FIRST BUSINESS FINANCIAL SERVICES, INC. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations General Unless otherwise indicated or unless the context requires otherwise, all references in this Report to the “Corporation,” “we,” “us,” “our,” or similar references mean First Business Financial Services, Inc. together with our subsidiary. “FBB” or the “Bank” refers to our subsidiary, First Business Bank. Forward-Looking Statements This report may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995, which reflect our current views with respect to future events and financial performance. Forward-looking statements are not based on historical information, but rather are related to future operations, strategies, financial results, or other developments. Forward-looking statements are based on management’s expectations as well as certain assumptions and estimates made by, and information available to, management at the time the statements are made. Such statements are subject to risks and uncertainties, including among other things: • Adverse changes in the economy or business conditions, either nationally or in our markets, including, without limitation, the adverse effects of the COVID-19 pandemic on the global, national, and local economy, which may affect the Corporation’s credit quality, revenue, and business operations. • Competitive pressures among depository and other financial institutions nationally and in our markets. • Increases in defaults by borrowers and other delinquencies. • Our ability to manage growth effectively, including the successful expansion of our client support, administrative infrastructure, and internal management systems. • Fluctuations in interest rates and market prices. • The consequences of continued bank acquisitions and mergers in our markets, resulting in fewer but much larger and financially stronger competitors. • Changes in legislative or regulatory requirements applicable to us and our subsidiaries. • Changes in tax requirements, including tax rate changes, new tax laws, and revised tax law interpretations. • Fraud, including client and system failure or breaches of our network security, including our internet banking activities. • Failure to comply with the applicable SBA regulations in order to maintain the eligibility of the guaranteed portions of SBA loans. These risks could cause actual results to differ materially from what we have anticipated or projected. These risk factors and uncertainties should be carefully considered by our stockholders and potential investors. See Part I, Item 1A — Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2020 for discussion relating to risk factors impacting us. Investors should not place undue reliance on any such forward-looking statements, which speak only as of the date made. The factors described within this Form 10-Q could affect our financial performance and could cause actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods. Where any such forward-looking statement includes a statement of the assumptions or bases underlying such forward-looking statement, we caution that, while our management believes such assumptions or bases are reasonable and are made in good faith, assumed facts or bases can vary from actual results, and the differences between assumed facts or bases and actual results can be material, depending on the circumstances. Where, in any forward-looking statement, an expectation or belief is expressed as to future results, such expectation or belief is expressed in good faith and believed to have a reasonable basis, but there can be no assurance that the statement of expectation or belief will be achieved or accomplished. We do not intend to, and specifically disclaim any obligation to, update any forward-looking statements. The following discussion and analysis is intended as a review of significant events and factors affecting our financial condition and results of operations for the periods indicated. The discussion should be read in conjunction with the unaudited Consolidated Financial Statements and the Notes thereto presented in this Form 10-Q. 40 Table of Contents Overview We are a registered bank holding company incorporated under the laws of the State of Wisconsin and are engaged in the commercial banking business through our wholly-owned banking subsidiary, FBB. All of our operations are conducted through FBB and First Business Specialty Finance, LLC (“FBSF”), a wholly-owned subsidiary of FBB. We operate as a business bank focusing on delivering a full line of commercial banking products and services tailored to meet the specific needs of small and medium-sized businesses, business owners, executives, professionals, and high net worth individuals. Our products and services include those for business banking, private wealth, and bank consulting. Within business banking, we offer commercial lending, consumer and other lending, asset-based lending, accounts receivable financing, equipment financing, floorplan financing, vendor financing, SBA lending and servicing, treasury management services, and company retirement plans. Our private wealth services for executives and individuals include trust and estate administration, financial planning, investment management, and private banking. For other financial institutions, our bank consulting experts provide investment portfolio administrative services, asset liability management services, and asset liability management process validation. We do not utilize a branch network to attract retail clients. Our operating philosophy is predicated on deep client relationships within our commercial bank markets and skilled expertise within our nationwide specialty finance business lines, combined with the efficiency of centralized administrative functions, such as information technology, loan and deposit operations, finance and accounting, credit administration, compliance, marketing, and human resources. Our focused model allows experienced staff to provide the level of financial expertise needed to develop and maintain long-term relationships with our clients. Financial Performance Summary Results as of and for the three and six months ended June 30, 2021 include: • Net income totaled $8.2 million, or diluted earnings per share of $0.95, for the three months ended June 30, 2021, compared to $3.3 million, or diluted earnings per share of $0.38, for the same period in 2020. Net income totaled $18.0 million, or diluted earnings per share of $2.08, for the six months ended June 30, 2021, compared to $6.6 million, or diluted earnings per share of $0.77, for the same period in 2020. • Annualized return on average assets and annualized return on average equity for the three months ended June 30, 2021 measured 1.26% and 15.09%, respectively, compared to 0.55% and 6.70% for the same period in 2020. Annualized return on average assets and annualized return on average equity for the six months ended June 30, 2021 measured 1.38% and 16.75%, respectively, compared to 0.58% and 6.92% for the same period in 2020. • Pre-tax, pre-provision adjusted earnings, which excludes certain one-time and discrete items, totaled $10.0 million for the three months ended June 30, 2021, up 2.4% from the same period in 2020. Pre-tax, pre-provision adjusted return on average assets was 1.53% for the three months ended June 30, 2021, compared to 1.61% for the same period in 2020. Pre-tax, pre-provision adjusted earnings totaled $20.6 million for the six months ended June 30, 2021, up 18.9% from the same period in 2020. Pre-tax, pre-provision adjusted return on average assets was 1.59% for the six months ended June 30, 2021, compared to 1.53% for the same period in 2020. • Net interest margin was 3.49% for the three months ended June 30, 2021, up from 3.34% for the same period in 2020. Adjusted net interest margin, which excludes certain one-time and volatile items, was 3.20% for the three months ended June 30, 2021 compared to 3.32% for the same period in 2020. Net interest margin was 3.46% for the six months ended June 30, 2021, up from 3.39% for the same period in 2020. Adjusted net interest margin was 3.20% for the six months ended June 30, 2021 compared to 3.32% for the same period in 2020. • Fees in lieu of interest, defined as prepayment fees, asset-based loan fees, non-accrual interest, and loan fee amortization, totaled $3.5 million for the three months ended June 30, 2021 compared to $2.3 million for the three months ended June 30, 2020. Fees in lieu of interest totaled $6.6 million for the six months ended June 30, 2021 compared to $3.1 million for the six months ended June 30, 2020. • Top line revenue, defined as net interest income plus non-interest income, totaled $28.0 million for the three months ended June 30, 2021, up 11.0% from the same period in 2020. Top line revenue totaled $56.0 million for the six months ended June 30, 2021, up 15.1% from the same period in 2020. • Provision for loan and lease losses was a benefit of $958,000 for the three months ended June 30, 2021 compared to an expense of $5.5 million for the same period in 2020. Provision for loan and lease losses was a benefit of $3.0 million for the six months ended June 30, 2021 compared to an expense of $8.7 million for the same period in 2020. • Non-interest income totaled $6.3 million for both the three months ended June 30, 2021 and 2020. Non-interest income totaled $13.5 million for the six months ended June 30, 2021, up 6.1% from the same period in 2020. • Non-interest expense was $18.2 million for the three months ended June 30, 2021 compared to $18.3 million for the three months ended June 30, 2020. Operating expense, which excludes certain one-time and discrete items, totaled $17.9 million for the three months ended June 30, 2021, up 16.2% compared to $15.4 million for the three months ended June 30, 2020. Non-interest expense was $35.5 million for the six months ended June 30, 2021 compared to 41 Table of Contents $34.5 million for the six months ended June 30, 2020. Operating expense totaled $35.4 million for the six months ended June 30, 2021, up 12.9% compared to $31.3 million for the six months ended June 30, 2020. • The efficiency ratio was 64.17% for the three months ended June 30, 2021, up from 61.22% for the three months ended June 30, 2020. The efficiency ratio improved to 63.18% for the six months ended June 30, 2021, down from 64.36% for the six months ended June 30, 2020. • Total assets at June 30, 2021 increased $297.8 million to $2.866 billion from $2.568 billion at December 31, 2020. • Period-end gross loans and leases receivable were $2.144 billion and $2.146 billion as of June 30, 2021 and December 31, 2020, respectively. Average gross loans and leases of $2.223 billion increased $240.2 million, or 12.1%, for the three months ended June 30, 2021, compared to $1.983 billion for the same period in 2020. • Period-end gross loans and leases receivable, excluding net PPP loans, at June 30, 2021 increased $102.2 million, or 10.6% annualized, to $2.023 billion from $1.921 billion as of December 31, 2020. Average gross loans and leases, excluding net PPP loans, of $1.994 billion increased $263.9 million, or 15.3%, for the three months ended June 30, 2021, compared to $1.730 billion for the same period in 2020. • Period-end gross PPP loans and PPP deferred processing fees were $123.8 million and $3.1 million, respectively, at June 30, 2021. Average PPP loans, net of deferred processing fees, were $229.2 million for the three months ended June 30, 2021. • Non-performing assets were $11.6 million and 0.40% of total assets as of June 30, 2021, compared to $26.7 million and 1.04% of total assets as of December 31, 2020. Non-performing assets to total assets, excluding net PPP loans, was 0.42% as of June 30, 2021, compared to 1.14% as of December 31, 2020. • The allowance for loan and lease losses decreased $2.8 million, or 10.0%, compared to December 31, 2020. The allowance for loan and lease losses decreased to 1.20% of total loans, compared to 1.33% at December 31, 2020. Excluding net PPP loans, the allowance for loan and lease losses decreased to 1.27% of total loans as of June 30, 2021, compared to 1.48% as of December 31, 2020. • Period-end in-market deposits at June 30, 2021 increased $333.2 million to $2.016 billion from $1.683 billion as of December 31, 2020. Average in-market deposits of $1.735 billion increased $164.8 million, or 10.5%, for the six months ended June 30, 2021, compared to $1.571 billion for the same period in 2020. • Private wealth and trust assets under management and