FIRST FINANCIAL BANKSHARES INC 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements This Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. When used in this Form 10-Q, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “predict,” “project,” and similar expressions, as they relate to us or our management, identify forward-looking statements. These forward-looking statements are based on information currently available to our management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors, including, but not limited, to those discussed in Part I, Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 and Part II, Item 1A of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2020, in each case under the heading “Risk Factors,” and the following: • general economic conditions, including local, state, national and international, and the impact they may have on us and our customers; • effect of the coronavirus (COVID-19) on our Company, the communities where we have our branches, the state of Texas and the United States, related to the economy and overall financial stability; • impact of reduction in interchange fees if assets exceed $10 billion; • government and regulatory responses to the COVID-19 pandemic; • effect of severe weather conditions, including hurricanes, tornadoes, flooding and droughts; • volatility and disruption in national and international financial and commodity markets and oil and gas prices; • government intervention in the U.S. financial system including the effects of recent legislative, tax, accounting and regulatory actions and reforms, including the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the Jumpstart Our Business Startups Act, the Consumer Financial Protection Bureau, the capital ratios of Basel III as adopted by the federal banking authorities and the Tax Cuts and Jobs Act; • political instability; • the ability of the Federal government to address the national economy; • changes in our competitive environment from other financial institutions and financial service providers; • the effects of and changes in trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”); • the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters; • the effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which we and our subsidiaries must comply; • changes in the demand for loans; • fluctuations in the value of collateral securing our loan portfolio and in the level of the allowance for loan losses; • potential risk of environmental liability associated with lending activities; • the accuracy of our estimates of future loan losses; • the accuracy of our estimates and assumptions regarding the performance of our securities portfolio; • soundness of other financial institutions with which we have transactions; • inflation, interest rate, market and monetary fluctuations; 37 Table of Contents • changes in consumer spending, borrowing and savings habits; • changes in commodity prices (e.g., oil and gas, cattle and wind energy); • our ability to attract deposits and increase market share; • changes in our liquidity position; • changes in the reliability of our vendors, internal control system or information systems; • cyber attacks on our technology information systems, including fraud from our customers and external third party vendors; • our ability to attract and retain qualified employees; • acquisitions and integration of acquired businesses; • the possible impairment of goodwill and other intangibles associated with our acquisitions; • consequences of continued bank mergers and acquisitions in our market area, resulting in fewer but much larger and stronger competitors; • expansion of operations, including branch openings, new product offerings and expansion into new markets; • changes in our compensation and benefit plans; • acts of God, pandemic, war or terrorism; and • our success at managing the risk involved in the foregoing items. Such forward-looking statements reflect the current views of our management with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategy and liquidity. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by this paragraph. We undertake no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise (except as required by law). Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expense is salaries and related employee benefits. We usually measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk-based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income, on a tax equivalent basis and noninterest income. The following discussion and analysis of operations and financial condition should be read in conjunction with the financial statements and accompanying footnotes included in Item 1 of this Form 10-Q as well as those included in the Company’s 2019 Annual Report on Form 10-K. Coronavirus Update/Status The coronavirus (COVID-19) pandemic has placed significant health, economic and other major pressure throughout the communities we serve, the state of Texas, the United States and the entire world. We have implemented a number of procedures in response to the pandemic to support the safety and well being of our employees, customers and shareholders that continue through the date of this report: • We have addressed the safety of our 78 branches and other locations, following the guidelines of the Center for Disease Control, and while the branches generally remain open to customers, we have taken steps, and continue to evaluate, to push as much traffic and transactions as possible to our motor banks; • We hold executive meetings weekly or more as needed to address issues that are changing rapidly; • We moved our Annual Shareholders’ Meeting from a physical meeting to a virtual meeting; 38 Table of Contents • Provided extensions and deferrals to loan customers effected by COVID-19 provided such customers were not 30 days past due at December 31, 2019; • We chose to participate in the CARES Act Paycheck Protection Program (PPP) that provided government guaranteed and forgivable loans to our customers. Through June 30, 2020, we completed approximately 6,500 applications and funded $703.12 million of such loans (see below). We believe these loans and our participation in the program was good for our customers and the communities we serve; and • We chose to participate in the Federal Reserve’s Main Street Lending Program to provide ongoing loans for our customers. No loans have yet been funded as of June 30, 2020. We continue to closely monitor this pandemic and expect to make future changes to respond to the pandemic as this situation continues to evolve. Critical Accounting Policies We prepare consolidated financial statements based on GAAP and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan loss expense and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. Our policy for (1) our allowance for loan losses and our provision for loan loss expense and (2) our valuation of securities is included in note 1 to our notes to consolidated financial statements (unaudited) which begins on page 10. Additional detailed information is included in notes 4 and 5 to our notes to the consolidated financial statements (unaudited) and should be read in conjunction with this analysis. Stock Split On April 23, 2019, the Company’s Board of Directors declared a two-for-one stock split in the form of a 100% stock dividend effective June 3, 2019. All per share amounts in this report have been restated to reflect this stock split. An amount equal to the par value of the additional common shares to be issued pursuant to the stock split was reflected as a transfer from retained earnings to common shares in the consolidated financial statements as of and for the six-months ended June 30, 2019. Stock Repurchase On March 12, 2020, the Company’s Board of Directors authorized the repurchase of up to 4,000,000 common shares through September 30, 2021. The stock buyback plan authorizes management to repurchase the stock at such time as repurchases are considered beneficial to the Company and stockholders. Any repurchase of stock will be made through the open market, block trades or in privately negotiated transactions in accordance with applicable laws and regulations. Under the repurchase plan, there is no minimum number of shares that the Company is required to repurchase. Through June 30, 2020, the Company repurchased 324,802 shares totaling $8.0 million under this repurchase plan. Subsequent to June 30, 2020 and through July 28, 2020, no additional shares were repurchased. 