What changed in this filing

/stocks — the workspaceLOADING

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

2023-03-01 compared with 2022-03-01 · 60 added, 119 removed, 37 unchanged (83% of the section changed)

2 unchanged sentences

A fundamental risk in banking is exposure to market risk, or interest rate risk, since a bank’s net income is largely dependent on net interest income.

The Bank’s ALCO formulates and monitors the management of interest rate risk through policies and guidelines established by it and the full Board of Directors and through review of detailed reports discussed quarterly.

In its consideration of risk limits, the ALCO considers the impact on earnings and capital, the level and direction of interest rates, liquidity, local economic conditions, outside threats and other factors.

Banking is generally a business of managing the maturity and repricing mismatch inherent in its asset and liability cash flows and to provide net interest income growth consistent with the Company’s profit objectives.

During the year ended December 31, 2021, the Company's net interest income increased by 1%, as a result of balance sheet growth even in the face of compression in the net interest margin.

The Company believes it is able to continue to manage its overall interest rate risk position to a moderate level.

Banking is generally a business of managing the maturity and repricing mismatch inherent in its asset and liability cash flows and providing net interest income growth consistent with the Company’s profit objectives.

The Company, through its ALCO and ongoing financial management practices, monitors the interest rate environment in which it operates and adjusts the rates and maturities of its assets and liabilities to remain competitive and to achieve its overall financial objectives subject to established risk limits.

In the current and expected future interest rate environment, the Company has been maintaining its investment portfolio to manage the balance between yield and prepayment/extension risk in its portfolio of mortgage-backed securities should interest rates prove more volatile.

Additionally, the Company has limited call risk in its U.S.

agency investment portfolio.

For the year ended December 31, 2021, the average investment portfolio balances increased by 82% as compared to the average balance at December 31, 2020, in the effort to deploy excess liquidity into higher earning assets in the face of reductions in loan volumes.

Cash flows from mortgage backed securities and calls of U.S.

agency securities were reinvested primarily into a similar combination of mortgage backed securities and agencies.

Additional investments have been made in community bank sub-debt and US Treasury bonds.

The percentage mix of municipal securities decreased to 5% of total investments at December 31, 2021 from 9% at December 31, 2020, as the focus shifted to shorter duration instruments with more cash flow.

The portion of the portfolio invested in mortgage backed securities decreased to 62% at December 31, 2021 from 72% at December 31, 2020 while the portion of the portfolio represented in U.S.

agency investments increased from 16% to 24%.

Shorter duration floating rate corporate bonds were 2% of total investments at December 31, 2021 and SBA bonds, which are included in agency securities, were 3% of total investments at December 31, 2021.

The repricing duration of the investment portfolio was 4.3 years at December 31, 2021 and 3.2 years at December 31, 2020.

The higher duration was due to the new purchases made largely in the second half of the year in a higher rate environment where prepayment speeds are excepted to slow.

In the loan portfolio, the repricing duration was 18 months at December 31, 2021 and 21 months at December 31, 2020, with fixed rate loans amounting to 43% of total loans at December 31, 2021 and 45% at December 31, 2020.

During 2022, average market interest rates were markedly higher and resulted in an inverted yield curve.

As compared to the year 2021, the average two year U.S.

Treasury rate in 2022 increased by 273 basis points from 0.26% to 2.99%.

The average five year U.S.

Treasury rate increased by 214 basis points from 0.86% to 3.00% while the average ten year U.S.

Treasury rate increased by 152 basis points from 1.43% to 2.95%.

In that environment, the Company's result for net interest spread in 2022 was 2.33% compared to 2.59% for the year of 2021.

The decline was due primarily to an increase in the rate on funding costs, of which lower average liquidity was a factor in ultimately reducing the net interest spread.

The Company believes that the change in the net interest spread for the full year 2022 has been consistent with its risk analysis at December 31, 2021 when accounting for balance sheet volume and mix changes.

On an annual basis, the Company back-tests the actual change in its net interest spread against expected change and actual market interest rate movements and other factors impacting actual as compared to projected results.

The loan portfolio increased, most significantly, towards the end of 2022.