administration increased by $315.4 million, or 28.0% annualized, to $2.564 billion at June 30, 2021, compared to $2.249 billion at December 31, 2020. COVID-19 Update Paycheck Protection Program On December 27, 2020, the Consolidated Appropriations Act, 2021 (“CAA”) was signed into law. The CAA is a $2.3 trillion spending bill that combines $900 billion in stimulus relief for the COVID-19 pandemic in the United States with a $1.4 trillion omnibus spending bill for the 2021 federal fiscal year and prevents a government shutdown. The CAA allows for a second draw for certain businesses under the PPP. Like the original program, loan proceeds are available to help fund payroll and group health benefit costs, as well as certain mortgage interest, rent and utilities. In addition, authorized costs now also include COVID-19 related worker protection costs, uninsured property damage costs due to looting or vandalism during 2020 and certain supplier costs and expenses for operations. The CAA also expands benefit costs to include group dental, vision, life and disability benefits. All of these changes are generally retroactive to the original CARES Act, meaning that the changes may be taken into account in processing loan forgiveness with respect to an original PPP loan. The Corporation began accepting and processing applications for second draw PPP loans on January 13, 2021. As of June 30, 2021, the Corporation had $123.8 million in gross PPP loans outstanding and deferred processing fees outstanding of $3.1 million. The processing fees are deferred and recognized over the contractual life of the loan, or accelerated at forgiveness, as an adjustment of yield using the interest method. During the three and six months ended June 30, 2021, $2.5 million and $4.8 million, respectively, was recognized in loans and leases interest income in the unaudited Consolidated Statements of Income. The SBA provides a guaranty to the lender of 100% of principal and interest, unless the lender violated an obligation under the agreement. As loan losses are expected to be immaterial, if any at all, due to the guaranty, management excluded the PPP loans from the allowance for loan and lease losses calculation. Management funded these short-term loans primarily through a combination of excess cash held at the Federal Reserve and from an increase in in-market deposits. Deferral Requests The Corporation provided loan modifications deferring payments for certain borrowers impacted by COVID-19 who were current in their payments at the inception of the Corporation’s loan modification program. Excluding gross PPP loans, as of June 30, 2021, the Corporation had deferred loans outstanding of $20.5 million, or 1.0% of gross loans and leases, compared to $27.0 million, or 1.4% of gross loans and leases as of December 31, 2020. Of the $20.5 million of deferred loans outstanding, which relate to five credits in total, $19.8 million relates to two hospitality credits that went on deferral during the 42 Table of Contents second quarter of 2021 and are both accruing and current on payments. Management believes there will be no losses associated with these two credits. The following tables represent a breakdown of the deferred loan balances by industry segment and collateral type: As of June 30, 2021 Collateral Type Industries Description Balance Real Estate Non Real Estate (In Thousands) Accommodation and Food Services $ 19,811 $ 19,811 $ — Manufacturing 310 310 — Agriculture, Forestry, Fishing, and Hunting 210 — 210 Educational Services 195 195 — Total deferred loan balances $ 20,526 $ 20,316 $ 210 The following table is a further breakdown of the deferred loan balances by certain credit quality indicators. Please refer to Note 6 — Loan and Lease Receivables, Impaired Loans and Leases and Allowance for Loan and Lease Losses for the risk category definitions. As of June 30, 2021 Category I II III IV Total (Dollars in Thousands) Total deferred loan balances $ 505 $ 210 $ 19,811 $ — $ 20,526 % of Total 2.5 % 1.0 % 96.5 % — % 100.0 % As of December 31, 2020 Category I II III IV Total (Dollars in Thousands) Total deferred loan balances $ 13,466 $ 13,448 $ 58 $ 38 $ 27,010 % of Total 49.9 % 49.8 % 0.2 % 0.1 % 100.0 % Exposure to Stressed Industries Certain industries have been and are expected to be particularly impacted by social distancing, quarantines, and the economic impact of the COVID-19 pandemic, such as the following: As of June 30, 2021 December 31, 2020 Industries: Balance % Gross Loans and Leases (1) Balance % Gross Loans and Leases (1) (Dollars in Thousands) Retail (2) (3) $ 75,588 3.7 % $ 62,719 3.3 % Hospitality 82,818 4.1 % 80,832 4.2 % Entertainment 13,729 0.7 % 14,208 0.7 % Restaurants & food service 23,340 1.2 % 24,854 1.3 % Total outstanding exposure $ 195,475 9.6 % $ 182,613 9.5 % (1) Excluding net PPP loans. (2) Includes $38.6 million and $48.9 million in loans secured by commercial real estate as of June 30, 2021 and December 31, 2020, respectively. (3) Includes $24.1 million and $7.7 million in fully collateralized asset-based loans as of June 30, 2021 and December 31, 2020, respectively. 43 Table of Contents As of June 30, 2021, the Corporation had no meaningful direct exposure to the energy sector, airline industry or retail consumer, and does not participate in Shared National Credits. Because of the uncertainties related to the ultimate duration of the COVID-19 pandemic and its effects on our clients and prospects, and on the national and local economy as a whole, there can be no assurances as to how the crisis may ultimately affect the Corporation’s loan portfolio. Results of Operations Top Line Revenue Top line revenue, comprised of net interest income and non-interest income, increased 11.0% for the three months ended June 30, 2021 compared to the same period in 2020 primarily due to a $2.8 million, or 14.6%, increase in net interest income. The increase in net interest income was driven by an increase in average loans and leases receivable and loan fees in lieu of interest. Top line revenue increased 15.1% for the six months ended June 30, 2021 compared to the same period in 2020 primarily due to higher net interest income driven by an increase average loans and leases receivable and fees in lieu of interest. Non-interest income increased due to stronger gains on the sale of SBA loans and private wealth fee income, which was partially offset by a decrease in swap fees from our commercial loan interest rate swap program. The components of top line revenue were as follows: For the Three Months Ended June 30, For the Six Months Ended June 30, 2021 2020 $ Change % Change 2021 2020 $ Change % Change (Dollars in Thousands) Net interest income $ 21,652 $ 18,888 $ 2,764 14.6 % $ 42,515 $ 35,937 $ 6,578 18.3 % Non-interest income 6,321 6,319 2 — 13,516 12,733 783 6.1 Top line revenue $ 27,973 $ 25,207 $ 2,766 11.0 $ 56,031 $ 48,670 $ 7,361 15.1 Annualized Return on Average Assets and Annualized Return on Average Equity ROAA for the three and six months ended June 30, 2021 increased significantly to 1.26% and 1.38%, compared to 0.55% and 0.58% for the three and six months ended June 30, 2020. The increase in ROAA was primarily due to a decrease in the provision for loan and lease losses related to a large loan recovery received in January 2021 and continued credit quality improvement following significant reserve build during the COVID-19 pandemic. ROAA also benefited from an increase in fees in lieu of interest, strong gains on sale of SBA loans, and consistently strong and growing private wealth fee income. The increase in profitability was partially offset by a decrease in commercial loan interest rate swap fee income and increase in non-interest expense. We consider ROAA a critical metric to measure the profitability of our organization and how efficiently our assets are deployed. ROAA also allows us to better benchmark our profitability to our peers without the need to consider different degrees of leverage which can ultimately influence return on equity measures. ROAE for the three and six months ended June 30, 2021 was 15.09% and 16.75%, compared to 6.70% and 6.92% for the three and six months ended June 30, 2020. The reasons for the increase in ROAE are consistent with the explanations discussed above with respect to ROAA. We view ROAE as an important measurement for monitoring profitability and continue to focus on improving our return to our shareholders by enhancing the overall profitability of our client relationships, controlling our expenses, and minimizing our costs of credit. Efficiency Ratio and Pre-Tax, Pre-Provision Adjusted Earnings Efficiency ratio is a non-GAAP measure representing non-interest expense excluding the effects of the SBA recourse benefit or provision, impairment of tax credit investments, net gains or losses on foreclosed properties, amortization of other intangible assets, losses on early extinguishment of debt, and other discrete items, if any, divided by operating revenue, which is equal to net interest income plus non-interest income less realized net gains or losses on securities, if any. Pre-tax, pre-provision adjusted earnings is defined as operating revenue less operating expense. In the judgment of the Corporation’s management, the adjustments made to non-interest expense and non-interest income allow investors and analysts to better assess the Corporation’s operating expenses in relation to its core operating revenue by removing the volatility associated with certain one-time items and other discrete items. 44 Table of Contents The efficiency ratio was 64.17% and 63.18% for the three and six months ended June 30, 2021, compared to 61.22% and 64.36% for the three and six months ended June 30, 2020. Operating expense growth exceeded operating revenue growth for the three months ended June 30, 2021 compared to the same period in 2020 primarily due to a $2.5 million, or 22.8%, increase in compensation principally driven by increased headcount and incentive compensation as compared to the same periods in 2020, reflecting in part the Corporation’s continued execution of its growth strategy and vastly improved performance for the six months ended June 30, 2021 compared to the same period in 2020. Operating revenue growth outpaced the change in operating expense for the six months ended June 30, 2021 compared to the same period in 2020, resulting in positive operating leverage for the first half of the year. This improvement was attributable to an increase in net interest income driven by a 12.1% increase in average loans and leases receivable, a $1.3 million increase in fees in lieu of interest. In addition, non-interest income increased $783,000, or 6.1%, as the increase in gains on the sale of SBA loans and private wealth fee income offset the decline in commercial loan swap fees. The increase in fees in lieu of interest included $2.5 million in PPP processing fees. The increase in operating revenue was partially offset by a $4.1 million, or 18.6%, increase in compensation expense . We believe we will continue to generate modest positive operating leverage annually and progress towards enhancing our long-term efficiency ratio at a measured pace as we focus on strategic initiatives directed toward revenue growth. These initiatives include efforts to expand our specialized lending commercial banking business lines, increase our commercial banking market share, and scale our private wealth management business in our less mature commercial banking markets. We believe the efficiency ratio and pre-tax, pre-provision adjusted earnings allow investors and analysts to better assess the Corporation’s operating expenses in relation to its top line revenue by removing the volatility that is associated with certain non-recurring and other discrete items. The efficiency ratio and pre-tax, pre-provision adjusted earnings also allow management to benchmark performance of our model to our peers without the influence of the loan loss provision and tax considerations, which will ultimately influence other traditional financial measurements, including ROAA and ROAE. The information provided below reconciles the efficiency ratio to its most comparable GAAP measure. 