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,” “indicate,” “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 Reports on Form 10-Q for the quarter ended March 31, 2020 and the quarter ended June 30, 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; 39 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, N.A. 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, return on average tangible equity, our regulatory leverage and risk-based capital ratios and our efficiency ratio, which is calculated net interest margin 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 pressures 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 have remained open to customers, we have taken steps, and continue to evaluate, to push as much traffic and transactions as possible to our motor banks and our online services; • We have held executive meetings weekly or as needed to address issues that are changing rapidly; 40 Table of Contents • We moved our Annual Shareholders’ Meeting from a physical meeting to a virtual meeting; • 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 September 30, 2020, we completed approximately 6,500 loans and funded $703.73 million of such loans. 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. One loan has been funded as of September 30, 2020 under this program. We continue to closely monitor this pandemic and continue to make changes to protect our employees and customers as we respond to the pandemic as this situation continues to evolve. Critical Accounting Policies We prepare consolidated financial statements based on U.S. 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 nine-months ended September 30, 2019. 41 Table of Contents Stock Repurchase On March 12, 2020, the Company’s Board of Directors authorized the repurchase of up to 4.00 million common shares through September 30, 2021. The stock buyback plan authorizes management to repurchase and retire 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 September 30, 2020, the Company repurchased 324,802 shares totaling $8.01 million under this repurchase plan. Subsequent to September 30, 2020 and through November 4, 2020, no additional shares were repurchased. 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 was completed. 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, N.A., 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 processing approximately 6,500 loans and funded $703.73 million. The Company received fees totaling approximately $26.26 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. During the second and third quarters of 2020, the Company recognized $2.83 million each quarter of this net amount into interest income. At September 30, 2020, the Company had approximately $15.97 million in unrecognized deferred loan fees on PPP loans. 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. 42 Table of Contents On March 27, 2020, the 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 completing 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 also included individuals from various functional areas including credit, risk management, accounting and information technology, among others. Our implementation plan 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 under the incurred model. 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 nine-months ended September 30, 2020, we have considered the following in developing our forecast and its effect on our future CECL calculations: • duration, extent and severity of COVID-19; • utilization of unfunded commitments; • effects of government assistance; • unemployment and the corresponding effects on the economy; • volatility of oil and gas prices; • value of real estate; and • the 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 September 30, 2020 and the provision for loan losses for the three and nine- months then ended. 43 Table of Contents Results of Operations Performance Summary . Net earnings for the third quarter of 2020 were $52.86 million compared with $43.08 million for the third quarter of 2019, represented in 22.69% increase. Basic and diluted earnings per share were $0.37 for the third quarter of 2020 compared with $0.32 in the same quarter a year ago. The return on average assets was 2.01% for the third quarter of 2020, as compared to 2.15% for the third quarter of 2019. The return on average equity was 13.14% for the third quarter of 2020 as compared to 14.46% for the third quarter of 2019. The return on average tangible equity was 16.41% for the third quarter of 2020 compared to 16.96% for the third quarter of 2019. Net earnings for the nine month period ended September 30, 2020 were $143.56 million compared to $123.42 million for the same period in 2019, representing a 16.31% increase. Basic and diluted earnings per share for the first nine months of 2020 were $1.01 compared to $0.91 for the same period in 2019. The return on average assets was 1.91% for the first nine months of 2020, as compared to 2.10% for the same period a year ago. The return on average equity was 12.46% for the first nine months of 2020 as compared to 14.67% for the same period in 2019. The return on average tangible equity was 15.71% for the first nine months of 2020 as compared to 17.36% a year ago. 