Item 2. Management’s Discussion and Analysis
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Cautionary Note Regarding Forward-Looking Statements
This Quarterly Report on Form 10-Q, including the documents incorporated by reference herein, contains, and from time to time our management may make, forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect our current views with respect to, among other things, future events and our financial performance. These statements are often, but not always, made through the use of words or phrases such as “may,” “might,” “should,” “could,” “predict,” “potential,” “believe,” “expect,” “continue,” “will,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “projection,” “would,” “annualized” and “outlook,” or the negative version of those words or other comparable words or phrases of a future or forward-looking nature. These forward-looking statements are not historical facts, and are based on current expectations, estimates and projections about our industry, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control. Accordingly, we caution you that any such forward-looking statements are not guarantees of future performance and are subject to risks, assumptions, estimates and uncertainties that are difficult to predict. Although we believe that the expectations reflected in these forward-looking statements are reasonable as of the date made, actual results may prove to be materially different from the results expressed or implied by the forward-looking statements.
A number of important factors could cause our actual results to differ materially from those indicated in these forward-looking statements, including the following: the geographic concentration of our business; current and future economic and market conditions in the United States generally or in Hawaii, Guam and Saipan in particular, including, among other things, the rate of growth and the unemployment rate; the impact on our business, operations, financial condition, liquidity, results of operations, prospects and the trading price of our shares as a result of the COVID-19 pandemic; our dependence on the real estate markets in which we operate; concentrated exposures to certain asset classes and individual obligors; the effect of the current low interest rate environment or changes in interest rates on our business including our net interest income, net interest margin, the fair value of our investment securities, and our mortgage loan originations, mortgage servicing rights and mortgage loans held for sale; changes in the method pursuant to which LIBOR and other benchmark rates are determined or the discontinuance of LIBOR; the possibility of a deterioration in credit quality in our portfolio; the possibility we might underestimate the credit losses inherent in our loan and lease portfolio; our ability to maintain our Bank’s reputation; the future value of the investment securities that we own, especially in light of the market volatility caused by the spread of COVID-19 and governmental and regulatory responses thereto; our ability to attract and retain customer deposits; our inability to receive dividends from our bank, pay dividends to our common stockholders and satisfy obligations as they become due; the effects of severe weather, geopolitical instability, including war, terrorist attacks, pandemics (including the ongoing COVID-19 pandemic) or other severe health emergencies and man-made and natural disasters; our ability to maintain consistent growth, earnings and profitability; our ability to attract and retain skilled employees or changes in our management personnel; possible changes in trade, monetary and fiscal policies of, and other activities undertaken by, governments, agencies, central banks and similar organizations, including quantitative easing, the lowering of interest rates and the imposition of tariffs that may harm sectors to which we are particularly exposed; our ability to effectively compete with other financial services companies and the effects of competition in the financial services industry on our business; the effectiveness of our risk management and internal disclosure controls and procedures; our ability to keep pace with technological changes; any failure or interruption of our information and communications systems; our ability to identify and address cybersecurity risks; the occurrence of fraudulent activity or effect of a material breach of, or disruption to, the security of any of our or our vendors’ systems; the failure to properly use and protect our customer and employee information and data; the possibility of employee misconduct or mistakes; our ability to successfully develop and commercialize new or enhanced products and services; changes in the demand for our products and services; the effects of problems encountered by other financial institutions; our access to sources of liquidity and capital to address our liquidity needs; our use of the secondary mortgage market as a source of liquidity; risks associated with the sale of loans and with our use of appraisals in valuing and monitoring loans; the possibility that actual results may differ from estimates and forecasts; fluctuations in the fair value of our assets and liabilities and off-balance sheet exposures; the effects of the failure of any component of our business infrastructure provided by a third party; the potential for environmental liability; the risk of being subject to litigation and the outcome thereof; the impact of, and changes in, applicable laws, regulations and accounting standards and policies, including the enactment of the Tax Act (Public Law 115-97) on December 22, 2017; possible changes in trade, monetary and fiscal policies of, and other activities undertaken by, governments, agencies, central banks and similar organizations; our likelihood of success in, and the impact of, litigation or regulatory actions; our ability to continue to pay dividends on our common stock or take other capital actions, which must comply with requirements under law or those imposed by our regulators and could
49
Table of Contents
impact our ability to return capital to stockholders; contingent liabilities and unexpected tax liabilities that may be applicable to us as a result of the Reorganization Transactions; and damage to our reputation from any of the factors described above.
The foregoing factors should not be considered an exhaustive list and should be read together with the risk factors and other cautionary statements included in our Annual Report on Form 10-K for the year ended December 31, 2019 and our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2020 and June 30, 2020. If one or more events related to these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may differ materially from what we anticipate. Accordingly, you should not place undue reliance on any such forward-looking statements. Any forward-looking statement speaks only as of the date on which it is made, and we do not undertake any obligation to update or review any forward-looking statement, whether as a result of new information, future developments or otherwise, except as required by applicable law.
Company Overview
FHI is a bank holding company, which owns 100% of the outstanding common stock of FHB, its only direct, wholly owned subsidiary. FHB was founded in 1858 under the name Bishop & Company and was the first successful banking partnership in the Kingdom of Hawaii and the second oldest bank formed west of the Mississippi River. The Bank operates its business through three operating segments: Retail Banking, Commercial Banking and Treasury and Other.
References to “we,” “our,” “us,” or the “Company” refer to the Parent and its subsidiary that are consolidated for financial reporting purposes.
Basis of Presentation
The accompanying unaudited interim consolidated financial statements of the Company reflect the results of operations, financial position and cash flows of FHI and its wholly owned subsidiary, FHB. All significant intercompany accounts and transactions have been eliminated in consolidation.
The accompanying unaudited interim consolidated financial statements of the Company have been prepared in accordance with GAAP for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and accompanying notes required by GAAP for complete financial statements. In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect normal recurring adjustments necessary for a fair presentation of the results for the interim periods.
The accompanying unaudited interim consolidated financial statements of the Company should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 and filed with the U.S. Securities and Exchange Commission (the “SEC”).
Recent Developments regarding COVID-19 and the Hawaii and Global Economy
Overview
The Coronavirus Disease (“COVID-19”) has spread throughout the world and has been declared a pandemic by the World Health Organization and continues to evolve. Several countries, including the U.S., have been particularly hard hit by COVID-19. Through October 2020, the U.S. has the highest number of confirmed cases and deaths reported as a result of COVID-19 in the world. Despite efforts to control the spread of COVID-19, the U.S. continues to experience a significant number of confirmed COVID-19 cases. The global and U.S. economies have entered into a pandemic-driven recession. The future impact of COVID-19 on the global and U.S. economies, and the timing and robustness of any related recovery, continues to remain uncertain.
50
Table of Contents
As a result of the COVID-19 outbreak and related response, the U.S. economy has deteriorated but is slowly improving. In March 2020, in many parts of the U.S., employees began working from home and businesses deemed nonessential were temporarily closed. Workers in the retail, restaurant, travel and leisure industries were particularly hard hit by layoffs as large parts of the U.S. went into lockdown. According to the Federal Reserve’s May 2020 Beige Book, declines in consumer spending were “especially severe in the leisure and hospitality sector, with very little activity at travel and tourism businesses.” The national seasonally adjusted unemployment rate increased from 4.4% in March 2020 to 14.7% in April 2020. In May 2020, state-by-state decisions began to be made on the pace and extent of reopening local businesses. The phased reopening of the U.S. economy brought the national seasonally adjusted unemployment rate down to 7.9% in September 2020. The August 2020 Beige Book reports “some improvements in tourism and retail sectors” but that “total spending was still below pre-pandemic levels.” New claims for unemployment insurance decreased to 800,000 per week in early October from above one million per week through July 2020. The U.S. real gross domestic product decreased at an annual rate by 5.0% in the first quarter of 2020, followed by a 31.4% decrease in the second quarter.
Hawaii Economy
Hawaii’s economy continues to be significantly impacted by COVID-19 and the responses to it. Hawaii’s economy began to suffer in February 2020 with flight cancellations to Hawaii due to the global COVID-19 pandemic. On March 5, 2020, the Governor of the State of Hawaii issued an emergency proclamation declaring a state of emergency in Hawaii. On March 21, 2020, the Governor of the State of Hawaii issued a supplementary emergency proclamation ordering all individuals, both residents and visitors, arriving or returning to the State of Hawaii to a mandatory 14-day self-quarantine. The mandate, which was the first such action in the nation, essentially brought the Hawaii tourism industry to a halt. Subsequently, on March 23, 2020, the Governor of the State of Hawaii issued a third supplemental emergency proclamation that required all residents to stay at home, with the exception of certain essential activities associated with identified essential businesses and services.
As a result of these measures, thus far, the spread of COVID-19 has been relatively well controlled in Hawaii. In May 2020, the Governor of the State of Hawaii issued a seventh and eighth supplemental emergency proclamation which effectively ended stay-at-home orders, allowed for the reopening of certain businesses deemed to be of lower risk for COVID-19 transmissions, and outlined a four-phase reopening strategy for Hawaii’s economy and allowing for a gradual reopening of medium-risk businesses in June 2020. Subsequently, the Governor issued a ninth, tenth, eleventh, and twelfth supplemental emergency proclamation on June 10, July 17, August 7, and August 20, 2020, respectively, enforcing the 14-day self-quarantine mandate for interisland travel and travel to Hawaii state. The Honolulu County Mayor also issued Emergency Order 2020-25 and 2020-26, essentially placing the island of Oahu under a second lockdown from August 27 through September 23, 2020. The Governor of the State of Hawaii issued his thirteenth supplemental emergency proclamation on September 23, 2020, that allows passengers from the U.S. mainland with an approved negative COVID-19 test within 72 hours prior to arrival in the State of Hawaii to bypass the state’s mandatory 14-day self-quarantine requirement, effective October 15.
For an economy that is heavily dependent on tourism, the combination of various response measures to the COVID-19 pandemic, including the stay-at-home orders for local residents and the mandatory 14-day self-quarantine for visitors resulted in an unprecedented increase in Hawaii unemployment. The statewide seasonally adjusted unemployment rate was 15.1% in September 2020 compared to 2.7% in September 2019, according to the State of Hawaii Department of Labor and Industrial Relations, while the national seasonally adjusted unemployment rate was 7.9% in September 2020 compared to 3.5% in September 2019. Visitor arrivals for the first nine months of 2020 decreased by 72% compared to the same period in 2019, according to the Hawaii Tourism Authority. Statistics on visitor spending were not available for 2020 due to insufficient data. While we may see a gradual improvement in unemployment as local businesses and the Hawaii tourism industry slowly reopen in the fourth quarter of 2020, the timing and extent of the return of air travel and the recovery of the Hawaii tourism industry is highly uncertain and beyond our control.