45 Table of Contents Please refer to the Non-Interest Income and Non-Interest Expense sections below for discussion on additional drivers of the year-over-year change in the efficiency ratio. For the Three Months Ended June 30, For the Six Months Ended June 30, 2021 2020 $ Change % Change 2021 2020 $ Change % Change (Dollars in Thousands) Total non-interest expense $ 18,184 $ 18,343 $ (159) (0.9) % $ 35,514 $ 34,488 $ 1,026 3.0 % Less: Net loss on foreclosed properties (1) 348 (349) NM 1 450 (449) (99.8) Amortization of other intangible assets 8 9 (1) (11.1) 15 18 (3) (16.7) SBA recourse (benefit) provision 245 (30) 275 NM 115 (5) 120 NM Tax credit investment impairment — 1,841 (1,841) NM — 1,954 (1,954) NM Loss on early extinguishment of debt — 744 (744) NM — 744 (744) NM Total operating expense $ 17,932 $ 15,431 $ 2,501 16.2 $ 35,383 $ 31,327 $ 4,056 12.9 Net interest income 21,652 18,888 2,764 14.6 $ 42,515 $ 35,937 $ 6,578 18.3 Total non-interest income 6,321 6,319 2 — 13,516 12,733 783 6.1 Less: Net loss on sale of securities 29 — 29 NM 29 (4) 33 NM Adjusted non-interest income 6,292 6,319 (27) (0.4) $ 13,487 $ 12,737 $ 750 5.9 Total operating revenue $ 27,944 $ 25,207 $ 2,737 10.9 $ 56,002 $ 48,674 $ 7,328 15.1 Efficiency ratio 64.17 % 61.22 % 63.18 % 64.36 % Pre-tax, pre-provision adjusted earnings $ 10,012 $ 9,776 $ 236 2.4 $ 20,619 $ 17,347 $ 3,272 18.9 Average total assets 2,621,340 2,425,767 195,573 8.1 2,599,373 2,265,315 334,058 14.7 Pre-tax, pre-provision adjusted return on average assets 1.53 % 1.61 % 1.59 % 1.53 % NM = Not Meaningful Net Interest Income Net interest income levels depend on the amount of and yield on interest-earning assets as compared to the amount of and rate paid on interest-bearing liabilities. Net interest income is sensitive to changes in market rates of interest and the asset/liability management processes to prepare for and respond to such changes. The following table provides information with respect to (1) the change in net interest income attributable to changes in rate (changes in rate multiplied by prior volume) and (2) the change in net interest income attributable to changes in volume (changes in volume multiplied by prior rate) for the three and six months ended June 30, 2021 compared to the same period in 2020. The change in net interest income attributable to changes in rate and volume (changes in rate multiplied by changes in volume) has been allocated to the rate and volume changes in proportion to the relationship of the absolute dollar amounts of the change in each. 46 Table of Contents Increase (Decrease) for the Three Months Ended June 30, Increase (Decrease) for the Six Months Ended June 30, 2021 Compared to 2020 2021 Compared to 2020 Rate Volume Net Rate Volume Net (In Thousands) Interest-earning assets Commercial real estate and other mortgage loans (1) $ (1,263) $ 1,900 $ 637 $ (4,395) $ 4,037 $ (358) Commercial and industrial loans (1) 986 542 1,528 (375) 3,671 3,296 Direct financing leases (1) (81) (92) (173) 94 (131) (37) Consumer and other loans (1) (26) 77 51 (78) 166 88 Total loans and leases receivable (384) 2,427 2,043 (4,754) 7,743 2,989 Mortgage-related securities (162) (119) (281) (460) (216) (676) Other investment securities (27) 54 27 (53) 140 87 FHLB and FRB Stock 1 48 49 (116) 114 (2) Short-term investments 2 (2) — (102) (22) (124) Total net change in income on interest-earning assets (570) 2,408 1,838 (5,485) 7,759 2,274 Interest-bearing liabilities Transaction accounts (127) 84 (43) (821) 381 (440) Money market accounts (100) 14 (86) (1,703) 23 (1,680) Certificates of deposit (233) (282) (515) (484) (605) (1,089) Wholesale deposits (576) 239 (337) (1,298) 429 (869) Total deposits (1,036) 55 (981) (4,306) 228 (4,078) FHLB advances 57 (56) 1 (448) 139 (309) Federal reserve PPP lending facility — (18) (18) — (18) (18) Other borrowings (36) 108 72 (49) 153 104 Junior subordinated notes — — — (4) 1 (3) Total net change in expense on interest-bearing liabilities (1,015) 89 (926) (4,807) 503 (4,304) Net change in net interest income $ 445 $ 2,319 $ 2,764 $ (678) $ 7,256 $ 6,578 (1) The average balances of loans and leases include non-accrual loans and leases and loans held for sale. 47 Table of Contents The tables below shows our average balances, interest, average yields/rates, net interest margin, and the spread between the combined average yields earned on interest-earning assets and average rates on interest-bearing liabilities for the three and six months ended June 30, 2021 and 2020. The average balances are derived from average daily balances. For the Three Months Ended June 30, 2021 2020 Average Balance Interest Average Yield/Rate (4) Average Balance Interest Average Yield/Rate (4) (Dollars in Thousands) Interest-earning assets Commercial real estate and other mortgage loans (1) $ 1,386,187 $ 13,087 3.78 % $ 1,192,530 $ 12,450 4.18 % Commercial and industrial loans (1) 772,257 9,875 5.11 726,862 8,347 4.59 Direct financing leases (1) 19,883 222 4.47 27,115 395 5.83 Consumer and other loans (1) 45,026 407 3.62 36,614 356 3.89 Total loans and leases receivable (1) 2,223,353 23,591 4.24 1,983,121 21,548 4.35 Mortgage-related securities (2) 149,253 631 1.69 174,113 912 2.10 Other investment securities (3) 41,569 185 1.78 30,194 158 2.09 FHLB and FRB stock 14,172 176 4.97 10,301 127 4.93 Short-term investments 55,100 16 0.12 61,030 16 0.10 Total interest-earning assets 2,483,447 24,599 3.96 2,258,759 22,761 4.03 Non-interest-earning assets 137,893 167,008 Total assets $ 2,621,340 $ 2,425,767 Interest-bearing liabilities Transaction accounts $ 499,040 248 0.20 $ 368,844 291 0.32 Money market accounts 662,919 282 0.17 637,714 368 0.23 Certificates of deposit 45,993 112 0.97 123,581 627 2.03 Wholesale deposits 162,580 301 0.74 105,597 638 2.42 Total interest-bearing deposits 1,370,532 943 0.28 1,235,736 1,924 0.62 FHLB advances 405,855 1,284 1.27 409,281 1,283 1.25 Federal reserve PPPLF — — — 20,821 18 0.35 Other borrowings 32,447 443 5.46 24,681 371 6.01 Junior subordinated notes 10,066 277 11.01 10,052 277 11.02 Total interest-bearing liabilities 1,818,900 2,947 0.65 1,700,571 3,873 0.91 Non-interest-bearing demand deposit accounts 527,441 440,413 Other non-interest-bearing liabilities 56,691 86,504 Total liabilities 2,403,032 2,227,488 Stockholders’ equity 218,308 198,279 Total liabilities and stockholders’ equity $ 2,621,340 $ 2,425,767 Net interest income $ 21,652 $ 18,888 Interest rate spread 3.31 % 3.12 % Net interest-earning assets $ 664,547 $ 558,188 Net interest margin 3.49 % 3.34 % Average interest-earning assets to average interest-bearing liabilities 136.54 % 132.82 % Return on average assets (4) 1.26 0.55 Return on average equity (4) 15.09 6.70 Average equity to average assets 8.33 8.17 Non-interest expense to average assets (4) 2.77 3.02 (1) The average balances of loans and leases include non-accrual loans and leases and loans held for sale. Interest income related to non-accrual loans and leases is recognized when collected. Interest income includes net loan fees in lieu of interest. (2) Includes amortized cost basis of assets available-for-sale and held-to-maturity. (3) Yields on tax-exempt municipal securities are not presented on a tax-equivalent basis in this table. (4) Represents annualized yields/rates. 48 Table of Contents For the Six Months Ended June 30, 2021 2020 Average Balance Interest Average Yield/Rate (4) Average Balance Interest Average Yield/Rate (4) (Dollars in Thousands) Interest-earning assets Commercial real estate and other mortgage loans (1) $ 1,371,744 $ 25,615 3.73 % $ 1,173,251 $ 25,973 4.43 % Commercial and industrial loans (1) 765,117 19,500 5.10 621,399 16,204 5.22 Direct financing leases (1) 21,071 466 4.42 27,538 503 3.65 Consumer and other loans (1) 45,335 805 3.55 36,244 717 3.96 Total loans and leases receivable (1) 2,203,267 46,386 4.21 1,858,432 43,397 4.67 Mortgage-related securities (2) 156,249 1,297 1.66 177,352 1,973 2.22 Other investment securities (3) 41,871 372 1.78 26,737 285 2.13 FHLB and FRB stock 13,323 329 4.94 9,407 331 7.04 Short-term investments 39,922 22 0.11 48,396 146 0.60 Total interest-earning assets 2,454,632 48,406 3.94 2,120,324 46,132 4.35 Non-interest-earning assets 144,741 144,991 Total assets $ 2,599,373 $ 2,265,315 Interest-bearing liabilities Transaction accounts $ 510,024 498 0.20 $ 320,188 938 0.59 Money market accounts 660,319 557 0.17 653,598 2,237 0.68 Certificates of deposit 51,677 288 1.11 128,791 1,377 2.14 Wholesale deposits 164,654 619 0.75 119,032 1,488 2.50 Total interest-bearing deposits 1,386,674 1,962 0.28 1,221,609 6,040 0.99 FHLB advances 386,371 2,533 1.31 367,604 2,842 1.55 Federal reserve PPPLF — — — 10,410 18 0.35 Other borrowings 29,886 844 5.65 24,533 740 6.03 Junior subordinated notes 10,064 552 10.97 10,050 555 11.04 Total interest-bearing liabilities 1,812,995 5,891 0.65 1,634,206 10,195 1.25 Non-interest-bearing demand deposit accounts 506,767 365,771 Other non-interest-bearing liabilities 65,146 74,436 Total liabilities 2,384,908 2,074,413 Stockholders’ equity 214,465 190,902 Total liabilities and stockholders’ equity $ 2,599,373 $ 2,265,315 Net interest income $ 42,515 $ 35,937 Interest rate spread 3.29 % 3.10 % Net interest-earning assets $ 641,637 $ 486,118 Net interest margin 3.46 % 3.39 % Average interest-earning assets to average interest-bearing liabilities 135.39 % 129.75 % Return on average assets (4) 1.38 0.58 Return on average equity (4) 16.75 6.92 Average equity to average assets 8.25 8.43 Non-interest expense to average assets (4) 2.73 3.04 (1) The average balances of loans and leases include non-accrual loans and leases and loans held for sale. Interest income related to non-accrual loans and leases is recognized when collected. Interest income includes net loan fees in lieu of interest. (2) Includes amortized cost basis of assets available-for-sale and held-to-maturity. (3) Yields on tax-exempt municipal securities are not presented on a tax-equivalent basis in this table. (4) Represents annualized yields/rates. 49 Table of Contents Comparison of Net Interest Income for the Three and Six Months Ended June 30, 2021 and 2020 Net interest income increased $2.8 million, or 14.6%, during the three months ended June 30, 2021 compared to the three months ended June 30, 2020. The increase in net interest income reflected an increase in average gross loans and leases, an increase in fees in lieu of interest, and a decrease in interest expense, partially offset by a reduction in the yield on average interest-earning assets. Fees in lieu of interest, which can vary from quarter to quarter, totaled $3.5 million for the three months ended June 30, 2021, compared to $2.3 million for the same period in 2020. Excluding fees in lieu of interest and interest income from PPP loans, net interest income increased $1.5 million, or 9.7%. Average gross loans and leases for the three months ended June 30, 2021 increased $240.2 million, or 12.1%, compared to the three months ended June 30, 2020. Excluding net PPP loans, average gross loans and leases for the three months ended June 30, 2021 increased $263.9 million, or 15.3%, compared to the three months ended June 30, 2020. Net interest income increased $6.6 million, or 18.3%, during the six months ended June 30, 2021 compared to the six months ended June 30, 2020. The reasons for the increase in net income for the six months ended June 30, 2021 are consistent with the explanations discussed above with respect to the three months ended June 30, 2021. Fees in lieu of interest totaled $6.6 million for the six months ended June 30, 2021, compared to $3.1 million for the same period in 2020. Excluding fees in lieu of interest and interest income from PPP loans, net interest income increased $2.5 million, or 7.7%. Average gross loans and leases for the six months ended June 30, 2021 increased $344.8 million, or 18.6%, compared to the six months ended June 30, 2020. Excluding net PPP loans, average gross loans and leases for the six months ended June 30, 2021 increased $235.6 million, or 13.6%, compared to the six months ended June 30, 2020. The yield on average loans and leases for the three and six months ended June 30, 2021 declined to 4.24% and 4.21%, respectively, compared to 4.35% and 4.67% for the three and six months ended June 30, 2020, respectively. Excluding the impact of fees in lieu of interest and PPP loan interest income, the yield on average loans and leases excluding net PPP loans for the three and six months ended June 30, 2021 was 3.91% and 3.92%, respectively, compared to 4.31% and 4.58% for the three and six months ended June 30, 2020, respectively. Similarly, the yield on average interest-earning assets for the three and six months ended June 30, 2021 measured 3.96% and 3.94%, respectively, compared to 4.03% and 4.35% three and six months ended June 30, 2020, respectively. Excluding fees in lieu of interest and PPP loan interest income, the yield