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 $92.38 million for the third quarter of 2020, as compared to $74.21 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 derived from our TB&T acquisition, an increase in investment securities held and the impact of the Company’s participation in the PPP loan program (see above). Average earning assets increased $2.33 billion for the third quarter of 2020 over the same period in 2019. Average loans and tax-exempt securities increased $1.24 billion and $925.75 million, respectively, for the third quarter of 2020 over the same quarter of 2019. Average interest-bearing liabilities increased $1.21 billion for the third 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 organic growth. The yield on earning assets decreased 52 basis points while the rate paid on interest-bearing liabilities decreased 54 basis points for the third quarter of 2020 compared to the third quarter of 2019. Tax-equivalent net interest income was $267.25 million for the first nine months of 2020, as compared to $218.83 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 (see above). Average earning assets increased $2.01 billion for the first nine months of 2020 over the same period in 2019. Average loans and tax-exempt securities increased $1.05 billion and $560.39 million, respectively, for the first nine months of 2020 over the first nine months of 2019. Average interest-bearing liabilities increased $1.15 billion for the first nine 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 organic growth. The yield on earning assets decreased 42 basis points while the rate paid on interest-bearing liabilities decreased 39 basis points for the first nine months of 2020 compared to the first nine months of 2019. 44 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 September 30, 2020 Compared to Three-Months Ended September 30, 2019 Nine-Months Ended September 30, 2020 Compared to Nine-Months Ended September 30, 2019 Change Attributable to Total Change Change Attributable to Total Change Volume Rate Volume Rate Short-term investments $ 949 $ (1,269 ) $ (320) $ 3,081 $ (3,845 ) $ (764) Taxable investment securities 24 (2,253 ) (2,229 ) 4,531 (5,288 ) (757 ) Tax-exempt investment securities (1) 8,237 (2,575 ) 5,662 15,235 (5,533 ) 9,702 Loans (1) (2) 17,388 (8,124 ) 9,264 43,301 (14,033 ) 29,268 Interest income 26,598 (14,221 ) 12,377 66,148 (28,699 ) 37,449 Interest-bearing deposits 1,908 (6,967 ) (5,059 ) 4,746 (14,524 ) (9,778 ) Short-term borrowings 202 (933 ) (731 ) 1,450 (2,650 ) (1,200 ) Interest expense 2,110 (7,900 ) (5,790 ) 6,196 (17,174 ) (10,978 ) Net interest income $ 24,488 $ (6,321 ) $ 18,167 $ 59,952 $ (11,525 ) $ 48,427 (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 third quarter of 2020 was 3.75%, a decrease of 19 basis points from the same period in 2019. The net interest margin for the first nine months of 2020 was 3.81%, a decrease of 16 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 (i) the extended period of fluctuating historically low levels of short-term interest rates and (ii) the 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 reducing the rates paid on our 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 negatively impacted the net interest margin from (i) the amortization of net deferred loan fees and (ii) the 1% loan rate. The net interest margin, which measures tax-equivalent net interest income as a percentage of average earning assets, is illustrated in Table 2. 45 Table of Contents Table 2 - Average Balances and Average Yields and Rates (in thousands, except percentages): Three-Months Ended September 30, 2020 2019 Average Balance Income/ Expense Yield/ Rate Average Balance Income/ Expense Yield/ Rate Assets Short-term investments (1) $ 225,113 $ 62 0.11 % $ 64,471 $ 382 2.35 % Taxable investment securities (2) 2,187,547 12,063 2.21 2,183,930 14,292 2.62 Tax-exempt investment securities (2)(3) 2,058,032 15,737 3.06 1,132,279 10,075 3.56 Loans (3)(4) 5,334,174 66,681 4.97 4,094,235 57,417 5.56 Total earning assets 9,804,866 $ 94,543 3.84 % 7,474,915 $ 82,166 4.36 % Cash and due from banks 186,177 165,868 Bank premises and equipment, net 139,758 133,191 Other assets 98,261 68,519 Goodwill and other intangible assets, net 319,059 174,005 Allowance for loan losses (71,881 ) (52,137 ) Total assets $ 10,476,240 $ 7,964,361 Liabilities and Shareholders’ Equity Interest-bearing deposits $ 5,270,600 $ 2,064 0.16 % $ 4,156,850 $ 7,123 0.68 % Short-term borrowings 482,555 99 0.08 388,235 830 0.85 Total interest-bearing liabilities 5,753,155 $ 2,163 0.15 % 4,545,085 $ 7,953 0.69 % Noninterest-bearing deposits 3,016,700 2,180,200 Other liabilities 106,295 57,262 Total liabilities 8,876,150 6,782,547 Shareholders’ equity 1,600,090 1,181,814 Total liabilities and shareholders’ equity $ 10,476,240 $ 7,964,361 Net interest income $ 92,380 $ 74,213 Rate Analysis: Interest income/earning assets 3.84 % 4.36 % Interest expense/earning assets (0.09 ) (0.42 ) Net interest margin 3.75 % 3.94 % 46 Table of Contents Nine-Months Ended September 30, 2020 2019 Average Balance Income/ Expense Yield/ Rate Average Balance Income/ Expense Yield/ Rate Assets Short-term investments (1) $ 269,704 $ 903 0.45 % $ 93,997 $ 1,667 2.37 % Taxable investment securities (2) 2,283,064 40,748 2.38 2,058,380 41,505 2.69 Tax-exempt investment securities (2)(3) 1,736,250 41,670 3.20 1,175,863 31,968 3.62 Loans (3)(4) 5,084,136 196,255 5.16 4,037,243 166,987 5.53 Total earning assets 9,373,154 $ 279,576 3.98 % 7,365,483 $ 242,127 4.40 % Cash and due from banks 188,241 173,647 Bank premises and equipment, net 139,600 133,886 Other assets 91,324 65,525 Goodwill and other intangible assets, net 318,902 174,264 Allowance for loan losses (64,742 ) (52,143 ) Total assets $ 10,046,479 $ 7,860,662 Liabilities and Shareholders’ Equity Interest-bearing deposits $ 5,104,096 $ 11,293 0.30 % $ 4,165,735 $ 21,071 0.68 % Short-term borrowings 606,291 1,030 0.23 391,680 2,230 0.76 Total interest-bearing liabilities 5,710,387 $ 12,323 0.29 % 4,557,415 $ 23,301 0.68 % Noninterest-bearing deposits 2,714,173 2,133,418 Other liabilities 82,670 44,994 Total liabilities 8,507,230 6,735,827 Shareholders’ equity 1,539,249 1,124,835 Total liabilities and shareholders’ equity $ 10,046,479 $ 7,860,662 Net interest income $ 267,253 $ 218,826 Rate Analysis: Interest income/earning assets 3.98 % 4.40 % Interest expense/earning assets (0.17 ) (0.43 ) Net interest margin 3.81 % 3.97 % (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 third quarter of 2020 increased to $38.58 million compared to $28.67 million in same period in 2019. Mortgage related income increased to $15.23 million compared with $5.73 million in the same quarter a year ago due to a significant increase in the volume of loans originated driven by the lower rate environment and a strong housing market in Texas. The Company’s mortgage loan pipeline increased to $235.63 million as of September 30, 2020 when compared to $62.79 million at September 30, 2019. ATM, interchange and credit card fees increased to $8.64 million compared with $7.73 million in the same quarter last year, driven by continued growth in the number of debit cards issued as well as our TB&T acquisition. Trust fees increased to $7.46 million in the third quarter of 2020 compared with $7.05 million in the same quarter last year. The fair value of Trust assets managed increased to $6.95 billion, up 9.36% at September 30, 2020, from $6.36 billion a year ago. Service charges on deposits were $5.01 million compared with $5.63 million in the same quarter a year ago. The decline in service charge revenue in 2020 when compared with 2019 has primarily been driven by lower overdraft fees in the current year as a result of the effects of the pandemic and related stimulus programs. 47 Table of Contents Noninterest income for the nine month period ended September 30, 2020 was $104.23 million, compared to $81.08 million in the same period in 2019. Mortgage related income increased in the first nine months of 2020 to $32.76 million when compared to $13.93 million in the same period a year ago due to a significant increase in the volume of loans originated driven by the lower rate environment and a strong housing market in Texas. The Company’s mortgage loan pipeline increased to $235.63 million as of September 30, 2020 when compared to $62.79 million at September 30, 2019. ATM, interchange and credit card fees increased to $24.09 million compared with $21.92 million in the same period last year driven by continued growth in the number of debit cards issued as well as our TB&T acquisition. Also included in noninterest income during the first nine months of 2020 was a gain on sale of securities of $3.61 million compared to $728 thousand from the first nine months of 2019. Trust fees increased slightly to $21.86 million in the first nine months of 2020 compared with $21.06 million in the same period in 2019. The fair value of Trust assets managed increased to $6.95 billion from $6.36 billion a year ago, but our revenue from oil and gas management decreased by $715 thousand due to decreased volumes in oil and gas production. Offsetting these increases was a $1.19 million decrease in interest on loan recoveries to $621 thousand for the first nine months of 2020 compared to $1.82 million in the same period in 2019 due to the collection of a larger loan during the first nine months of 2019 that had previously been on nonaccrual. In addition, service charges on deposits decreased to $15.24 million compared with $16.18 million in the same period a year ago as a result of the effects of the pandemic and related stimulus programs. 