39 Table of Contents Acquisition On September 19, 2019, we entered into an agreement and plan of reorganization to acquire TB&T Bancshares, Inc. and its wholly-owned bank subsidiary, The Bank & Trust of Bryan/College Station, Texas. On January 1, 2020, the transaction closed. Pursuant to the agreement, we issued 6.28 million shares of the Company’s common shares in exchange for all of the outstanding shares of TB&T Bancshares, Inc. In addition, in accordance with the plan of reorganization, TB&T Bancshares, Inc. paid a special dividend totaling $1.92 million to its shareholders prior to the closing of this transaction. At the closing, Brazos Merger Sub., Inc., a wholly-owned subsidiary of the Company, merged into TB&T Bancshares Inc., with TB&T Bancshares, Inc. surviving as a wholly owned subsidiary of the Company. Immediately following such merger, TB&T Bancshares, Inc. was merged into the Company and The Bank & Trust of Bryan/College Station, Texas was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value of the net assets acquired by approximately $141.92 million and the Company recorded such excess as goodwill. The balance sheet and results of operations of TB&T Bancshares, Inc. have been included in the financial statements of the Company effective January 1, 2020. See note 11 to the consolidated financial statements for additional information and disclosure. Participation in PPP Loans The Company elected to participate in the PPP loan program, subject to prepayment, processing approximately 6,500 loans and funded $703.12 million. The Company received fees totaling approximately $26.07 million and incurred incremental direct origination costs of $3.62 million, both of which have been deferred and are being amortized over the shorter of the repayment period or 24 months, the contractual life of these loans. The Company recognized $2.83 million of this net amount into interest income in the second quarter of 2020. Status of New Accounting Standard for Allowance for Credit Losses On January 1, 2020, ASU 2016-13 Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments , became effective for the Company which replaced the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (CECL) methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost, including loan receivables. It also applies to off-balance sheet credit exposures not accounted for as insurance (loan commitments, standby letters of credit, financial guarantees, and other similar instruments). In addition, ASU 2016-13 made changes to the accounting for available-for-sale debt securities. One such change is to require credit losses to be presented as an allowance rather than as a write-down on available-for-sale debt securities management does not intend to sell or believes that it is more likely than not they will be required to sell. On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was signed by the President of the United States that included an option for entities to delay the implementation of ASC 326 until the earlier of the termination date of the national emergency declaration by the President or December 31, 2020. The Company elected to delay its implementation of ASU 2016-13 and has calculated and recorded its provision for loan losses under the incurred loss model that existed prior to ASU 2016-13. Prior to the CARES Act being signed and our decision to delay the implementation of CECL, we were continuing our CECL implementation plan with our cross-functional working group, under the direction of our Chief Credit Officer along with our Chief Accounting Officer, Chief Lending Officer and Chief Financial Officer. The working group includes individuals from various functional areas including credit, risk management, accounting and information technology, among others. Our implementation plan 40 Table of Contents included assessment and documentation of processes, internal controls and data sources; model development, documentation and validation; and system configuration, among other things. We contracted with a third-party vendor to assist us in the implementation of CECL. Had we completed the adoption and implementation of CECL, we believe our allowance for loan losses amount at January 1, 2020 would have been approximately $52.0 million. At December 31, 2019, our allowance for loan losses totaled $52.5 million. In addition, we have evaluated our expected credit losses for certain debt securities and other financial assets and do not expect these allowances to be significant. Additionally, the adoption and implementation of ASU 2016-13 is not expected to have a significant impact on our regulatory capital ratios. As we continue to evaluate the provisions of ASU 2016-13 as of and for the three- and six- months ended June 30, 2020, we have considered the following in developing our forecast and its effect on our CECL calculations: • duration, extent and severity of COVID-19; • effect of government assistance; • unemployment and effect on economies and markets; • price of oil and gas and effect on economy; • value of real estate; and • effect of our TB&T Bancshares, Inc. acquisition on our combined loan portfolio. We are unable as of the date of this report to provide an estimate of our allowance for loan losses under the CECL model as of June 30, 2020 and the provision for loan losses for the three- and six- months then ended. 41 Table of Contents Results of Operations Performance Summary . Net earnings for the second quarter of 2020 were $53.47 million, up $11.38 million when compared with earnings of $42.09 million in the same quarter last year. Basic earnings per share were $0.38 for the second quarter of 2020 compared with $0.31 in the same quarter a year ago. The return on average assets was 2.06% for the second quarter of 2020, as compared to 2.14% for the second quarter of 2019. The return on average equity was 14.00% for the second quarter of 2020 as compared to 15.04% for the second quarter of 2019. The return on average tangible equity was 17.67% for the second quarter of 2020 compared to 17.81% for the second quarter of 2019. Net earnings for the six-month period ended June 30, 2020 were $90.70 million compared to $80.35 million for the same period in 2019. Basic earnings per share for the first six months of 2020 were $0.64 compared to $0.59 for the same period in 2019. The return on average assets was 1.86% for the first six months of 2020, as compared to 2.08% for the same period a year ago. The return on average equity was 12.09% for the first six months of 2020 as compared to 14.78% for the first six months of 2019. The return on average tangible equity was 15.33% for the first six months of 2020 as compared to 17.58% for the first six months of 2019. Net Interest Income . Net interest income is the difference between interest income on earning assets and interest expense on liabilities incurred to fund those assets. Our earning assets consist primarily of loans and investment securities. Our liabilities to fund those assets consist primarily of noninterest-bearing and interest-bearing deposits. Tax-equivalent net interest income was $92.14 million for the second quarter of 2020, as compared to $73.28 million for the same period last year. The increase in 2020 compared to 2019 was largely attributable to the increase in interest earning assets primarily from our TB&T acquisition, an increase in investment securities held and the impact of the Company’s participation in the PPP loan programax-exempt securities increased $1.20 billion and $630.45 million, respectively, for the second quarter of 2020 over the same quarter of 2019. Average interest-bearing liabilities increased $1.44 billion for the second quarter of 2020, as compared to the same period in 2019 primarily from our customers depositing their PPP loan amounts into our Bank, the TB&T acquisition and internal organic growth. The yield on earning assets decreased 51 basis points while the rate paid on interest-bearing liabilities decreased 50 basis points for the second quarter of 2020 compared to the second quarter of 2019. Tax-equivalent net interest income was $174.87 million for the first six months of 2020, as compared to $144.61 million for the same period last year. The increase in 2020 compared to 2019 was largely attributable to the increase in interest earning assets primarily from our TB&T acquisition, an increase in investment securities held and the impact of the Company’s participation in the PPP loan program. Average earning assets increased $1.85 billion for the first six months of 2020 over the same period in 2019. Average loans and tax-exempt securities increased $949.47 million and $375.58 million, respectively, for the first six months of 2020 over the first six months of 2019. Average interest-bearing liabilities increased $1.13 billion for the first six months of 2020, as compared to the same period in 2019 primarily from our customers depositing their PPP loan amounts into our Bank, the TB&T acquisition and internal organic growth. The yield on earning assets decreased 35 basis points while the rate paid on interest-bearing liabilities decreased 32 basis points for the first six months of 2020 compared to the first six months of 2019. 