51
Table of Contents
Although the volume of home sales on Oahu has decreased year-over-year due to stay-at-home orders that were in place earlier in the year, prices have remained stable. For the nine months ended September 30, 2020, the volume of single-family home sales decreased by 1.4%, while condominium sales decreased by 18.9% compared to the same period in 2019, according to the Honolulu Board of Realtors. The median price of single-family home sales and condominium sales on Oahu was $811,000 and $430,000, respectively, or an increase of 3.3% and 1.2%, respectively, for the nine months ended September 30, 2020 as compared to the same period in 2019. As of September 30, 2020, months of inventory of single-family homes and condominiums on Oahu remained low at approximately 1.9 and 4 months, respectively. Lastly, state general excise and use tax revenues decreased by 11% for the first seven months of 2020 as compared to the same period in 2019, according to the Hawaii Department of Business, Economic Development & Tourism. We expect tax revenues for the state to continue to be significantly lower when reported for the remainder of 2020.
Legislative and Regulatory Developments
Recent actions taken by the federal government and the Federal Reserve and other bank regulatory agencies to partially mitigate the economic effects of COVID-19 and related containment measures will also have an impact on our financial position and results of operations. These actions are further discussed below.
In response to market conditions resulting from the COVID-19 pandemic, the Federal Reserve has taken a number of proactive measures, including cutting its target for the federal funds rate by a total of 1.50%, bringing it down to a range of 0.00% to 0.25%. In September 2020, the Federal Reserve indicated that it expects to maintain the targeted federal funds rate at current levels until such time that labor market conditions have reached levels consistent with the Federal Open Market Committee's assessments of maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time. This timeframe is currently expected to last through 2023.
The Federal Reserve has instituted a number of other measures, to mitigate the lasting impact from the COVID-19 pandemic, including the following:
● establishing a temporary repurchase agreement facility for foreign and international monetary authorities;
● committing to quantitative easing through large-scale asset-purchase programs;
● lowering the rate charged on its discount window and extending the length of the loans offered;
● increasing the frequency of engagement with currency swap lines with foreign central banks;
● expanding the collateral accepted by its Term Asset-Backed Securities Loan Facility; and
● introducing a number of additional facilities, such as the Main Street Lending Facility, which is designed to enhance support for small and mid-sized businesses that were in good financial standing before the crisis.
The U.S. government has also enacted certain fiscal stimulus measures in several phases to counteract the economic disruption caused by COVID-19. The CARES Act, enacted on March 27, 2020, is an approximately $2 trillion emergency economic stimulus package in response to the COVID-19 outbreak. Among other provisions, the CARES Act (i) authorized the Secretary of the Treasury to make loans, loan guarantees and other investments, up to $500 billion, for assistance to eligible businesses, States and municipalities with limited, targeted relief for passenger air carriers, cargo air carriers, and businesses critical to maintaining national security, (ii) created a $670 billion loan program (the “Paycheck Protection Program” or the “PPP”) for fully guaranteed loans (which may then be forgiven) to small businesses for, among other things, payroll, group health care benefit costs and qualifying mortgage, rent and utility payments (program dollar amount includes amount approved under the original program in March 2020 and a second tranche which was approved in April 2020), (iii) provides certain credits against the 2020 personal income tax for eligible individuals and their dependents, (iv) expanded eligibility for unemployment insurance and provides eligible recipients with an additional $600 per week on top of the unemployment amount determined by each State and (v) set a 60-day foreclosure moratorium beginning on March 18, 2020 for federally backed mortgage loans (the Federal Housing Administration has subsequently announced a second extension of the foreclosure and eviction moratorium through August 31, 2020).
52
Table of Contents
The Paycheck Protection Program Flexibility Act of 2020 (the “PPPF Act”) was enacted on June 5, 2020 and modified the PPP as follows: (i) established a minimum maturity of five years for all loans made after the enactment of the PPPF Act and permits an extension of the maturity of existing loans to five years if the borrower and lender agree; (ii) extended the “covered period” of the CARES Act from June 30, 2020, to December 31, 2020; (iii) extended the eight-week “covered period” for expenditures that qualify for forgiveness to the earlier of 24 weeks following loan origination and December 31, 2020; (iv) extended the deferral period for payment of principal, interest and fees to the date on which the forgiveness amount is remitted to the lender by the U.S. Small Business Administration (“SBA”); (v) required the borrower to use at least 60% (down from 75%) of the proceeds of the loan for payroll costs, and up to 40% (up from 25%), for other permitted purposes, as a condition to obtaining forgiveness of the loan; (vi) delayed from June 30, 2020 to December 31, 2020, the date by which employees must be rehired to avoid a reduction in the amount of forgiveness of a loan, and creates a “rehiring safe harbor” that allows businesses to remain eligible for loan forgiveness if they make a good faith attempt to rehire employees or hire similarly qualified employees, but are unable to do so, or are able to document an inability to return to pre-COVID-19 levels of business activity due to compliance with social distancing measures; and (vii) allowed borrowers to receive both loan forgiveness under the PPP and the payroll tax deferral permitted under the CARES Act, rather than having to choose the more advantageous option.
In July 2020, the CARES Act was amended to extend, through August 8, 2020, the SBA’s authority to make commitments under the PPP. The SBA’s existing authority had previously expired on June 30, 2020.
In August 2020, President Trump signed four executive actions to provide additional COVID-19 relief. These executive orders seek to (i) allocate $44 billion from the Disaster Relief Fund to provide additional unemployment benefits through the authorization of the Lost Wages Assistance Program, which provides for a $400-per-week payment to those currently receiving more than $100 a week in unemployment benefits due to disruptions caused by COVID-19, (ii) extend the moratorium on payments and interest accrual on student loans held by the government until the end of 2020, (iii) defer collections of certain employee social security payroll taxes, and (iv) identify options to help renters and homeowners avoid evictions and foreclosures.
We are continuing to monitor the potential development of additional legislation and further actions taken by the U.S. government.
The State of Hawaii is expected to receive at least $1.25 billion in federal aid from the CARES Act. We expect that the majority of this federal aid will be used to help fund state and county government response efforts to COVID-19. Additional federal funding is expected to provide for unemployment assistance, direct cash payments to Hawaii residents and funding to support local schools and colleges.
Impact to our Operations
As noted above, on March 23, 2020, the Governor of the State of Hawaii issued a third supplemental emergency proclamation that ordered all residents to stay at home, with the exception of certain essential activities associated with identified essential businesses and services. A stay-at-home order was in place until May 31, 2020, and then reinstated from August 27, 2020 through September 23, 2020. While the Bank is an essential business in Hawaii, we saw a significant decrease in customer traffic in our branches in recent periods. As a result, we strategically closed 26 of our branch locations on a temporary basis and have decided to close four of them permanently by November 2020. From June to early November 2020, we reopened 18 of the temporarily closed branch locations in connection with the reopening of local businesses. The temporary (or in certain cases, permanent) closures of bank branches and the safety precautions implemented at re-opened branches could result in consumers becoming more comfortable with technology and devaluing face-to-face interaction. Our business is relationship driven and such changes could necessitate changes to our business practices to accommodate changing consumer behaviors. We continue to provide service to all customers and operate our businesses on all islands of Hawaii, Guam and Saipan. Additionally, as part of our contingency plans, we have established a redundant operations center for our administrative operations, and many of our employees are working remotely.
53
Table of Contents
Impact on our Financial Position and Results of Operations
Due to the widespread impact that COVID-19 is having on Hawaii’s economy, we expect that adverse economic conditions will continue. While its effects continue to materialize, the COVID-19 pandemic has resulted in a significant decrease in commercial activity throughout the State of Hawaii and nationally. This decrease in commercial activity has caused and may continue to cause our customers (including affected businesses and individuals), vendors and counterparties to be unable to meet existing payment or other obligations to us. As Hawaii’s economy begins to reopen, we expect that local consumption of goods and services will begin to resume over an extended period of time. Additionally, the timing and extent of the return of air travel and the recovery of the Hawaii tourism industry is highly uncertain and is dependent upon, among other things, the number of cases declining around the globe, in the United States and, in particular, in Hawaii, visitor receptiveness to Hawaii’s new pre-travel COVID-19 testing requirements, an extended period in which there is no subsequent “wave” of infections and the widespread availability of a vaccine, treatment or testing, tracking and tracing capabilities.
During this time of uncertainty, we remain committed to servicing our customers, caring for our employees and supporting the community. The economic pressures and uncertainties arising from the COVID-19 pandemic has resulted in and may continue to result in specific changes in consumer and business spending and borrowing and saving habits, affecting the demand for loans and other products and services we offer. For example, certain industries may take longer to recover (particularly those that rely on travel or large gatherings) as consumers may be hesitant to travel or return to full social interaction. We lend to customers operating in such industries including tourism, hotels/lodging, restaurants, entertainment and commercial real estate, among others. We will continue to closely monitor the impact that COVID-19 and the recession in Hawaii has on our customers and will adjust the means by which we assist our customers during this period of financial hardship. We are working with our customers impacted by COVID-19 through offering payment deferrals and forbearance on certain loan products. We are continuing to care for our employees by enabling more of our employees to work from home, and for those employees who are deemed essential and unable to work from home, we continue to emphasize the importance of practicing social distancing and good hygiene practices in the workplace. We also launched an initiative to support local restaurants and, through our foundation, to donate up to $1 million to support non-profit organizations with food supply and health and human service programs for those impacted by COVID-19. We have also partnered with the Hawaii Community Foundation by contributing $1 million, through our foundation, to establish the $2 million Stronger Together Hawai’i Scholarship Fund, which provides scholarship opportunities to public high school seniors who graduated amidst the pandemic. Unlike traditional scholarships that are limited to tuition and college materials, students awarded with the scholarship can use the funds in a variety of ways, with the intent to help students overcome barriers to their education caused by COVID-19.
The shut-down of Hawaii’s tourism industry, stay-at-home measures, the recession in Hawaii and record low interest rates will continue to have a negative impact on our financial position and results of operations. A continued decrease in interest rates, or sustained period of interest rates, would be expected to reduce our net interest margin, as, currently, our interest rate profile is such that we project net interest income will benefit from higher interest rates as our assets would reprice faster and to a greater degree than our liabilities, while in the case of lower interest rates, our assets would reprice downward and to a greater degree than our liabilities. Our net interest margin also may be reduced as a result of our participation in the PPP, with loans made thereunder that are not forgiven carrying an interest rate of 1%.
Our credit risk profile has also been, and we expect that it will continue to be, adversely impacted during this period of financial hardship for our customers. We also expect that we will see temporary decreases in non-interest income, partially driven by certain measures we have taken to assist customers during the COVID-19 pandemic.
Moreover, we have seen increased draws by some of our customers on lines of credit as they have sought to improve their liquidity positions. While we expect a significant portion of loans made by the Bank through our participation in the PPP to be forgiven, we expect that a sizeable portion of such loans will remain on our balance sheet for up to two years. As a result, we expect to see higher loan volumes and reduced capital levels as a result of the COVID-19 pandemic.