on average interest-earning assets excluding net PPP loans for the three and six months ended June 30, 2021 was 3.64% and 3.66%, respectively, compared to 3.96% and 4.26% for the three and six months ended June 30, 2020, respectively. The decline in yields for both periods of comparison was primarily due to the decrease in LIBOR and Prime rates and related impact on variable-rate loans, in addition to the renewal of fixed-rate loans and reinvestment of security cash flows at historically low interest rates. The average rate paid on total interest-bearing liabilities for the both three and six months ended June 30, 2021 decreased to 0.65% compared to 0.91% and 1.25% for the three and six months ended June 30, 2020, respectively. Total interest-bearing liabilities include interest-bearing deposits, federal funds purchased, FHLB advances, subordinated and junior subordinated notes payable, and other borrowings. The average rate paid declined as the Corporation decreased deposit rates in response to the Federal Open Market Committee’s (“FOMC”) decision to lower the target federal funds rate 150 basis points from January 2020 to March 2020. For the six months ended June 30, 2021 compared to the six months ended June 30, 2020, the average target federal funds rate decreased 58 basis points. Consistent with the Corporation’s longstanding funding strategy to manage interest rate risk and use the most efficient and cost effective source of wholesale funds, a combination of fixed rate wholesale deposits and fixed rate FHLB advances are used at various maturity terms to meet the Corporation’s funding needs. Average FHLB advances for the three months ended June 30, 2021 decreased $3.4 million to $405.9 million at an average rate paid of 1.27%, compared to $409.3 million at an average rate paid of 1.25% for the three months ended June 30, 2020. Average FHLB advances for the six months ended June 30, 2021 increased $18.8 million to $386.4 million at an average rate paid of 1.31%, compared to $367.6 million at an average rate paid of 1.55% for the six months ended June 30, 2020. As of June 30, 2021, the weighted average original maturity of our FHLB term advances was 6.1 years, compared to 5.3 years as of June 30, 2020. Average wholesale deposits, consisting of brokered certificates of deposit, deposits gathered from internet listing services, and non-reciprocal interest bearing transaction accounts, for the three months ended June 30, 2021 increased $57.0 million to $162.6 million at an average rate paid of 0.74%, compared to $105.6 million at an average rate paid of 2.42%. The increase in wholesale deposits was primarily due to adding non-maturity brokered deposits at a favorable rate compared to alternative funding sources. Average wholesale deposits for the six months ended June 30, 2021 increased $45.6 million to $164.7 million at an average rate paid of 0.75%, compared to $119.0 million at an average rate paid of 2.50%. As of June 30, 2021, the weighted average original maturity of our termed wholesale deposits was 3.5 years, compared to 4.6 years as of June 30, 2020. The rate paid on average wholesale funding is greater than the cost of in-market deposits and changes more gradually because the portfolio includes longer original maturities as the Corporation match-funds its longer-term fixed rate loans to mitigate interest rates risk. Net interest margin was 3.49% and 3.46% for the three and six months ended June 30, 2021, respectively, compared to 3.34% and 3.39% for the three and six months ended June 30, 2020, respectively. Excluding fees in lieu of interest, PPP loan interest income, Federal Reserve interest income, and FHLB dividends, adjusted net interest margin measured 3.20% for both 50 Table of Contents the three and six months ended June 30, 2021, compared to 3.32% and 3.32% for the three and six months ended June 30, 2020, respectively. The decrease in adjusted net interest margin for both periods of comparison was primarily due to the decrease in average yield on loans and leases receivable and investment securities, partially offset by a decrease in the average rate paid on in-market deposits and wholesale funding. Management believes its success in growing in-market deposits, disciplined loan pricing, and increased production in existing higher-yielding specialized lending commercial banking products will allow the Corporation to achieve a net interest margin of at least 3.50%, on average, over the long-term. However, the collection of loan fees in lieu of interest is an expected source of volatility to quarterly net interest income and net interest margin, particularly given the nature of the Corporation’s asset-based lending business and the Corporation’s participation in the PPP. Net interest margin may also experience volatility due to events such as the collection of interest on loans previously in non-accrual status or the accumulation of significant short-term deposit inflows. Despite an uncertain rate environment, management expects to effectively manage the Corporation’s liability structure in both term and rate. Further, we expect to attract new in-market deposit relationships which we believe will contribute to our ability to maintain an appropriate cost of funds. In-market deposits, comprised of all transaction accounts, money market accounts, and non-wholesale deposits, increased $333.2 million, or 39.6% annualized, to $2.016 billion at June 30, 2021, compared to $1.683 billion at December 31, 2020. The large increase in deposits was partially due to the proceeds of a commercial client’s business sale late in the second quarter, the majority of which was moved off the balance sheet in third quarter. Excluding this temporary deposit, total period-end in-market deposits increased $108.2 million to $1.791 billion, or 12.9% annualized. Average in-market deposits increased $164.8 million, or 10.5%, to $1.735 billion for the three months ended June 30, 2021, compared to $1.571 billion for the three months ended June 30, 2020. This significant increase in deposits was due to successful business development efforts combined with excess liquidity resulting from our clients’ participation in the PPP. Provision for Loan and Lease Losses We determine our provision for loan and lease losses pursuant to our allowance for loan and lease loss methodology, which is based on the magnitude of current and historical net charge-offs recorded throughout the established look-back period, the evaluation of several qualitative factors for each portfolio category, and the amount of specific reserves established for impaired loans that present collateral shortfall positions. Refer to Allowance for Loan and Lease Losses , below, for further information regarding our allowance for loan and lease loss methodology. The long-term impact of COVID-19 on the economy is unknown, however, economic conditions have improved steadily in 2021 following the vaccine rollout and the termination of various pandemic safety protocols by states and businesses. While the outbreak did have a temporary adverse impact on certain industries the Corporation serves, including retail, hospitality, entertainment, and restaurants and food services, management believes the long-term impact it may have on the Corporation’s loan portfolio will be limited. Additional detail about certain exposure to stressed industries is included in the section titled COVID-19 Update , above. The Corporation recognized a $1.0 million and $3.0 million provision benefit for the three and six months ended June 30, 2021, respectively, compared to provision expense of $5.5 million and $8.7 million for the three and six months ended June 30, 2020, respectively. The provision benefit for the three months ended June 30, 2021 was primarily due to a $1.7 million reduction in the general reserve from improving historical loss rates and a $1.5 million decrease in specific reserves. These decreases were partially offset by $2.3 million in net charge-offs and a $498,000 increase in the general reserve due to loan growth. Net charge-offs for the quarter principally consisted of a $2.2 million charge-off of one previously identified and partially reserved for legacy SBA loan. The provision benefit for the six months ended June 30, 2021 was primarily due to a $2.7 million reduction in the general reserve from improving historical loss rates and a $1.7 million decrease in specific reserves. These decreases were partially offset by a $1.1 million increase in the general reserve due to loan growth. 51 Table of Contents The following table shows the components of the provision for loan and lease losses for the three and six months ended June 30, 2021 compared to the three and six months ended June 30, 2020. For the Three Months Ended June 30, For the Six Months Ended June 30, 2021 2020 2021 2020 (In Thousands) Change in general reserve due to subjective factor changes $ (652) $ 2,388 $ 430 $ 5,224 Change in general reserve due to historical loss factor changes (1,687) (54) (2,671) (334) Charge-offs 2,894 817 3,038 948 Recoveries (545) (64) (3,218) (241) Change in specific reserves on impaired loans, net (1,466) 2,122 (1,660) 2,559 Change due to loan growth, net 498 260 1,055 495 Total provision for loan and lease losses $ (958) $ 5,469 $ (3,026) $ 8,651 The legacy on-balance sheet SBA portfolio, defined as SBA 7(a) and Express loans originated in 2016 and prior, has been a source of elevated non-performing assets. Additional information on our legacy SBA portfolio is as follows: As of June 30, 2021 March 31, 2021 June 30, 2020 (In Thousands) Performing loans: Off-balance sheet loans $ 14,161 $ 17,523 $ 28,843 On-balance sheet loans 6,836 7,340 16,554 Gross loans 20,997 24,863 45,397 Non-performing loans: Off-balance sheet loans 3,943 1,835 1,640 On-balance sheet loans 1,800 6,832 9,725 Gross loans 5,743 8,667 11,365 Total loans: Off-balance sheet loans 18,104 19,358 30,483 On-balance sheet loans 8,636 14,172 26,279 Gross loans $ 26,740 $ 33,530 $ 56,762 The addition of specific reserves on impaired loans represents new specific reserves established when collateral shortfalls or government guaranty deficiencies are present, while conversely the release of specific reserves represents the reduction of previously established reserves that are no longer required. Changes in the allowance for loan and lease losses due to subjective factor changes reflect management’s evaluation of the level of risk within the portfolio based upon several factors for each portfolio segment. Charge-offs in excess of previously established specific reserves require an additional provision for loan and lease losses to maintain the allowance for loan and lease losses at a level deemed appropriate by management. This amount is net of the release of any specific reserve that may have already been provided. Change in the inherent risk of the portfolio is primarily influenced by the overall growth in gross loans and leases and an analysis of loans previously charged off, as well as movement of existing loans and leases in and out of an impaired loan classification where a specific evaluation of a particular credit may be required rather than the application of a general reserve loss rate. Refer to Asset Quality , below, for further information regarding the overall credit quality of our loan and lease portfolio. Because of the significant uncertainties related to the ultimate duration of the COVID-19 pandemic and its potential effects on clients and prospects, and on the national and local economy as a whole, there can be no assurances as to how the crisis may ultimately affect the Corporation’s loan portfolio. 