The repricing duration on loans was 13 months at December 31, 2022 and 18 months at December 31, 2021, with fixed-rate loans amounting to 38% of total loans at December 31, 2022 and 43% at December 31, 2021.

Variable and adjustable rate loans comprised 62% of total loans at December 31, 2022 and 57% for 2021.

1 unchanged sentence

Treasury interest rate.

The duration of the deposit portfolio slightly decreased to 41 months at December 31, 2021 from 42 months at December 31, 2020.

The Company experienced $792.3 million in total deposit growth for the year ended December 31, 2021 as compared to a total loan decrease of $694.6 million.

While loan growth was impacted in 2021 due to the continuing COVID-19 pandemic and the sale of SBA PPP loans, the Company has continued its emphasis on funding loans in its marketplace, and has continued to achieve disciplined loan pricing, even at the expense of growing new loans.

A disciplined approach to loan pricing has resulted in a loan portfolio yield of 4.62% for the year ended December 31, 2021 as compared to 4.66% for the same period in 2020.

In the competitive interest rate environment of 2021, the interest rates on new loan originations have been below the rates of loan paydowns and payoffs.

Additionally, significant amounts of variable and adjustable rate loans have repriced down to meet market interest rates.

The net unrealized loss before income tax on the investment portfolio was $18.6 million at December 31, 2021 as compared to a net unrealized gain before tax of $22.0 million at December 31, 2020, with $3.0 million of realized net gains recorded during the year ended December 31, 2021.

The net unrealized loss on the investment portfolio was due primarily to higher interest rates at year end 2021 as compared to year end 2020.

At December 31, 2021, the unrealized gain position represented 0.7% of the portfolio’s book value.

Interest rate floors on certain of the Company's variable and adjustable rate loans may provide asset yield protection in a low-interest rate environment;

however, they are also expected to delay the impact of increases to market rates on interest income until such floors have been exceeded.

The majority of loans with floors repriced above those floor levels in 2022, increasing the impact of rising rates on interest income when modeling positive interest rate shocks at December 31, 2022.

This is what the Bank experienced in the first half of 2022 when the first 150 basis points of rate hikes earlier in the year did not exceed the majority of loans' floor rates.

This is why the weighted average rate of the Company's variable rate loans increased by approximately 293 basis points from December 31, 2021 to December 31, 2022 in connection with the 425 basis points in Fed Funds rate hikes caused by actions taken by the FRB.

At December 31, 2022, the Company had a portfolio of 3.1 billion of variable and adjustable rate loans that were subject to interest rate floors with a weighted average rate of 7.08%.

At December 31, 2022, only $241 million of loans held by the Company were earning interest at their floor rate, largely because these loans have not reached their initial adjustment date yet.

The Company has credit Risk Participation Agreements ("RPAs") with institutional counterparties, under which the Company assumes its pro-rata share of the credit exposure associated with a borrower’s performance related to interest rate derivative contracts.

3 unchanged sentences

The changes in fair value for these contracts are recognized directly in earnings.

There can be no assurance that the Company will be able to successfully achieve its optimal asset liability mix, as a result of competitive pressures, customer preferences and the inability to perfectly forecast future interest rates and movements.

One of the tools used by the Company to manage its interest rate risk is a static gap analysis presented below.

The Company also employs an earnings simulation model on a quarterly basis to monitor its interest rate sensitivity and risk and to model its balance sheet cash flows and the related income statement effects in different interest rate scenarios.

The duration of the deposit portfolio decreased to 29 months at December 31, 2022 from 41 months at December 31, 2021.

The Company experienced a total deposit decrease of $1.3 billion for the year ended December 31, 2022 as compared to a total loan increase of $570.0 million for the same period.

This decrease in deposits was primarily the result of rate increases from the Federal Reserve and the related deposit disintermediation associated with those higher rates.

Additionally, the Company’s cost of interest increased by 91 basis points across its interest-bearing deposits, which comprise 63.84% of its total deposits, at December 31, 2022.

Management relies on the use of models in order to measure the expected future impact on interest income of various interest rate environments, as described above.

Through its modeling, the Company makes certain estimates that may vary from actual results.

There can be no assurance that the Company will be able to successfully achieve its optimal asset liability mix, given competitive pressures, customer preferences and the inability to forecast future interest rates and movements with complete accuracy.