In light of volatility in the capital markets and economic disruptions, we continue to carefully monitor our capital and liquidity positions. As of September 30, 2020, the Company was “well-capitalized” and met all applicable regulatory capital requirements, including a Common Equity Tier 1 capital ratio of 12.22%, compared to the minimum requirement of 4.50%. We continue to anticipate that we will have sufficient capital levels to meet all of these requirements. Additionally, we continue to access our routine short-term funding sources, such as borrowings and repurchase agreements, and to assess longer-term funding sources. For additional discussions regarding our capital and liquidity positions and related risks, refer to the sections titled “Liquidity” and “Capital” in this MD&A.
54
Table of Contents
Selected Financial Data
Our financial highlights for the periods indicated are presented in Table 1:
Financial Highlights
Table 1
For the Three Months Ended
For the Nine Months Ended
September 30,
September 30,
(dollars in thousands, except per share data)
2020
2019
2020
2019
Income Statement Data:
Interest income
$
141,927
$
170,181
$
441,078
$
516,560
Interest expense
7,925
27,100
40,571
82,777
Net interest income
134,002
143,081
400,507
433,783
Provision for credit losses
5,072
—
101,718
9,550
Net interest income after provision for credit losses
128,930
143,081
298,789
424,233
Noninterest income
48,898
49,980
143,782
145,825
Noninterest expense
91,629
93,466
279,545
279,379
Income before provision for income taxes
86,199
99,595
163,026
290,679
Provision for income taxes
21,098
25,396
39,011
74,123
Net income
$
65,101
$
74,199
$
124,015
$
216,556
Basic earnings per share
$
0.50
$
0.56
$
0.95
$
1.62
Diluted earnings per share
$
0.50
$
0.56
$
0.95
$
1.61
Basic weighted-average outstanding shares
129,896,054
132,583,902
129,882,878
133,957,192
Diluted weighted-average outstanding shares
130,085,534
132,877,769
130,129,690
134,231,762
Dividends declared per share
$
0.26
$
0.26
$
0.78
$
0.78
Dividend payout ratio
52.00
%
46.43
%
82.11
%
48.45
%
Supplemental Income Statement Data (non-GAAP) (1) :
Core net interest income
$
134,002
$
143,081
$
400,507
$
433,783
Core noninterest income
48,874
49,980
143,884
148,417
Core noninterest expense
91,629
91,222
279,545
276,613
Core net income
65,083
75,871
124,090
220,535
Core basic earnings per share
0.50
0.57
0.96
1.65
Core diluted earnings per share
0.50
0.57
0.95
1.64
Other Financial Information / Performance Ratios: (2)
Net interest margin
2.70
%
3.19
%
2.79
%
3.22
%
Core net interest margin (non-GAAP) (1),(3)
2.70
%
3.19
%
2.79
%
3.22
%
Efficiency ratio
50.01
%
48.41
%
51.32
%
48.20
%
Core efficiency ratio (non-GAAP) (1),(4)
50.02
%
47.25
%
51.31
%
47.51
%
Return on average total assets
1.16
%
1.45
%
0.76
%
1.42
%
Core return on average total assets (non-GAAP) (1),(5)
1.16
%
1.48
%
0.76
%
1.44
%
Return on average tangible assets (non-GAAP) (11)
1.21
%
1.52
%
0.80
%
1.49
%
Core return on average tangible assets (non-GAAP) (1),(6)
1.21
%
1.56
%
0.80
%
1.52
%
Return on average total stockholders' equity
9.58
%
11.12
%
6.16
%
11.13
%
Core return on average total stockholders' equity (non-GAAP) (1),(7)
9.57
%
11.37
%
6.17
%
11.34
%
Return on average tangible stockholders' equity (non-GAAP) (11)
15.16
%
17.81
%
9.79
%
18.04
%
Core return on average tangible stockholders' equity (non-GAAP) (1),(8)
15.15
%
18.21
%
9.80
%
18.37
%
Noninterest expense to average assets
1.63
%
1.82
%
1.72
%
1.83
%
Core noninterest expense to average assets (non-GAAP) (1),(9)
1.63
%
1.78
%
1.72
%
1.81
%
55
Table of Contents
September 30,
December 31,
2020
2019
Balance Sheet Data:
Cash and cash equivalents
$
816,329
$
694,017
Investment securities
5,692,883
4,075,644
Loans and leases
13,499,969
13,211,650
Allowance for credit losses for loans and leases
195,876
130,530
Goodwill
995,492
995,492
Total assets
22,310,701
20,166,734
Total deposits
18,897,762
16,444,994
Short-term borrowings
—
400,000
Long-term borrowings
200,010
200,019
Total liabilities
19,576,767
17,526,476
Total stockholders' equity
2,733,934
2,640,258
Book value per share
$
21.04
$
20.32
Tangible book value per share (non-GAAP) (11)
$
13.38
$
12.66
Asset Quality Ratios:
Non-accrual loans and leases / total loans and leases
0.13
%
0.04
%
Allowance for credit losses for loans and leases / total loans and leases
1.45
%
0.99
%
Net charge-offs / average total loans and leases (10)
0.29
%
0.19
%
September 30,
December 31,
Capital Ratios:
2020
2019
Common Equity Tier 1 Capital Ratio
12.22
%
11.88
%
Tier 1 Capital Ratio
12.22
%
11.88
%
Total Capital Ratio
13.47
%
12.81
%
Tier 1 Leverage Ratio
7.91
%
8.79
%
Total stockholders' equity to total assets
12.25
%
13.09
%
Tangible stockholders' equity to tangible assets (non-GAAP) (11)
8.16
%
8.58
%
(1) We present net interest income, noninterest income, noninterest expense, net income, basic earnings per share, diluted earnings per share and the related ratios described below, on an adjusted, or “core,” basis, each a non-GAAP financial measure. These core measures exclude from the corresponding GAAP measure the impact of certain items that we do not believe are representative of our financial results. We believe that the presentation of these non-GAAP measures helps identify underlying trends in our business from period to period that could otherwise be distorted by the effect of certain expenses, gains and other items included in our operating results. We believe that these core measures provide useful information about our operating results and enhance the overall understanding of our past performance and future performance. Investors should consider our performance and financial condition as reported under GAAP and all other relevant information when assessing our performance or financial condition. Non-GAAP measures have limitations as analytical tools and investors should not consider them in isolation or as a substitute for analysis of our financial results or financial condition as reported under GAAP.
56
Table of Contents
The following table provides a reconciliation of net interest income, noninterest income, noninterest expense and net income to their “core” non-GAAP financial measures:
GAAP to Non-GAAP Reconciliation
Table 2
For the Three Months Ended
For the Nine Months Ended
September 30,
September 30,
(dollars in thousands, except per share data)
2020
2019
2020
2019
Net interest income
$
134,002
$
143,081
$
400,507
$
433,783
Core net interest income (non-GAAP)
$
134,002
$
143,081
$
400,507
$
433,783
Noninterest income
$
48,898
$
49,980
$
143,782
$
145,825
(Gains) losses on sale of securities
(24)
—
102
2,592
Core noninterest income (non-GAAP)
$
48,874
$
49,980
$
143,884
$
148,417
Noninterest expense
$
91,629
$
93,466
$
279,545
$
279,379
One-time items (a)
—
(2,244)
—
(2,766)
Core noninterest expense (non-GAAP)
$
91,629
$
91,222
$
279,545
$
276,613
Net income
$
65,101
$
74,199
$
124,015
$
216,556
(Gains) losses on sale of securities
(24)
—
102
2,592
One-time noninterest expense items (a)
—
2,244
—
2,766
Tax adjustments (b)
6
(572)
(27)
(1,379)
Total core adjustments
(18)
1,672
75
3,979
Core net income (non-GAAP)
$
65,083
$
75,871
$
124,090
$
220,535
Basic earnings per share
$
0.50
$
0.56
$
0.95
$
1.62
Diluted earnings per share
$
0.50
$
0.56
$
0.95
$
1.61
Efficiency ratio
50.01
%
48.41
%
51.32
%
48.20
%
Core basic earnings per share (non-GAAP)
$
0.50
$
0.57
$
0.96
$
1.65
Core diluted earnings per share (non-GAAP)
$
0.50
$
0.57
$
0.95
$
1.64
Core efficiency ratio (non-GAAP)
50.02
%
47.25
%
51.31
%
47.51
%
(a) One-time items for the three and nine months ended September 30, 2019 included costs related to a nonrecurring payment for a former executive of the Company pursuant to the Bank’s Executive Change-in-Control Retention Plan, nonrecurring offering costs and the loss on our funding swap as a result of a 2019 decrease in the conversion rate of our Visa Class B restricted shares sold in 2016.
(b) Represents the adjustments to net income, tax effected at the Company’s effective tax rate for the respective period.
(2) Except for the efficiency ratio and the core efficiency ratio, amounts are annualized for the three and nine months ended September 30, 2020 and 2019.
(3) Core net interest margin is a non-GAAP financial measure. We compute our core net interest margin as the ratio of core net interest income to average earning assets. For a reconciliation to the most directly comparable GAAP financial measure for core net interest income, see Table 2, GAAP to Non-GAAP Reconciliation.
(4) Core efficiency ratio is a non-GAAP financial measure. We compute our core efficiency ratio as the ratio of core noninterest expense to the sum of core net interest income and core noninterest income. For a reconciliation to the most directly comparable GAAP financial measure for core noninterest expense, core net interest income and core noninterest income, see Table 2, GAAP to Non-GAAP Reconciliation.
(5) Core return on average total assets is a non-GAAP financial measure. We compute our core return on average total assets as the ratio of core net income to average total assets. For a reconciliation to the most directly comparable GAAP financial measure for core net income, see Table 2, GAAP to Non-GAAP Reconciliation.
(6) Core return on average tangible assets is a non-GAAP financial measure. We compute our core return on average tangible assets as the ratio of core net income to average tangible assets, which is calculated by subtracting (and thereby effectively excluding) amounts related to the effect of goodwill from our average total assets. For a reconciliation to the most directly comparable GAAP financial measure for core net income, see Table 2, GAAP to Non-GAAP Reconciliation.
57
Table of Contents
(7) Core return on average total stockholders’ equity is a non-GAAP financial measure. We compute our core return on average total stockholders’ equity as the ratio of core net income to average total stockholders’ equity. For a reconciliation to the most directly comparable GAAP financial measure for core net income, see Table 2, GAAP to Non-GAAP Reconciliation.
(8) Core return on average tangible stockholders’ equity is a non-GAAP financial measure. We compute our core return on average tangible stockholders’ equity as the ratio of core net income to average tangible stockholders’ equity, which is calculated by subtracting (and thereby effectively excluding) amounts related to the effect of goodwill from our average total stockholders’ equity. For a reconciliation to the most directly comparable GAAP financial measure for core net income, see Table 2, GAAP to Non-GAAP Reconciliation.