52 Table of Contents Comparison of Non-Interest Income for the Three and Six Months Ended June 30, 2021 and 2020 Non-Interest Income Non-interest income was $6.3 million for both the three months ended June 30, 2021 and June 30, 2020. Non-interest income increased $783,000, or 6.1%, to $13.5 million for the six months ended June 30, 2021 compared to $12.7 million for the same period in 2020. Management continues to focus on revenue growth from multiple non-interest income sources in order to maintain a diversified revenue stream. Total non-interest income accounted for 22.6% and 24.1% of total revenues for the three and six months ended June 30, 2021, compared to 25.1% and 26.2% for the three and six months ended June 30, 2020. The decline in fee revenue compared to total revenue is primarily due to an increase in net interest income and a reduction in commercial loan swap fees. Management believes the continued gradual expansion of its SBA lending program and the geographic expansion of its private wealth management division in bank markets outside of South Central Wisconsin will allow the Corporation to sustain a strategic target of 25% over the long-term. The components of non-interest income were as follows: For the Three Months Ended June 30, For the Six Months Ended June 30, 2021 2020 $ Change % Change 2021 2020 $ Change % Change (Dollars in Thousands) Private wealth management services fee income $ 2,744 $ 2,124 $ 620 29.2 % $ 5,151 $ 4,235 $ 916 21.6 % Gain on sale of SBA loans 1,203 574 629 109.6 2,281 839 1,442 171.9 Service charges on deposits 941 829 112 13.5 1,859 1,647 212 12.9 Loan fees 569 451 118 26.2 1,114 936 178 19.0 Increase in cash surrender value of bank-owned life insurance 350 377 (27) (7.2) 699 672 27 4.0 Net loss on sale of securities 29 — 29 NM 29 (4) 33 NM Swap fees — 1,655 (1,655) (100.0) 684 3,336 (2,652) (79.5) Other non-interest income 485 309 176 57.0 1,699 1,072 627 58.5 Total non-interest income $ 6,321 $ 6,319 $ 2 — $ 13,516 $ 12,733 $ 783 6.1 Fee income ratio (1) 22.6 % 25.1 % 24.1 % 26.2 % (1) Fee income ratio is fee income, per the above table, divided by top line revenue (defined as net interest income plus non-interest income). Private wealth management service fees increased $620,000, or 29.2%, and $916,000, or 21.6%, for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. Private wealth management services fee income is primarily driven by the amount of assets under management and administration, as well as the mix of business at different fee structures, and can be positively or negatively influenced by the timing and magnitude of volatility within the capital markets. This increase was driven by growth in assets under management and administration attributable to both new client relationships and increased equity market values. As of June 30, 2021, private wealth and trust assets under management and administration totaled a record $2.564 billion, increasing $315.4 million, or 14.0%, compared to $2.249 billion as of December 31, 2020 and $691.0 million, or 36.9%, compared to $1.873 billion as of June 30, 2020. No commercial loan interest rate swap fee income was recognized for the three months ended June 30, 2021, compared to $1.7 million for the same period in 2020. Commercial loan interest rate swap fee income was $684,000 for the six months ended June 30, 2021, compared to $3.3 million for the six months ended June 30, 2020. We originate commercial real estate loans in which we offer clients a floating rate and an interest rate swap. The client’s swap is then offset with a counter-party dealer. The execution of these transactions generates swap fee income. The aggregate amortizing notional value of interest rate swaps with various borrowers was $637.0 million as of June 30, 2021, compared to $467.1 million as of June 30, 2020. Interest rate swaps can be an attractive product for our commercial borrowers, although associated fee income can be variable from period to period based on client demand and the interest rate environment in any given quarter. Gains on sale of SBA loans increased $629,000, or 109.6%, and $1.4 million, or 171.9%, for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. Gross SBA loan commitments closed for the three and six months ended June 30, 2021 totaled $9.7 million and $19.4 million, respectively, compared to $18.1 million and $24.2 million for the same period in 2020. Management believes the gain on sale of traditional SBA loans, while variable based on timing of closings, will continue to increase annually at a measured pace. 53 Table of Contents Other non-interest income increased $176,000, or 57.0%, and $627,000, or 58.5%, for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The increase in both periods of comparison was primarily due to an increase in returns from the Corporation’s investments in mezzanine funds and an increase in bank consulting services fee income. Comparison of Non-Interest Expense for the Three and Six Months Ended June 30, 2021 and 2020 Non-Interest Expense Non-interest expense for the three months ended June 30, 2021 decreased by $159,000, or 0.9%, to $18.2 million compared to $18.3 million for the same period in 2020. Operating expense, which excludes certain one-time and discrete items as defined in the Efficiency Ratio table above, increased $2.5 million, or 16.2%, to $17.9 million for the three months ended June 30, 2021 compared to $15.4 million for the same period in 2020. Non-interest expense for the six months ended June 30, 2021 increased by $1.0 million, or 3.0%, to $35.5 million compared to $34.5 million for the same period in 2020. Operating expense increased $4.1 million, or 12.9%, to $35.4 million for the six months ended June 30, 2021 compared to $31.3 million for the same period in 2020. The increase in operating expense in both periods of comparison was primarily due to an increase in compensation, marketing, computer software, and FDIC insurance expense, partially offset by a decrease in other non-interest expense. The components of non-interest expense were as follows : For the Three Months Ended June 30, For the Six Months Ended June 30, 2021 2020 $ Change % Change 2021 2020 $ Change % Change (Dollars in Thousands) Compensation $ 13,255 $ 10,796 $ 2,459 22.8 % $ 25,912 $ 21,848 $ 4,064 18.6 % Occupancy 533 554 (21) (3.8) 1,085 1,126 (41) (3.6) Professional fees 913 859 54 6.3 1,778 1,678 100 6.0 Data processing 798 710 88 12.4 1,569 1,386 183 13.2 Marketing 511 352 159 45.2 902 813 89 10.9 Equipment 261 304 (43) (14.1) 506 595 (89) (15.0) Computer software 1,129 966 163 16.9 2,244 1,856 388 20.9 FDIC insurance 280 239 41 17.2 642 448 194 43.3 Collateral liquidation costs 84 115 (31) (27.0) 178 236 (58) (24.6) Net (gain) loss on foreclosed properties (1) 348 (349) NM 1 450 (449) (99.8) Impairment on tax credit investments — 1,841 (1,841) NM — 1,954 (1,954) (100.0) SBA recourse (benefit) provision 245 (30) 275 NM 115 (5) 120 NM Loss on early extinguishment of debt — 744 (744) NM — 744 (744) NM Other non-interest expense 176 545 (369) (67.7) 582 1,359 (777) (57.2) Total non-interest expense $ 18,184 $ 18,343 $ (159) (0.9) $ 35,514 $ 34,488 $ 1,026 3.0 Total operating expense (1) $ 17,932 $ 15,431 $ 2,501 16.2 $ 35,383 $ 31,327 $ 4,056 12.9 Full-time equivalent employees 319 283 319 283 (1) Total operating expense represents total non-interest expense, adjusted to exclude the impact of discrete items as previously defined in the non-GAAP efficiency ratio calculation, above. Compensation expense for the three and six months ended June 30, 2021 was $13.3 million, an increase of $2.5 million, or 22.8%, and $25.9 million, an increase of $4.1 million, or 18.6%, respectively, compared to the three and six months ended June 30, 2020. The increase in both periods of comparison reflects new hires, annual merit increases, growth in employee benefit costs, and an increase in the expected payout on annual corporate and individual incentive compensation plans. The annual corporate bonus and individual incentive compensation plans for the three and six months ended June 30, 2021 totaled $2.5 million and $4.1 million, respectively, due to strong Bank performance driven by effective business development efforts and continued improvement in credit, compared to $1.2 million and $2.2 million for three and six months ended June 30, 2020, 54 Table of Contents respectively. Average full-time equivalent employees increased to 312, up 11.0% for the quarter ended June 30, 2021, compared to 281 for the quarter ended June 30, 2020. We expect to continue investing in talent, both in the form of additional business development and operational staff, to support our long-term strategic plan. Computer software expense increased $163,000, or 16.9%, and $388,000, or 20.9%, for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The increase was principally due to investments in and maintenance of technology platforms to improve the client experience and continuing our strategic focus on scaling the Corporation to efficiently execute our growth strategy. Marketing expense increased $159,000, or 45.2%, and $89,000, or 10.9%, for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. Management expects marketing expense to continue to increase modestly and return to pre-pandemic levels over the next several quarters primarily driven by sponsorships and business development activities. FDIC insurance expense increased $41,000, or 17.2%, and $194,000, or 43.3%, for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. Management expects FDIC insurance expense to increase commensurate with asset growth going forward. No historic tax credits or related impairment were recognized for the three and six months ended June 30, 2021. The impairment on tax credit investments for the three and six months ended June 30, 2020 are related to a new market and historic tax credits. The impairment on tax credits are more than offset by a reduction to income tax expense resulting in a net benefit to earnings in the year the credits are earned. Management intends to continue actively pursuing in-market tax credit opportunities throughout 2021 and beyond. SBA recourse provision expense totaled $245,000 and $115,000 for the three and six months ended June 30, 2021, respectively, compared to recourse benefit of $30,000 and $5,000 for the three and six months ended June 30, 2020, respectively. The total recourse reserve balance was $830,000, or 0.9% of total sold SBA loans outstanding, at June 30, 2021, compared to $723,000, or 0.9%, at December 31, 2020, and $1.0 million, or 1.4%, at June 30, 2020. Changes to SBA recourse reserves may be a source of non-interest expense volatility in future quarters, though the magnitude of this volatility should continue to diminish over time as the outstanding balance of sold legacy SBA loans continues to decline. The Corporation incurred a $744,000 loss, recognized through non-interest expense, on the early extinguishment of $59.5 million in FHLB term advances late in the second quarter of 2020, as the Corporation lowered wholesale funding costs and improved the Corporation’s funding position. Other non-interest expense decreased $369,000, or 67.7%, and $777,000, or 57.2%, for the three and six months ended June 30, 2021, respectively, compared to the three and six months ended June 30, 2020. The decrease was principally due to a reduction in the credit valuation adjustment (“CVA”) related to the commercial loan interest rate swap program and a reduction in the loan servicing valuation adjustment related to the Bank’s SBA portfolio. The CVA represents a change in the market value of the Company’s commercial loan interest rate swaps to estimate potential borrower credit risk within the portfolio. The CVA can vary from period to period based on the size of the portfolio, credit metrics, and the interest rate environment in any given quarter. There was no CVA as of June 30, 2020. Income Taxes Income tax expense totaled $5.6 million for the six months ended June 30, 2021 compared to an income tax benefit of $1.1 million for the six months ended June 30, 2020. The effective tax rate, excluding tax credits and other discrete items, for the six months ended June 30, 2021 was 23.6% compared to 18.6% for the six months ended June 30, 2020. 