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 $14.00 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 September 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 and growth in deposits from related activities. 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. 48 Table of Contents Table 3 - Noninterest Income (in thousands): Three-Months Ended September 30, Nine-Months Ended September 30, 2020 Increase (Decrease) 2019 2020 Increase (Decrease) 2019 Trust fees $ 7,461 $ 410 $ 7,051 $ 21,859 $ 802 $ 21,057 Service charges on deposit accounts 5,009 (620 ) 5,629 15,242 (937 ) 16,179 ATM, interchange and credit card fees 8,644 916 7,728 24,093 2,173 21,920 Gain on sale and fees on mortgage loans 15,228 9,495 5,733 32,756 18,828 13,928 Net gain on sale of available-for-sale securities 36 (16 ) 52 3,610 2,882 728 Net gain on sale of foreclosed assets 19 (52 ) 71 72 (121 ) 193 Net gain (loss) on sale of assets (2 ) (237 ) 235 90 (151 ) 241 Interest on loan recoveries 202 (373 ) 575 621 (1,194 ) 1,815 Other: Check printing fees 55 — 55 177 34 143 Safe deposit rental fees 185 70 115 555 126 429 Credit life fees 130 (54 ) 184 696 (102 ) 798 Brokerage commissions 301 (105 ) 406 1,020 (149 ) 1,169 Miscellaneous income 1,307 472 835 3,435 954 2,481 Total other 1,978 383 1,595 5,883 863 5,020 Total Noninterest Income $ 38,575 $ 9,906 $ 28,669 $ 104,226 $ 23,145 $ 81,081 Noninterest Expense . Total noninterest expense for the third quarter of 2020 was $55.59 million, compared to $48.91 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 third quarter of 2020 was 42.45% compared to 47.54% for the same quarter in 2019. Salaries, commissions and employee benefits for the third quarter of 2020 totaled $33.65 million, compared to $28.55 million the same period in 2019. The increase over the prior year 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. All other categories of noninterest expense for the third quarter of 2020 totaled $21.94 million, up from $20.36 million in the same quarter a year ago. Total noninterest expense for the first nine months of 2020 was $164.23 million, compared to $144.58 million in the same period in 2019. Our efficiency ratio for the first nine months of 2020 was 44.21%, compared to 48.21% from the same period in 2019. Management notes the reduction in the Company’s efficiency ratio during 2020 primarily resulted from the growth in the Company’s balance sheet and interest-earning assets as a result of the Company’s participation in the PPP loan program and the deferral of $3.62 million in noninterest expenses related to PPP loan origination costs during the second quarter of 2020. Salaries, commissions and employee benefits for the first nine months of 2020 totaled $94.11 million, compared to $83.37 million 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 and incentives offset by the deferral of $3.62 million in PPP loan origination costs. All other categories of noninterest expense for the first nine months of 2020 totaled $70.13 million, compared to $61.22 million for the same period in 2019. Included in other noninterest expenses in the first nine months of 2020 were technology contract termination and conversion related costs totaling $4.40 million related to the TB&T acquisition. 49 Table of Contents Table 4 - Noninterest Expense (in thousands): Three-Months Ended September 30, Nine-Months Ended September 30, 2020 Increase (Decrease) 2019 2020 Increase (Decrease) 2019 Salaries and commissions $ 26,470 $ 4,273 $ 22,197 $ 72,443 $ 10,003 $ 62,440 Medical 2,461 360 2,101 7,442 558 6,884 Profit sharing 1,545 25 1,520 4,495 (400 ) 4,895 Pension — (31 ) 31 — (73 ) 73 401(k) match expense 840 172 668 2,576 482 2,094 Payroll taxes 1,570 216 1,354 5,100 735 4,365 Stock option and stock grant expense 763 84 679 2,049 332 1,717 Total salaries and employee benefits 33,649 5,099 28,550 94,105 11,637 82,468 Loss from partial settlement of pension plan — — — — (900 ) 900 Net occupancy expense 3,193 363 2,830 9,321 949 8,372 Equipment expense 2,157 (68 ) 2,225 6,242 (767 ) 7,009 FDIC assessment fees 587 572 15 1,095 4 1,091 ATM, interchange and credit card expense 2,829 202 2,627 8,424 987 7,437 Professional and service fees 2,237 335 