(9) Core noninterest expense to average assets is a non-GAAP financial measure. We compute our core noninterest expense to average assets as the ratio of core noninterest expense to average total assets. For a reconciliation to the most directly comparable GAAP financial measure for core noninterest expense, see Table 2, GAAP to Non-GAAP Reconciliation.
(10) Net charge-offs / average total loans and leases is annualized for the nine months ended September 30, 2020.
(11) Return on average tangible assets, return on average tangible stockholders’ equity, tangible book value per share and tangible stockholders’ equity to tangible assets are non-GAAP financial measures. We compute our return on average tangible assets as the ratio of net income to average tangible assets. We compute our return on average tangible stockholders’ equity as the ratio of net income to average tangible stockholders’ equity. We compute our tangible book value per share as the ratio of tangible stockholders’ equity to outstanding shares. We compute our tangible stockholders’ equity to tangible assets as the ratio of tangible stockholders’ equity to tangible assets. We believe that these financial measures are useful for investors, regulators, management and others to evaluate financial performance and capital adequacy relative to other financial institutions. Although these non-GAAP financial measures are frequently used by shareholders in the evaluation of a company, they have limitations as analytical tools and should not be considered in isolation or as a substitute for analyses of results as reported under GAAP.
The following table provides a reconciliation of these non-GAAP financial measures with their most closely related GAAP measures for the periods indicated:
GAAP to Non-GAAP Reconciliation
Table 3
For the Three Months Ended
For the Nine Months Ended
September 30,
September 30,
(dollars in thousands, except per share data)
2020
2019
2020
2019
Income Statement Data:
Noninterest expense
$
91,629
$
93,466
$
279,545
$
279,379
Core noninterest expense
$
91,629
$
91,222
$
279,545
$
276,613
Net income
$
65,101
$
74,199
$
124,015
$
216,556
Core net income
$
65,083
$
75,871
$
124,090
$
220,535
Average total stockholders' equity
$
2,704,129
$
2,648,428
$
2,687,632
$
2,600,259
Less: average goodwill
995,492
995,492
995,492
995,492
Average tangible stockholders' equity
$
1,708,637
$
1,652,936
$
1,692,140
$
1,604,767
Average total assets
$
22,341,485
$
20,332,457
$
21,667,948
$
20,405,261
Less: average goodwill
995,492
995,492
995,492
995,492
Average tangible assets
$
21,345,993
$
19,336,965
$
20,672,456
$
19,409,769
Return on average total stockholders' equity (a)
9.58
%
11.12
%
6.16
%
11.13
%
Core return on average total stockholders' equity (non-GAAP) (a)
9.57
%
11.37
%
6.17
%
11.34
%
Return on average tangible stockholders' equity (non-GAAP) (a)
15.16
%
17.81
%
9.79
%
18.04
%
Core return on average tangible stockholders' equity (non-GAAP) (a)
15.15
%
18.21
%
9.80
%
18.37
%
Return on average total assets (a)
1.16
%
1.45
%
0.76
%
1.42
%
Core return on average total assets (non-GAAP) (a)
1.16
%
1.48
%
0.76
%
1.44
%
Return on average tangible assets (non-GAAP) (a)
1.21
%
1.52
%
0.80
%
1.49
%
Core return on average tangible assets (non-GAAP) (a)
1.21
%
1.56
%
0.80
%
1.52
%
Noninterest expense to average assets (a)
1.63
%
1.82
%
1.72
%
1.83
%
Core noninterest expense to average assets (non-GAAP) (a)
1.63
%
1.78
%
1.72
%
1.81
%
58
Table of Contents
As of
As of
September 30,
December 31,
2020
2019
Balance Sheet Data:
Total stockholders' equity
$
2,733,934
$
2,640,258
Less: goodwill
995,492
995,492
Tangible stockholders' equity
$
1,738,442
$
1,644,766
Total assets
$
22,310,701
$
20,166,734
Less: goodwill
995,492
995,492
Tangible assets
$
21,315,209
$
19,171,242
Shares outstanding
129,911,789
129,928,479
Total stockholders' equity to total assets
12.25
%
13.09
%
Tangible stockholders' equity to tangible assets (non-GAAP)
8.16
%
8.58
%
Book value per share
$
21.04
$
20.32
Tangible book value per share (non-GAAP)
$
13.38
$
12.66
(a) Annualized for the three and nine months ended September 30, 2020 and 2019.
Financial Highlights
Net income was $65.1 million for the three months ended September 30, 2020, a decrease of $9.1 million or 12% as compared to the same period in 2019. Basic and diluted earnings per share were both $0.50 per share for the three months ended September 30, 2020, a decrease of $0.06 per share or 11% as compared to the same period in 2019. The decrease in net income was primarily due to a $9.1 million decrease in net interest income, a $5.1 million increase in the provision for credit losses (the “Provision”) and a $1.1 million decrease in noninterest income, partially offset by a $4.3 million decrease in the provision for income taxes and a $1.8 million decrease in noninterest expense for the three months ended September 30, 2020.
Our return on average total assets was 1.16% for the three months ended September 30, 2020, a decrease of 29 basis points from the same period in 2019, and our return on average total stockholders’ equity was 9.58% for the three months ended September 30, 2020, a decrease of 154 basis points from the same period in 2019. Our return on average tangible assets was 1.21% for the three months ended September 30, 2020, a decrease of 31 basis points from the same period in 2019, and our return on average tangible stockholders’ equity was 15.16% for the three months ended September 30, 2020, down from 17.81% for the same period in 2019. We continued to prudently manage our expenses, as our efficiency ratio was 50.01% for the three months ended September 30, 2020 compared to 48.41% for the same period in 2019.
Our results for the three months ended September 30, 2020 were highlighted by the following:
● Net interest income was $134.0 million for the three months ended September 30, 2020, a decrease of $9.1 million or 6% as compared to the same period in 2019. Our net interest margin was 2.70% for the three months ended September 30, 2020, a decrease of 49 basis points as compared to the same period in 2019. The decrease in net interest income was primarily due to lower yields in all loan categories and lower yields in our investment securities portfolio and interest-bearing deposits in other banks, partially offset by lower deposit funding costs and higher average balances in our investment securities portfolio during the three months ended September 30, 2020.
● The Provision was $5.1 million for the three months ended September 30, 2020, compared to nil for the same period in 2019. This increase was primarily due to higher expected credit losses as a result of COVID-19 and its impact on Hawaii’s economy, key industries, businesses and our customers. The Provision is recorded to maintain the Allowance for Credit Losses (“ACL”) at levels deemed adequate to absorb lifetime expected credit losses in our loan and lease portfolio as of the balance sheet date.
● Noninterest income was $48.9 million for the three months ended September 30, 2020, a decrease of $1.1 million or 2% as compared to the same period in 2019. The decrease was primarily due to a $2.8 million decrease in credit and debit card fees, a $2.0 million decrease in service charges on deposit accounts and a $0.8 million decrease in bank-owned life insurance (“BOLI”) income, partially offset by a $4.5 million increase in other noninterest income.
59
Table of Contents
● Noninterest expense was $91.6 million for the three months ended September 30, 2020, a decrease of $1.8 million or 2% compared to the same period in 2019. The decrease in noninterest expense was primarily due to a $1.9 million decrease in card rewards program expense, a $0.7 million decrease in other expenses and a $0.7 million decrease in salaries and employee benefits, partially offset by a $1.1 million increase in equipment expense.
Net income was $124.0 million for the nine months ended September 30, 2020, a decrease of $92.5 million or 43% as compared to the same period in 2019. Basic earnings per share was $0.95 per share for the nine months ended September 30, 2020, a decrease of $0.67 per share or 41% as compared to the same period in 2019. Diluted earnings per share was $0.95 per share for the nine months ended September 30, 2020, a decrease of $0.66 per share or 41% as compared to the same period in 2019. The decrease in net income was primarily due to a $92.2 million increase in the Provision, a $33.3 million decrease in net interest income and a $2.0 million decrease in noninterest income, partially offset by a $35.1 million decrease in the provision for income taxes for the nine months ended September 30, 2020.
Our return on average total assets was 0.76% for the nine months ended September 30, 2020, a decrease of 66 basis points from the same period in 2019, and our return on average total stockholders’ equity was 6.16% for the nine months ended September 30, 2020, a decrease of 497 basis points from the same period in 2019. Our return on average tangible assets was 0.80% for the nine months ended September 30, 2020, a decrease of 69 basis points from the same period in 2019, and our return on average tangible stockholders’ equity was 9.79% for the nine months ended September 30, 2020, down from 18.04% for the same period in 2019. Our efficiency ratio was 51.32% for the nine months ended September 30, 2020 compared to 48.20% for the same period in 2019.
Our results for the nine months ended September 30, 2020 were highlighted by the following:
● Net interest income was $400.5 million for the nine months ended September 30, 2020, a decrease of $33.3 million or 8% as compared to the same period in 2019. Our net interest margin was 2.79% for the nine months ended September 30, 2020, a decrease of 43 basis points as compared to the same period in 2019. The decrease in net interest income was primarily due to lower yields in most loan categories and lower yields in our investment securities portfolio and interest-bearing deposits in other banks. This was partially offset by lower deposit funding costs.
● The Provision was $101.7 million for the nine months ended September 30, 2020, an increase of $92.2 million as compared to the same period in 2019. This increase was primarily due to higher expected credit losses as a result of COVID-19 and its impact on Hawaii’s economy, key industries, businesses and our customers. The Provision is recorded to maintain the ACL at levels deemed adequate to absorb lifetime expected credit losses in our loan and lease portfolio as of the balance sheet date.
● Noninterest income was $143.8 million for the nine months ended September 30, 2020, a decrease of $2.0 million or 1% as compared to the same period in 2019. The decrease was primarily due to a $10.3 million decrease in credit and debit card fees, a $3.3 million decrease on service charges on deposit accounts, a $2.0 million decrease in other service charges and fees and a $1.4 million decrease in BOLI income, partially offset by a $11.7 million increase in other income, a $2.5 million decrease in losses from the sale of available for sale investment securities and a $0.7 million increase in trust and investment services income.
● Noninterest expense was $279.5 million for the nine months ended September 30, 2020, an increase of $0.2 million as compared to the same period in 2019. The increase in noninterest expense was primarily due to a $4.0 million increase in contracted services and professional fees, a $2.2 million increase in equipment expense and a $0.9 million increase in regulatory assessment fees, partially offset by a $4.1 million decrease in card rewards program expense, a $1.3 million decrease in other noninterest expense, a $1.0 million decrease in advertising and marketing expense and a $0.5 million decrease in salaries and employee benefits.
