the tax credit. In March of 2023, FASB issued ASU 2023-02, which allows for proportional amortization of tax credit investments that meet certain criteria. We determined that our New Market Tax Credit investment met the criteria of ASU 2023-02 and chose to early adopt using the modified retrospective approach as of January 1, 2023. Under ASU 2023-02, the amortization of the investment is now included in income tax expense. The increase in other expenses during the three and six months ended June 30, 2023, from the comparable prior year periods is largely related to costs related to expenses to support new products and product expansion. 68 Income Taxes. Income tax expense was $1.1 and $2.4 million for the three and six months ended June 30, 2023, respectively, compared to $1.4 and $2.9 million for the three and six months ended June 30, 2022. The effective tax rate was 25.5% for the three and six-month periods ended June 30, 2023, compared to 24.4% and 24.3% for the comparable prior year periods. The higher effective tax rate is due to the impact of the New Market Tax Credit investment depletion, now being included in income tax expense, partially offset by the impact of lower pre-tax income. BALANCE SHEET ANALYSIS Cash and Cash Equivalents. Our cash balances increased $7.6 million to $43.0 million compared to $35.4 million at December 31, 2022, as we increased our interest-bearing cash deposits at the Federal Reserve by $12.4 million at June 30, 2023, compared to December 31, 2022. Investment Securities. We manage our securities portfolio to provide liquidity and enhance income. Our investment portfolio is comprised of securities available for sale and securities held to maturity. Securities available for sale, which represent the majority of our investment portfolio, were $161.1 million at June 30, 2023, compared with $166.0 million at December 31, 2022. The decrease in the available for sale portfolio is primarily due to the sale of $5.1 million of floating-rate SBA backed pass-through securities, principal repayments and an increase in the unrealized loss of $1.7 million arising during the period, partially offset by the purchases of $11.0 million of primarily floating rate SBA backed pass-through securities. Securities held to maturity decreased to $93.8 million at June 30, 2023, compared to $96.4 million at December 31, 2022. This decrease was due to principal repayments. The unrealized loss on the held to maturity portfolio decreased by $0.5 million in the first half of 2023, to $19.1 million. The amortized cost and market values of our available for sale securities by asset categories as of the dates indicated below were as follows: Available for sale securities Amortized Cost Fair Value June 30, 2023 U.S. government agency obligations $ 18,820 $ 18,703 Mortgage-backed securities 94,382 75,976 Corporate debt securities 47,147 40,253 Corporate asset-backed securities 26,823 26,203 Totals $ 187,172 $ 161,135 December 31, 2022 U.S. government agency obligations $ 18,373 $ 18,313 Mortgage-backed securities 97,458 78,610 Corporate debt securities 44,636 40,251 Corporate asset-backed securities 29,877 28,817 Totals $ 190,344 $ 165,991 69 The amortized cost and fair value of our held to maturity securities by asset categories as of the dates noted below were as follows: Held to maturity securities Amortized Cost Fair Value June 30, 2023 Obligations of states and political subdivisions $ 600 $ 551 Mortgage-backed securities 93,200 74,130 Totals $ 93,800 $ 74,681 December 31, 2022 Obligations of states and political subdivisions $ 600 $ 546 Mortgage-backed securities 95,779 76,233 Totals $ 96,379 $ 76,779 The composition of our available for sale portfolios by credit rating as of the dates indicated below was as follows: June 30, 2023 December 31, 2022 Available for sale securities Amortized Cost Fair Value Amortized Cost Fair Value U.S. government agency $ 103,495 $ 85,056 $ 112,477 $ 93,669 AAA 10,546 10,241 8,640 8,334 AA 25,984 25,585 24,591 23,737 A 8,200 7,362 5,700 5,133 BBB 38,947 32,891 38,936 35,118 Non-rated — — — — Total available for sale securities $ 187,172 $ 161,135 $ 190,344 $ 165,991 The composition of our held to maturity portfolio by credit rating as of the dates indicated was as follows: June 30, 2023 December 31, 2022 Held to maturity securities Amortized Cost Fair Value Amortized Cost Fair Value U.S. government agency $ 93,200 $ 74,130 $ 95,779 $ 76,233 AAA — — — — AA — — — — A 600 551 600 546 Total $ 93,800 $ 74,681 $ 96,379 $ 76,779 At June 30, 2023, the Bank has pledged mortgage-backed securities with a carrying value of $30.0 million as collateral against a borrowing line of credit with the Federal Reserve Bank with no borrowings outstanding on this line of credit. As of June 30, 2023, the Bank has pledged U.S. Government Agency securities with a carrying value of $2.0 million and mortgage-backed securities with a carrying value of $2.2 million as collateral against specific municipal deposits. As of June 30, 2023, the Bank also has mortgage-backed securities with a carrying value of $0.2 million pledged as collateral to the Federal Home Loan Bank of Des Moines. At December 31, 2022, the Bank had pledged certain of its mortgage-backed securities with a carrying value of $5.4 million as collateral to secure a line of credit with the Federal Reserve Bank with no borrowings outstanding on this line of credit. As of December 31, 2022, the Bank had pledged certain of its U.S. Government Agency securities with a carrying value of $2.6 million and mortgage-backed securities with a carrying value of $2.2 million as collateral against specific municipal deposits. As of December 31, 2022, the Bank also had mortgage-backed securities with a carrying value of $0.1 million pledged as collateral to the Federal Home Loan Bank of Des Moines. 