1,902 7,327 1,606 5,721 Printing, stationery and supplies 615 135 480 1,714 366 1,348 Operational and other losses 621 114 507 1,925 672 1,253 Software amortization and expense 2,265 498 1,767 6,299 1,152 5,147 Amortization of intangible assets 490 244 246 1,507 729 778 Other: Data processing fees 367 (39 ) 406 1,234 60 1,174 Postage 377 (30 ) 407 1,062 (186 ) 1,248 Advertising 248 (659 ) 907 1,053 (1,616 ) 2,669 Correspondent bank service charges 235 64 171 666 148 518 Telephone 912 (6 ) 918 2,788 (53 ) 2,841 Public relations and business development 548 (290 ) 838 1,949 (404 ) 2,353 Directors’ fees 547 23 524 1,783 314 1,469 Audit and accounting fees 565 208 357 1,779 497 1,282 Legal fees 339 (17 ) 356 1,037 99 938 Regulatory exam fees 276 (22 ) 298 829 (52 ) 881 Travel 220 (144 ) 364 732 (507 ) 1,239 Courier expense 217 (4 ) 221 634 23 611 Other real estate owned 18 (19 ) 37 89 (20 ) 109 Other 2,081 124 1,957 10,639 4,912 5,727 Total other 6,950 (811 ) 7,761 26,274 3,215 23,059 Total Noninterest Expense $ 55,593 $ 6,683 $ 48,910 $ 164,233 $ 19,650 $ 144,583 50 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 September 30, 2020, total loans held-for-investment were $5.29 billion, an increase of $1.10 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 $632.02 million, agricultural loans decreased $9.67 million, real estate loans increased $464.23 million and consumer loans increased $12.13 million. Loans averaged $5.33 billion during the third quarter of 2020, an increase of $1.24 billion from the prior year third quarter average balances. Loans averaged $5.08 billion during the first nine months of 2020, an increase of $1.05 billion from the prior year nine month period average balances. Table 5 - Composition of Loans (in thousands): September 30, December 31, 2019 2020 2019 Commercial $ 1,488,345 $ 836,644 $ 856,326 Agricultural 93,972 102,054 103,640 Real estate 3,287,605 2,749,552 2,823,372 Consumer 423,757 412,066 411,631 Total loans held-for-investment $ 5,293,679 $ 4,100,316 $ 4,194,969 At September 30, 2020, our real estate loans represented approximately 62.10% of our loan portfolio and were comprised of (i) 1-4 family residence loans of 38.94%, (ii) commercial real estate loans of 29.54%, (iii) other loans, which includes ranches, hospitals and universities, of 14.76%, (iv) residential development and construction loans of 9.21%, which includes our custom and speculative home construction loans and (v) commercial development and construction loans of 7.55%. Loans held-for-sale, consisting of secondary market mortgage loans, totaled $101.06 million, $40.50 million, and $28.23 million at September 30, 2020 and 2019, and December 31, 2019, respectively. At September 30, 2020 and 2019 and December 31, 2019, $6.39 million, $764 thousand 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. 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 $43.05 million at September 30, 2020, as compared to $27.21 million at September 30, 2019 and $25.77 million at December 31, 2019. As a percent of loans held-for-investment and foreclosed assets, these assets were 0.81% at September 30, 2020, as compared to 0.66% at September 30, 2019 and 0.61% at December 31, 2019. As a percent of total assets, these assets were 0.41% at September 30, 2020, as compared to 0.34% at September 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 September 30, 2020. 51 Table of Contents Supplemental Oil and Gas Information . As of September 30, 2020, the Company’s exposure to the oil and gas industry totaled 2.58% of total loans held-for-investment, excluding PPP loans, or $118.57 million, down $1.22 million from December 31, 2019 year-end levels, and consisted (based on collateral supporting the loan) of (i) development and production loans of 10.36%, (ii) oil and gas field servicing loans of 7.82%, (iii) real estate loans of 43.10%, (iv) accounts receivable and inventory of 1.48%, (v) automobile of 7.80% and (vi) other of 29.44%. The following oil and gas information is as of and for the quarters ended September 30, 2020 and 2019, and December 31, 2019 (in thousands, except percentages): September 30, December 31, 2019 2020 2019 Oil and gas related loans, excluding PPP loans $ 118,567 $ 122,908 $ 119,789 Oil and gas related loans as a % of total loans held-for-investment, excluding PPP loans 2.58 % 3.00 % 2.86 % Classified oil and gas related loans $ 26,823 $ 7,953 $ 7,041 Nonaccrual oil and gas related loans 6,800 519 481 Net charge-offs for oil and gas related loans for quarter/year then ended — — — Allowance for oil and gas related loans as a % of oil and gas loans 8.01 % 2.87 % 2.54 % Supplemental COVID-19 Industry Exposure. In addition, at September 30, 2020, loan balances in the retail/restaurant/hospitality industries totaled $359.02 