The Company employs an earnings simulation model (immediate parallel shifts along the yield curve) on a quarterly basis to monitor its interest rate sensitivity and risk and to model its balance sheet cash flows and the related income statement effects in different interest rate scenarios.

The model utilizes current balance sheet data and attributes and is adjusted for assumptions as to investment maturities (including prepayments), loan prepayments, interest rates and the level of noninterest income and noninterest expense.

Further discussion of the limitations of this analysis are listed below and in Item 1A.

Risk Factors.

The data is then subjected to a “shock test” which assumes a simultaneous change in interest rates up 100, 200, 300 and 400 basis points or down 100, 200 and 300 basis points, along the entire yield curve, but not below zero.

The results are analyzed as to the impact on net interest income, net income and the market equity over the next twelve and twenty-four month periods from December 31, 2022.

In addition to analysis of simultaneous changes in interest rates along the yield curve, changes based on interest rate “ramps” is also performed and reviewed by ALCO, but is not herein disclosed.

In addition to analysis of immediate parallel shifts in interest rates along the yield curve, changes based on interest rate “ramps” is also performed and reviewed by ALCO, but is not herein disclosed.

Such analysis represents the impact of a more gradual change in interest rates, as well as yield curve shape changes.

For the analysis presented below, at December 31, 2021, the simulation assumes a 50 basis point change in interest rates on money market and interest bearing transaction deposits for each 100 basis point change in market interest rates in a decreasing interest rate shock scenario with a floor of 10 basis points, and assumes a 50 basis point change in interest rates on money market and interest bearing transaction deposits for each 100 basis point change in market interest rates in an increasing interest rate shock scenario.

As quantified in the table below, the Company’s analysis at December 31, 2021 shows a moderate effect on net interest income over the next 12 months, as well as a modest effect on the economic value of equity when interest rates are shocked both down 100 and 200 basis points and up 100, 200, 300, and 400 basis points.

This moderate impact is due substantially to the significant level of variable rate and repriceable assets and liabilities and related shorter asset and liability durations.

The repricing duration of the investment portfolio at December 31, 2021 is 4.3 years, the loan portfolio 1.5 years, the interest bearing deposit portfolio 2.65 years and the borrowed funds portfolio 5.8 years.

The following table reflects the result of simulation analysis on the December 31, 2021 asset and liability balances:

For the analysis presented below, at December 31, 2022, the simulation assumes a 70 basis point change in interest rates on interest bearing deposits for each 100 basis point change in market interest rates in a decreasing interest rate shock scenario with a floor of 10 basis points and assumes a 70 basis point change in interest rates on interest bearing deposits for each 100 basis point change in market interest rates in an increasing interest rate shock scenario.

Because competitive market behavior does not necessarily track the trend of interest rates but at times moves ahead of financial market influences, the change in the cost of liabilities may be different than anticipated by the interest rate risk model.

If this were to occur, the effects of a rising or declining interest rate environment may not be in accordance with management’s expectations.

As quantified in the table below, the Company’s analysis at December 31, 2022 shows an increasingly significant effect on net interest income over the next 12 months, as well as an increasingly significant effect on the economic value of equity when interest rates are shocked down 100, 200 and 300 basis points and up 100, 200, 300 and 400 basis points.

This impact is due substantially to the significant level of variable rate and repriceable assets and liabilities and related shorter asset and liability durations.

In a normal rising interest rate environment, the Company expects its interest income on variable and adjustable rate loans to increase and the interest expense on its deposit liabilities to increase based on our funding needs, market conditions and certain contractual obligations.

The following table reflects the result of the simulation analysis on the December 31, 2022 asset and liability balances:

Change in interest

9 unchanged sentences

(200) (11.4) (18.1) (8.9)

The results of simulation analysis are within the relevant policy limits adopted by the Company except for the negative 200 basis point scenario for the market value of portfolio equity, which becomes harder to interpret as assets and liabilities go down to the zero lower bound in the simulation.

(300) (17.7) (28.0) (17.2)

The results of the simulation are within the relevant policy limits adopted by the Company for percentage change in net interest income.