70 Loans. Total loans outstanding, net of deferred loan fees and costs and unamortized discount on acquired loans, increased by $13.2 million, to $1.42 billion as of June 30, 2023, from $1.41 billion at December 31, 2022. The following table reflects the composition, of our loan portfolio at June 30, 2023, and December 31, 2022: June 30, 2023 December 31, 2022 Amount Percent Amount Percent Real estate loans: Commercial/Agricultural real estate Commercial real estate $ 732,435 51.4 % $ 725,971 51.5 % Agricultural real estate 87,198 6.1 % 87,908 6.2 % Multi-family real estate 208,211 14.6 % 208,908 14.8 % Construction and land development 105,625 7.4 % 102,492 7.3 % Residential mortgage Residential mortgage 119,724 8.4 % 105,389 7.5 % Purchased HELOC loans 3,216 0.2 % 3,262 0.2 % Total real estate loans 1,256,409 88.1 % 1,233,930 87.5 % C&I/Agricultural operating and Consumer Installment Loans: C&I/Agricultural operating Commercial and industrial (“C&I”) 133,763 9.4 % 136,013 9.6 % Agricultural operating 24,358 1.7 % 28,806 2.0 % Consumer installment Originated indirect paper 8,189 0.6 % 10,236 0.7 % Other consumer 6,487 0.5 % 7,150 0.5 % Total C&I/Agricultural operating and Consumer installment Loans 172,797 12.2 % 182,205 12.8 % Gross loans $ 1,429,206 100.3 % $ 1,416,135 100.3 % Unearned net deferred fees and costs and loans in process (2,827) (0.2) % (2,585) (0.2) % Unamortized discount on acquired loans (1,391) (0.1) % (1,766) (0.1) % Total loans (net of unearned income and deferred expense) 1,424,988 100.0 % 1,411,784 100.0 % Allowance for credit losses (23,164) (17,939) Total loans receivable, net $ 1,401,824 $ 1,393,845 71 Allowance for Credit Losses - Loans. The Allowance for Credit Losses - Loans (“ACL”) is a valuation allowance for expected future credit losses in the Company’s loan portfolio as of the balance sheet date. In determining the allowance, the Company estimates credit losses over the loan’s entire contractual term, adjusted for expected prepayments when appropriate. The allowance estimate considers qualitative and quantitative relevant information from internal and external sources relating to historical loss experience; known and inherent risks in our portfolio; information about specific borrowers’ ability to repay; estimated collateral values; current economic conditions; reasonable and supportable forecasts for future conditions; and other relevant factors determined by management. To ensure that the ACL is maintained at an adequate level, a detailed analysis is performed on a quarterly basis and an appropriate provision is made to adjust the allowance. The entire ACL balance is available for any loan that, in management’s judgment, should be charged off. The determination of the ACL requires significant judgement to estimate credit losses. The ACL is measured collectively on a pooled basis when similar risk characteristics exist, and on an individual basis when management determines that the loan does not share similar risk characteristics with other loans. The ACL on loans collectively evaluated is measured using the loss rate model. The Company categorizes its loan portfolio into four segments based on similar risk characteristics. Loans within each segment are pooled based on individual loan characteristics. Aggregated risk drivers are then calculated at a pool level. Risk drivers are identified attributes that have proven to be predictive of loan loss rates and vary based on loan segment and type. A loss rate is calculated and applied to the pool utilizing a model that combines the pool’s risk drivers, historical loss experience, and reasonable and supportable future economic forecasts to project lifetime losses. The loss rate is then combined with the loan’s balance and contractual maturity, adjusted for expected prepayments, to determine expected future losses. Future and supportable economic forecasts are based on national economic conditions and their reversion to the mean is implicit in the model and generally occurs over a period of two years. Qualitative adjustments are made to the allowance calculated on collectively evaluated loans to incorporate factors not included in the model. Qualitative factors include but are not limited to: lending policies and procedures, the experience and ability of lending and other staff, the volume and severity of problem credits, quality of the loan review system, and other external factors. Loans that exhibit different risk characteristics from the pool are individually evaluated for impairment. Loans can be identified for individual evaluation for a variety of reasons including delinquency, nonaccrual status, risk rating and loan modification. Accruing loans that exhibit different risk characteristics from their pool may also be within scope. On these loans, an allowance may be established so that the loan is reported, net, at the lower of (a) its amortized cost; (b) the present value of the loan’s estimated future cash flows using the loan’s existing rate; or (c) at the fair value of any loan collateral, less estimated disposal costs, if the loan is collateral dependent. Collateral dependency is determined using the practical expedient when: 1) the borrower is experiencing financial difficulty; and 2) repayment is expected to be provided substantially through the sale or operation of the collateral. In addition, various regulatory agencies periodically review the ACL. These agencies may require the company to make additions to the ACL or may require that certain loan balances be charged off or downgraded into