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Item 7A. Quantitative and Qualitative Disclosures About Market Risk

2024-02-29 compared with 2023-03-01 · 55 added, 27 removed, 70 unchanged (54% of the section changed)

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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 monthly by ALCO and quarterly by the Board.

The Bank’s ALCO formulates and monitors the management of interest rate risk through policies and guidelines established by it and overseen by the Audit Committee and the full Board 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 providing net interest income growth consistent with the Company’s profit objectives.

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

During the year ended December 31, 2023, the Company was able to produce a net interest margin of 2.53% as compared to 2.93% during the same period in 2022 and continues to manage its overall interest rate risk position.

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.

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

During 2023, average market interest rates were increased across the yield curve as compared to the 2022 year end.

As compared to the year 2022, the average two year U.S.

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Treasury rate increased by 101 basis points from 2.95% to 3.96%.

The Company’s cost of interest bearing deposits increased by 96 basis points across its interest-bearing deposits, which comprise 74% of its total deposits, at December 31, 2023.

In that environment, the Company's result for net interest spread in 2023 was 1.28% compared to 2.33% for the year of 2022.

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 decline in the net interest spread 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 2023 has been consistent with its risk analysis at December 31, 2022 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.

Variable rate loans are generally indexed to either the one-month London Interbank Offered Rate (“LIBOR”) with fallback language to reference the Secured Overnight Funding Rate ("SOFR") or the Wall Street Journal prime interest rate, while adjustable rate loans are indexed primarily to the five year U.S.

Treasury interest rate.

Although the Company has experienced net interest margin compression during the year ended December 31, 2023, the Company's interest rate risk modeling shows net interest margin expansion in an increasing rate environment.

The model's prediction is the result of increases in both interest income on variable and adjustable rate loans and interest expense on its deposit liabilities, based on our funding needs, market conditions and certain contractual obligations but with no changes in the mix of assets or liabilities or the spreads we are able to earn.

The model also assumes a stable interest rate environment after the programmed rate change, allowing assets and liabilities to reprice at their schedule in a stable environment, which may be quite different than real world conditions.

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.

however, they are also expected to delay the impact of increases to market rates on interest income until such floors have been exceeded, although this is not relevant for the current rate environment with most variable rate loans well above their floor rate.

The weighted average rate of the Company's variable rate loans increased by approximately 85 basis points from December 31, 2022 to December 31, 2023 in connection with the increase in 100 basis points for the same period in Fed Funds rate hikes caused by actions taken by the Federal Reserve Bank.

At December 31, 2023, the Company had a portfolio of $3.0 billion of variable and adjustable rate loans that were subject to interest rate floors with a weighted average rate of 7.99%.

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.

At December 31, 2023, only $183.9 million of loans held by the Company were earning interest at their floor rate, as compared to $241.0 million at December 31, 2022.

The majority of those loans are expected to reset at rates higher than their floor at their next rate reset date.

The loan portfolio increased throughout 2023.

The re-pricing duration on the loan portfolio was 12 months at December 31, 2023 and 13 months at December 31, 2022, with fixed-rate loans amounting to 38% of total loans at December 31, 2023 and 2022.

Variable and adjustable rate loans comprised 62% of total loans at December 31, 2023 and 2022.

Variable rate loans are generally indexed to either the one-month London Interbank Offered Rate (“LIBOR”) (prior to the June 30, 2023 LIBOR cessation date), with fallback language to reference the Secured Overnight Funding Rate ("SOFR"), or the Wall Street Journal prime interest rate, while adjustable rate loans are indexed primarily to the five year U.S.

Treasury interest rate.

The few remaining loans that were still tied to LIBOR based rates on June 30, 2023 were transitioned to their appropriate fallback rate on July 3, 2023.

In the current and expected future interest rate environment, the Company has been maintaining its investment portfolio with the goal of managing the balance between yield and risk in its portfolio of MBS.

Further, the Company has been principally collecting cash flows from the investment portfolio to provide liquidity.

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

agency investment portfolio.

At December 31, 2023, the amortized cost less allowance of the investment portfolio decreased by $213.2 million, or 7.4%, as compared to the balance at December 31, 2022.

The percentage mix of municipal securities was 5% of total investments at December 31, 2023 and 2022.

The portion of the portfolio invested in MBS was 61% and 63% at December 31, 2023 and 2022.

The portion of the portfolio invested in U.S.

agency investments was 27% at December 31, 2023 and 25% at December 31, 2022.