Hawaii’s economy continues to be significantly impacted by COVID-19 and the responses to it. These responses included stay-at-home orders for businesses deemed nonessential, from March 23, 2020 to May 31, 2020 and from August 27, 2020 to September 23, 2020. It also included the implementation of the mandatory 14-day self-quarantine for residents and visitors arriving or returning to the State of Hawaii. For an economy that is heavily dependent on tourism, the combination of these various response measures to the COVID-19 pandemic resulted in an unprecedented increase in Hawaii unemployment. While we may see a gradual improvement in unemployment as local businesses and the Hawaii tourism industry slowly reopen, the timing and extent of the return of air travel and the recovery of the Hawaii tourism industry is highly uncertain
60
Table of Contents
and beyond our control. As such, we increased our Provision in order to maintain adequate reserves for expected losses. We also continued to maintain high levels of liquidity and remained well-capitalized as of September 30, 2020.
● Total loans and leases were $13.5 billion as of September 30, 2020, an increase of $288.3 million or 2% from December 31, 2019. The increase was primarily due to growth in commercial and industrial loans stemming from PPP loans totaling $920.2 million, partially offset by decreases in our Shared National Credits and dealer flooring portfolios during the nine months ended September 30, 2020. Additionally, the increase in loans was also due to increases in our construction portfolio, partially offset by decreases in our consumer portfolio, primarily due to decreases in credit card balances and indirect automobile loans, as well as in our residential portfolio.
● The ACL was $195.9 million as of September 30, 2020, an increase of $65.3 million or 50% from December 31, 2019. This increase was primarily due to the aforementioned higher expected credit losses as a result of COVID-19 and its impact on Hawaii’s economy, key industries, businesses and our customers. The ratio of our ACL to total loans and leases outstanding was 1.45% as of September 30, 2020, an increase of 46 basis points compared to December 31, 2019.
● We continued to invest in high-grade investment securities, primarily collateralized mortgage obligations issued by the Government National Mortgage Association (“Ginnie Mae”), the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”). The total fair value of our investment securities portfolio was $5.7 billion as of September 30, 2020, an increase of $1.6 billion or 40% compared to December 31, 2019. The increase was primarily due to purchases in this portfolio as we invested excess liquidity into securities.
● Total deposits were $18.9 billion as of September 30, 2020, an increase of $2.5 billion or 15% as compared to December 31, 2019. The increase in total deposits was primarily due to a $1.0 billion increase in demand deposit balances, a $1.0 billion increase in savings deposit balances, a $324.2 million increase in money market deposit balances and a $104.7 million increase in time deposit balances. Deposits were increased in anticipation of a surge in funding needs due to our participation in the PPP and other additional liquidity needs.
● Total stockholders’ equity was $2.7 billion as of September 30, 2020, an increase of $93.7 million or 4% from December 31, 2019. The increase in stockholders’ equity was primarily due to earnings for the period of $124.0 million and a net unrealized gain in the fair value of our investment securities of $83.1 million. This was partially offset by dividends declared and paid to the Company’s stockholders of $101.3 million and the cumulative effect adjustment of a change in an accounting principle of $12.5 million during the nine months ended September 30, 2020.
61
Table of Contents
Analysis of Results of Operations
Net Interest Income
For the three months ended September 30, 2020 and 2019, average balances, related income and expenses, on a fully taxable-equivalent basis, and resulting yields and rates are presented in Table 4. An analysis of the change in net interest income, on a fully taxable-equivalent basis, is presented in Table 5.
Average Balances and Interest Rates
Table 4
Three Months Ended
Three Months Ended
September 30, 2020
September 30, 2019
Average
Average
Average
Income/
Yield/
Average
Income/
Yield/
(dollars in millions)
Balance
Expense
Rate
Balance
Expense
Rate
Earning Assets
Interest-Bearing Deposits in Other Banks
$
889.6
$
0.2
0.10
%
$
447.8
$
2.3
2.02
%
Available-for-Sale Investment Securities
5,334.2
20.3
1.53
4,296.3
22.3
2.07
Loans Held for Sale
10.2
0.1
2.67
1.4
—
2.36
Loans and Leases (1)
Commercial and industrial
3,230.4
21.6
2.67
2,885.9
30.0
4.12
Commercial real estate
3,418.0
27.8
3.23
3,294.7
37.3
4.49
Construction
637.6
5.2
3.22
477.2
5.6
4.67
Residential:
Residential mortgage
3,680.5
37.9
4.12
3,644.9
38.6
4.23
Home equity line
871.1
6.6
3.02
912.8
8.6
3.74
Consumer
1,474.4
20.2
5.46
1,651.4
23.3
5.61
Lease financing
247.4
1.8
2.90
165.4
1.3
3.14
Total Loans and Leases
13,559.4
121.1
3.56
13,032.3
144.7
4.41
Other Earning Assets
53.3
0.5
3.32
84.8
0.9
4.47
Total Earning Assets (2)
19,846.7
142.2
2.86
17,862.6
170.2
3.79
Cash and Due from Banks
307.9
341.7
Other Assets
2,186.9
2,128.2
Total Assets
$
22,341.5
$
20,332.5
Interest-Bearing Liabilities
Interest-Bearing Deposits
Savings
$
5,768.3
$
0.6
0.04
%
$
4,891.5
$
4.6
0.37
%
Money Market
3,288.2
0.4
0.05
3,067.4
7.1
0.92
Time
3,029.8
5.2
0.69
2,872.6
11.1
1.54
Total Interest-Bearing Deposits
12,086.3
6.2
0.20
10,831.5
22.8
0.83
Short-Term Borrowings
45.1
0.3
2.69
370.0
2.6
2.84
Long-Term Borrowings
200.0
1.4
2.77
239.1
1.7
2.82
Total Interest-Bearing Liabilities
12,331.4
7.9
0.26
11,440.6
27.1
0.94
Net Interest Income
$
134.3
$
143.1
Interest Rate Spread
2.60
%
2.85
%
Net Interest Margin
2.70
%
3.19
%
Noninterest-Bearing Demand Deposits
6,805.7
5,742.3
Other Liabilities
500.3
501.2
Stockholders' Equity
2,704.1
2,648.4
Total Liabilities and Stockholders' Equity
$
22,341.5
$
20,332.5
(1) Non-performing loans and leases are included in the respective average loan and lease balances. Income, if any, on such loans and leases is recognized on a cash basis.
(2) Interest income includes taxable-equivalent basis adjustments of $0.3 million and nil for the three months ended September 30, 2020 and 2019, respectively.
62
Table of Contents
Analysis of Change in Net Interest Income
Table 5
Three Months Ended September 30, 2020
Compared to September 30, 2019
(dollars in millions)
Volume
Rate
Total (1)
Change in Interest Income:
Interest-Bearing Deposits in Other Banks
$
1.1
$
(3.2)
$
(2.1)
Available-for-Sale Investment Securities
4.6
(6.6)
(2.0)
Loans Held for Sale
0.1
—
0.1
Loans and Leases
Commercial and industrial
3.2
(11.6)
(8.4)
Commercial real estate
1.3
(10.8)
(9.5)
Construction
1.6
(2.0)
(0.4)
Residential:
Residential mortgage
0.4
(1.1)
(0.7)
Home equity line
(0.4)
(1.6)
(2.0)
Consumer
(2.5)
(0.6)
(3.1)
Lease financing
0.6
(0.1)
0.5
Total Loans and Leases
4.2
(27.8)
(23.6)
Other Earning Assets
(0.3)
(0.1)
(0.4)
Total Change in Interest Income
9.7
(37.7)
(28.0)
Change in Interest Expense:
Interest-Bearing Deposits
Savings
0.7
(4.7)
(4.0)
Money Market
0.4
(7.1)
(6.7)
Time
0.6
(6.5)
(5.9)
Total Interest-Bearing Deposits
1.7
(18.3)
(16.6)
Short-term Borrowings
(2.2)
(0.1)
(2.3)
Long-term Borrowings
(0.3)
—
(0.3)
Total Change in Interest Expense
(0.8)
(18.4)
(19.2)
Change in Net Interest Income
$
10.5
$
(19.3)
$
(8.8)
(1) The change in interest income and expense not solely due to changes in volume or rate has been allocated on a pro-rata basis to the volume and rate columns.
Net interest income, on a fully taxable-equivalent basis, was $134.3 million for the three months ended September 30, 2020, a decrease of $8.8 million or 6% compared to the same period in 2019. Our net interest margin was 2.70% for the three months ended September 30, 2020, a decrease of 49 basis points from the same period in 2019. The decrease in net interest income, on a fully taxable-equivalent basis, was primarily due to lower yields in all loan categories and lower yields in our investment securities portfolio and interest-bearing deposits in other banks, partially offset by lower deposit funding costs and higher average balances in our investment securities portfolio during the three months ended September 30, 2020. Yields on our loans and leases were 3.56% for the three months ended September 30, 2020, a decrease of 85 basis points as compared to the same period in 2019. We experienced a decrease in our yields from total loans primarily due to decreases in adjustable rate commercial and industrial and commercial real estate loans, which are typically based on the LIBOR. Decreases in the yield on commercial and industrial loans also stemmed from our participation in the PPP, as these loans have a fixed interest rate of one percent per annum. The yield in our investment securities portfolio was 1.53% for the three months ended September 30, 2020, a decrease of 54 basis points from the same period in 2019. Deposit funding costs were $6.2 million for the three months ended September 30, 2020, a decrease of $16.6 million or 73% compared to the same period in 2019. Rates paid on our interest-bearing deposits were 20 basis points for the three months ended September 30, 2020, a decrease of 63 basis points compared to the same period in 2019.
63
Table of Contents
For the nine months ended September 30, 2020 and 2019, average balances, related income and expenses, on a fully taxable-equivalent basis, and resulting yields and rates are presented in Table 6. An analysis of the change in net interest income, on a fully taxable-equivalent basis, is presented in Table 7.