classified loan categories when the agencies’s evaluation differs from management’s evaluation based on their judgments of collectability from the information available to them at the time of examination. The Allowance for Credit Losses - unfunded commitments is a liability for expected future credit losses on the Company’s commitments to lend. The Company estimates expected credit losses over the contractual period for which the Company is exposed to credit risk, via a contractual obligation to extend credit, unless the obligation is unconditionally cancellable by the Company. The Allowance for Credit Losses - unfunded commitments on off-balance sheet exposures is included in other liabilities on the consolidated balance sheet. On January 1, 2023, the Company adopted Accounting Standards Update (“ASU”) 2016-13, Financial Instruments using the modified retrospective method. This adoption resulted in a $4.7 million increase in the ACL on loans (“ACL - Loans”) and established a $1.5 million ACL on unfunded commitments (“ACL - Unfunded Commitments”). The increase in transition ACL is primarily due to the interaction of change from an incurred loss model to a lifetime loss model and the duration of our portfolio. Since transition, the ACL- Loans modestly increased $0.5 million to $23.2 million at June 30, 2023, representing 1.63% of loans receivable. The allowance for loan losses, prior to the ASU 2016-13 transition, was $17.9 million at December 31, 2022, representing 1.27% of loans receivable. The increase in the ACL - Loans, was due to a provision of $0.5 million and a small amount of net recoveries. The ACL - Unfunded Commitments, established under ASU 2016-13, was $1.5 million at June 30, 2023. During the six months ended June 30, 2023, the ACL - Unfunded Commitments increased $0.01 million due to an increase in projected loss rates. 72 Allowance for Credit Losses - Loans Roll Forward (in thousands, except ratios) June 30, 2023 and Three Months Ended March 31, 2023 and Three Months Ended December 31, 2022 and Twelve Months Ended Allowance for Credit Losses (“ACL”) ACL - Loans, at beginning of period $ 22,679 $ 17,939 $ 16,913 Cumulative effect of ASU 2016-13 adoption — 4,706 — Loans charged off: Commercial/Agricultural real estate (14) (32) (205) C&I/Agricultural operating — — (346) Residential mortgage (10) (14) (68) Consumer installment (16) (11) (48) Total loans charged off (40) (57) (667) Recoveries of loans previously charged off: Commercial/Agricultural real estate 27 3 102 C&I/Agricultural operating 16 15 36 Residential mortgage 36 4 29 Consumer installment 10 12 51 Total recoveries of loans previously charged off: 89 34 218 Net loan recoveries/(charge-offs) (“NCOs”) 49 (23) (449) Additions to ACL - Loans via provision for credit losses charged to operations 436 57 1,475 ACL - Loans, at end of period $ 23,164 $ 22,679 $ 17,939 Average outstanding loan balance $ 1,414,925 $ 1,421,096 $ 1,351,052 Ratios: NCOs (annualized) to average loans (0.01) % 0.01 % 0.03 % Allowance for Credit Losses - Loans Activity by Segment (in thousands, except ratios) Commercial/Agricultural Real Estate C&I/Agricultural operating Residential Mortgage Consumer Installment Unallocated Total Three months ended June 30, 2023 Allowance for Credit Losses - Loans: ACL - Loans, at beginning of period $ 18,496 $ 1,848 $ 2,000 $ 335 $ — $ 22,679 Charge-offs (14) — (10) (16) — (40) Recoveries 27 16 36 10 — 89 Additions to ACL - Loans via provision for credit losses charged to operations 424 (406) 426 (8) — 436 ACL - Loans, at end of period $ 18,933 $ 1,458 $ 2,452 $ 321 $ — $ 23,164 Commercial/Agricultural Real Estate C&I/Agricultural operating Residential Mortgage Consumer Installment Unallocated Total Six months ended June 30, 2023 Allowance for Credit Losses - Loans: ACL - Loans, at beginning of period $ 14,085 $ 2,318 $ 599 $ 129 $ 808 $ 17,939 Cumulative effect of ASU 2016-13 adoption 4,510 (331) 1,119 216 (808) 4,706 Charge-offs (46) — (24) (27) — (97) Recoveries 30 31 40 22 — 123 Additions to ACL - Loans via provision for credit losses charged to operations 354 (560) 718 (19) — 493 ACL - Loans, at end of period $ 18,933 $ 1,458 $ 2,452 $ 321 $ — $ 23,164 73 Allowance for Credit Losses - Loans to Percentage (in thousands, except ratios) June 30, 2023 December 31, 2022 Loans, end of period $ 1,424,988 $ 1,411,784 ACL - Loans $ 23,164 $ 17,939 ACL - Loans to loans, end of period 1.63 % 1.27 % Allowance for Credit Losses - Unfunded Commitments: (in thousands) In addition to the ACL - Loans, the Company has established an ACL - Unfunded Commitments of $1.5 million at June 30, 2023 and $0 at December 31, 2022, classified in other liabilities on the consolidated balance sheets. June 30, 2023 and Three Months Ended June 30, 2023 and Six Months Ended ACL - Unfunded commitments - beginning of period $ 1,530 $ — Cumulative effect of ASU 2016-13 adoption — 1,537 Increases to ACL - Unfunded commitments via provision for credit losses charged to operations 14 7 ACL - Unfunded commitments - end of period $ 1,544 $ 1,544 Nonperforming Loans, Potential Problem Loans and Foreclosed Properties. We practice early identification of nonaccrual and problem loans in order to minimize the Bank’s risk of loss. Nonperforming loans are defined as nonaccrual loans and restructured loans that were 90 days or more past due at the time of their restructure, or when management determines that such classification is warranted. The accrual of interest income is discontinued on our loans according to the following schedule: • Commercial/agricultural real estate loans, past due 90 days or more; • C&I/Agricultural operating loans, past due 90 days or more; • Closed ended