million or 7.82% of the Company’s total loans held-for-investment, excluding PPP loans. Classified and nonperforming loans for these industries combined at September 30, 2020, totaled $28.17 million and $5.69 million, respectively. Net charge-offs related to this portfolio totaled 52 Table of Contents $26 thousand and $334 thousand for the three and nine-months ended September 30, 2020, respectively. Additional information related to the Company’s retail/restaurant/hospitality industries follows below (in thousands, except percentages): September 30, June 30, 2020 2020 Retail loans $ 229,386 $ 216,244 Restaurant loans 39,523 46,418 Hotel loans 63,273 51,957 Other hospitality loans 26,041 23,230 Travel loans 801 908 Total Retail/Restaurant/Hospitality loans, excluding PPP loans $ 359,024 $ 338,757 Retail/Restaurant/Hospitality loans as a % of total loans held-for-investment , excluding PPP loans 7.82 % 7.45 % Classified Retail/Restaurant/Hospitality loans $ 28,171 $ 15,837 Nonaccrual Retail/Restaurant/Hospitality loans 5,689 5,752 Net Charge-Offs for Retail/Restaurant/Hospitality loans 26 178 Table 6 – Non-accrual, Past Due 90 Days or More and Still Accruing, Restructured Loans and Foreclosed Assets (in thousands, except percentages): September 30, December 31, 2019 2020 2019 Nonaccrual loans* $ 42,673 $ 25,717 $ 24,582 Loans still accruing and past due 90 days or more 23 104 153 Troubled debt restructured loans** 25 27 26 Nonperforming loans 42,721 25,848 24,761 Foreclosed assets 331 1,364 1,009 Total nonperforming assets $ 43,052 $ 27,212 $ 25,770 As a % of loans held-for-investment and foreclosed assets 0.81 % 0.66 % 0.61 % As a % of total assets 0.41 0.34 0.31 * Includes $5.98 million, $342 thousand and $251 thousand of purchased credit impaired loans as of September 30, 2020 and 2019, and December 31, 2019, respectively. ** Other troubled debt restructured loans of $4.48 million, $3.98 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 September 30, 2020 and 2019, and December 31, 2019, respectively. 53 Table of Contents 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. 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 credit losses was $9.00 million, including $1.50 million in provision for unfunded commitments for the third quarter of 2020, as compared to $450 thousand for the third quarter of 2019. The provision for credit losses was $27.55 million for the nine month period ended September 30, 2020 as compared to $2.02 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 volatility of oil and gas prices. As a percent of average loans, net loan charge-offs were 0.03% for the third quarter of 2020, as compared to 0.04% for the third quarter of 2019. As a percentage of average loans, net loan charge-offs were 0.07% for the first nine months of 2020, as compared to 0.04% for the first nine months of 2019. The allowance for loan losses as a percent of loans held-for-investment was 1.44% as of September 30, 2020, as compared to 1.27% as of September 30, 2019 and 1.25% as of December 31, 2019. In addition, management notes the acquisition of $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 $5.04 million at September 30, 2020. Table 7 - Loan Loss Experience and Allowance for Loan Losses (in thousands, except percentages): Three-Months Ended September 30, Nine-Months Ended September 30, 2020 2019 2020 2019 Allowance for loan losses at period-end $ 76,038 $ 51,889 $ 76,038 $ 51,889 Loans held-for-investment at period-end 5,293,679 4,100,316 5,293,679 4,100,316 Average loans for period 5,334,174 4,094,235 5,084,136 4,037,243 Net charge-offs/average loans (annualized) 0.03 % 0.04 % 0.07 % 0.04 % Allowance for loan losses/period-end loans held-for-investment 1.44 % 1.27 % 1.44 % 1.27 % Allowance for loan losses/non-accrual loans, past due 90 days still accruing and restructured loans 177.99 % 200.75 % 177.99 % 200.75 % Interest-Bearing Demand Deposits in Banks. At September 30, 2020, our interest-bearing deposits in banks were $58.93 million compared to $31.41 million at September 30, 2019 and $47.92 million at December 31, 2019, respectively. At September 30, 2020, interest-bearing deposits in banks included $58.56 million maintained at the Federal Reserve Bank of Dallas and $369 thousand on deposit with the FHLB. 54 Table of Contents Available-for-Sale Securities . At September 30, 2020, securities with a fair value of $4.43 billion were classified as securities available-for-sale. As compared to December 31, 2019, the available-for-sale portfolio at September 30, 2020 reflected (i) a decrease in U.S. Treasury securities of $10.02 million, (ii) an increase of $1.08 billion in obligations of states and political subdivisions, (iii) a decrease of $139 thousand in corporate bonds and other, and (iv) a decrease