Average Balances and Interest Rates
Table 6
Nine Months Ended
Nine Months Ended
September 30, 2020
September 30, 2019
Average
Income/
Yield/
Average
Income/
Yield/
(dollars in millions)
Balance
Expense
Rate
Balance
Expense
Rate
Earning Assets
Interest-Bearing Deposits in Other Banks
$
947.3
$
2.2
0.31
%
$
400.6
$
6.9
2.31
%
Available-for-Sale Investment Securities
4,588.7
59.1
1.72
4,383.6
71.5
2.18
Loans Held for Sale
11.9
0.2
2.31
0.8
—
2.52
Loans and Leases (1)
Commercial and industrial
3,202.4
70.5
2.94
3,094.8
97.5
4.21
Commercial real estate
3,423.9
90.7
3.54
3,129.8
108.1
4.62
Construction
586.9
15.8
3.59
565.2
20.0
4.73
Residential:
Residential mortgage
3,700.8
111.3
4.01
3,590.2
112.4
4.17
Home equity line
881.2
21.1
3.20
912.4
25.9
3.79
Consumer
1,537.5
63.9
5.55
1,658.7
68.5
5.52
Lease financing
236.4
5.1
2.90
154.0
3.6
3.15
Total Loans and Leases
13,569.1
378.4
3.72
13,105.1
436.0
4.44
Other Earning Assets
57.3
1.6
3.78
84.3
2.2
3.37
Total Earning Assets (2)
19,174.3
441.5
3.07
17,974.4
516.6
3.84
Cash and Due from Banks
310.1
348.1
Other Assets
2,183.5
2,082.8
Total Assets
$
21,667.9
$
20,405.3
Interest-Bearing Liabilities
Interest-Bearing Deposits
Savings
$
5,454.7
$
4.7
0.12
%
$
4,806.0
$
12.8
0.35
%
Money Market
3,208.1
6.1
0.25
3,125.5
22.1
0.95
Time
2,966.9
19.6
0.88
2,999.0
34.8
1.55
Total Interest-Bearing Deposits
11,629.7
30.4
0.35
10,930.5
69.7
0.85
Short-Term Borrowings
279.9
6.0
2.87
145.7
3.0
2.76
Long-Term Borrowings
200.0
4.2
2.77
476.2
10.1
2.84
Total Interest-Bearing Liabilities
12,109.6
40.6
0.45
11,552.4
82.8
0.96
Net Interest Income
$
400.9
$
433.8
Interest Rate Spread
2.62
%
2.88
%
Net Interest Margin
2.79
%
3.22
%
Noninterest-Bearing Demand Deposits
6,365.5
5,769.9
Other Liabilities
505.2
482.7
Stockholders' Equity
2,687.6
2,600.3
Total Liabilities and Stockholders' Equity
$
21,667.9
$
20,405.3
(1) Non-performing loans and leases are included in the respective average loan and lease balances. Income, if any, on such loans and leases is recognized on a cash basis.
(2) Interest income includes taxable-equivalent basis adjustments of $0.4 million and nil for the nine months ended September 30, 2020 and 2019, respectively.
64
Table of Contents
Analysis of Change in Net Interest Income
Table 7
Nine Months Ended September 30, 2020
Compared to September 30, 2019
(dollars in millions)
Volume
Rate
Total (1)
Change in Interest Income:
Interest-Bearing Deposits in Other Banks
$
4.5
$
(9.2)
$
(4.7)
Available-for-Sale Investment Securities
3.2
(15.6)
(12.4)
Loans Held for Sale
0.2
—
0.2
Loans and Leases
Commercial and industrial
3.3
(30.3)
(27.0)
Commercial real estate
9.5
(26.9)
(17.4)
Construction
0.8
(5.0)
(4.2)
Residential:
Residential mortgage
3.3
(4.4)
(1.1)
Home equity line
(0.9)
(3.9)
(4.8)
Consumer
(5.0)
0.4
(4.6)
Lease financing
1.8
(0.3)
1.5
Total Loans and Leases
12.8
(70.4)
(57.6)
Other Earning Assets
(0.8)
0.2
(0.6)
Total Change in Interest Income
19.9
(95.0)
(75.1)
Change in Interest Expense:
Interest-Bearing Deposits
Savings
1.4
(9.5)
(8.1)
Money Market
0.6
(16.6)
(16.0)
Time
(0.4)
(14.8)
(15.2)
Total Interest-Bearing Deposits
1.6
(40.9)
(39.3)
Short-Term Borrowings
2.9
0.1
3.0
Long-Term Borrowings
(5.7)
(0.2)
(5.9)
Total Change in Interest Expense
(1.2)
(41.0)
(42.2)
Change in Net Interest Income
$
21.1
$
(54.0)
$
(32.9)
(1) The change in interest income and expense not solely due to changes in volume or rate has been allocated on a pro-rata basis to the volume and rate columns.
Net interest income, on a fully taxable-equivalent basis, was $400.9 million for the nine months ended September 30, 2020, a decrease of $32.9 million or 8% compared to the same period in 2019. Our net interest margin was 2.79% for the nine months ended September 30, 2020, a decrease of 43 basis points from the same period in 2019. The decrease in net interest income, on a fully taxable-equivalent basis, was primarily due to lower yields in most loan categories and lower yields in our investment securities portfolio and interest-bearing deposits in other banks. This was partially offset by lower deposit funding costs. Yields on our loans and leases were 3.72% for the nine months ended September 30, 2020, a decrease of 72 basis points as compared to the same period in 2019. We experienced a decrease in our yield from total loans primarily due to decreases in adjustable rate commercial and industrial and commercial real estate loans, which are typically based on LIBOR. Decreases in the yield on commercial and industrial loans also stemmed from our participation in the PPP, as these loans have a fixed interest rate of one percent per annum. For the nine months ended September 30, 2020, the yield in our investment securities portfolio was 1.72%, a decrease of 46 basis points compared to the same period in 2019. Deposit funding costs were $30.4 million for the nine months ended September 30, 2020, a decrease of $39.3 million or 56% compared to the same period in 2019. Rates paid on our interest-bearing deposits were 35 basis points for the nine months ended September 30, 2020, a decrease of 50 basis points compared to the same period in 2019.
The Federal Reserve influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. Our loan portfolio is affected by changes in the prime interest rate. The prime rate began in 2019 at 5.50% and decreased 50 basis points during the third quarter of 2019 (25 basis points in each of August and September) and 25 basis points in October 2019 to end the year at 4.75%. During 2020, the prime rate decreased 150 basis points in March to end the first quarter at 3.25%, where it remained as at the end of the third quarter of 2020. As noted above, our loan portfolio is also impacted by changes in the LIBOR. At September 30, 2020, the one-month and three-month U.S. dollar LIBOR interest rates were 0.15% and 0.23%, respectively, while at September 30, 2019, the one-month and three-month U.S. dollar LIBOR interest rates were 2.02% and 2.09%, respectively. The target range for the federal funds rate, which is the cost of immediately available overnight funds, began 2019 at 2.25% to 2.50% and decreased 50 basis points during the third quarter of 2019 (25 basis points in each of August and September) and 25 basis points in October 2019 to end the year at 1.50 to 1.75%. During 2020, the target range for the federal funds rate decreased 150 basis points in March to end the first quarter
65
Table of Contents
at 0.00% to 0.25%, where it remained as at the end of the third quarter of 2020. In September 2020, the Federal Reserve indicated that it expects to maintain the targeted federal funds rate at current levels through 2023. The decrease in the target range for the federal funds rate in 2020 was largely an emergency measure by the Federal Reserve aimed at mitigating the economic impact of COVID-19.
Provision for Credit Losses
The Provision was $5.1 million for the three months ended September 30, 2020, compared to nil for the same period in 2019. For the three months ended September 30, 2020, the Provision included $3.7 million in provision for credit losses for loans and leases and $1.4 million in provision for credit losses for the reserve for unfunded commitments. We recorded net recoveries of loans and leases of $0.1 million for the three months ended September 30, 2020 and net charge-offs of $5.6 million for the three months ended September 30, 2019. This represented charge-offs of nil and 0.17% of average loans and leases, on an annualized basis, for the three months ended September 30, 2020 and 2019, respectively. The Provision was $101.7 million for the nine months ended September 30, 2020, which represented an increase of $92.2 million compared to the same period in 2019. For the nine months ended September 30, 2020, the Provision included $94.0 million in provision for credit losses for loans and leases and $7.7 million in provision for credit losses for the reserve for unfunded commitments. The increase in the Provision was primarily due to an adjustment related to COVID-19 and the impact we expect it to have on our customers. We recorded net charge-offs of loans and leases of $29.4 million and $18.3 million for the nine months ended September 30, 2020 and 2019, respectively. This represented net charge-offs of 0.29% and 0.19% of average loans and leases, on an annualized basis, for the nine months ended September 30, 2020 and 2019, respectively. The ACL was $195.9 million as of September 30, 2020, an increase of $65.3 million or 50% from December 31, 2019 and represented 1.45% of total outstanding loans and leases as of September 30, 2020, compared to 0.99% of total outstanding loans and leases as of December 31, 2019. The reserve for unfunded commitments was $24.6 million as of September 30, 2020, compared to $0.6 million as of December 31, 2019. The Provision is recorded to maintain the ACL and the reserve for unfunded commitments at levels deemed adequate by management based on the factors noted in the “Risk Governance and Quantitative and Qualitative Disclosures About Market Risk — Credit Risk” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”).
Noninterest Income
Table 8 presents the major components of noninterest income for the three months ended September 30, 2020 and 2019 and Table 9 presents the major components of noninterest income for the nine months ended September 30, 2020 and 2019:
Noninterest Income
Table 8
Three Months Ended
September 30,
Dollar
Percent
(dollars in thousands)
2020
2019
Change
Change
Service charges on deposit accounts
$
6,523
$
8,554
$
(2,031)
(24)
%
Credit and debit card fees
14,049
16,839
(2,790)
(17)
Other service charges and fees
9,021
8,903
118
1
Trust and investment services income
8,664
8,698
(34)
—
Bank-owned life insurance
4,903
5,743
(840)
(15)
Investment securities gains, net
24
—
24
n/m
Other
5,714
1,243
4,471
n/m
Total noninterest income
$
48,898
$
49,980
$
(1,082)
(2)
%
n/m – Denotes a variance that is not a meaningful metric to inform the change in noninterest income for the three months ended September 30, 2020 to the same period in 2019.
66
Table of Contents
Noninterest Income
Table 9
Nine Months Ended
September 30,
Dollar
Percent
(dollars in thousands)
2020
2019
Change
Change
Service charges on deposit accounts
$
21,400
$
24,737
$
(3,337)
(13)
%
Credit and debit card fees
39,868
50,123
(10,255)
(20)
Other service charges and fees
25,472
27,435
(1,963)
(7)
Trust and investment services income
26,919
26,247
672
3
Bank-owned life insurance
11,595
12,946
(1,351)
(10)
Investment securities losses, net
(102)
(2,592)
2,490
n/m
Other
18,630
6,929
11,701
n/m
Total noninterest income
$
143,782
$
145,825
$
(2,043)
(1)
%
n/m – Denotes a variance that is not a meaningful metric to inform the change in noninterest income for the nine months ended September 30, 2020 to the same period in 2019.
Total noninterest income was $48.9 million for the three months ended September 30, 2020, a decrease of $1.1 million or 2% as compared to the same period in 2019. Total noninterest income was $143.8 million for the nine months ended September 30, 2020, a decrease of $2.0 million or 1% as compared to the same period in 2019.
Service charges on deposit accounts were $6.5 million for the three months ended September 30, 2020, a decrease of $2.0 million or 24% as compared to the same period in 2019. This decrease was primarily due to a $1.8 million decrease in overdraft and checking account fees. Service charges on deposit accounts were $21.4 million for the nine months ended September 30, 2020, a decrease of $3.3 million or 13% as compared to the same period in 2019. This decrease was primarily due to a $3.7 million decrease in overdraft and checking account fees and a $0.6 million decrease in ATM interchange fees from customers, partially offset by a $0.9 million increase in account analysis service charges.