consumer installment loans, past due 120 days or more; and • Residential mortgage loans and open-ended consumer installment loans, past due 180 days or more. When interest accruals are discontinued, interest credited to income is reversed. If collection is in doubt, cash receipts on non-accrual loans are used to reduce principal rather than being recorded as interest income. The Company adopted ASU 2022-02 on January 1, 2023, which eliminated special accounting rules for TDRs. Prior to the elimination of the special accounting rules, TDR loans were accounted for under ASC 310-40. A TDR typically involved granting some concession to the borrower involving a loan modification, such as modifying the payment schedule or making interest rate changes. TDR loans may have involved loans that had a charge-off taken against the loan to reduce the carrying amount of the loan to fair market value as determined pursuant to ASC 310-10. 74 The following table identifies the various components of nonperforming assets and other balance sheet information as of the dates indicated below and changes in the ACL for the periods then ended: June 30, 2023 and Six Months Then Ended (1) December 31, 2022 and Twelve Months Then Ended (2) Nonperforming assets: Nonaccrual loans Commercial real estate $ 11,359 $ 5,736 Agricultural real estate 1,712 2,742 Construction and land development 94 — Commercial and industrial 4 552 Agricultural operating 1,436 890 Residential mortgage 1,029 1,253 Consumer installment 29 31 Total nonaccrual loans $ 15,663 $ 11,204 Accruing loans past due 90 days or more 492 246 Total nonperforming loans (“NPLs”) 16,155 11,450 Other real estate owned 1,199 1,265 Other collateral owned — 6 Total nonperforming assets (“NPAs”) $ 17,354 $ 12,721 Average outstanding loan balance $ 1,412,870 $ 1,351,052 Loans, end of period $ 1,424,988 $ 1,411,784 Total assets, end of period $ 1,829,837 $ 1,816,386 ACL - Loans, at beginning of period $ 17,939 $ 16,913 Cumulative effect of ASU 2016-13 adoption 4,706 — Loans charged off: Commercial/Agricultural real estate (46) (205) C&I/Agricultural operating — (346) Residential mortgage (24) (68) Consumer installment (27) (48) Total loans charged off (97) (667) Recoveries of loans previously charged off: Commercial/Agricultural real estate 30 102 C&I/Agricultural operating 31 36 Residential mortgage 40 29 Consumer installment 22 51 Total recoveries of loans previously charged off: 123 218 Net loan recoveries/(charge-offs) (“NCOs”) 26 (449) Additions to ACL - loans via provision for credit losses charged to operations 493 1,475 ACL - Loans, at end of period $ 23,164 $ 17,939 Ratios: ACL-Loans to NCOs (annualized) (44,180.02) % 3,995.32 % NCOs (annualized) to average loans — % 0.03 % ACL-Loans to total loans 1.63 % 1.27 % ACL-Loans to nonaccrual loans 147.89 % 160.11 % Nonaccrual loans to total loans 1.10 % 0.79 % NPLs to total loans 1.13 % 0.81 % NPAs to total assets 0.95 % 0.70 % (1) Loan balances are stated at amortized cost. (2) Loan balances are stated at the unpaid principal balance of the loan. 75 Nonaccrual Loans Roll Forward: Quarter Ended June 30, 2023 March 31, 2023 December 31, 2022 September 30, 2022 June 30, 2022 Balance, beginning of period $ 10,410 $ 11,204 $ 10,772 $ 10,434 $ 11,858 Additions 7,826 154 1,039 257 1,918 Charge offs (23) (49) (37) (4) (437) Transfers to OREO (110) (25) — (27) (65) Return to accrual status — (252) — (117) — Repurchases of government guaranteed loans — — — 517 — Payments received (2,429) (527) (561) (288) (2,830) Other, net (11) (95) (9) — (10) Balance, end of period $ 15,663 $ 10,410 $ 11,204 $ 10,772 $ 10,434 Nonaccrual loans increased by $4.5 million at June 30, 2023, from $11.2 million at December 31, 2022, largely due to adding a $5.4 million hotel loan from special mention to substandard in the second quarter of 2023, partially offset by payments received. Nonperforming assets increased to $17.4 million or 0.95% of total assets at June 30, 2023, compared to $12.7 million, or 0.70% of total assets at December 31, 2022 due to increases in nonaccrual loans. Refer to the “Allowance for Credit Losses - Loans” and “Nonperforming Loans, Potential Problem Loans and Foreclosed Properties” sections above for more information related to nonperforming loans. Below is a summary of loan modifications made to borrowers experiencing financial difficulty during the six months ended June 30, 2023. Term Extension Loan Class Amortized Cost Basis at June 30, 2023 % of Total Class of Financing Receivables Commercial real estate $ 5,337 0.73 % Commercial and industrial $ 8 0.01 % Agricultural operating $ 179 0.73 % Residential mortgage $ 37 0.03 % Other-Than-Insignificant Payment Delay Loan Class Amortized Cost Basis at June 30, 2023 % of Total Class of Financing Receivables Residential mortgage $ 69 0.06 % Other consumer $ 22 0.34 % 76 Included in the nonaccrual loans roll forward table above, for periods prior to the January 1, 2023 adoption of ASU 2022-02 are nonaccrual TDR loans. Nonaccrual TDR loans were $2.6 million at December 31, 2022. December 31, 2022 Number of Modifications Recorded Investment Troubled debt restructurings: Accrual Status Commercial/Agricultural real estate 10 $ 1,336 C&I/Agricultural operating 5 960 Residential mortgage 36 2,875 Consumer installment — — Total loans 51 $ 5,171 The table below shows a summary of criticized loans, split by special mention and substandard for the past five quarters. A $5.4 million commercial real estate loan secured by a hotel (50% LTV at origination) was included in special mention at March 31, 2023, and in the second quarter of 2023 this loan was moved to substandard. A $10.4 million fully secured working capital