42 Table of Contents Table 1 allocates the change in tax-equivalent net interest income between the amount of change attributable to volume and to rate. Table 1 - Changes in Interest Income and Interest Expense (in thousands): Three Months Ended June 30, 2020 Compared to Three Months Ended June 30, 2019 Six Months Ended June 30, 2020 Compared to Six Months Ended June 30, 2019 Change Attributable to Total Change Change Attributable to Total Change Volume Rate Volume Rate Short-term investments $ 1,401 $ (1,981 ) $ (580 ) $ 2,132 $ (2,576 ) $ (444 ) Taxable investment securities 2,268 (2,163 ) 105 4,596 (3,124 ) 1,472 Tax-exempt investment securities (1) 5,720 (1,602 ) 4,118 6,863 (2,823 ) 4,040 Loans (1) (2) 16,700 (6,484 ) 10,216 25,953 (5,950 ) 20,003 Interest income 26,089 (12,230 ) 13,859 39,544 (14,473 ) 25,071 Interest-bearing deposits 1,632 (6,368 ) (4,736 ) 2,842 (7,558 ) (4,716 ) Short-term borrowings 890 (1,153 ) (263 ) 981 (1,454 ) (473 ) Interest expense 2,522 (7,521 ) (4,999 ) 3,823 (9,012 ) (5,189 ) Net interest income (1) $ 23,567 $ (4,709 ) $ 18,858 $ 35,721 $ (5,461 ) $ 30,260 (1) Computed on a tax-equivalent basis assuming a marginal tax rate of 21%. (2) Non-accrual loans are included in loans. The net interest margin for the second quarter of 2020 was 3.78%, a decrease of 20 basis points from the same period in 2019. The net interest margin for the first six months of 2020 was 3.84%, a decrease of 15 basis points from the same period in 2019. We continue to experience downward pressures on our net interest margin in 2020 and 2019 primarily due to the extended period of fluctuating historically low levels of short-term interest rates and a flat to inverted yield curve currently being experienced in the bond market. We have been able to somewhat mitigate the impact of these lower short-term interest rates and the flat/inverted yield curve by establishing minimum interest rates on certain of our loans, improving the pricing for loan risk, and minimizing rates paid on interest bearing liabilities. In March 2020, as the market experienced volatility, we took advantage of that volatility to purchase high quality municipal bonds at favorable tax equivalent interest yields. The Federal Reserve increased rates 100 basis points in 2018 but then decreased rates 75 basis points during the third and fourth quarters of 2019 and then an additional 150 basis points in the first quarter of 2020, resulting in a current target rate range of zero to 25 basis points. The Company’s participation in the PPP loan program impacted the net interest margin from (i) the amortization of loan fees (positive) and (ii) the 1% loan rate (negative). 43 Table of Contents The net interest margin, which measures tax-equivalent net interest income as a percentage of average earning assets, is illustrated in Table 2. Table 2 - Average Balances and Average Yields and Rates (in thousands, except percentages): Three Months Ended June 30, 2020 2019 Average Balance Income/ Expense Yield/ Rate Average Balance Income/ Expense Yield/ Rate Assets Short-term investments (1) $ 353,468 $ 87 0.10 % $ 112,817 $ 667 2.37 % Taxable investment securities (2) 2,399,364 14,030 2.34 2,063,497 13,925 2.70 Tax-exempt investment securities (2)(3) 1,800,339 14,733 3.27 1,169,889 10,615 3.63 Loans (3)(4) 5,248,052 66,249 5.08 4,043,055 56,033 5.56 Total earning assets 9,801,223 $ 95,099 3.90 % 7,389,258 $ 81,240 4.41 % Cash and due from banks 181,752 167,764 Bank premises and equipment, net 138,744 134,280 Other assets 87,091 63,629 Goodwill and other intangible assets, net 319,200 174,263 Allowance for loan losses (63,192 ) (52,005 ) Total assets $ 10,464,818 $ 7,877,189 Liabilities and Shareholders’ Equity Interest-bearing deposits $ 5,135,772 $ 2,550 0.20 % $ 4,196,123 $ 7,286 0.70 % Short-term borrowings 877,076 412 0.19 378,389 675 0.72 Total interest-bearing liabilities 6,012,848 $ 2,962 0.20 % 4,574,512 $ 7,961 0.70 % Noninterest-bearing deposits 2,830,960 2,136,264 Other liabilities 84,501 44,097 Total liabilities 8,928,309 6,754,873 Shareholders’ equity 1,536,509 1,122,316 Total liabilities and shareholders’ equity $ 10,464,818 $ 7,877,189 Net interest income (3) $ 92,137 $ 73,279 Rate Analysis: Interest income/earning assets 3.90 % 4.41 % Interest expense/earning assets (0.12 ) (0.43 ) Net interest margin 3.78 % 3.98 % 44 Table of Contents Six Months Ended June 30, 2020 2019 Average Balance Income/ Expense Yield/ Rate Average Balance Income/ Expense Yield/ Rate Assets Short-term investments (1) $ 292,245 $ 842 0.58 % $ 109,005 $ 1,286 2.38 % Taxable investment securities (2) 2,331,347 28,685 2.46 1,994,563 27,213 2.73 Tax-exempt investment securities (2)(3) 1,573,591 25,933 3.30 1,198,016 21,893 3.65 Loans (3)(4) 4,957,744 129,572 5.26 4,008,275 109,569 5.51 Total earning assets 9,154,927 $ 185,032 4.06 % 7,309,859 $ 159,961 4.41 % Cash and due from banks 189,285 177,601 Bank premises and equipment, net 139,520 134,239 Other assets 87,818 64,004 Goodwill and other intangible assets, net 318,822 174,396 Allowance for loan losses (61,134 ) (52,146 ) Total assets $ 9,829,238 $ 7,807,953 Liabilities and Shareholders’ Equity Interest-bearing deposits $ 5,019,929 $ 9,231 0.37 % $ 4,170,250 $ 13,947 0.67 % Short-term borrowings 668,840 928 0.28 393,432 1,401 0.72 Total interest-bearing liabilities 5,688,769 $ 10,159 0.36 % 4,563,682 $ 15,348 0.68 % Noninterest-bearing deposits 2,561,248 2,109,640 Other liabilities 70,726 38,758 Total liabilities 8,320,743 6,712,080 Shareholders’ equity 1,508,495 1,095,873 Total liabilities and shareholders’ equity $ 9,829,238 $ 7,807,953 Net interest income (3) $ 174,873 $ 144,613 Rate Analysis: Interest income/earning assets 4.06 % 4.41 % Interest expense/earning assets (0.22 ) (0.42 ) Net interest margin 3.84 % 3.99 % (1) Short-term investments are comprised of federal funds sold, interest-bearing deposits in banks and interest-bearing time deposits in banks. (2) Average balances include unrealized gains and losses on available-for-sale securities. (3) Computed on a tax-equivalent basis assuming a marginal tax rate of 21%. (4) Non-accrual loans are included in loans. Noninterest Income . Noninterest income for the second quarter of 2020 increased to $36.92 million compared to $27.98 million in same period in 2019. Mortgage related income increased 189.68% to $13.68 million compared with $4.72 million in the same quarter a year ago due to a significant increase in the volume of loans originated. The Company’s mortgage loan pipeline increased to $182.14 million as of June 30, 2020 when compared to $65.90 million at June 30, 2019. ATM, interchange and credit card fees increased 9.48% to $8.05 million compared with $7.35 million in the same quarter last year due to continued growth in the number of debit cards issued and our TB&T acquisition. Also included in noninterest income during the second quarter of 2020 was a gain on sale of securities of $1.51 million compared to $676 thousand from the same quarter a year ago. Trust fees decreased $66 thousand to $6.96 million in the second quarter of 2020 compared with $7.03 million in the same quarter last year due primarily to reduced mineral and lease bonus fees. The fair value of Trust assets managed increased to $6.78 billion from $6.19 billion a year ago. Service charges on deposits decreased to $4.32 million compared with $5.37 million in the same quarter a year ago due largely to the lack of economic activity caused by the pandemic during the second quarter of 2020. Noninterest income for the six-month period ended June 30, 2020 was $65.65 million, an increase of $13.24 million compared to the same period in 2019. Mortgage related income increased in the first six months of 2020 to $17.53 million when compared to $8.20 million in the same period a year ago due to a significant increase in the volume of loans originated and additional income from the change to mandatory delivery related to sales in the secondary mortgage market (see notes 4 and 5 to the consolidated financial statements (unaudited)). ATM, interchange and credit card fees increased 8.86% to $15.45 million compared with $14.19 million in the same period last year due to continued growth in 45 Table of Contents debit cards and our TB&T