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Item 3. Quantitative and Qualitative Disclosures About Market Risk

2022-05-10 compared with 2021-11-09 · 27 added, 47 removed, 14 unchanged (84% of the section changed)

1 unchanged sentence

INTEREST RATE RISK (INCLUDING QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK)

Net interest income is our most significant component of earnings.

Notwithstanding changes in volumes of loans and deposits, our level of net interest income is continually at risk due to the effect that changes in general market interest rate trends have on interest yields earned and paid with respect to our various categories of earning assets and interest-bearing liabilities.

Net interest income is our most significant component of earnings and we consider interest rate risk to be our most significant market risk.

In addition to changes in volumes of loans and deposits, our level of net interest income is continually at risk due to the effect that changes in general market interest rate trends have on interest yields earned and paid with respect to our various categories of earning assets and interest-bearing liabilities.

It is our policy to maintain portfolios of earning assets and interest-bearing liabilities with maturities and repricing opportunities that will afford protection, to the extent practical, against wide interest rate fluctuations.

Our exposure to interest rate risk is analyzed on a regular basis by management using standard GAP reports, maturity reports, and an asset/liability software model that simulates future levels of interest income and expense based on current interest rates, expected future interest rates, and various intervals of “shock” interest rates.

Over the years, we have been able to maintain a fairly consistent yield on average earning assets (net interest margin), even during periods of changing interest rates.

Over the past five calendar years, our net interest margin has ranged from a low of 3.56% (realized in 2020) to a high of 4.09% (realized in 2018).

Our 2021 margins have decreased from our low in 2020, with our net interest margins amounting to 3.03% and 3.17% for the three and nine months ended September 30, 2021, respectively, as discussed below.

Our generally consistent net interest margin has been aided by the relatively low level of long-term interest rate exposure that we maintain.

At September 30, 2021 a majority of our interest-earning assets are subject to repricing within five years (because they are either adjustable rate assets or they are fixed rate assets that mature) and substantially all of our interest-bearing liabilities reprice within five years.

Using stated maturities for all fixed rate instruments except mortgage-backed securities (which are allocated in the periods of their expected payback) and securities and borrowings with call features that are expected to be called (which are shown in the period of their expected call), at September 30, 2021, we had approximately $3 billion more in interest-bearing liabilities that are subject to interest rate changes within one year than earning assets.

Our exposure to interest rate risk is analyzed on a regular basis by management using standard "gap" reports (which measure the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that time period), maturity reports, and an asset/liability software model that simulates future levels of interest income and expense based on current interest rates, expected future interest rates, and various intervals of “shock” interest rates.

Over the years, we have been able to maintain a fairly consistent yield on average earning assets (NIM), even during periods of changing interest rates.

Over the past five calendar years, our NIM has ranged from a low of 3.16% (realized in 2021) to a high of 4.09% (realized in 2018).

The 93 basis point fluctuation in NIM between the high and low point during this period was a direct result of the FRB monetary policy enacted at the beginning of the COVID-19 pandemic resulting in a reduction in short-term market interest rates totaling 150 basis points in March 2020.

During the first quarter of 2022, the FRB implemented monetary policy to combat inflationary conditions and increased short-term rates 25 basis points, with the anticipation of additional rate increases to occur throughout 2022.

There has be no significant change in the Company-estimated net interest income sensitivity from December 31, 2021.

Using stated maturities for all fixed rate instruments except mortgage-backed securities (which are allocated in the periods of their expected payback) and securities and borrowings with call features that are expected to be called (which are shown in the period of their expected call), at March 31, 2022, we had approximately $3.2 billion more in interest-bearing liabilities that are subject to interest rate changes within one year than earning assets.

This generally would indicate that net interest income would experience downward pressure in a rising interest rate environment and would benefit from a declining interest rate environment.

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In addition to the effects of “when” various rate-sensitive products reprice, market rate changes may not result in uniform changes in rates among all products.

For example, included in interest-bearing liabilities subject to interest rate changes within one year at September 30, 2021 were deposits totaling $4.0 b illion comprised of checking, savings, and certain types of money market deposits with interest rates set by management.