55 Table of Contents Financial Condition General Total assets increased by $297.8 million, or 11.6%, to $2.866 billion as of June 30, 2021 compared to $2.568 billion at December 31, 2020. The increase in total assets was primarily driven by short-term investments, partially offset by a decrease in securities and loans and leases receivable. Short-Term Investments Short-term investments increased by $338.0 million to $365.4 million at June 30, 2021 from $27.4 million at December 31, 2020. The large increase in short-term investments was primarily due to the proceeds of a commercial client’s business sale late in the second quarter, the majority of which was moved off the balance sheet in July, and PPP loan forgiveness proceeds. Excluding the temporary business sale proceeds, total short-term investments increased $113.1 million to $140.4 million. Our short-term investments primarily consist of interest-bearing deposits held at the FRB. We value the safety and soundness provided by the FRB and therefore incorporate short-term investments in our on-balance sheet liquidity program. In general, the level of our short-term investments will be influenced by the timing of deposit gathering, scheduled maturities of wholesale deposits, funding of loan and lease growth when opportunities are presented, and the level of our securities portfolio. Please refer to the section entitled Liquidity and Capital Resources for further discussion. Securities Total securities, including available-for-sale and held-to-maturity, decreased by $16.7 million, or 7.9%, to $193.6 million at June 30, 2021 compared to $210.3 million at December 31, 2020. During the six months ended June 30, 2021 we recognized unrealized losses of $1.6 million before income taxes through other comprehensive income, compared to gains of $4.2 million for the same period in 2020. As of June 30, 2021 and December 31, 2020, our overall securities portfolio, including available-for-sale securities and held-to-maturity securities, had an estimated weighted-average expected maturity of 5.6 years and 5.0 years, respectively. Our investment philosophy remains as stated in our most recent Annual Report on Form 10-K. We use a third-party pricing service as our primary source of market prices for our securities portfolio. On a quarterly basis, we validate the reasonableness of prices received from this source through independent verification, data integrity validation primarily through comparison of current price to an expectation-based analysis of movement in prices based upon the changes in the related yield curves, and other market factors. No securities within our portfolio were deemed to be other-than-temporarily impaired as of June 30, 2021. Loans and Leases Receivable Loans and leases receivable, net of allowance for loan and lease losses, increased by $437,000 to $2.118 billion at June 30, 2021 from $2.117 billion at December 31, 2020 which was driven by commercial loan growth, partially offset by PPP loan forgiveness. Loans and leases receivable, net of allowance for loan and lease losses and excluding net PPP loans, increased by $105.0 million, or 11.1% annualized, to $1.997 billion at June 30, 2021 from December 31, 2020. Excluding net PPP loans, C&I loans increased $67.7 million, or 26.7% annualized, to $574.7 million from $507.0 million at December 31, 2020 primarily due to a $59.9 million increase in loans from our specialized lending business lines. The majority of our specialized lending commercial banking business lines are early stage and faster growing while the more mature business lines, like asset-based lending, have historically experienced counter cyclical growth, growing during and following times of economic stress. Management expects specialized lending volume to continue to increase in 2021 and 2022 following the proactive investments made prior to and during the COVID-19 pandemic. Including net PPP loans, our C&I portfolio decreased $36.9 million to $695.4 million from $732.3 million at December 31, 2020. Total commercial real estate (“CRE”) increased $32.9 million to $1.392 billion, up from $1.359 billion at December 31, 2020. Non-owner occupied CRE and multi-family loans were the largest contributors to CRE loan growth as of June 30, 2021, increasing $49.8 million, and $7.8 million, respectively, from December 31, 2020. There continues to be a concentration in CRE loans which represented 68.7% and 70.6% of our total loans, excluding net PPP loans, as of June 30, 2021 and December 31, 2020, respectively. As of June 30, 2021, 18.2% of the CRE loans were owner-occupied CRE, compared to 18.7% as of December 31, 2020. We consider owner-occupied CRE more characteristic of the Corporation’s C&I portfolio as, in general, the client’s primary source of repayment is the cash flow from the operating entity occupying the commercial real estate property. Management has elevated its underwriting standards during the 56 Table of Contents COVID-19 pandemic to ensure business owners and guarantors have robust liquidity, operating performance, and collateral positions. Even with these higher standards, the Corporation has been able to grow loans and deepen banking relationships. Underwriting of new credit is primarily through approval from a serial sign-off or committee process and is a key component of our operating philosophy. Business development officers have no individual lending authority limits, and thus, a significant portion of our new credit extensions require approval from a loan approval committee regardless of the type of loan or lease, amount of the credit, or the related complexities of each proposal. In addition, we make every reasonable effort to ensure that there is appropriate collateral or a government guarantee at the time of origination to protect our interest in the related loan or lease. To monitor the ongoing credit quality of our loans and leases, each credit is evaluated for proper risk rating using a nine grade risk rating system at the time of origination, subsequent renewal, evaluation of updated financial information from our borrowers, or as other circumstances dictate. While we continue to experience significant competition from banks operating in our primary geographic areas, we remain committed to our underwriting standards and will not deviate from those standards for the sole purpose of growing our loan and lease portfolio. We continue to expect our new loan and lease activity to be adequate to replace normal amortization, allowing us to continue growing in future years. The types of loans and leases we originate and the various risks associated with these originations remain consistent with information previously outlined in our most recent Annual Report on Form 10-K. Deposits As of June 30, 2021, deposits increased by $305.2 million, or 32.9% annualized, to $2.161 billion from $1.856 billion at December 31, 2020 primarily due to a $309.1 million and $43.6 million increase in transaction accounts and money market accounts, respectively, partially offset by a decrease in wholesale deposits and certificates of deposit of $28.0 million and $19.6 million, respectively. The large increase in deposits was primarily due to the proceeds of a commercial client’s business sale late in the second quarter, the majority of which was moved off the balance sheet in July, and PPP forgiveness proceeds. Excluding the temporary deposits described above, total deposits increased $80.2 million to $1.936 billion, or 8.6% annualized. Excluding the temporary deposits, transaction and money market accounts increased $84.2 million. Period-end deposit balances associated with in-market relationships will fluctuate based upon maturity of time deposits, client demands for the use of their cash, and our ability to maintain existing and new client relationships. Our strategic efforts remain focused on adding in-market deposit relationships. We measure the success of in-market deposit gathering efforts based on the number and average balances of our deposit accounts as compared to ending balances due to the volatility of some of our larger relationships. The Bank’s average in-market deposits, consisting of all transaction accounts, money market accounts, and certificates of deposit, were approximately $1.729 billion for the six months ended June 30, 2021, compared to $1.569 billion for the year ended December 31, 2020. FHLB Advances and Other Borrowings As of June 30, 2021, FHLB advances and other borrowings increased by $946,000, or 0.5% annualized, to $420.1 million from $419.2 million at December 31, 2020. While total wholesale funding as a percentage of total bank funding has decreased meaningfully overall due to significant in-market deposit growth, we continue to replace the majority of our maturing brokered certificates of deposit with FHLB advances at lower rates, as needed, to match-fund fixed rate loans and mitigate interest rate risk. Total bank funding is defined as total deposits plus FHLB advances, and Federal Reserve Discount Window advances. As of June 30, 2021 and December 31, 2020, the Corporation had other borrowings of $8.5 million and $920,000 respectively, which consisted of sold loans which were accounted for as a secured borrowing, because they did not qualify for true sale accounting and borrowings associated with our investment in a community development entity. During the second quarter of 2020, the Corporation tested its ability to borrow from the Federal Reserve PPPLF in the event funding was required to support the Banks PPP lending efforts. On April 28, 2020, the Corporation borrowed $29.6 million from the PPPLF at a rate of 0.35%. As of November 2, 2020, the borrowing was paid in full. Consistent with our funding philosophy to manage interest rate risk, we will use the most efficient and cost effective source of wholesale funds. We will utilize FHLB advances to the extent we maintain an adequate level of excess borrowing capacity for liquidity and contingency funding purposes and pricing remains favorable in comparison to the wholesale deposit alternative. We will use FHLB advances and/or brokered certificates of deposit in specific maturity periods needed, typically three to five years, to match-fund fixed rate loans and effectively mitigate the interest rate risk measured through our asset/liability management process and to support asset growth initiatives while taking into consideration our operating goals and desired level of usage of wholesale funds. Please refer to the section titled Liquidity and Capital Resources , below, for further information regarding our use and monitoring of wholesale funds. 57 Table of Contents Derivatives The Corporation’s derivative financial instruments, under which the Corporation is required to either receive cash from or pay cash to counterparties depending on changes in interest rates applied to notional amounts, are carried at fair value on the consolidated balance sheets. We offer interest rate swap products directly to qualified commercial borrowers, originating a floating rate loan and an interest rate swap providing a fixed rate to the borrower. The client’s swap is then offset with a counter-party dealer. The execution of these transactions generates swap fee income. The aggregate amortizing notional value of interest rate swaps with various borrowers increased $7.9 million, or 1.3%, to $637.0 million as of June 30, 2021, compared to $629.1 million as of December 31, 2020. The fair value of these interest rate swaps decreased $17.0 million, or 34.4%, to $32.4 million as of June 30, 2021, compared to $49.4 million as of December 31, 2020. The decline in fair value of the derivative contracts is directly related to the level of interest rates as of June 30, 2021, compared to the maturity term and amortization rates when the derivative contracts were originally executed. For further information and discussion of our derivatives, see Note 13 — Derivative Financial Instruments of the Consolidated Financial Statements. Asset Quality Impaired Assets Total impaired assets consisted of the following at June 30, 2021 and December 31, 2020, respectively: June 30, 2021 December 31, 2020 (Dollars in Thousands) Non-accrual loans and leases Commercial real estate: Commercial real estate - owner occupied $ 2,125 $ 5,429 Commercial real estate - non-owner occupied 2,998 3,783 Land development — 890 Construction — — Multi-family — — 1-4 family 44 250 Total non-accrual commercial real estate 5,167 10,352 Commercial and industrial 6,160 16,155 Direct financing leases, net 49 49 Consumer and other: Home equity and second mortgages 35 40 Other 11 21 Total non-accrual consumer and other loans 46 61 Total non-accrual loans and leases 11,422 26,617 Foreclosed properties, net 179 34 Total non-performing assets 11,601 26,651 Performing troubled debt restructurings 56 46 Total impaired assets $ 11,657 $ 26,697 Total non-accrual loans and leases to gross loans and leases 0.53 % 1.24 % Total non-performing assets to gross loans and leases plus foreclosed properties, net 0.54 1.24 Total non-performing assets to total assets 0.40 1.04 Allowance for loan and lease losses to gross loans and leases 1.20 1.33 Allowance for loan and lease losses to non-accrual loans and leases 224.79 107.15 58 Table of Contents Net PPP loans outstanding as of June 30, 2021 and December 31, 2020, were $120.7 million and $225.3 million, respectively. The following asset quality ratios exclude net PPP loans as they are fully guaranteed by the SBA: June 30, 2021 December 31, 2020 Total non-accrual loans and leases to gross loans and leases 0.56 % 1.38 % Total non-performing assets to gross loans and leases plus foreclosed properties, net 0.57 1.38 Total non-performing assets to total assets 0.42 1.14 Allowance for loan and lease losses