of $50.39 million in mortgage-backed securities. The shift to mortgage-backed securities from obligations of state and political subdivisions was due to the change in the federal income tax rate of 21% from 35% effective January 1, 2018, although we have seen an increase in our purchases of state and political subdivisions bonds in the first nine months 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 September 30, 2020 and 2019, and December 31, 2019. Table 8 - Maturities and Yields of Available-for-Sale Securities Held at September 30, 2020 (in thousands, except percentages): Maturing by Contractual Maturity 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 Obligations of states and political subdivisions $ 115,637 4.80 % $ 669,407 4.03 % $ 1,536,734 2.90 % $ 45,711 2.24 % $ 2,367,489 3.30 % Mortgage-backed securities 174,409 2.19 1,693,861 2.36 190,952 1.98 — — 2,059,222 2.31 Other securities 4,569 1.96 — — — — — — 4,569 1.96 Total $ 294,615 3.21 % $ 2,363,268 2.83 % $ 1,727,686 2.80 % $ 45,711 2.24 % $ 4,431,280 2.84 % 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 September 30, 2020, the investment portfolio had an overall tax equivalent yield of 2.84%, a weighted average life of 4.62 years and modified duration of 4.10 years. Deposits . Deposits held by our subsidiary bank represent our primary source of funding. Total deposits were $8.29 billion as of September 30, 2020, as compared to $6.40 billion as of September 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 nine-month periods ended September 30, 2020 and 2019, respectively. 55 Table of Contents Table 9 - Composition of Average Deposits (in thousands, except percentages): Three-Months Ended September 30, 2020 2019 Average Balance Average Rate Average Balance Average Rate Noninterest-bearing deposits $ 3,016,700 — % $ 2,180,200 — % Interest-bearing deposits: Interest-bearing checking 2,498,641 0.10 2,046,792 0.69 Savings and money market accounts 2,301,920 0.12 1,679,684 0.58 Time deposits under $100,000 193,991 0.35 184,843 0.79 Time deposits of $100,000 or more 276,048 0.81 245,531 1.15 Total interest-bearing deposits 5,270,600 0.16 % 4,156,850 0.68 % Total average deposits $ 8,287,300 $ 6,337,050 Total cost of deposits 0.10 % 0.45 % Nine-Months Ended September 30, 2020 2019 Average Balance Average Rate Average Balance Average Rate Noninterest-bearing deposits $ 2,714,173 — % $ 2,133,418 — % Interest-bearing deposits: Interest-bearing checking 2,477,034 0.26 2,052,943 0.73 Savings and money market accounts 2,156,907 0.24 1,677,181 0.57 Time deposits under $100,000 196,627 0.49 188,210 0.68 Time deposits of $100,000 or more 273,528 0.96 247,401 1.01 Total interest-bearing deposits 5,104,096 0.30 % 4,165,735 0.68 % Total average deposits $ 7,818,269 $ 6,299,153 Total cost of deposits 0.19 % 0.45 % 56 Table of Contents Borrowings. Included in borrowings were federal funds purchased, securities sold under repurchase agreements and advances from the FHLB of $503.16 million, $400.16 million and $381.36 million at September 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 $482.56 million and $388.24 million in the third quarters of 2020 and 2019, respectively. The weighted average interest rates paid on these borrowings were 0.08% and 0.85% for the third quarters of 2020 and 2019, respectively. The average balances of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB was $606.29 million and $391.68 million for the nine-month periods ended September 30, 2020 and 2019, respectively. The weighted average interest rate on these short-term borrowings was 0.23% and 0.76% for the first nine 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 $1.62 billion, or 15.33% of total assets at September 30, 2020, as compared to $1.21 billion, or 14.85% of total assets at September 30, 2019, and $1.23 billion, or 14.85% of total assets at December 31, 2019. Included in shareholders’ equity at September 30, 2020 and 2019 and December 31, 2019 were $152.06 million, $73.52 million and $67.51 million, respectively, in unrealized gains on investment securities available-for-sale, net of related income taxes. For the third quarter of 2020, total shareholders’ equity averaged $1.60 billion, or 15.27% of average assets, as compared to $1.18 billion, or 14.84% of average assets, during the same period in 2019. For the nine-months ended September 30, 2020, total shareholders’ equity averaged $1.54 billion, or 15.32%, as compared to $1.12 billion, or 14.31% 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 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 September 30, 2020 and 2019, and December 31, 2019, we had a total capital to risk-weighted assets ratio of 21.82%, 21.14% and 21.13%, a Tier 1 capital to risk-weighted assets ratio of 20.56%, 20.05% and 20.06%; a common equity Tier 1 to risk-weighted assets ratio of 20.56%, 20.05% and 20.06% and a leverage ratio of 11.65%, 12.58% and 12.60%, respectively. The regulatory capital ratios as of September 30, 2020 and 2019, and December 31, 2019 were calculated under Basel III rules. 