acquisition. Also included in noninterest income during the first six months of 2020 was a gain on sale of securities of $3.57 million compared to $676 thousand from the same quarter a year ago. Trust fees increased slightly to $14.40 million in the first six months of 2020 compared with $14.01 million in the same period in 2019. The fair value of Trust assets managed increased to $6.78 billion from $6.19 billion a year ago, but our revenue from oil and gas management decreased by $438 thousand due to decreased volumes in oil and gas production. Offsetting these increases was a $822 thousand decrease in interest on loan recoveries to $419 thousand for the first six months of 2020 compared to $1.24 million in the same period in 2019 due to the collection of a larger loan during the first six months of 2019 that had previously been on nonaccrual. In addition, service charges on deposits decreased to $10.23 million compared with $10.55 million in the same period last year ago due largely to the lack of economic activity caused by the pandemic during the second quarter of 2020. ATM and interchange fees are charges that merchants pay to us and other card-issuing banks for processing electronic payment transactions. ATM and interchange fees consist of income from debit card usage, point of sale income for debit card transactions and ATM service fees. Federal Reserve rules applicable to financial institutions that have assets of $10 billion or more provide that the maximum permissible interchange fee for an electronic debit transaction is limited to the sum of 21 cents per transaction plus 5 basis points multiplied by the value of the transaction. Management has estimated the impact of this reduction in ATM and interchange fees to approximate $12.00 million annually (pre-tax) once the Company reaches $10 billion. Federal Reserve requirements stipulate that these rules would go into effect on July 1 st following the year-end in which a financial institution’s total assets exceeded $10 billion at December 31 st . At June 30, 2020, the Company’s total assets exceeded the $10 billion threshold, due primarily to the effect of the Company’s participation in the PPP loan program. Management continues to monitor the Company’s balance sheet levels and may utilize strategies to reduce the Company’s asset levels below $10 billion to mitigate the loss of debit card income. Table 3 - Noninterest Income (in thousands): Three Months Ended June 30, Six Months Ended June 30, 2020 Increase (Decrease) 2019 2020 Increase (Decrease) 2019 Trust fees $ 6,961 $ (66 ) $ 7,027 $ 14,398 $ 392 $ 14,006 Service charges on deposit accounts 4,318 (1,056 ) 5,374 10,233 (317 ) 10,550 ATM, interchange and credit card fees 8,049 697 7,352 15,449 1,257 14,192 Gain on sale and fees on mortgage loans 13,676 8,955 4,721 17,528 9,333 8,195 Net gain on sale of available-for-sale securities 1,512 836 676 3,574 2,898 676 Net gain on sale of foreclosed assets 52 (1 ) 53 53 (69 ) 122 Net gain (loss) on sale of assets (24 ) (30 ) 6 92 86 6 Interest on loan recoveries 154 (749 ) 903 419 (822 ) 1,241 Other: Check printing fees 60 12 48 122 33 89 Safe deposit rental fees 177 58 119 370 57 313 Credit life fees 394 (26 ) 420 566 (48 ) 614 Brokerage commissions 334 (83 ) 417 719 (44 ) 763 Miscellaneous income 1,256 396 860 2,128 482 1,646 Total other 2,221 357 1,864 3,905 480 3,425 Total Noninterest Income $ 36,919 $ 8,943 $ 27,976 $ 65,651 $ 13,238 $ 52,413 46 Table of Contents Noninterest Expense . Total noninterest expense for the second quarter of 2020 was $53.32 million, an increase of $5.02 million compared to $48.30 million in the same period of 2019. An important measure in determining whether a financial institution effectively manages noninterest expense is the efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax-equivalent basis and noninterest income. Lower ratios indicate better efficiency since more income is generated with a lower noninterest expense total. Our efficiency ratio for the second quarter of 2020 was 41.32% compared to 47.71% for the same quarter in 2019. The reduction in the Company’s efficiency ratio during the second quarter of 2020 primarily resulted from the deferral of $3.62 million in noninterest expenses related to PPP loan origination costs. Salaries, commissions and employee benefits for the second quarter of 2020 totaled $30.81 million, an increase of $3.42 million compared to the same period in 2019. The increase was primarily driven by (i) the TB&T acquisition, (ii) annual merit-based pay increases that were effective March 1, 2020 and (iii) higher mortgage related commission, offset by the deferral of $3.62 million PPP origination costs. All other categories of noninterest expense for the second quarter of 2020 totaled $22.51 million, up from $20.91 million in the same quarter a year ago. Included in noninterest expense in the second quarter of 2020 were technology contract termination and conversion related costs totaling $583 thousand related to the TB&T acquisition. Total noninterest expense for the first six months of 2020 was $108.64 million, an increase of $12.97 million when compared to $95.67 million in the same period in 2019. Our efficiency ratio for the first six months of 2020 was 45.17%, compared to 48.56% from the same period in 2019. Management notes the reduction in the Company’s efficiency ratio for the first six months of 2020 primarily resulted from the deferral of $3.62 million in noninterest expenses related to PPP loan origination costs. Salaries, commissions and employee benefits for the first six months of 2020 totaled $60.46 million, an increase of $6.54 million when compared to the same period in 2019. The increase was primarily driven by (i) the TB&T acquisition, (ii) annual pay increases that were effective March 1, 2020 and (iii) higher mortgage related commission, offset by the deferral of $3.62 million PPP origination costs. All other categories of noninterest expense for the first six months of 2020 totaled $48.18 million, an increase of $6.43 million when compared to the same period in 2019. Included in noninterest expense in the first six months period of 2020 were technology contract termination and conversion related costs totaling $4.39 million related to the TB&T acquisition. 47 Table of Contents Table 4 - Noninterest Expense (in thousands): Three Months Ended June 30, Six Months Ended June 30, 2020 Increase (Decrease) 2019 2020 Increase (Decrease) 2019 Salaries and commissions $ 23,270 $ 2,703 $ 20,567 $ 45,973 $ 5,729 $ 40,244 Medical 2,284 (4 ) 2,288 4,981 198 4,783 Profit sharing 1,978 94 1,884 2,950 (425 ) 3,375 Pension — (19 ) 19 — (42 ) 42 401(k) match expense 897 196 701 1,736 311 1,425 Payroll taxes 1,714 302 1,412 3,530 521 3,009 Stock option and stock grant expense 671 148 523 1,286 246 1,040 Total salaries and employee benefits 30,814 3,420 27,394 60,456 6,538 53,918 Loss from partial settlement of pension plan — — — — (900 ) 900 Net occupancy expense 3,101 322 2,779 6,128 586 5,542 Equipment expense 2,010 (321 ) 2,331 4,085 (699 ) 4,784 FDIC assessment fees 463 (75 ) 538 508 (568 ) 1,076 ATM, interchange and credit card expense 2,610 183 2,427 5,595 785 4,810 Professional and service fees 2,497 510 1,987 5,090 1,270 3,820 Printing, stationery and supplies 533 31 502 1,099 231 868 Operational and other losses 728 248 480 1,304 558 746 Software amortization and expense 2,010 227 1,783 4,034 654 3,380 Amortization of intangible assets 508 244 264 1,017 485 532 Other: Data processing fees 444 92 352 867 100 767 Postage 384 (22 ) 406 685 (156 ) 841 Advertising 485 (393 ) 878 805 (957 ) 1,762 Correspondent bank service charges 227 51 176 431 84 347 Telephone 913 (50 ) 963 1,876 (47 ) 1,923 Public relations and business development 526 (226 ) 752 1,401 (115 ) 1,516 Directors’ fees 611 123 488 1,236 291 945 Audit and accounting fees 770 286 484 1,214 288 926 Legal fees 404 118 286 698 115 583 Regulatory exam fees 277 (14 ) 291 553 (29 ) 582 Travel 200 (336 ) 536 512 (363 ) 875 Courier expense 201 11 190 417 27 390 Other real estate owned 31 (31 ) 62 71 (1 ) 72 Other miscellaneous expense 2,574 619 1,955 8,558 4,790 3,768 Total other 8,047 228 7,819 19,324 4,027 15,297 Total Noninterest Expense $ 53,321 $ 5,017 $ 48,304 $ 108,640 $ 12,967 $ 95,673 48 Table of Contents Balance Sheet Review Loans . Our portfolio is comprised of loans made to businesses, professionals, individuals, and farm and ranch operations located in the primary trade areas served by our subsidiary bank. Real estate loans represent loans primarily for 1-4 family residences and commercial real estate. The structure of loans in the real estate mortgage area