For example, included in interest-bearing liabilities subject to interest rate changes within one year as of March 31, 2022 were deposits totaling $4.9 billion comprised of checking, savings, and certain types of money market deposits with interest rates set by management.

These types of deposits historically have not repriced with, or in the same proportion, as general market indicators.

Overall, we believe that in the near term (twelve months), net interest income will not likely experience significant downward pressure from rising interest rates.

Similarly, we would not expect a significant increase in near term net interest income from falling interest rates.

Generally, when rates change, our interest-sensitive assets that are subject to adjustment reprice immediately at the full amount of the change, while our interest-sensitive liabilities that are subject to adjustment reprice at a lag to the rate change and typically not to the full extent of the rate change.

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However, in the twelve-month and longer horizon, the impact of having a higher level of interest-sensitive liabilities generally lessens the short-term effects of changes in interest rates.

Overall we believe that in the near-term (twelve months), net interest income will not likely experience significant pressure from fluctuations in interest rates, and specifically from the anticipated rise in interest rates.

Because of the static nature and limitations as discussed above of the gap report, we also employ an earnings simulation model to analyze the sensitivity of net interest income to movements in interest rates.

The model is based on actual cash flows and repricing characteristics for on- and off-balance sheet instruments and incorporates market-based assumptions regarding the impact of changing interest rates on the prepayment rate of certain assets and liabilities.

Earnings-simulation analysis captures not only the potential of these interest sensitive assets and liabilities to mature or reprice, but also the probability that they will do so.

Moreover, earnings-simulation analysis considers the relative sensitivities of these balance sheet items and projects their behavior over an extended period of time.

The general discussion in the foregoing paragraph applies most directly in a “normal” interest rate environment in which longer-term maturity instruments carry higher interest rates than short-term maturity instruments, and is less applicable in periods in which there is a “flat” interest rate curve.

A “flat yield curve” means that short-term interest rates are substantially the same as long-term interest rates.

Due to actions taken by the Federal Reserve related to short-term interest rates and the impact of the global economy on longer-term interest rates, we are currently in a

very low and flat interest rate curve environment.

A flat interest rate curve is an unfavorable interest rate environment for many banks, including First Bank, as short-term interest rates generally drive our deposit pricing and longer-term interest rates generally drive loan pricing.

Actions taken by the FRB at the beginning of the pandemic resulted in a very low and flat interest rate curve environment.

Recent actions to raise short-term interest rates have resulted in a some steepening of the yield curve on the short end (within 3 years).

However, the longer end of the curve continues to be flat.

A flat interest rate curve is an unfavorable interest rate environment for many banks, including the Bank, as short-term interest rates generally drive our deposit pricing and longer-term interest rates generally drive loan pricing.

When these rates converge, the profit spread we realize between loan yields and deposit rates narrows, which pressures our net interest margin.

While there have been periods in the last few years that the yield curve has steepened slightly, it currently remains very flat.

This flat yield curve and the intense competition for high-quality loans in our market areas have resulted in lower interest rates on loans.

In an effort to address concerns about the national and global economy the Federal Reserve cut interest rates by 75 basis points in the second half of 2019.

And in March 2020, the Federal Reserve cut interest rates by an additional 150 basis points in response to the COVID-19 pandemic.

Our interest-bearing cash balances and most of our variable rate loans, generally reset to lower rates soon after these interest rate cuts.

We reduced our offering rates on most deposit products and our borrowing costs were also reduced by lower rates and repaying a significant portion of our outstanding borrowings.

Overall however, the impact of the interest rate cuts negatively impacted our net interest margin in 2020 and 2021.

The impact of the lower interest rates combined with the high liquidity arising from high deposit growth led to the decline in our net interest margins in 2021 when compared to prior periods.

Assuming no significant changes in interest rates in the next twelve months, we expect continued pressure on our net interest margin (excluding the impact of PPP - see below) as a result of the flat yield curve and the expectation of lower interest rates on the redeployment of cash received on maturing loans and investments that will likely not be fully offset by lower funding costs.