Credit and debit card fees were $14.0 million for the three months ended September 30, 2020, a decrease of $2.8 million or 17% as compared to the same period in 2019. This decrease was primarily due to a $2.4 million decrease in interchange settlement fees from credit and debit cards, a $1.9 million decrease in merchant service revenues and a $0.4 million decrease in ATM surcharge fees. This was partially offset by a $2.1 million decrease in network association dues. Credit and debit card fees were $39.9 million for the nine months ended September 30, 2020, a decrease of $10.3 million or 20% as compared to the same period in 2019. This decrease was primarily due to a $6.2 million decrease in interchange settlement fees from credit and debit cards, a $5.6 million decrease in merchant service revenues and a $1.9 million decrease in ATM surcharge fees. This was partially offset by a $3.9 million decrease in network association dues.
Other service charges and fees were $9.0 million for the three months ended September 30, 2020, an increase of $0.1 million or 1% as compared to the same period in 2019. Other service charges and fees were $25.5 million for the nine months ended September 30, 2020, a decrease of $2.0 million or 7% as compared to the same period in 2019. This decrease was primarily due to a $0.5 million decrease in insurance income, a $0.5 million decrease in online banking fees, a $0.5 million decrease in service fees related to participation loans, a $0.4 million decrease in foreign exchange processing fees, a $0.2 million decrease in cash management service fees and a $0.2 million decrease in wire transfer fees. This was partially offset by a $0.7 million increase in fees from annuities and securities.
Trust and investment services income was $8.7 million for the three months ended September 30, 2020, a minimal change as compared to the same period in 2019. Trust and investment services income was $26.9 million for the nine months ended September 30, 2020, an increase of $0.7 million or 3% as compared to the same period in 2019. This increase was primarily due to a $1.0 million increase in investment management fees and a $0.5 million increase in money market fund trust account fees, partially offset by a $0.6 million decrease in business cash management fees.
BOLI income was $4.9 million for the three months ended September 30, 2020, a decrease of $0.8 million or 15% as compared to the same period in 2019. This decrease was due to a $1.4 million decrease in death benefit proceeds from life insurance policies, offset by a $0.6 million increase in BOLI earnings. BOLI income was $11.6 million for the nine months ended September 30, 2020, a decrease of $1.4 million or 10% as compared to the same period in 2019. This decrease was due to a $1.1 million decrease in death benefit proceeds from life insurance policies and a $0.3 million decrease in BOLI earnings.
67
Table of Contents
Net gains on the sale of investment securities were approximately nil for both the three months ended September 30, 2020 and 2019. Net losses on the sale of investment securities were $0.1 million and $2.6 million for the nine months ended September 30, 2020 and 2019, respectively. The decrease in losses of $2.5 million was primarily due to our investment portfolio restructuring and sale of 48 investment securities in January 2019, which contributed to the $2.6 million loss for the nine months ended September 30, 2019.
Other noninterest income was $5.7 million for the three months ended September 30, 2020, an increase of $4.5 million as compared to the same period in 2019. This increase was primarily due to a $3.8 million increase in gains on the sale of residential loans to government-sponsored enterprises. The Company sold $95.9 million residential loans for the three months ended September 30, 2020. Increases in other noninterest income also stemmed from a $1.5 million increase in volume-based incentives and a $0.4 million increase in gains recognized in income related to derivative contracts. This was partially offset by a $1.4 million decrease in customer-related interest rate swap fees. Other noninterest income was $18.6 million for the nine months ended September 30, 2020, an increase of $11.7 million as compared to the same period in 2019. This increase was primarily due to a $6.1 million increase in gains on the sale of residential loans to government-sponsored enterprises. The Company sold $344.3 million residential loans for the nine months ended September 30, 2020. Increases in other noninterest income also stemmed from a $3.2 million increase in customer-related interest rate swap fees, a $2.3 million increase in volume-based incentives and a $0.8 million increase in mortgage servicing rights, partially offset by a $0.5 million decrease in market adjustments for foreign exchange transactions.
Noninterest Expense
Table 10 presents the major components of noninterest expense for the three months ended September 30, 2020 and 2019 and Table 11 presents the major components of noninterest expense for the nine months ended September 30, 2020 and 2019:
Noninterest Expense
Table 10
Three Months Ended
September 30,
Dollar
Percentage
(dollars in thousands)
2020
2019
Change
Change
Salaries and employee benefits
$
44,291
$
44,955
$
(664)
(1)
%
Contracted services and professional fees
15,073
14,649
424
3
Occupancy
6,921
7,250
(329)
(5)
Equipment
5,137
4,024
1,113
28
Regulatory assessment and fees
2,445
1,992
453
23
Advertising and marketing
1,374
1,647
(273)
(17)
Card rewards program
5,046
6,930
(1,884)
(27)
Other
11,342
12,019
(677)
(6)
Total noninterest expense
$
91,629
$
93,466
$
(1,837)
(2)
%
Noninterest Expense
Table 11
Nine Months Ended
September 30,
Dollar
Percentage
(dollars in thousands)
2020
2019
Change
Change
Salaries and employee benefits
$
131,534
$
132,000
$
(466)
—
%
Contracted services and professional fees
46,606
42,597
4,009
9
Occupancy
21,466
21,522
(56)
—
Equipment
15,052
12,852
2,200
17
Regulatory assessment and fees
6,491
5,588
903
16
Advertising and marketing
4,599
5,593
(994)
(18)
Card rewards program
17,224
21,326
(4,102)
(19)
Other
36,573
37,901
(1,328)
(4)
Total noninterest expense
$
279,545
$
279,379
$
166
—
%
Total noninterest expense was $91.6 million for the three months ended September 30, 2020, a decrease of $1.8 million or 2% as compared to the same period in 2019. Total noninterest expense was $279.5 million for the nine months ended September 30, 2020, an increase of 0.2 million or less than 1% as compared to the same period in 2019.
68
Table of Contents
Salaries and employee benefits expense was $44.3 million for the three months ended September 30, 2020, a decrease of $0.7 million or 1% as compared to the same period in 2019. This was primarily due to a $1.4 million decrease in other compensation, primarily related to bonuses resulting from the initial public offering and related stock-based compensation, a $0.6 million increase in deferred loan origination costs, a $0.4 million decrease in group health plan costs and a $0.4 million decrease in incentive compensation. This was partially offset by a $2.3 million increase in base salaries and related payroll taxes. Salaries and employee benefits expense was $131.5 million for the nine months ended September 30, 2020, a decrease of $0.5 million or less than 1% as compared to the same period in 2019. This decrease was primarily due to a $4.8 million increase in deferred loan origination costs and a $2.2 million decrease in other compensation, primarily related to bonuses resulting from the initial public offering and related stock-based compensation. This was partially offset by a $5.5 million increase in base salaries and related payroll taxes and a $0.9 million increase in incentive compensation.
Contracted services and professional fees were $15.1 million for the three months ended September 30, 2020, an increase of $0.4 million or 3% as compared to the same period in 2019. This increase was primarily due to a $0.8 million increase in contracted data processing expenses, primarily related to system upgrades and product enhancements, and a $0.3 million increase in outside services, primarily attributable to marketing and new customer services. This was partially offset by a $0.6 million decrease in audit, legal and consultant fees. Contracted services and professional fees were $46.6 million for the nine months ended September 30, 2020, an increase of $4.0 million or 9% as compared to the same period in 2019. This increase was primarily due to a $2.9 million increase in contracted data processing expenses, primarily related to system upgrades and product enhancements, and a $1.3 million increase in outside services, primarily attributable to marketing and new customer services.
Occupancy expense was $6.9 million for the three months ended September 30, 2020, a decrease of $0.3 million or 5% as compared to the same period in 2019. Occupancy expense was $21.5 million for the nine months ended September 30, 2020, a decrease of $0.1 million or less than 1% as compared to the same period in 2019.
Equipment expense was $5.1 million for the three months ended September 30, 2020, an increase of $1.1 million or 28% as compared to the same period in 2019. This increase was primarily due to a $0.8 million increase in technology-related license and maintenance fees and a $0.3 million increase in furniture and equipment depreciation expense. Equipment expense was $15.1 million for the nine months ended September 30, 2020, an increase of $2.2 million or 17% as compared to the same period in 2019. This increase was primarily due to a $1.1 million increase in technology-related license and maintenance fees and a $0.9 million increase in furniture and equipment depreciation expense.
Regulatory assessment and fees were $2.4 million for the three months ended September 30, 2020, an increase of $0.5 million or 23% as compared to the same period in 2019. This increase was primarily due to a $0.5 million increase in the FDIC insurance assessment. Regulatory assessment and fees were $6.5 million for the nine months ended September 30, 2020, an increase of $0.9 million or 16% as compared to the same period in 2019. This increase was primarily due to a $0.9 million increase in the FDIC insurance assessment.
Advertising and marketing expense was $1.4 million for the three months ended September 30, 2020, a decrease of $0.3 million or 17% as compared to the same period in 2019. Advertising and marketing expense was $4.6 million for the nine months ended September 30, 2020, a decrease of $1.0 million or 18% as compared to the same period in 2019. This decrease was primarily due to a $0.8 million decrease in advertising costs and a $0.2 million decrease due to higher vendor reimbursements.
Card rewards program expense was $5.0 million for the three months ended September 30, 2020, a decrease of $1.9 million or 27% as compared to the same period in 2019. This decrease was primarily due to a $0.9 million decrease in priority rewards card redemptions, a $0.7 million decrease in interchange fees paid to our credit card partners and a $0.3 million decrease in credit card cash reward redemptions. Card rewards program expense was $17.2 million for the nine months ended September 30, 2020, a decrease of $4.1 million or 19% as compared to the same period in 2019. This decrease was primarily due to a $2.3 million decrease in priority rewards card redemptions, a $1.0 million decrease in interchange fees paid to our credit card partners and a $0.8 million decrease in credit card cash reward redemptions.
69
Table of Contents
Other noninterest expense was $11.3 million for the three months ended September 30, 2020, decrease of $0.7 million or 6% as compared to the same period in 2019. This decrease was primarily due to a $0.5 million decrease in pension-related expenses, a $0.4 million decrease in travel expenses, a $0.3 million decrease in postage expenses and a $0.3 million decrease in shipping and delivery expenses. This was partially offset by a $1.1 million increase in other tax expense. Other noninterest expense was $36.6 million for the nine months ended September 30, 2020, a decrease of $1.3 million or 4% as compared to the same period in 2019. This decrease was primarily due to a $1.4 million decrease in pension-related expenses.