Corporate bonds made up 5% of total investments at December 31, 2023 and 2022.

treasury bonds were 2% of total investments at December 31, 2023 and 2022.

The duration of the investment portfolio decreased to 4.4 years at December 31, 2023 from 4.8 years at December 31, 2022.

At December 31, 2023, $79.3 million of corporate bonds were subordinated debt from other financial institutions.

Corporate bonds generally, and subordinated debt in particular, pose credit risk such that if any of these issuers were to enter bankruptcy or insolvency proceedings, we could experience losses that may be material to operating results and our financial condition.

We may also experience increases in provisions for credit losses, adversely affecting our net income, if the creditworthiness of the issuers declines, whether due to idiosyncratic factors, economic conditions generally or otherwise.

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.

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Total expected exposure incorporates both the current and potential future exposure of the derivatives, derived from using observable inputs, such as yield curves and volatilities.

These derivatives are not designated as hedges, are not speculative and have a notional value of $25.9 million as of December 31, 2022.

These derivatives are not designated as hedges, are not speculative and have an asset position with a notional value of $49.5 million as of December 31, 2023.

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

The duration of the deposit portfolio decreased to 28 months at December 31, 2023 from 29 months at December 31, 2022.

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.

The Company experienced a total deposit increase of $94.9 million for the year ended December 31, 2023 as compared to a total loan increase of $333.1 million for the same period.

The shortfall was funded by increased borrowings, primarily with BTFP borrowings during the year ended December 31, 2023.

The funding mix has continued to change throughout the year ended December 31, 2023.

Deposits at year end were $8.8 billion and $8.7 billion at December 31, 2023 and 2022, respectively.

The increase was primarily attributable to a $1.4 billion increase in interest bearing time deposits, offset by a $871.7 million reduction in noninterest bearing deposits and a $326.7 million reduction in savings and money market accounts as a result of an increase of disintermediation driven primarily by an increase in interest rates.

The growth in interest bearing deposits was driven by the increased utilization of brokered deposits, particularly brokered time deposits, during the year ended December 31, 2023, as discussed in "Deposits and Other Borrowings" above.

Additionally, the Company’s cost of interest increased by 269 basis points across its interest-bearing deposits, which comprise 74.12% of its total deposits, at December 31, 2022.

The net unrealized loss before income tax on the investment securities available-for-sale portfolio was $162.0 million and $205.3 million at December 31, 2023 and 2022, respectively.

At December 31, 2023, the net unrealized loss position represented 9.72% of the investment portfolio's book value.

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.

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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.

The model utilizes current balance sheet data and attributes and is adjusted for assumptions as to investment maturities (including prepayments), loan prepayments, interest rates, deposit decay 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.

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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, 2023.

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.

In addition to analysis of simultaneous changes in interest rates along the yield curve, an analysis of changes based on interest rate “ramps” is also performed.

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, 2023, the simulation assumes a 100 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 100 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.

The Bank does have deposits with contractual terms which means these deposits will change 100 basis points for every 100 basis points change in market rates.

Thus, the overall measure of the correlation between deposit costs and market rate changes is modeled at 100%.

At December 31, 2022, the Company assumed a 70 basis point change in interest rates on interest bearing deposits for each 100 basis point change in market interest rates, with a floor of 10 basis points and 0 basis points on decreasing and increasing rate shock scenarios, respectively.

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.

As quantified in the table below, the Company’s analysis at December 31, 2023 shows a moderate effect on net interest income over the next 12 months, as well as a moderate 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 moderate impact is due substantially to the significant level of variable rate and repriceable assets and liabilities and related shorter relative durations.

The repricing duration of the investment portfolio at December 31, 2023 is 4.4 years, the loan portfolio 1.0 years, the interest bearing deposit portfolio 1.2 years, and the borrowed funds portfolio 0.3 years.

The following table reflects the result of the simulation analysis on the December 31, 2023 asset and liability balances:

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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.

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.

The impact of (0.4)% in net interest income and (0.9)% in net income given a 100 basis point increase in market interest rates at December 31, 2023 compares to 9.9% in net interest income and 16.4% in net income for the same period in 2022 and reflects in large measure the beta factor discussion above.

At the end of 2023 compared in the end of 2022, increasing rates do not lead to increased income because we model that rate increases pass through to our borrowers basis point for basis point as opposed to the prior year where our model suggested rising rates would not be fully passed on to depositors.

The changes in net interest income, net income and the economic value of equity in higher interest rate shock scenarios at December 31, 2023 are not believed to be excessive.

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

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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.

SOFR, 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.

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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