While our net interest margin is expected to continue to decline, the impact of that decline, as discussed previously, has been more that offset most quarters by incremental earnings associated with higher levels of interest-earnings assets arising from the high deposit growth.

The result has been that our net interest income, exclusive of loan discount accretion and PPP fee amortization (both are discussed below), has generally trended upwards for the last several years and reached an all-time high of $55.2 million in the third quarter of 2021.

Since the announcement of the PPP program, we have originated at total of approximately $353 million in PPP loans, of which $67 million and $241 million were outstanding at September 30, 2021 and December 31, 2020, respectively.

These loans all have an interest rate of 1.00%.

In addition to the interest rate, the SBA compensated us with an origination fee for each loan of between 1% to 5% of the loan amount, depending on the size of each loan.

We received a total of approximately $16.9 million in these fees, which were netted against the direct cost to originate each loan that totaled approximately $0.7 million, with the net deferral amount initially being amortized as interest income over their contractual lives of either two years or five years using the effective interest method of recognition.

Early repayments, including the loan forgiveness provisions contained in the PPP, result in accelerated amortization.

In 2020, we amortized $4.1 million of the PPP loan fees as interest income.

For the first nine months of 2021, we amortized $7.8 million of the PPP loan fees as interest income.

The Company has $4.3 million in remaining deferred PPP loan fees.

While the exact timing of the forgiveness approvals from PPP loans is uncertain, of the remaining fees at September 30, 2021, we currently expect approximately half to be recognized in the fourth quarter of 2021, with substantially all of the remainder recognized in the first quarter of 2022.

As previously discussed in the section “Net Interest Income,” our net interest income has been impacted by certain purchase accounting adjustments related to the acquired banks.

The purchase accounting adjustments related to the premium amortization on loans, deposits and borrowings are based on amortization schedules and are thus systematic and predictable.

The accretion of the loan discount on acquired loans amounted to $4.2 million and $3.0 million for the first nine months of 2021 and 2020, respectively, is less predictable and could be materially different among periods.

This is because of the magnitude of the discounts that are initially recorded and the fact that the accretion being recorded is dependent on both the credit quality of the acquired loans and the impact of any accelerated loan repayments, including payoffs.

If the credit quality of the loans declines, some, or all, of the remaining discount will cease to be accreted into income.

If the underlying loans experience accelerated paydowns or improved performance expectations, the remaining discount will be accreted into income on an accelerated basis.

In the event of total payoff, the remaining discount will be entirely accreted into income in the period of the payoff.

For example, in the second quarter of 2021, we experienced pay-offs on five former failed-bank loans that resulted in the elevated level of discount accretion recorded for the quarter.

Each of these factors is difficult to predict and susceptible to volatility.

The remaining loan discount on acquired loans amounted to $4.8 million at September 30, 2021 compared to $8.9 million at December 31, 2020.

We have no market risk sensitive instruments held for trading purposes, nor do we maintain any foreign currency positions.

See additional discussion regarding net interest income, as well as discussion of the changes in the annual net interest margin in the section entitled “Net Interest Income” above.

Assuming that short term rates continue to rise over the next 12 months, we may see some benefit to our net interest margin from raising rates if we are able to maintain stable funding costs.

Our experience historically has been that our demand deposit accounts have lagged the timing and amount of general market increases.

However, we expect continued pressure on net interest margin from market competition for quality loans and the investment of liquidity in lower earning assets until loan demand increases sufficiently to deploy excess liquidity from short-term investments and securities.

Because the assets and liabilities of a bank are primarily monetary in nature (payable in fixed, determinable amounts), the performance of a bank is affected more by changes in interest rates than by inflation as discussed above under Interest Rate Risk.

Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same.

The effect of inflation on banks is normally not as significant as its influence on those businesses that have large investments in plant and inventories.

During periods of high inflation, there are normally corresponding increases in the money supply, and banks will normally experience above average growth in assets, loans, and deposits.

Also, general increases in the price of goods and services will result in increased operating expenses.

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

What changed 10-Q

Item 3. Quantitative and Qualitative Disclosures About Market Risk