to gross loans and leases 1.27 1.48 Non-accrual loans decreased $15.2 million, or 57.1%, to $11.4 million at June 30, 2021, compared to $26.6 million at December 31, 2020. The decrease in non-accrual loans was principally due to loan payoffs, loans returning to accrual status, and $3.0 million of charge-offs, of which $2.2 million was from the legacy SBA portfolio and $471,000 from the small ticket vendor finance program. All charge-offs for the six months ended June 30, 2021 were previously identified impaired loans, unrelated to the economic slowdown from the COVID-19 pandemic. Management does not view these charge-offs as being indicative of any systemic issues across the Corporation’s loan and lease portfolio. The Corporation’s non-accrual loans as a percentage of total gross loans and leases measured 0.53% and 1.24% at June 30, 2021 and December 31, 2020, respectively. Non-accrual loans as a percentage of total gross loans and leases, excluding net PPP loans, was 0.56% and 1.38% at June 30, 2021 and December 31, 2020, respectively. As of June 30, 2021 and December 31, 2020, $523,000 and $6.5 million of non-accrual loans and leases were considered troubled debt restructurings, respectively. Please refer to the section titled COVID-19 Update for additional information on credit quality. We use a wide variety of available metrics to assess the overall asset quality of the portfolio and no one metric is used independently to make a final conclusion as to the asset quality of the portfolio. Non-performing assets as a percentage of total assets decreased to 0.40% at June 30, 2021 from 1.04% at December 31, 2020. As of June 30, 2021, the payment performance of our loans and leases did not point to any new areas of concern, as approximately 99.9% of the total portfolio was in a current payment status, compared to 99.0% as of December 31, 2020. We also monitor asset quality through our established categories as defined in Note 6 – Loan and Lease Receivables, Impaired Loans and Leases and Allowance for Loan and Lease Losses of the Consolidated Financial Statements. As we continue to actively monitor the credit quality of our loan and lease portfolios, we may identify additional loans and leases for which the borrowers or lessees are having difficulties making the required principal and interest payments based upon factors including, but not limited to, the inability to sell the underlying collateral, inadequate cash flow from the operations of the underlying businesses, liquidation events, or bankruptcy filings. We are proactively working with our impaired loan borrowers to find meaningful solutions to difficult situations that are in the best interests of the Bank. As of June 30, 2021, as well as in all previous reporting periods, there were no loans over 90 days past due and still accruing interest. Loans and leases greater than 90 days past due are considered impaired and are placed on non-accrual status. Cash received while a loan or a lease is on non-accrual status is generally applied solely against the outstanding principal. If collectability of the contractual principal and interest is not in doubt, payments received may be applied to both interest due on a cash basis and principal. 59 Table of Contents The following represents additional information regarding our impaired loans and leases: As of and for the Six Months Ended June 30, As of and for the Year Ended December 31, 2021 2020 2020 (In Thousands) Impaired loans and leases with no impairment reserves required $ 7,948 $ 10,742 $ 18,966 Impaired loans and leases with impairment reserves required 3,530 13,402 7,697 Total impaired loans and leases 11,478 24,144 26,663 Less: Impairment reserve (included in allowance for loan and lease losses) 2,021 5,924 3,681 Net impaired loans and leases $ 9,457 $ 18,220 $ 22,982 Average impaired loans and leases $ 19,420 $ 23,847 $ 27,703 Foregone interest income attributable to impaired loans and leases $ 1,081 $ 1,114 $ 2,794 Less: Interest income recognized on impaired loans and leases 153 458 636 Net foregone interest income on impaired loans and leases $ 928 $ 656 $ 2,158 Non-performing assets also include foreclosed properties. A summary of foreclosed properties activity is as follows: As of and for the Six Months Ended June 30, As of and for the Year Ended December 31, 2021 2020 2020 (In Thousands) Balance at the beginning of the period $ 34 $ 2,919 $ 2,919 Transfer of loans and leases to foreclosed properties 149 80 80 Proceeds from sale of foreclosed properties — (1,160) (2,582) Net loss on sale of foreclosed properties — (54) (20) Impairment adjustments (4) (396) (363) Balance at the end of the period $ 179 $ 1,389 $ 34 Allowance for Loan and Lease Losses The allowance for loan and lease losses decreased $2.8 million, or 10.0%, from $28.5 million as of December 31, 2020 to $25.7 million as of June 30, 2021. The allowance for loan and lease losses as a percentage of gross loans and leases decreased from 1.33% as of December 31, 2020 to 1.20% as of June 30, 2021. The allowance for loan and lease losses as a percentage of gross loans and leases, excluding net PPP loans, was 1.27% as of June 30, 2021 compared to 1.47% as of December 31, 2020. The decrease in allowance for loan and lease losses as a percent of gross loans and leases was principally driven by a significant commercial real estate loan recovery during the first quarter of 2021, and the related impact it had on our commercial real estate historical loss factors, and the release of specific reserves following loan payoffs and charge-offs. These general and specific reserve releases were partially offset primarily by an increase in general reserve commensurate with loan growth. There have been no substantive changes to our methodology for estimating the appropriate level of allowance for loan and lease loss reserves from what was previously outlined in our most recent Annual Report on Form 10-K. During the six months ended June 30, 2021, we recorded net recoveries on impaired loans and leases of $180,000, comprised of $3.0 million of charge-offs and $3.2 million of recoveries. While we likely will continue to experience some level of periodic charge-offs in the future as exit strategies are considered and executed, management believes charge-offs in the foreseeable future will be at lower levels based on our total non-accrual loans and leases as a percentage of gross loans and leases of 0.53% at June 30, 2021, is the Corporation’s lowest level of non-accrual loans since the fourth quarter of 2006. Loans and leases with previously established specific reserves, however, may ultimately result in a charge-off under a variety of scenarios. 60 Table of Contents As of June 30, 2021 and December 31, 2020, our ratio of allowance for loan and lease losses to total non-accrual loans and leases was 224.79% and 107.15%, respectively. This ratio continues to increase due to the significant decline in non-accrual loans and as our remaining non-accrual loan and lease portfolio has a larger proportion of SBA loans when compared to December 31, 2020, which historically carry larger collateral shortfalls when compared to our conventional commercial loans. Impaired loans and leases exhibit weaknesses that inhibit repayment in compliance with the original terms of the note or lease. However, the measurement of impairment on loans and leases may not always result in a specific reserve included in the allowance for loan and lease losses. As part of the underwriting process, as well as our ongoing monitoring efforts, we try to ensure that we have sufficient collateral to protect our interest in the related loan or lease. As a result of this practice, a significant portion of our outstanding balance of non-performing loans or leases either does not require additional specific reserves or requires only a minimal amount of required specific reserve, as we believe the loans and leases are adequately collateralized as of the measurement period. In addition, management is proactive in recording charge-offs to bring loans to their net realizable value in situations where it is determined with certainty that we will not recover the entire amount of our principal. This practice may lead to a lower allowance for loan and lease loss to non-accrual loans and leases ratio as compared to our peers or industry expectations. As asset quality strengthens, our allowance for loan and lease losses is measured more through general characteristics, including historical loss experience, of our portfolio rather than through specific identification and we would therefore expect this ratio to rise. Conversely, if we identify further impaired loans, this ratio could fall if the impaired loans are adequately collateralized and therefore require no specific or general reserve. Given our business practices and evaluation of our existing loan and lease portfolio, we believe this coverage ratio is appropriate for the probable losses inherent in our loan and lease portfolio as of June 30, 2021. To determine the level and composition of the allowance for loan and lease losses, we break out the portfolio by segments with similar risk characteristics. First, we evaluate loans and leases for potential impairment classification. We analyze each loan and lease identified as impaired on an individual basis to determine a specific reserve based upon the estimated value of the underlying collateral for collateral-dependent loans, or alternatively, the present value of expected cash flows. For each segment of loans and leases that has not been individually evaluated, management segregates the Bank’s loss factors into a quantitative general reserve component based on historical loss rates throughout the defined look back period. The quantitative general reserve component also considers an estimate of the historical loss emergence period, which is the period of time between the event that triggers the loss to the charge-off of that loss. The methodology also focuses on evaluation of several qualitative factors for each portfolio category, including but not limited to: management’s ongoing review and grading of the loan and lease portfolios, consideration of delinquency experience, changes in the size of the loan and lease portfolios, existing economic conditions, level of loans and leases subject to more frequent review by management, changes in underlying collateral, concentrations of loans to specific industries, and other qualitative factors that could affect credit losses such as the economic uncertainty related to the COVID-19 pandemic. As of June 30, 2021, the allowance for loan and lease losses included $726,000 in general reserve related to economic uncertainty, compared to $947,000 as of December 31, 2020. Management removed qualitative factors due to COVID-19 uncertainty from the majority of our specialized lending and commercial and industrial portfolios reflecting continued strong performance while maintaining a general reserve on industries previously identified as stressed, specifically hospitality and retail. When it is determined that we will not receive our entire contractual principal or the loss is confirmed, we record a charge against the allowance for loan and lease loss reserve to bring the loan or lease to its net realizable value. Many of the impaired loans as of June 30, 2021 are collateral dependent. It is typically part of our process to obtain appraisals on impaired loans and leases that are primarily secured by real estate or equipment at least annually, or more frequently as circumstances warrant. As we have completed new appraisals and/or market evaluations, we have found that in general real estate values have been stable or improved; however, in specific situations current fair values collateralizing certain impaired loans were inadequate to support the entire amount of the outstanding debt. Foreclosure actions may have been initiated on certain of these commercial real estate and other mortgage loans. As a result of our review process, we have concluded an appropriate allowance for loan and lease losses for the existing loan and lease portfolio was $25.7 million, or 1.20% of gross loans and leases, at June 30, 2021. However, given ongoing complexities with current workout situations and the uncertainty surrounding future economic conditions, further charge-offs, and increased provisions for loan and lease losses may be recorded if additional facts and circumstances lead us to a different conclusion. In addition, various federal and state regulatory agencies review the allowance for loan and lease losses. These agencies could require certain loan and lease balances to be classified differently or charged off when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. 