For net interest income, the Company has adopted a policy limit of -10% for a 100 basis point change, -12% for a 200 basis point change, -18% for a 300 basis point change and -24% for a 400 basis point change.

For the market value of equity, the Company has adopted a policy limit of -12% for a 100 basis point change, -15% for a 200 basis point change, -25% for a 300 basis point change and -30% for a 400 basis point change.

Due to the level of market rates at December 31, 2021, all down interest rate shocks (-100, -200, -300 and -400 basis points) leave the Bank with zero and negative rate instruments and are not considered practical or informative.

The changes in net interest income, net income and the economic value of equity in both a higher and lower interest rate shock scenario at December 31,

2021 are not considered to be excessive.

The positive impact of +4.7% in net interest income and +8.1% in net income given a 100 basis point increase in market interest rates at December 31, 2021 compares to +1.6% in net interest income and +2.8% in net income for the same period in 2020 and reflects in large measure the repricing of cash on hand and tempered by the impact of variable and adjustable rate loans that are at floor rates at December 31, 2021 and won’t reprice above floors without more significant rate movements.

Generally speaking, the loss of economic value of portfolio equity in a lower interest rate environment is due to lower values of core deposits more than offsetting the gains in loan and investment values;

The impact of +9.9% in net interest income and +16.4% in net income given a 100 basis point increase in market interest rates at December 31, 2022 compares to +4.7% in net interest income and +8.1% in net income for the same period in 2021 and reflects in large measure the floor rate discussion above.

At the end of 2022, the variable rate loans with floors do not have to overcome their floor rate before their yield adjusts and the income increase is immediate, as opposed to the end of 2021, where a 100 basis point increase would not have moved that subset of loans off their floors, muting the impact of the rate increase on income.

Generally speaking, the loss of Economic Value of Equity ("EVE") in a lower interest rate environment is due to lower values of core deposits more than offsetting the gains in loan and investment values;

while the gain of economic value of portfolio equity in a higher interest rate environment is due to higher value of core deposits more than offsetting lower values of fixed rate loans and investments.

Recent increases in deposit decay rates, however, have lowered the modeled valuation of core deposits.

As a result, the model shows that the value increase of more rate sensitive core deposits in a rising rate environment does not rise fast enough to overcome the valuation decline in assets.

If decay rates return to more normal historical speeds, the normal pattern of increasing income correlating with an increasing EVE (Economic Value of Equity) would return.

The Company believes its balance sheet is well positioned in the current interest rate environment.

During 2021, largely as a result of the COVID-19 pandemic, the Company continued to experience higher levels of deposit growth as compared to loan growth.

This resulted in extraordinary levels of liquidity which management was able to invest in overnight funds and marketable securities.

This event resulted in a decline in the net interest spread.

Additionally, while a significant mix of the deposit growth was in noninterest bearing funds, the value of these interest free funds decreased in the lower market rate environment.

The interest rate risk position at December 31, 2021 was dissimilar to the interest rate risk position at December 31, 2020, in that there was more expected net interest income in rising rates as a percentage.

This is partly a mathematical consequence of starting from a low level for the Net Interest Margin at the end of 2021.

As compared to December 31, 2020, the sum of federal funds sold, interest bearing deposits with banks and other short-term investments and loans held for sale decreased by $120 million at December 31, 2020, and as noted above, there is still a significant amount of variable rate loans that are below floor levels at December 31, 2021.

Certain shortcomings are inherent in the method of analysis presented in the foregoing table.

4 unchanged sentences

Finally, the ability of many borrowers to service their debt may decrease in the event of a significant interest rate increase.

During 2021, average market interest rates were mixed , and resulted in a steepening of the yield curve.

As compared to the year 2020, the average two year U.S.

Treasury rate in 2021 decreased by 13 basis points from 0.39% to 0.26%.

The average five year U.S.

Treasury rate increased by 32 basis points from 0.54% to 0.86% while the average ten year U.S.

Treasury rate increased by 55 basis points from 0.88% to 1.43%.

In that environment, the Company was able to achieve a net interest spread for 2021 of 2.59% compared to 2.81% for the year of 2020.

The decline was due primarily to a decrease in the yield on earnings assets, of which higher average liquidity was a significant factor.