generally provides re-pricing intervals to minimize the interest rate risk inherent in long-term fixed rate loans. As of June 30, 2020, total loans held for investment were $5.25 billion, an increase of $1.06 billion, as compared to December 31, 2019 balances. This increase is due primarily from our participation in the PPP loan program and our TB&T acquisition. As compared to December 31, 2019, commercial loans increased $653.13 million, agricultural loans decreased $6.19 million, real estate loans increased $411.84 million and consumer loans decreased $674 thousand. Loans averaged $5.25 billion during the second quarter of 2020, an increase of $1.20 billion from the prior year second quarter average balances. Loans averaged $4.96 billion during the first six months of 2020, an increase of $949.47 million from the prior year six-month period average balances. Table 5 - Composition of Loans (in thousands): June 30, December 31, 2019 2020 2019 Commercial $ 1,509,454 $ 813,887 $ 856,326 Agricultural 97,448 97,535 103,640 Real estate 3,235,208 2,730,585 2,823,372 Consumer 410,957 398,945 411,631 Total loans held-for-investment $ 5,253,067 $ 4,040,952 $ 4,194,969 At June 30, 2020, our real estate loans represented approximately 61.59% of our loan portfolio and were comprised of (i) 1-4 family residence loans of 39.45%, (ii) commercial real estate loans of 29.58%, generally owner occupied, (iii) other loans, which includes ranches, hospitals and universities, of 14.51%, (iv) residential development and construction loans of 9.29%, which includes our custom and speculative home construction loans and (v) commercial development and construction loans of 7.17%. Loans held for sale, consisting of secondary market mortgage loans, totaled $66.37 million, $22.31 million, and $28.23 million at June 30, 2020 and 2019, and December 31, 2019, respectively. At June 30, 2020 and 2019 and December 31, 2019, $3.08 million, $3.32 million and $5.15 million, respectively, are valued using the lower of cost or fair value method and the remaining amounts are valued under the fair value option method. See notes 4 and 5 to the consolidated financial statements (unaudited) related to the change to mandatory delivery for sales in the secondary mortgage market. Asset Quality . Our loan portfolio is subject to periodic reviews by our centralized independent loan review group as well as periodic examinations by the Office of the Comptroller of the Currency (“OCC”). Loans are placed on nonaccrual status when, in the judgment of management, the collectability of principal or interest under the original terms becomes doubtful. Nonaccrual, past due 90 days or more and still accruing, and restructured loans plus foreclosed assets were $39.72 million at June 30, 2020, as compared to $27.86 million at June 30, 2019 and $25.77 million at December 31, 2019. As a percent of loans and foreclosed assets, these assets were 0.75% at June 30, 2020, as compared to 0.69% at June 30, 2019 and 0.61% at December 31, 2019. As a percent of total assets, these assets were 0.38% at June 30, 2020, as compared to 0.35% at June 30, 2019 and 0.31% at December 31, 2019. We believe the level of these assets to be manageable and are not aware of any material classified credits not properly disclosed as nonperforming at June 30, 2020. Supplemental Oil and Gas Information . As of June 30, 2020, the Company’s exposure to the oil and gas industry totaled 2.78% of total loans, excluding PPP loans, or $128.14 million, up $8.35 million from December 31, 2019 49 Table of Contents year-end levels, and consisted (based on collateral supporting the loan) of (i) development and production loans of 10.09%, (ii) oil and gas field servicing loans of 7.36%, (iii) real estate loans of 41.50%, (iv) accounts receivable and inventory of 2.15%, (v) automobile of 10.82% and (vi) other of 28.08%. The following oil and gas information is as of and for the quarters ended June 30, 2020 and 2019, and December 31, 2019: June 30, December 31, 2019 2020 2019 Oil and gas related loans, excluding PPP loans $ 128,143 $ 107,097 $ 119,789 Oil and gas related loans as a % of total loans, excluding PPP loans 2.78 % 2.64 % 2.84 % Classified oil and gas related loans $ 28,366 $ 3,438 $ 7,041 Non-accrual oil and gas related loans 3,702 621 481 Net charge-offs for oil and gas related loans for quarter/year then ended 195 — — Allowance for oil and gas related loans as a % of oil and gas loans 4.17 % 2.95 % 2.54 % Supplemental COVID-19 Industry Exposure. In addition, at June 30, 2020, loan balances in the retail/restaurant/hospitality industries totaled $338.76 million or 7.34% of the Company’s total loans, excluding PPP loans. Classified and nonperforming loans for these industries combined at June 30, 2020, totaled $15.84 million and $5.75 million, respectively. Net charge-offs related to this portfolio totaled $178 thousand and $308 thousand for the three and six-months ended June 30, 2020, respectively. Additional information related to the Company’s retail/restaurant/hospitality industries follows below: June 30, March 31, 2020 2020 Retail loans $ 216,244 $ 217,380 Restaurant loans 46,418 25,570 Hotel loans 51,957 46,690 Other hospitality loans 23,230 8,470 Travel loans 908 937 Total Retail/Restaurant/Hospitality loans, excluding PPP loans $ 338,757 $ 299,047 Retail/Restaurant/Hospitality as a % of total loans, excluding PPP loans 7.34 % 6.39 % Classified Retail/Restaurant/Hospitality loans $ 15,837 $ 5,680 Nonaccrual Retail/Restaurant/Hospitality loans 5,752 867 Net Charge-Offs for Retail/Restaurant/Hospitality loans 178 130 50 Table of Contents Table 6 – Non-accrual, Past Due 90 Days or More and Still Accruing, Restructured Loans and Foreclosed Assets (in thousands, except percentages): June 30, December 31, 2019 2020 2019 Non-accrual loans* $ 39,320 $ 26,408 $ 24,582 Loans still accruing and past due 90 days or more 92 300 153 Troubled debt restructured loans** 25 471 26 Nonperforming Loans 39,437 27,179 24,761 Foreclosed assets 287 681 1,009 Total nonperforming assets $ 39,724 $ 27,860 $ 25,770 As a % of loans and foreclosed assets 0.75 % 0.69 % 0.61 % As a % of total assets 0.38 0.35 0.31 * Includes $7.28 million, $464 thousand and $251 thousand of purchased credit impaired loans as of June 30, 2020 and 2019, and December 31, 2019, respectively. ** Other troubled debt restructured loans of $4.67 million, $3.91 million and $4.79 million, whose interest collection, after considering economic and business conditions and collection efforts, is doubtful are included in non-accrual loans at June 30, 2020 and 2019, and December 31, 2019, respectively. We record interest payments received on non-accrual loans as reductions of principal. Prior to the loans being placed on non-accrual, we recognized interest income on impaired loans of approximately $151 thousand for the year ended December 31, 2019. If interest on these impaired loans had been recognized on a full accrual basis during the year ended December 31, 2019, such income would have approximated $2.39 million. Such amounts for the 2020 and 2019 interim periods were not significant. 51 Table of Contents Provision and Allowance for Loan Losses . The allowance for loan losses is the amount we determine as of a specific date to be appropriate to absorb probable losses on existing loans in which full collectability is unlikely based on our review and evaluation of the loan portfolio. For a discussion of our methodology, see note 1 to our notes to the consolidated financial statements (unaudited). The provision for loan losses was $8.70 million for the second quarter of 2020, as compared to $600 thousand for the second quarter of 2019. The provision for loan losses was $18.55 million for the six-month period ended June 30, 2020 as compared to $1.57 million for the same period in 2019. The provision for loan losses in 2020 reflects primarily the stress on our loan portfolio from the increase in unemployment and economic effects of the COVID-19 pandemic and the decrease in oil and gas prices. As a percent of average loans, net loan charge-offs were 0.01% for the second quarter of 2020, as compared to 0.04% for the second quarter of 2019. As a percentage of average loans, net loan charge-offs were 0.09% for the first six months of 2020, as compared to 0.05% for the first six months of 2019. The allowance for loan losses as a percent of total loans was 1.30% as of June 30, 2020, as compared to 1.28% as of June 30, 2019 and 1.24% as of December 31, 2019. While we note that our allowance for loan losses as a percentage of total loans has remained relatively flat, we acquired $455.18 million in loans in the TB&T