C&I loan was included in special mention at June 30, 2022. In the third quarter of 2022, this C&I loan balance increased by $2.4 million due to a draw on a secured line of credit. In the fourth quarter of 2022, repayments were made on this C&I loan and in the first quarter of 2023, this C&I loan was paid off. In the second quarter of 2023, a loan relationship of approximately $9 million was added to special mention. Since the issuance of our earnings press release on July 24, 2023, a separate relationship of approximately $9 million was also added to special mention. The increase in substandard loan balances in the June 2023 quarter is due to the hotel loan mentioned above moving from special mention to substandard. See Note 3, “Loans and Allowance for Credit Losses” for additional information. In addition to our discussion of criticized, special mention, and substandard loans above, the following information provides further insights about our loans to certain industries. As of June 30, 2023, hotel loans totaled $91 million with a weighted average LTV of 56% and average balance of $3.4 million. Restaurant loans totaled $51 million, at June 30, 2023. The weighted-average LTV percentage on these restaurant loans was 51% and the average loan balance was $702 thousand. Approximately $37 million of restaurant loans are to franchise quick-service restaurants. At June 30, 2023 we have $45 million of office loans with a weighted average LTV of 66% and average loan balance of $618 thousand. 98% of the related office properties are located outside of large cities. (in thousands) (Loan balance at unpaid principal balance) June 30, 2023 March 31, 2023 December 31, 2022 September 30, 2022 June 30, 2022 Special mention loan balances $ 20,507 $ 6,636 $ 12,170 $ 20,178 $ 17,274 Substandard loan balances 19,203 15,439 17,319 20,227 20,680 Criticized loans, end of period $ 39,710 $ 22,075 $ 29,489 $ 40,405 $ 37,954 Mortgage Servicing Rights. Mortgage servicing rights (“MSR”) assets are initially measured at fair value; assessed at least quarterly for impairment; carried at the lower of the initial capitalized amount, net of accumulated amortization, or estimated fair value. MSR assets are amortized in proportion to and over the period of estimated net servicing income, with the amortization recorded in non-interest expense in the consolidated statement of operations. The valuation of MSRs and related amortization thereon are based on numerous factors, assumptions, and judgments, such as those for: changes in the mix of loans, interest rates, prepayment speeds, and default rates. Changes in these factors, assumptions and judgments may have a material effect on the valuation and amortization of MSRs. Although management believes that the assumptions used to evaluate the MSRs for impairment are reasonable, future adjustment may be necessary if future economic conditions differ substantially from the economic assumptions used to determine the value of MSRs. The fair market value of the Company’s MSR asset remained stable at $5.7 million at both December 31, 2022, and June 30, 2023 as a higher fair value percentage offset the lower balance of loans serviced. At June 30, 2023 and December 31, 2022, the Company did not have an MSR impairment, or related valuation allowance. 77 The unpaid balances of one-to-four family residential real estate loans serviced for others as of June 30, 2023, and December 31, 2022, were $503.0 million and $523.7 million, respectively. The fair market value of the Company’s MSR asset as a percentage of its servicing portfolio at June 30, 2023, and December 31, 2022, was 1.13% and 1.08%, respectively. Deposits. From a quarter-end perspective, deposits have grown since both December 31, 2022 and March 31, 2023. From March 7, 2023 to March 31, 2023, a period closely monitored for unusual withdrawal activity, balances remained stable. Deposit composition changed during the six months ended June 30, 2023, as both business and retail depositors sought higher yields on deposit accounts. For the six months ended June 30, 2023, retail deposits decreased slightly, with customers returning to higher yielding certificates with their money moving from money market and savings accounts to certificate accounts. In January 2023, commercial non-interest-bearing deposits fell as commercial customers decreased their cash balances to support the needs of their businesses. These commercial deposits have modestly recovered at June 30, 2023. Modest brokered deposit growth supplemented deposit growth, with $54.3 million of brokered certificate net growth and $3.2 million new growth of brokered money market accounts. Consumer, commercial and government deposits have been stable since January 31, 2023, and since the two large coastal bank failures in early March. There are no material customer or industry deposit concentrations. A decrease in deposits during January occurred as commercial customers decreased their cash balances to support the needs of their businesses. June 30, 2023 March 31, 2023 December 31, 2022 Consumer deposits $ 790,404 $ 786,614 $ 805,598 Commercial deposits 401,079 391,534 405,733 Public deposits 175,869 194,683 173,548 Brokered deposits 97,330 63,962 39,841 Total deposits $ 1,464,682 $ 1,436,793 $ 1,424,720 At June 30, 2023 our deposit portfolio composition was 54% consumer, 27% commercial, 12% public and 7% brokered deposits. At December 31, 2022 our deposit portfolio composition was 57% consumer, 28% commercial, 12% public and 3% brokered deposits. June 30, 2023 March 31, 2023 December 31, 2022 Non-interest bearing demand deposits $ 261,876 $ 247,735 $ 284,722 Interest bearing demand deposits 358,226 390,730 