The Company believes that the change in the net interest spread for the full year 2021 has been consistent with its risk analysis at December 31, 2020.

Banks and other financial institutions earnings are significantly dependent upon net interest income, which is the difference between interest earned on earning assets and interest expense on interest bearing liabilities.

Net interest income represented 89% and 88% of the Company’s revenue for the years ended December 31, 2021 and December 31, 2020, respectively.

The Company’s net interest margin was 2.81% for the year ended December 31, 2021, as compared to 3.19% for the year ended December 31, 2020.

The decline in net interest margin for the year ended December 31, 2021 as compared to the year ended December 31, 2020, was due to decreasing average loan balances and the balance sheet asset mix skewing towards lower yielding marketable securities, as the Bank continued to experience high levels of on balance sheet liquidity.

In falling interest rate environments, net interest income is maximized with longer term, higher yielding assets being funded by lower yielding short-term funds, or what is referred to as a negative mismatch or negative gap.

Conversely, in a rising interest rate environment, net interest income is maximized with shorter term, higher yielding assets being funded by longer-term liabilities or what is referred to as a positive mismatch or positive gap.

The gap position, which is a measure of the difference in maturity and repricing volume between assets and liabilities, is a means of monitoring the sensitivity of a financial institution to changes in interest rates.

The chart below provides an indication of the sensitivity of the Company to changes in interest rates.

A negative gap indicates the degree to which the volume of repriceable liabilities exceeds repriceable assets in given time periods.

At December 31, 2021, the Company had a negative gap position of approximately $267 million or 2% of total assets out to three months and a positive cumulative gap position of $102 million or 0.86% of total assets out to 12 months;

as compared to a positive gap position of approximately $464 million or 4% of total assets out to three months and a positive cumulative gap position of approximately $352 million or 3% of total assets out to 12 months at December 31, 2020.

The change in the positive gap position at December 31, 2021, as compared to December 2020, was due to the increase in savings and money market accounts and moving those balances into the securities portfolio rather than holding them all in short term cash accounts.

The change in the gap position at December 31, 2021 as compared to December 31, 2020 is not deemed material to the Company’s overall interest rate risk position.

The overall interest rate risk position relies more heavily on simulation analysis, which captures the full optionality within the balance sheet.

The current position is within guideline limits established by the ALCO.

While management believes that this overall position creates a reasonable balance in managing its interest rate risk and maximizing its net interest margin within plan objectives, there can be no assurance as to actual results.

Management has carefully considered its strategy to maximize interest income by reviewing interest rate levels, economic indicators and call features within its investment portfolio.

These factors have been discussed with the ALCO and management believes that current strategies are appropriate to current economic and interest rate trends.

If interest rates increase by 100 basis points, the Company’s net interest income and net interest margin are expected to increase due to the repricing of variable rate assets and the assumption of an increase in money market interest rates by 50% of the change in market interest rates.

If interest rates decline by 100 basis points, the Company’s net interest income and margin are expected to decline modestly as the impact of lower market rates on a large amount of liquid assets more than offsets the ability to lower interest rates on interest bearing liabilities.

If this were to occur, the effects of a declining interest rate environment may not be in accordance with management’s expectations.

December 31, 2021

(dollars in thousands)

Repricible in:

0-3 months 4-12 months 13-36 months 37-60 months Over 60 months Total Rate

Sensitive Non Sensitive Total

RATE SENSITIVE ASSETS:

Investment securities $ 175,592 $ 282,605 $ 584,996 $ 571,101 $ 1,009,114 $ 2,623,408

3,668,220 762,802 1,509,019 692,713 480,061 7,112,815

Fed funds and other short-term investments 1,701,337 — — — — 1,701,337

Other earning assets 108,789 — — — — 108,789

Total $ 5,653,938 $ 1,045,407 $ 2,094,015 $ 1,263,814 $ 1,489,175 $ 11,546,349 300,961 $ 11,847,310

RATE SENSITIVE LIABILITIES:

Noninterest bearing demand (3)