Bancshares, Inc. acquisition that were recorded at fair value, including credit considerations, with no corresponding allowance for loan losses being recorded. The Company recorded a $7.65 million discount on the acquired loan portfolio at acquisition date and such amounts totaled $6.69 million at June 30, 2020. Table 7 - Loan Loss Experience and Allowance for Loan Losses (in thousands, except percentages): Three Months Ended June 30, Six Months Ended June 30, 2020 2019 2020 2019 Allowance for loan losses at period-end $ 68,947 $ 51,820 $ 68,947 $ 51,820 Loans held for investment at period-end 5,253,067 4,040,952 5,253,067 4,040,952 Average total loans for period 5,248,052 4,043,055 4,957,744 4,008,275 Net charge-offs/average loans (annualized) 0.01 % 0.04 % 0.09 % 0.05 % Allowance for loan losses/period-end total loans 1.30 % 1.28 % 1.30 % 1.28 % Allowance for loan losses/non-accrual loans, past due 90 days still accruing and restructured loans 174.83 % 190.66 % 174.83 % 190.66 % Interest-Bearing Demand Deposits in Banks. At June 30, 2020, our interest-bearing deposits in banks were $196.43 million compared to $129.61 million at June 30, 2019 and $47.92 million at December 31, 2019, respectively. At June 30, 2020, interest-bearing deposits in banks included $196.12 million maintained at the Federal Reserve Bank of Dallas and $302 thousand on deposit with the Federal Home Loan Bank of Dallas (“FHLB”). Available-for-Sale Securities . At June 30, 2020, securities with a fair value of $4.12 billion were classified as securities available-for-sale. As compared to December 31, 2019, the available-for-sale portfolio at June 30, 2020 reflected (i) an increase in U.S. Treasury securities of $103 thousand, (ii) an increase of $661.30 million in obligations of states and political subdivisions, (iii) a decrease of $139 thousand in corporate bonds and other, and (iv) an increase of $44.29 million in mortgage-backed securities. We have seen an increase in our purchases of state and political subdivisions bonds in the first half of 2020 due to favorable shifts in tax equivalent yields. Our mortgage related securities are backed by GNMA, FNMA or FHLMC or are collateralized by securities backed by these agencies. See note 2 to the consolidated financial statements (unaudited) for additional disclosures relating to the investment portfolio at June 30, 2020 and 2019, and December 31, 2019. 52 Table of Contents Table 8 - Maturities and Yields of Available-for-Sale Securities Held at June 30, 2020 (in thousands, except percentages): Maturing One Year or Less After One Year Through Five Years After Five Years Through Ten Years After Ten Years Total Available-for-Sale: Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield U.S. Treasury securities $ 10,122 0.85 % $ — — % $ — — % $ — — % $ 10,122 0.85 % Obligations of states and political subdivisions 114,830 4.81 669,229 4.09 1,148,866 3.27 17,354 3.39 1,950,279 3.64 Corporate bonds and other securities 4,569 2.11 — — — — — — 4,569 2.11 Mortgage-backed securities 120,484 2.30 1,686,942 2.54 346,467 2.43 — — 2,153,893 2.51 Total $ 250,005 3.39 % $ 2,356,171 2.98 % $ 1,495,333 3.07 % $ 17,354 3.39 % $ 4,118,863 3.04 % All yields are computed on a tax-equivalent basis assuming a marginal tax rate of 21%. Yields on available-for-sale securities are based on amortized cost. Maturities of mortgage-backed securities are based on contractual maturities and could differ due to prepayments of underlying mortgages. Maturities of other securities are reported at the earlier of maturity date or call date. As of June 30, 2020, the investment portfolio had an overall tax equivalent yield of 3.04%, a weighted average life of 4.42 years and modified duration of 3.94 years. Deposits . Deposits held by our subsidiary bank represent our primary source of funding. Total deposits were $8.16 billion as of June 30, 2020, as compared to $6.37 billion as of June 30, 2019 and $6.60 billion as of December 31, 2019. Table 9 provides a breakdown of average deposits and rates paid for the three and six-month periods ended June 30, 2020 and 2019, respectively. Table 9 — Composition of Average Deposits (in thousands, except percentages): Three Months Ended June 30, 2020 2019 Average Balance Average Rate Average Balance Average Rate Noninterest-bearing deposits $ 2,830,960 — % $ 2,136,264 — % Interest-bearing deposits: Interest-bearing checking 2,486,194 0.14 2,054,770 0.77 Savings and money market accounts 2,183,507 0.16 1,705,154 0.56 Time deposits under $100,000 196,165 0.31 188,188 0.69 Time deposits of $100,000 or more 269,906 0.92 248,011 1.04 Total interest-bearing deposits 5,135,772 0.20 % 4,196,123 0.70 % Total average deposits $ 7,966,732 $ 6,332,387 Total cost of deposits 0.13 % 0.46 % 53 Table of Contents Six Months Ended June 30, 2020 2019 Average Balance Average Rate Average Balance Average Rate Noninterest-bearing deposits $ 2,561,248 — % $ 2,109,640 — % Interest-bearing deposits: Interest-bearing checking 2,466,112 0.33 2,056,068 0.74 Savings and money market accounts 2,083,604 0.31 1,675,909 0.56 Time deposits under $100,000 197,960 0.56 189,921 0.62 Time deposits of $100,000 or more 272,253 1.03 248,352 0.94 Total interest-bearing deposits 5,019,929 0.37 % 4,170,250 0.67 % Total average deposits $ 7,581,177 $ 6,279,890 Total cost of deposits 0.25 % 0.45 % Borrowings. Included in borrowings were federal funds purchased, securities sold under repurchase agreements and advances from the FHLB of $449.22 million, $362.01 million and $381.36 million at June 30, 2020 and 2019 and December 31, 2019, respectively. Securities sold under repurchase agreements are generally with significant customers of the Company that require short-term liquidity for their funds for which we pledge certain securities that have a fair value equal to at least the amount of the borrowings. The average balance of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were $877.08 million and $378.39 million in the second quarters of 2020 and 2019, respectively. The weighted average interest rates paid on these borrowings were 0.19% and 0.72% for the second quarters of 2020 and 2019, respectively. The average balances of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB was $668.84 million and $393.43 million for the six-month periods ended June 30, 2020 and 2019, respectively. The weighted average interest rate on these short-term borrowings was 0.28% and 0.72% for the first six months of 2020 and 2019, respectively. Capital Resources We evaluate capital resources by our ability to maintain adequate regulatory capital ratios to do business in the banking industry. Issues related to capital resources arise primarily when we are growing at an accelerated rate but not retaining a significant amount of our profits or when we experience significant asset quality deterioration. Total shareholders’ equity was $1.58 billion, or 15.30% of total assets at June 30, 2020, as compared to $1.16 billion or 14.60% of total assets at June 30, 2019 and $1.23 billion, or 14.85% of total assets at December 31, 2019. Included in shareholders’ equity at June 30, 2020 and 2019 and December 31, 2019, were $151.24 million, $60.57 million and $67.51 million, respectively, in unrealized gains (losses) on investment securities available-for-sale, net of related income taxes. For the second quarter of 2020, total shareholders’ equity averaged $1.54 billion, or 14.68% of average assets, as compared to $1.12 billion, or 14.25% of average assets, during the same period in 2019. For the six months ended June 30, 2020, total shareholders’ equity averaged $1.51 billion or 15.35%, as compared to $1.10 billion or 14.04% of total assets during the same period in 2019. Banking regulators measure capital adequacy by means of the risk-based capital ratios and the leverage ratio under the Basel III regulatory capital framework and prompt corrective action regulations. The risk-based capital rules provide for the weighting of assets and off-balance-sheet commitments and 54 Table of Contents contingencies according to prescribed risk categories. Regulatory capital is then divided by risk-weighted assets to determine the risk-adjusted capital ratios. The leverage ratio is computed by dividing shareholders’ equity less intangible assets by quarter-to-date average assets less intangible assets. Beginning in January 2015, under the Basel III regulatory capital framework, the implementation of the capital conservation buffer was effective for the Company starting at the 0.625% level and increasing 0.625% each year thereafter, until it reached 2.50% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress and requires