371,210 Savings accounts 206,380 214,537 220,019 Money market accounts 288,934 309,005 323,435 Certificate accounts 349,266 274,786 225,334 Total deposits $ 1,464,682 $ 1,436,793 $ 1,424,720 Uninsured and uncollateralized deposits were $268.1 million, or 18% of total deposits, at June 30, 2023 and $298.8 million, or 21% of total deposits, at December 31, 2022. Uninsured deposits at June 30, 2023 were $413.0 million, or 28% of total deposits, and $441.2 million, or 31% of total deposits at December 31, 2022, with the difference from the above sentence being fully secured government deposits. On-balance sheet liquidity, collateralized borrowing and uncommitted federal funds availability totaled $611.1 million, or 228% of uninsured and uncollateralized deposits at June 30, 2023. At December 31, 2022 on-balance sheet liquidity, collateralized borrowing and uncommitted federal funds availability totaled $570.0 million, or 191% of uninsured and uncollateralized deposits. 78 Federal Home Loan Bank (FHLB) advances and Other Borrowings. A summary of Federal Home Loan Bank (FHLB) advances and other borrowings at March 31, 2023 and December 31, 2022 is as follows: June 30, 2023 December 31, 2022 Stated Maturity Amount Range of Stated Rates Stated Maturity Amount Range of Stated Rates Federal Home Loan Bank advances (1), (2), (3) (4) 2023 $ 82,000 1.43 % 5.29 % 2023 $ 117,000 1.43 % 4.31 % 2024 20,530 0.00 % 1.45 % 2024 20,530 0.00 % 1.45 % 2025 5,000 1.45 % 1.45 % 2025 5,000 1.45 % 1.45 % 2028 15,000 3.57 % 3.59 % Federal Home Loan Bank advances $ 122,530 $ 142,530 Senior Notes (5) 2034 $ 18,083 6.75 % 7.50 % 2034 $ 23,250 3.00 % 6.75 % Subordinated Notes (6) 2030 $ 15,000 6.00 % 6.00 % 2030 $ 15,000 6.00 % 6.00 % 2032 35,000 4.75 % 4.75 % 2032 35,000 4.75 % 4.75 % $ 50,000 $ 50,000 Unamortized debt issuance costs (726) (841) Total other borrowings $ 67,357 $ 72,409 Totals $ 189,887 $ 214,939 (1) The FHLB advances bear fixed rates, require interest-only monthly payments, and are collateralized by a blanket lien on pre-qualifying first mortgages, home equity lines, multi-family loans and certain other loans which had a pledged balance of $1,040.5 million and $984.9 million at June 30, 2023 and December 31, 2022, respectively. At June 30, 2023, the Bank’s available and unused portion under the FHLB borrowing arrangement was approximately $294.4 million compared to $256.8 million as of December 31, 2022. (2) Maximum month-end borrowed amounts outstanding under this borrowing agreement were $217.5 million and $157.5 million, during the six months ended June 30, 2023 and the twelve months ended December 31, 2022, respectively. (3) The weighted-average interest rate on FHLB borrowings maturing within twelve months as of June 30, 2023 and December 31, 2022 were 4.58% and 4.09%, respectively. (4) FHLB term notes totaling $15.0 million, with 2028 maturity dates, are callable once by the FHLB in December of 2023. (5) Senior notes, entered into by the Company in June 2019 consist of the following: (a) A term note, which was subsequently refinanced in March 2022 and modified in February of 2023, requiring quarterly interest-only payments through March 2027, and quarterly principal and interest payments thereafter. Interest is variable, based on US Prime rate minus 75 basis points with a floor rate of 3.00%. (b) A $5.0 million line of credit, maturing August 1, 2023, that remains undrawn upon. This line was renewed effective August 1, 2023 and will mature August 1, 2024. 79 (6) Subordinated notes resulted from the following: (a) The Company’s Subordinated Note Purchase Agreement entered into with certain purchasers in August 2020, which bears a fixed interest rate of 6.00% for five years. In September 2025, the fixed interest rate will be reset quarterly to equal the three-month term Secured Overnight Financing Rate plus 591 basis points. The note is callable by the Bank when, and anytime after, the floating rate is initially set. Interest-only payments are due semi-annually each year during the fixed interest period and quarterly during the floating interest period. (b) The Company’s Subordinated Note Purchase Agreement entered into with certain purchasers in March 2022, which bears a fixed interest rate of 4.75% for five years. In April 2027, the fixed interest rate will be reset quarterly to equal the three-month term Secured Overnight Financing Rate plus 329 basis points. The note is callable by the Bank when, and anytime after, the floating rate is initially set. Interest-only payments are due semi-annually each year during the fixed interest period and quarterly during the floating interest period. FHLB advances decreased $20.0 million to $122.5 million as of June 30, 2023, compared to $142.5 million as of December 31, 2022. The decrease is a result of decreased funding needs due to increases in deposits partially offset by loan growth, as well as the Bank’s desire to manage its liquidity and increase cash on hand in response to recent events. At June 30, 2023, short-term FHLB advances consisted of $47 million maturing overnight and an additional $30 million of short-term advances maturing in July 2023. The Bank has an irrevocable Standby Letter of Credit Master Reimbursement Agreement with the Federal Home Loan Bank. This irrevocable standby letter of credit (“LOC”) is supported by loan collateral as an alternative to directly pledging investment securities on behalf of a municipal customer as collateral for their interest-bearing deposit balances. The Bank’s current unused borrowing capacity, supported by loan collateral as of June 30, 2023, is approximately $294.4 million. At June 30, 2023 and December 31 2022, the Bank had the ability