$ 117,696 $ 327,398 $ 710,692 $ 524,335 $ 1,597,834 $ 3,277,955

Interest bearing transaction 777,255 — — — — 777,255

Savings and money market 4,872,248 — 225,000 100,000 5,197,248

Time deposits 129,459 349,102 226,683 20,708 3,130 729,082

Customer repurchase agreements and fed funds purchased 23,918 — — — — 23,918

Other borrowings — 69,670 — 300,000 369,670

Total $ 5,920,576 $ 676,500 $ 1,232,045 $ 645,043 $ 1,900,964 $ 10,375,128 121,407 $ 10,496,535

Gap $ (266,638) $ 368,907 $ 861,970 $ 618,771 $ (411,789) $ 1,171,221

Cumulative Gap $ (266,638) $ 102,269 $ 964,239 $ 1,583,010 $ 1,171,221

Cumulative gap as percent of total assets (2.25) % 0.86 % 8.14 % 13.36 % 9.89 %

OFF BALANCE-SHEET:

Interest Rate Swaps - Fed Funds based — — — — — $ —

Total $ — $ — $ — $ — $ — $ — $ — $ —

Gap $ (266,638) $ 368,907 $ 861,970 $ 618,771 $ (411,789) $ 1,171,221

Cumulative Gap $ (266,638) $ 102,269 $ 964,239 $ 1,583,010 $ 1,171,221

Cumulative gap as percent of total assets (2.25) % 0.86 % 8.14 % 13.36 % 9.89 %

(1) Includes loans held for sale

(2) Nonaccrual loans are included in the over 60 months category

(3) Non-Interest Bearing demand, while assumed to be non-rate sensitive, are displayed based on the expected deposit decay period

The sum of federal funds sold, interest bearing deposits with banks and other short-term investments decreased by $80 million at December 31, 2021 as compared to December 31, 2020.

Although NOW and money market accounts are subject to immediate repricing, the Bank generally expects there to be a lag in rate changes based on our experience that could change the actual results from what is modeled here.

While an instantaneous parallel shift in interest rates was used in this analysis to provide an estimate of exposure under these scenarios, we believe that a non-immediate parallel shifts in interest rates would have a more modest impact.

Further, the earnings simulation model does not take into account factors such as future balance sheet growth, changes in product mix, changes in yield curve relationships, the various rate indexes do not move in parallel (e.g.

SOFR, LIBOR, Fed Funds), hedging activities we might take and changing product spreads that could mitigate any potential beneficial or adverse impact of changes in interest rates.

Another key factor to consider is the behavior of our deposit portfolio in the baseline forecast and in alternate interest rate scenarios set out in the table above is a key assumption in our projected estimates of net interest income.

The projected impact on net interest income in the table above assumes no change in deposit portfolio size or mix from the baseline forecast in alternative rate environments.

In higher rate scenarios, any customer activity resulting in the replacement of low-cost or noninterest-bearing deposits with higher-yielding deposits or market-based funding would reduce the assumed benefit of those deposits.

The projected impact on net interest income in the table above also assumes a "through-the-cycle" non-maturity deposit beta which may not be an accurate predictor of actual deposit rate changes realized in scenarios of smaller and/or non-parallel interest rate movements.

Each of the above analyses may not, on its own, be an accurate indicator of how our net interest income will be affected by changes in interest rates.

Income associated with interest-earning assets and costs associated with interest-bearing liabilities may not be affected uniformly by changes in interest rates.

In addition, the magnitude and duration of changes in interest rates may have a significant impact on net interest income.

For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react to different degrees to changes in market interest rates.

Interest rates on certain types of assets and liabilities fluctuate in advance of changes in general market rates, while interest rates on other types may lag behind changes in general market rates.

In addition, certain assets, such as adjustable-rate mortgage loans, have features (generally referred to as interest rate caps and floors) that limit changes in interest rates.

Prepayment and early withdrawal levels also could deviate significantly from those assumed in calculating the maturity of certain instruments.

The ability of many borrowers to service their debts also may decrease during periods of rising interest rates.

ALCO reviews each of the above interest rate sensitivity analyses along with several different interest rate scenarios as part of its responsibility to provide a satisfactory, consistent level of profitability within the framework of established liquidity, loan, investment, borrowing and capital policies.

Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-K

Item 7A. Quantitative and Qualitative Disclosures About Market Risk