61 Table of Contents A summary of the activity in the allowance for loan and lease losses follows: As of and for the Three Months Ended June 30, As of and for the Six Months Ended June 30, 2021 2020 2021 2020 (Dollars in Thousands) Allowance at beginning of period $ 28,982 $ 22,748 $ 28,521 $ 19,520 Charge-offs: Commercial real estate: Commercial real estate — owner occupied (4) (27) (4) (27) Commercial real estate — non-owner occupied — — — — Construction and land development — — — — Multi-family — — — — 1-4 family (245) — (245) — Commercial and industrial (2,621) (729) (2,765) (854) Direct financing leases — (55) — (55) Consumer and other: Home equity and second mortgages — — — — Other (24) (6) (24) (12) Total charge-offs (2,894) (817) (3,038) (948) Recoveries: Commercial real estate: Commercial real estate — owner occupied 84 — 225 1 Commercial real estate — non-owner occupied — 2 — 2 Construction and land development — — 2,078 — Multi-family — — — — 1-4 family — — — — Commercial and industrial 460 62 913 238 Direct financing leases — — — — Consumer and other: Home equity and second mortgages — — 1 — Other 1 — 1 — Total recoveries 545 64 3,218 241 Net recoveries (2,349) (753) 180 (707) Provision for loan and lease losses (958) 5,469 (3,026) 8,651 Allowance at end of period $ 25,675 $ 27,464 $ 25,675 $ 27,464 Annualized net charge-offs (recoveries) as a percent of average gross loans and leases 0.42 % 0.15 % (0.02) % 0.08 % Annualized net charge-offs (recoveries) as a percent of average gross loans and leases, excluding average net PPP loans 0.47 % 0.17 % (0.02) % 0.08 % 62 Table of Contents Liquidity and Capital Resources The Corporation expects to meet its liquidity needs through existing cash on hand, established cash flow sources, its third party senior line of credit, and dividends received from the Bank. While the Bank is subject to certain generally applicable regulatory limitations regarding its ability to pay dividends to the Corporation, we do not believe that the Corporation will be adversely affected by these dividend limitations. The Corporation’s principal liquidity requirements at June 30, 2021 were the interest payments due on subordinated and junior subordinated notes. On April 30, 2021, the Bank’s Board of Directors declared a dividend in the aggregate amount of $2.5 million bringing year-to-date dividend declarations to $4.5 million. The capital ratios of the Bank met all applicable regulatory capital adequacy requirements in effect on June 30, 2021, and continue to meet the heightened requirements imposed by Basel III, including the capital conservation buffer that was fully phased-in as of January 1, 2019. The Corporation’s Board and management teams adhere to the appropriate regulatory guidelines on decisions which affect their capital positions, including but not limited to, decisions relating to the payment of dividends and increasing indebtedness. The Bank maintains liquidity by obtaining funds from several sources. The Bank’s primary source of funds are principal and interest payments on loans receivable and mortgage-related securities, deposits, and other borrowings, such as federal funds, FHLB advances, and Federal Reserve Discount Window advances. The scheduled payments of loans and mortgage-related securities are generally a predictable source of funds. Deposit flows and loan prepayments, however, are greatly influenced by general interest rates, economic conditions, and competition. We view on-balance sheet liquidity as a critical element to maintaining adequate liquidity to meet our cash and collateral obligations. We define our on-balance sheet liquidity as the total of our short-term investments, our unencumbered securities available-for-sale, and our unencumbered pledged loans. As of June 30, 2021 and December 31, 2020, our immediate on-balance sheet liquidity was $829.0 million and $640.2 million, respectively. The increase as of June 30, 2021 compared to December 31, 2020 was principally due to the proceeds from a commercial client’s business sale late in the second quarter, the majority of which was moved off the balance sheet in July, and PPP forgiveness proceeds. Immediate on-balance sheet liquidity as of December 31, 2020 included $225.3 million of availability from the Federal Reserve’s PPPLF advance program. Excluding the temporary proceeds from the commercial client’s business sale and the PPPLF advance program, immediate on-balance sheet liquidity was $604.0 million and $414.9 million as of June 30, 2021 and December 31, 2020, respectively. This increase in on-balance sheet liquidity compared to December 31, 2020 is primarily due to excess cash held at the FRB due to PPP loan forgiveness proceeds. At June 30, 2021 and December 31, 2020, the Bank had $364.5 million and $26.7 million on deposit with the FRB recorded in short-term investments, respectively. Any excess funds not used for loan funding or satisfying other cash obligations were maintained as part of our on-balance sheet liquidity in our interest-bearing accounts with the FRB, as we value the safety and soundness provided by the FRB. We plan to utilize excess liquidity to fund loan and lease portfolio growth, pay down maturing debt, allow run off of maturing wholesale certificates of deposit or invest in securities to maintain adequate liquidity at an improved margin. We had $532.3 million of outstanding wholesale funds at June 30, 2021, compared to $567.0 million of wholesale funds as of December 31, 2020, which represented 20.9% and 25.2%, respectively, of ending balance total bank funding. Wholesale funds include FHLB advances, brokered certificates of deposit, deposits gathered from reciprocal deposit programs above the general cap if, applicable, and receive only deposits from reciprocal deposit programs. Total bank funding is defined as total deposits plus FHLB advances. We are committed to raising in-market deposits while utilizing wholesale funds to mitigate interest rate risk. Wholesale funds continue to be an efficient and cost effective source of funding for the Bank and allows it to gather funds across a larger geographic base at price levels and maturities that are more attractive than local time deposits when required to raise a similar level of in-market deposits within a short time period. Access to such deposits and borrowings allows us the flexibility to refrain from pursuing single service deposit relationships in markets that have experienced unfavorable pricing levels. In addition, the administrative costs associated with wholesale funds are considerably lower than those that would be incurred to administer a similar level of local deposits with a similar maturity structure. During the time frames necessary to accumulate wholesale funds in an orderly manner, we will use short-term FHLB advances to meet our temporary funding needs. The short-term FHLB advances will typically have terms of one week to one month to cover the overall expected funding demands. Excluding temporary deposits from the sale of a commercial client’s business, period-end in-market deposits increased $108.2 million, or 12.9% annualized, to $1.791 billion at June 30, 2021 from $1.683 billion at December 31, 2020 as in-market deposit balances increased due to our client’s PPP loan proceeds and successful business development efforts. Our in-market relationships remain stable; however, deposit balances associated with those relationships will fluctuate. We expect to establish new client relationships and continue marketing efforts aimed at increasing the balances in existing clients’ deposit accounts. Nonetheless, we will continue to use wholesale funds in specific maturity periods, typically three to five years, needed to effectively mitigate the interest rate risk measured through our asset/liability management process or in shorter time periods if in-market deposit balances decline. In order to provide for ongoing liquidity and funding, all of our wholesale 63 Table of Contents certificates of deposit do not allow for withdrawal at the option of the depositor before the stated maturity (with the exception of deposits accumulated through the internet listing service which have the same early withdrawal privileges and fees as do our other in-market deposits) and FHLB advances with contractual maturity terms. The Bank limits the percentage of wholesale funds to total bank funds in accordance with liquidity policies approved by its Board. The Bank was in compliance with its policy limits as of June 30, 2021. The Bank was able to access the wholesale funding market as needed at rates and terms comparable to market standards during the year ended June 30, 2021. In the event that there is a disruption in the availability of wholesale funds at maturity, the Bank has managed the maturity structure, in compliance with our approved liquidity policy, so at least one year of maturities could be funded through on-balance sheet liquidity. These potential funding sources include deposits maintained at the FRB or Federal Reserve Discount Window utilizing currently unencumbered securities and acceptable loans as collateral. As of June 30, 2021, the available liquidity was in excess of the stated policy minimum. We believe the Bank will also have access to the unused federal funds lines, cash flows from borrower repayments, and cash flows from security maturities. The Bank also has the ability to raise local market deposits by offering attractive rates to generate the level required to fulfill its liquidity needs. The Bank is required by federal regulation to maintain sufficient liquidity to ensure safe and sound operations. We believe that the Bank has sufficient liquidity to match the balance of net withdrawable deposits and short-term borrowings in light of present economic conditions and deposit flows. The Corporation's capital ratios continued to exceed the highest required regulatory benchmark levels. As of June 30, 2021, total capital to risk-weighted assets was 11.22%, tier 1 capital to risk-weighted assets was 9.14%, tier 1 leverage capital to adjusted average assets was 8.48% and common equity tier 1 capital to risk-weighted assets was 8.72%. In addition, as of June 30, 2021, tangible common equity to tangible assets was 7.33%. As of July 29, 2021, the Corporation had purchased 46,513 shares of its common stock, since the adoption of its previously disclosed stock repurchase program, at a weighted average price of $26.53 per share, for a total value of $1.2 million. The Corporation had $3.8 million of buyback authority remaining under the program as of July 29, 2021. As previously announced, during the second quarter of 2021, the Corporation’s Board of Directors declared a regular quarterly dividend of $0.18 per share. The dividend was paid on May 24, 2021 to stockholders of record at the close of business on May 10, 2021. Measured against second quarter 2021 diluted earnings per share of $0.95, the dividend represents a 18.9% payout ratio. The Board of Directors routinely considers dividend declarations as part of its normal course of business. During the six months ended June 30, 2021, operating activities resulted in a net cash inflow of $15.0 million, which included net income of $18.0 million, partially offset by a $3.0 million provision for loan and lease loss benefit. Net cash provided by investing activities for the six months ended June 30, 2021 was $15.9 million primarily due to proceeds received from the sale of securities available for sale. Net cash provided by financing activities was $302.2 million for the six months ended June 30, 2021 primarily due to a net increase in deposits, partially offset by a net reduction in FHLB advances and cash dividends paid. Please refer to the Consolidated Statements of Cash Flows included in PART I., Item 1 for further details regarding significant sources of cash flow for the Corporation. Contractual Obligations and Off-Balance Sheet Arrangements As of June 30, 2021, there were no material changes to our contractual obligations and off-balance sheet arrangements disclosed in our Annual Report on Form 10-K for the year ended December 31, 2020. We continue to believe that we have adequate capital and liquidity available from various sources to fund projected contractual obligations and commitments. Item 3. Quantitative and Qualitative Disclosures about Market Risk Not applicable. 64 Table of Contents