to borrow $23.9 million and $4.1 million from the Federal Reserve Bank of Minneapolis. The ability to borrow is based on mortgage-backed securities pledged with a carrying value of $30.0 million and $5.4 million as of June 30, 2023 and December 31, 2022, respectively. There were no related Federal Reserve borrowings outstanding as of June 30, 2023, or December 31, 2022. In addition, The Bank has been approved to obtain funding from the Federal Reserve’s new Bank Term Funding Program (“BTFP”). As of June 30, 2023, the Bank has not borrowed from this facility and has not pledged any collateral to this facility. The Bank maintains two unsecured federal funds purchased lines of credit with banking partners which total $70 million. These lines bear interest at the lender banks announced daily federal funds rate, mature daily, and are revocable at the discretion of the lending institution. There were no borrowings outstanding on these lines of credit as of June 30, 2023, or December 31, 2022. Additionally, we have a $5.0 million revolving line of credit which is available as needed for general liquidity purposes. See Note 7, “Federal Home Loan Bank Advances and Other Borrowings” for more information. At June 30, 2023, the Bank has pledged $1.04 billion of loans to secure the current FHLB outstanding advances and letters of credit and to provide the unused borrowing capacity, compared to $0.98 billion of loans pledged at December 31, 2022. Stockholders’ Equity. Total stockholders’ equity was $165.6 million at June 30, 2023, compared to $167.1 million at December 31, 2022. The decrease in stockholder’s equity was attributable to: 1) the $4.4 million cumulative effect adjustment from the adoption of ASU 2016-13; 2) the payment of the annual cash dividend paid in February to common stockholders of $0.29 per share or $3.0 million; and 3) an increase in the unrealized loss on available for sale securities of $1.2 million. These reductions to equity were partially offset by: 1) net income of $6.9 million and 2) the $0.1 million cumulative effect adjustment from the adoption of ASU 2023-02. On July 23, 2021, the Board of Directors adopted a share repurchase program. Approximately 14 thousand shares were repurchased under this program in the second quarter of 2023. There were no shares repurchased during the first quarter of 2023. As of June 30, 2023, an additional 229 thousand shares remain available for repurchase. Liquidity and Asset / Liability Management . Liquidity management refers to our ability to ensure cash is available in a timely manner to meet loan demand, depositors’ needs, and meet other financial obligations as they become due without undue cost, risk, or disruption to normal operating activities. We manage and monitor our short-term and long-term liquidity positions and needs through a regular review of maturity profiles, funding sources, and loan and deposit forecasts to minimize funding risk. A key metric we monitor is our liquidity ratio, calculated as cash and unpledged securities portfolio divided by total assets. At June 30, 2023, our on-balance sheet liquidity ratio decreased to 12.2% percent from 13.0% at December 31, 2022. This was largely due to an increase in pledges of held-to-maturity securities and reductions in the value of available-for-sale securities, partially offset by increases in interest-bearing cash. 80 Consumer, commercial and government deposits have been stable since January 31, 2023, and since the two large coastal bank failures in early March. There are no material customer or industry deposit concentrations. A decrease in deposits during January occurred as commercial customers decreased their cash balances to support the needs of their businesses. At June 30, 2023 our deposit portfolio composition was 54% consumer, 27% commercial, 12% public and 7% brokered deposits. At December 31, 2022 our deposit portfolio composition was 57% consumer, 28% commercial, 12% public and 3% brokered deposits. Uninsured and uncollateralized deposits were $268.1 million, or 18% of total deposits, at June 30, 2023 and $298.8 million, or 21% of total deposits, at December 31, 2022. Uninsured deposits alone at June 30, 2023 were $413.0 million, or 28% of total deposits, and $441.2 million, or 31% of total deposits at December 31, 2022, with the difference being fully secured government deposits. On-balance sheet liquidity, collateralized borrowing and uncommitted federal funds availability was $611.1 million, or 228% of uninsured and uncollateralized deposits at June 30, 2023. At December 31, 2022 on-balance sheet liquidity, collateralized borrowing and uncommitted federal funds availability was $570.0 million, or 191% of uninsured and uncollateralized deposits. Our primary sources of funds are deposits, amortization, prepayments and maturities on the investment and loan portfolios and funds provided from operations. We use our sources of funds primarily to meet ongoing commitments, to pay maturing certificates of deposit and savings withdrawals, and to fund loan commitments. While scheduled payments from the amortization of loans and maturing short-term investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. Although $271.2 million of our $349.3 million (78%) CD portfolio will mature within the next 12 months, we have historically retained a majority of our maturing CD’s. However, due to strategic pricing decisions regarding rate matching and branch closures, our retention rate decreased in 2021 and early 2022. Since June of 2022, we strategically increased deposit pricing, which resulted in modest growth in certificates. Retail non-maturity interest-bearing accounts have increased at approximately