increased capital levels for the purpose of capital distributions and other payments. Failure to meet the amount of the buffer will result in restrictions on the Company’s ability to make capital distributions, including dividend payments and stock repurchases, and to pay discretionary bonuses to executive officers. As of June 30, 2020 and 2019, and December 31, 2019, we had a total capital to risk-weighted assets ratio of 22.03%, 21.16% and 21.13%, a Tier 1 capital to risk-weighted assets ratio of 20.78%, 20.04% and 20.06%; a common equity Tier 1 to risk-weighted assets ratio of 20.78%, 20.04% and 20.06% and a leverage ratio of 11.25%, 12.29% and 12.60%, respectively. The regulatory capital ratios as of June 30, 2020 and 2019, and December 31, 2019 were calculated under Basel III rules. The regulatory capital ratios of the Company and Bank under the Basel III regulatory capital framework are as follows: Actual Minimum Capital Required-Basel III Fully Phased-In* Required to be Considered Well- Capitalized As of June 30, 2020: Amount Ratio Amount Ratio Amount Ratio Total Capital to Risk-Weighted Assets: Consolidated $ 1,191,492 22.03 % $ 567,829 10.50 % $ 540,789 10.00 % First Financial Bank, N.A $ 1,086,019 20.13 % $ 566,561 10.50 % $ 539,582 10.00 % Tier 1 Capital to Risk-Weighted Assets: Consolidated $ 1,123,866 20.78 % $ 459,671 8.50 % $ 324,474 6.00 % First Financial Bank, N.A $ 1,018,543 18.88 % $ 458,645 8.50 % $ 431,666 8.00 % Common Equity Tier 1 Capital to Risk-Weighted Assets: Consolidated $ 1,123,866 20.78 % $ 378,552 7.00 % — N/A First Financial Bank, N.A $ 1,018,543 18.88 % $ 377,708 7.00 % $ 350,728 6.50 % Leverage Ratio: Consolidated $ 1,123,866 11.25 % $ 399,750 4.00 % — N/A First Financial Bank, N.A $ 1,018,543 10.22 % $ 398,459 4.00 % $ 498,074 5.00 % * At June 30, 2020, the capital conservation buffer under Basel III has been fully phased-in. 55 Table of Contents Actual Minimum Capital Required-Basel III Fully Phased-In* Required to be Considered Well- Capitalized As of June 30, 2019: Amount Ratio Amount Ratio Amount Ratio Total Capital to Risk-Weighted Assets: Consolidated $ 995,299 21.16 % $ 493,803 10.50 % $ 470,288 10.00 % First Financial Bank, N.A $ 901,188 19.21 % $ 492,484 10.50 % $ 469,032 10.00 % Tier 1 Capital to Risk-Weighted Assets: Consolidated $ 942,670 20.04 % $ 399,745 8.50 % $ 282,173 6.00 % First Financial Bank, N.A $ 848,560 18.09 % $ 398,677 8.50 % $ 375,226 8.00 % Common Equity Tier 1 Capital to Risk-Weighted Assets: Consolidated $ 942,670 20.04 % $ 329,202 7.00 % — N/A First Financial Bank, N.A $ 848,560 18.09 % $ 328,323 7.00 % $ 304,871 6.50 % Leverage Ratio: Consolidated $ 942,670 12.29 % $ 306,707 4.00 % — N/A First Financial Bank, N.A $ 848,560 11.11 % $ 305,515 4.00 % $ 381,893 5.00 % Actual Minimum Capital Required Under Basel III Phase-In Required to be Considered Well- Capitalized As of December 31, 2019: Amount Ratio Amount Ratio Amount Ratio Total Capital to Risk-Weighted Assets: Consolidated $ 1,051,029 21.13 % $ 522,275 10.50 % $ 497,405 10.00 % First Financial Bank, N.A $ 908,778 18.31 % $ 521,081 10.50 % $ 496,268 10.00 % Tier 1 Capital to Risk-Weighted Assets: Consolidated $ 997,721 20.06 % $ 422,794 8.50 % $ 298,443 6.00 % First Financial Bank, N.A $ 855,470 17.24 % $ 421,828 8.50 % $ 397,014 8.00 % Common Equity Tier 1 Capital to Risk-Weighted Assets: Consolidated $ 997,721 20.06 % $ 348,184 7.00 % — N/A First Financial Bank, N.A $ 855,470 17.24 % $ 347,388 7.00 % $ 322,574 6.50 % Leverage Ratio: Consolidated $ 997,721 12.60 % $ 316,850 4.00 % — N/A First Financial Bank, N.A $ 855,470 10.84 % $ 315,570 4.00 % $ 394,463 5.00 % In connection with the adoption of the Basel III regulatory capital framework, our subsidiary bank made the election to continue to exclude accumulated other comprehensive income from available-for-sale securities (“AOCI”) from capital in connection with its quarterly financial filing and, in effect, to retain the AOCI treatment under the prior capital rules. Interest Rate Risk Interest rate risk results when the maturity or repricing intervals of interest-earning assets and interest-bearing liabilities are different. Our exposure to interest rate risk is managed primarily through our strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. We use no off-balance sheet financial instruments to manage interest rate risk. Our subsidiary bank has an asset liability management committee that monitors interest rate risk and compliance with investment policies. The subsidiary bank utilizes an earnings simulation model as the 56 Table of Contents primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model quantifies the effects of various interest rate scenarios on projected net interest income and net income over the next twelve months. The model measures the impact on net interest income relative to a base case scenario of hypothetical fluctuations in interest rates over the next twelve months. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the re-pricing and maturity characteristics of the existing and projected balance sheet. As of June 30, 2020, the model simulations projected that 100 and 200 basis point increases in interest rates would result in positive variances in net interest income of 4.43% and 8.86%, respectively, relative to the current financial statement structure over the next twelve months, while a decrease in interest rates of 100 and 200 basis points would result in a negative variance in net interest income of 3.05% and 5.03%, respectively, relative to the current financial statement structure over the next twelve months. These are good faith estimates and assume that the composition of our interest sensitive assets and liabilities existing at each year-end will remain constant over the relevant twelve-month measurement period and that changes in market interest rates are instantaneous and sustained across the yield curve regardless of duration of pricing characteristics on specific assets or liabilities. Also, this analysis does not contemplate any actions that we might undertake in response to changes in market interest rates. We believe these estimates are not necessarily indicative of what actually could occur in the event of immediate interest rate increases or decreases of this magnitude. As interest-bearing assets and liabilities re-price in different time frames and proportions to market interest rate movements, various assumptions must be made based on historical relationships of these variables in reaching any conclusion. Since these correlations are based on competitive and market conditions, we anticipate that our future results will likely be different from the foregoing estimates, and such differences could be material. Should we be unable to maintain a reasonable balance of maturities and repricing of our interest-earning assets and our interest-bearing liabilities, we could be required to dispose of our assets in an unfavorable manner or pay a higher than market rate to fund our activities. Our asset liability committee oversees and monitors this risk. Liquidity Liquidity is our ability to meet cash demands as they arise. Such needs can develop from loan demand, deposit withdrawals or acquisition opportunities. Potential obligations resulting from the issuance of standby letters of credit and commitments to fund future borrowings to our loan customers are other factors affecting our liquidity needs. Many of these obligations and commitments are expected to expire without being drawn upon; therefore the total commitment amounts do not necessarily represent future cash requirements affecting our liquidity position. The potential need for liquidity arising from these types of financial instruments is represented by the contractual notional amount of the instrument. Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. Liquid assets include cash, federal funds sold, and short-term investments in time deposits in banks. Liquidity is also provided by access to funding sources, which include core depositors and correspondent banks that maintain accounts with and sell federal funds to our subsidiary bank. Other sources of funds include our ability to borrow from short-term sources, such as purchasing federal funds from correspondent banks, sales of securities under agreements to repurchase and advances from the FHLB (see below) and an unfunded $25.00 million revolving line of credit established with Frost Bank, a nonaffiliated bank, which matures in June 2021 (see next paragraph). Our subsidiary bank also has federal funds purchased lines of credit with two non-affiliated banks totaling $130.00 million. At June 30, 2020, no amounts were drawn on these lines of credit. Our subsidiary bank also has (i) an available a line of credit with the FHLB totaling $1.79 billion at June 30, 2020, secured by portions of our loan portfolio and certain investment securities and (ii) access to the Federal Reserve Bank of Dallas lending program. At June 30, 2020, the Company had no outstanding advances under these lines of credit. The Company renewed its loan agreement, effective June 30, 2019, with Frost Bank. Under the loan agreement, as renewed and amended, we are permitted to draw up to $25.00 million on a revolving line of 57 Table of Contents credit. Prior to June 30, 2021, interest is paid quarterly at The Wall Street Journal Prime Rate and the line of credit matures June 30, 2021. If a balance exists at June 30, 2021, the principal balance converts to a term facility payable quarterly over five years and interest is paid quarterly at The Wall Street Journal Prime Rate. The line of credit is unsecured. Among other provisions in the credit agreement, we must satisfy certain financial covenants during the term of the loan agreement, including, without limitation, covenants that require us to maintain certain capital, tangible net worth, loan loss reserve, non-performing asset and cash flow coverage ratios. In addition, the credit agreement contains certain operational covenants, which among others, restricts the payment of dividends above 55% of consolidated net income, limits the incurrence of debt (excluding any amounts acquired in an acquisition) and prohibits the disposal of assets except in the ordinary course of business. Since 1995, we have historically declared dividends as a percentage of our consolidated net income in a range of 37% (low) in 1995 to 53% (high) in 2003 and 2006. The Company was in compliance with the financial and operational covenants at June 30, 2020. There was no outstanding balance under the line of credit as of June 30, 2020 or December 31, 2019. In addition, we anticipate that future acquisitions of financial institutions, expansion of branch locations or offerings of new products could also place a demand on our cash resources. Available cash and cash equivalents at our parent company which totaled $89.85 million at June 30, 2020, investment securities which totaled $3.62 million at June 30, 2020 and mature over 9 to 10 years, available dividends from our subsidiaries which totaled $257.09 million at June 30, 2020, utilization of available lines of credit, and future debt or equity offerings are expected to be the source of funding for these potential acquisitions or expansions. Our liquidity position is continuously monitored and adjustments are made to the balance between sources and uses of funds as deemed appropriate. Liquidity risk management is an important element in our asset/liability management process. We regularly model liquidity stress scenarios to assess potential liquidity outflows or funding problems resulting from economic disruptions, volatility in the financial markets, unexpected credit events or other significant occurrences deemed potentially problematic by management. These scenarios are incorporated into our contingency funding plan, which provides the basis for the identification of our liquidity needs. As of June 30, 2020, management is not aware of any events that are reasonably likely to have a material adverse effect on our liquidity, capital resources or operations. We are monitoring closely the economic impact of the coronavirus on our customers and the communities we serve. Given the strong core deposit base and relatively low loan to deposit ratios maintained at our subsidiary bank, we consider our current liquidity position to be adequate to meet our short-term and long-term liquidity needs. In addition, management is not aware of any regulatory recommendations regarding liquidity that would have a material adverse effect on us. Off-Balance Sheet Arrangements. We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include unfunded lines of credit, commitments to extend credit and federal funds sold to correspondent banks and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in our consolidated balance sheets. Our exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for unfunded lines of credit, commitments to extend credit and standby letters of credit is represented by the contractual notional amount of these instruments. We generally use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. Unfunded lines of credit and commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. These commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, as we deem necessary upon extension of credit, is based on our credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment and income-producing commercial properties. 58 Table of Contents Standby letters of credit are conditional commitments we issue to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The average collateral value held on letters of credit usually exceeds the contract amount. Table 10 – Commitments as of June 30, 2020 (in thousands): Total Notional Amounts Committed Unfunded lines of credit $ 810,957 Unfunded commitments to extend credit 520,515 Standby letters of credit 40,214 Total commercial commitments $ 1,371,686 We believe we have no other off-balance sheet arrangements or transactions with unconsolidated, special purpose entities that would expose us to liability that is not reflected on the face of the financial statements. Amounts related to interest rate lock commitments are not included in this table. Parent Company Funding . Our ability to fund various operating expenses, dividends, and cash acquisitions is generally dependent on our own earnings (without giving effect to our subsidiaries), cash reserves and funds derived from our subsidiaries. These funds historically have been produced by intercompany dividends and management fees that are limited to reimbursement of actual expenses. We anticipate that our recurring cash sources will continue to include dividends and management fees from our subsidiaries. At June 30, 2020, approximately $257.09 million was available for the payment of intercompany dividends by our subsidiaries without the prior approval of regulatory agencies. Our subsidiaries paid aggregate dividends of $5.00 million and $4.00 million for the six-month periods ended June 30, 2020 and 2019, respectively. Dividends . Our long-term dividend policy is to pay cash dividends to our shareholders of approximately 40% of annual net earnings while maintaining adequate capital to support growth. We are also restricted by a loan covenant within our line of credit agreement with Frost Bank to dividend no greater than 55% of net income, as defined in such loan agreement. The cash dividend payout ratios have amounted to 39.17% and 38.00% of net earnings for the first six months of 2020 and 2019, respectively. Given our current capital position and projected earnings and asset growth rates, we do not anticipate any significant change in our current dividend policy. On April 28, 2020 the Board of Directors declared a $0.13 per share cash dividend for the second quarter of 2020, an 8.33% increase over 2019. Our bank subsidiary, which is a national banking association and a member of the Federal Reserve System, is required by federal law to obtain the prior approval of the OCC to declare and pay dividends if the total of all dividends declared in any calendar year would exceed the total of (1) such bank’s net profits (as defined and interpreted by regulation) for that year plus (2) its retained net profits (as defined and interpreted by regulation) for the preceding two calendar years, less any required transfers to surplus. To pay dividends, we and our subsidiary bank must maintain adequate capital above regulatory guidelines. In addition, if the applicable regulatory authority believes that a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), the authority may require, after notice and hearing, that such bank cease and desist from the unsafe practice. The Federal Reserve, the FDIC and the OCC have each indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. The Federal Reserve, the OCC and the FDIC have issued policy statements that recommend that bank holding companies and insured banks should generally only pay dividends out of current operating earnings. 59 Table of Contents Item 3. Quantitative and Qualitative Disclosures About Market Risk Management considers interest rate risk to be a significant market risk for the Company. See “Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources - Interest Rate Risk” for disclosure regarding this market risk.