57 Table of Contents 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 September 30, 2020: Amount Ratio Amount Ratio Amount Ratio Total Capital to Risk-Weighted Assets: Consolidated $ 1,231,395 21.82 % $ 592,680 10.50 % $ 564,457 10.00 % First Financial Bank, N.A $ 1,102,365 19.57 % $ 591,382 10.50 % $ 563,221 10.00 % Tier 1 Capital to Risk-Weighted Assets: Consolidated $ 1,160,742 20.56 % $ 479,788 8.50 % $ 338,674 6.00 % First Financial Bank, N.A $ 1,031,864 18.32 % $ 478,738 8.50 % $ 450,577 8.00 % Common Equity Tier 1 Capital to Risk-Weighted Assets: Consolidated $ 1,160,742 20.56 % $ 395,120 7.00 % — N/A First Financial Bank, N.A $ 1,031,864 18.32 % $ 394,255 7.00 % $ 366,094 6.50 % Leverage Ratio: Consolidated $ 1,160,742 11.65 % $ 398,660 4.00 % — N/A First Financial Bank, N.A $ 1,031,864 10.39 % $ 397,410 4.00 % $ 496,763 5.00 % * At September 30, 2020, the capital conservation buffer under Basel III has been fully phased-in. Actual Minimum Capital Required-Basel III Fully Phased-In* Required to be Considered Well- Capitalized As of September 30, 2019: Amount Ratio Amount Ratio Amount Ratio Total Capital to Risk-Weighted Assets: Consolidated $ 1,023,229 21.14 % $ 508,149 10.50 % $ 483,951 10.00 % First Financial Bank, N.A $ 905,495 18.75 % $ 506,957 10.50 % $ 482,816 10.00 % Tier 1 Capital to Risk-Weighted Assets: Consolidated $ 970,532 20.05 % $ 411,359 8.50 % $ 290,371 6.00 % First Financial Bank, N.A $ 852,798 17.66 % $ 410,394 8.50 % $ 386,253 8.00 % Common Equity Tier 1 Capital to Risk-Weighted Assets: Consolidated $ 970,532 20.05 % $ 338,766 7.00 % — N/A First Financial Bank, N.A $ 852,798 17.66 % $ 337,971 7.00 % $ 313,830 6.50 % Leverage Ratio: Consolidated $ 970,532 12.58 % $ 308,675 4.00 % — N/A First Financial Bank, N.A $ 852,798 11.10 % $ 307,442 4.00 % $ 384,302 5.00 % 58 Table of Contents 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 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. 59 Table of Contents As of September 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 3.93% and 7.81%, 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 4.23% and 6.21%, respectively, relative to the current financial statement structure over the next twelve months. Our model simulation as of September 30, 2020 indicates that our balance sheet is relatively asset/liability neutral. 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 September 30, 2020, no amounts were drawn on these federal funds lines of credit. Our subsidiary bank also has (i) an available line of credit with the FHLB totaling $1.77 billion at September 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 September 30, 2020, the Company had $30.00 million in outstanding advances from the FHLB. 60 Table of Contents 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 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 September 30, 2020. There was no outstanding balance under the line of credit as of September 30, 2020 and 2019, 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 $113.72 million at September 30, 2020, investment securities which totaled $3.60 million at September 30, 2020 and mature over 9 to 10 years, available dividends from our subsidiaries which totaled $270.17 million at September 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 September 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. At September 30, 2020, the Company’s reserve for unfunded commitments totaled $2.30 million which is recorded in other liabilities. 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. 61 Table of Contents 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. 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 September 30, 2020 (in thousands): Total Notional Amounts Committed Unfunded lines of credit $ 814,963 Unfunded commitments to extend credit 719,677 Standby letters of credit 36,992 Total commercial commitments $ 1,571,632 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. 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 September 30, 2020, $270.17 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 $46.00 million and $44.50 million for the nine-month periods ended September 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 37.62% and 37.94% of net earnings for the first nine 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. 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. 62 Table of Contents 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. 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.