the same rate as the certificate accounts, as our customers have moved to higher-yielding certificates and spent money. Through new deposit product offerings to our branch and commercial customers, we are currently attempting to strengthen customer relationships to attract additional non-rate sensitive deposits. However, this is challenging in the current competitive environment. We maintain access to additional sources of funds including FHLB borrowings and lines of credit with the Federal Reserve Bank, and our correspondent banks. We utilize FHLB borrowings to leverage our capital base, to provide funds for our lending and investment activities, and to manage our interest rate risk. Our borrowing arrangement with the FHLB calls for pledging certain qualified real estate, commercial and industrial loans, and borrowing up to 75% of the value of those loans, not to exceed 35% of the Bank’s total assets. Currently, we have approximately $294.4 million available to borrow under this arrangement, supported by loan collateral as of June 30, 2023. We also had borrowing capacity of $23.9 million at the Federal Reserve Bank and have been approved to access the Bank Term Funding Program (“BTFP”) if the need should arise. The bank maintains $70 million of uncommitted federal funds purchased lines with correspondent banks as part of our contingency funding plan. In addition, the Company has a $5.0 million revolving line of credit which is available as needed for general liquidity purposes. While the Bank does not have formal brokered certificate lines of credit with counter parties at June 30, 2023, we believe that the Bank could access this market, which provides an additional potential source of liquidity, as evidenced by access to this market during the past four quarters. See Note 7, “Federal Home Loan Bank and Other Borrowings” of “Notes to Consolidated Financial Statements” which are included in Part I, Item 1, “Financial Statements and Supplementary Data” of this Form 10-Q, for further detail. In reviewing the adequacy of our liquidity, we review and evaluate historical financial information, including information regarding general economic conditions, current ratios, management goals and the resources available to meet our anticipated liquidity needs. Management believes that our liquidity is adequate, and to management’s knowledge, there are no known events or uncertainties that will result or are likely to reasonably result in a material increase or decrease in our liquidity. Off-Balance Sheet Liabilities . In the ordinary course of business, the Bank has entered into off-balance sheet financial instruments, issued to meet customer financial needs. Such financial instruments are recorded in the financial statements when they become payable. These instruments include unused commitments for lines of credit, overdraft protection lines of credit and home equity lines of credit, as well as commitments to extend credit. As of June 30, 2023, the Company had approximately $278.2 million in unused loan commitments, compared to approximately $243.0 million in unused commitments as of December 31, 2022. In addition, there are $4.4 million of commitments for contributions of capital to an SBIC and an investment company at June 30, 2023. These commitments totaled $4.7 million at December 31, 2022. 81 Capital Resources. As of June 30, 2023, and December 31, 2022, as shown in the table below, the Bank’s Tier 1 and Risk-based capital levels exceeded levels necessary to be considered “Well Capitalized” under Prompt Corrective Action provisions. Below are the amounts and ratios for our capital levels as of the dates noted below for the Bank: Actual For Capital Adequacy Purposes To Be Well Capitalized Under Prompt Corrective Action Provisions Amount Ratio Amount Ratio Amount Ratio As of June 30, 2023 (Unaudited) Total capital (to risk weighted assets) $ 230,053 14.7 % $ 125,304 > = 8.0 % $ 156,630 > = 10.0 % Tier 1 capital (to risk weighted assets) 210,459 13.5 % 93,978 > = 6.0 % 125,304 > = 8.0 % Common equity tier 1 capital (to risk weighted assets) 210,459 13.5 % 70,484 > = 4.5 % 101,810 > = 6.5 % Tier 1 leverage ratio (to adjusted total assets) 210,459 11.7 % 72,054 > = 4.0 % 90,067 > = 5.0 % As of December 31, 2022 (Audited) Total capital (to risk weighted assets) $ 221,361 14.2 % $ 124,971 > = 8.0 % $ 156,213 > = 10.0 % Tier 1 capital (to risk weighted assets) 203,422 13.0 % 93,728 > = 6.0 % 124,971 > = 8.0 % Common equity tier 1 capital (to risk weighted assets) 203,422 13.0 % 70,296 > = 4.5 % 101,539 > = 6.5 % Tier 1 leverage ratio (to adjusted total assets) 203,422 11.5 % 70,610 > = 4.0 % 88,262 > = 5.0 % At June 30, 2023, and December 31, 2022, the Bank was categorized as “Well Capitalized” under Prompt Corrective Action Provisions, as determined by the OCC, our primary regulator. Below are the amounts and ratios for our capital levels as of the dates noted below for the Company: Actual For Capital Adequacy Purposes Amount Ratio Amount Ratio As of June 30, 2023 (Unaudited) Total capital (to risk weighted assets) $ 223,802 14.3 % $ 125,304 > = 8.0 % Tier 1 capital (to risk weighted assets) 154,208 9.9 % 93,978 > = 6.0 % Common equity tier 1 capital (to risk weighted assets) 154,208 9.9 % 70,484 > = 4.5 % Tier 1 leverage ratio (to adjusted total assets) 154,208 8.6 % 72,054 > = 4.0 % As of December 31, 2022 (Audited) Total capital (to risk weighted assets) $ 218,737 14.0 % $ 124,971 > = 8.0 % Tier 1 capital (to risk weighted assets) 150,798 9.7 % 93,728 > = 6.0 % Common equity tier 1 capital (to risk weighted assets) 150,798 9.7 % 70,296 > = 4.5 % Tier 1 leverage ratio (to adjusted total assets) 150,798 8.5 % 70,610 > = 4.0 % 82