Provision for Income Taxes
The provision for income taxes was $21.1 million (an effective tax rate of 24.48%) for the three months ended September 30, 2020, compared with the provision for income taxes of $25.4 million (an effective tax rate of 25.50%) for the same period in 2019. The provision for income taxes was $39.0 million (an effective tax rate of 23.93%) for the nine months ended September 30, 2020, compared with the provision for income taxes of $74.1 million (an effective tax rate of 25.50%) for the same period in 2019. The decrease in the effective tax rate was primarily due to the reduction in pretax income compared to prior periods and a state tax settlement with BNP Paribas USA, Inc. during the period ended March 31, 2020, related to periods during which the Company was included in the state combined returns of BNP Paribas USA, Inc.
Analysis of Business Segments
Our business segments are Retail Banking, Commercial Banking and Treasury and Other. Table 12 summarizes net income from our business segments for the three and nine months ended September 30, 2020 and 2019. Additional information about operating segment performance is presented in “Note 18. Reportable Operating Segments” contained in our unaudited interim consolidated financial statements.
In 2019, the Company made changes to the internal measurement of segment operating profits for the purpose of evaluating segment performance and resource allocation. The primary reason for the change was to align deposit balances within the business segment that directly manages them. Specifically, certain deposit balances previously included as part of the Retail Banking segment have been reclassified to the Commercial Banking segment. The reallocation of select deposit balances affected net interest income, net interest income after provision for credit losses, noninterest income, provision for income taxes and net income. The Company has reported its selected financial information using the new deposit balance alignments for the three and nine months ended September 30, 2020. The Company has restated the selected financial information for the three and nine months ended September 30, 2019 in order to conform with the current presentation.
Additionally, during the fourth quarter of 2019, the Company changed its assumptions embedded in allocating deposit costs to business segments. The Company has reported its selected financial information using the new deposit cost assumptions starting with the fourth quarter of 2019.
Business Segment Net Income
Table 12
Three Months Ended
Nine Months Ended
September 30,
September 30,
(dollars in thousands)
2020
2019
2020
2019
Retail Banking
$
50,962
$
53,552
$
105,026
$
159,040
Commercial Banking
21,595
24,659
33,213
70,788
Treasury and Other
(7,456)
(4,012)
(14,224)
(13,272)
Total
$
65,101
$
74,199
$
124,015
$
216,556
Retail Banking. Our Retail Banking segment includes the financial products and services we provide to consumers, small businesses and certain commercial customers. Loan and lease products offered include residential and commercial mortgage loans, home equity lines of credit, automobile loans and leases, personal lines of credit, installment loans and small business loans and leases. Deposit products offered include checking, savings and time deposit accounts. Our Retail Banking segment also includes our wealth management services.
Net income for the Retail Banking segment was $51.0 million for the three months ended September 30, 2020, a decrease of $2.6 million or 5% as compared to the same period in 2019. The decrease in net income for the Retail Banking segment was primarily due to a $2.2 million decrease in net interest income and a $2.1 million increase in the Provision, partially offset by a $1.2 million decrease in the provision for income taxes. The decrease in net interest income was primarily due to a decrease in transfer pricing credits on interest expenses from deposits as a result of lower yields on our deposit portfolio.
70
Table of Contents
The increase in the Provision was primarily due to the adjustment related to COVID-19 and the impact that we expect it to have on our customers. The decrease in the provision for income taxes was primarily due to lower pretax income.
Net income for the Retail Banking segment was $105.0 million for the nine months ended September 30, 2020, a decrease of $54.0 million or 34% as compared to the same period in 2019. The decrease in net income for the Retail Banking segment was primarily due to a $42.2 million increase in the Provision, a $31.1 million decrease in net interest income and a $2.8 million increase in noninterest expense, offset by a $20.1 million decrease in the provision for income taxes and a $2.0 million increase in noninterest income. The increase in the Provision was primarily due to the adjustment related to COVID-19 and the impact that we expect it to have on our customers. The decrease in net interest income was primarily due to a decrease in transfer pricing credits on interest expenses from deposits as a result of lower yields on our deposit portfolio. The increase in noninterest expense was primarily due to higher overall expenses that were allocated to the Retail Banking segment and an increase in contracted services and professional fees, partially offset by a decrease in salaries and benefits expense. The decrease in the provision for income taxes was primarily due to the decrease in pretax income. The increase in noninterest income was primarily due to higher gains on the sale of residential mortgage loans, partially offset by decreases in overdraft and checking account fees and other service charges and fees.
The increase in total assets for the Retail Banking segment was primarily due to PPP loans, partially offset by the sale of residential mortgages during the nine months ended September 30, 2020.
Commercial Banking. Our Commercial Banking segment includes our corporate banking, residential and commercial real estate loans, commercial lease financing, automobile loans and auto dealer financing, business deposit products and credit cards that we provide primarily to middle market and large companies in Hawaii, Guam, Saipan and California.
Net income for the Commercial Banking segment was $21.6 million for the three months ended September 30, 2020, a decrease of $3.1 million or 12% as compared to the same period in 2019. The decrease in net income for the Commercial Banking segment was primarily due to a $3.2 million decrease in net interest income and a $1.5 million increase in the Provision, partially offset by a $1.9 million decrease in the provision for income taxes. The decrease in net interest income was primarily due to a decrease in transfer pricing credits on interest expenses from deposits as a result of lower yields on our deposit portfolio. The increase in the Provision was primarily due to the adjustment related to COVID-19 and the expected impact that it will have on our customers. The decrease in the provision for income taxes was primarily due to the decrease in pretax income.
Net income for the Commercial Banking segment was $33.2 million for the nine months ended September 30, 2020, a decrease of $37.6 million or 53% as compared to the same period in 2019. The decrease in net income for the Commercial Banking segment was primarily due to a $42.3 million increase in the Provision, a $5.3 million decrease in net interest income, a $2.2 million increase in noninterest expense and a $2.0 million decrease in noninterest income, partially offset by a $14.3 million decrease in the provision for income taxes. The increase in the Provision was primarily due to the adjustment related to COVID-19 and the expected impact that it will have on our customers. The decrease in net interest income was primarily due to a decrease in transfer pricing credits on interest expenses from deposits as a result of lower yields on our deposit portfolio. The increase in noninterest expense was primarily due to increases in salaries and benefits expense, contracted services and professional fees, higher overall expenses that were allocated to the Commercial Banking segment, and an increase in other tax expense, partially offset by a decrease in card reward expenses. The decrease in noninterest income was primarily due to a decrease in credit and debit card fees, partially offset by an increase in customer-related swap fees, an increase in volume-based incentives and the loss on the sale of our commercial and industrial loans in 2019. The decrease in the provision for income taxes was primarily due to the decrease in pretax income.
The decrease in total assets for the Commercial Banking segment was primarily due to decreases in our Shared National
Credits, dealer flooring portfolios, indirect automobile loans and credit card balances, partially offset by higher draws on lines by existing customers and PPP loans during the nine months ended September 30, 2020.
71
Table of Contents
Treasury and Other. Our Treasury and Other segment includes our treasury business, which consists of corporate asset and liability management activities, including interest rate risk management. The assets and liabilities (and related interest income and expense) of our treasury business consist of interest-bearing deposits, investment securities, federal funds sold and purchased, government deposits, short- and long-term borrowings and bank-owned properties. Our primary sources of noninterest income are from bank-owned life insurance, net gains from the sale of investment securities, foreign exchange income related to customer driven currency requests from merchants and island visitors and management of bank-owned properties in Hawaii and Guam. The net residual effect of the transfer pricing of assets and liabilities is included in Treasury and Other, along with the elimination of intercompany transactions.
Other organizational units (Technology, Operations, Credit and Risk Management, Human Resources, Finance, Administration, Marketing and Corporate and Regulatory Administration) provide a wide range of support to our other income earning segments. Expenses incurred by these support units are charged to the applicable business segments through an internal cost allocation process.
Net loss for the Treasury and Other segment was $7.5 million for the three months ended September 30, 2020, an increase in loss of $3.4 million or 86% as compared to the same period in 2019. The increase in the net loss was primarily due to a $3.8 million increase in net interest expense, a $1.4 million increase in the Provision and a $1.0 million decrease in noninterest income, partially offset by a $1.5 million decrease in noninterest expense and a $1.2 million increase in the benefit for income taxes. The increase in net interest expense was primarily due to lower earnings credits as a result of lower average yields in our loan portfolio and lower average yields in our interest-bearing deposits in other banks and investment securities portfolio, partially offset by a decrease in transfer pricing charges as a result of lower yields on our deposit portfolio. The increase in the Provision was primarily due to the adjustment related to COVID-19 and the expected impact that it will have on our customers. The decrease in noninterest income was primarily due to a decrease in BOLI income. The decrease in noninterest expense was primarily due to a decrease in salaries and employee benefits expense. The increase in the benefit for income taxes was primarily due to the increase in pretax loss.
Net loss for the Treasury and Other segment was $14.2 million for the nine months ended September 30, 2020, an increase in loss of $1.0 million or 7% as compared to the same period in 2019. The increase in net loss was primarily due to a $7.7 million increase in the Provision and a $2.0 million decrease in noninterest income, partially offset by a $4.9 million decrease in noninterest expense and a $3.1 million increase in net interest income. The increase in the Provision was primarily due to the adjustment related to COVID-19 and the expected impact that it will have on our customers. The decrease in noninterest income was primarily due to decreases in ATM surcharge fees, BOLI income, ATM interchange from customers and other service charges and fees, partially offset by a decrease in net losses on the sale of investment securities as a result of the investment portfolio restructuring and sale of 48 investment securities in January 2019. The decrease in noninterest expense was primarily due to higher overall expenses that led to a larger credit allocation to the Treasury and Other segment, as well as decreases in pension-related expenses and advertising and marketing expenses, partially offset by an increase in equipment expenses. The increase in net interest income was primarily due to a decrease in transfer pricing charges as a result of lower yields on our deposit portfolio, partially offset by lower earnings credits as a result of lower average yields in our loan portfolio and lower average yields in our investment securities portfolio and interest-bearing deposits in other banks.
The increase in total assets for the Treasury and Other segment was primarily due to increases in the investment securities portfolio and interest-bearing deposits in other banks during the nine months ended September 30, 2020.
Analysis of Financial Condition
Liquidity
Liquidity refers to our ability to maintain cash flow that is adequate to fund operations and meet present and future financial obligations through either the sale or maturity of existing assets or by obtaining additional funding through liability management. We consider the effective and prudent management of liquidity to be fundamental to our health and strength. Our objective is to manage our cash flow and liquidity reserves so that they are adequate to fund our obligations and other commitments on a timely basis and at a reasonable cost.
Liquidity is managed to ensure stable, reliable and cost-effective sources of funds to satisfy demand for credit, deposit withdrawals and investment opportunities. Funding requirements are impacted by loan originations and refinancings, deposit balance changes, liability issuances and settlements and off-balance sheet funding commitments. We consider and comply with various regulatory and internal guidelines regarding required liquidity levels and periodically monitor our liquidity
72
Table of Contents
position in light of the changing economic environment and customer activity. Based on periodic liquidity assessments, we may alter our asset, liability and off-balance sheet positions. The Company’s Asset Liability Management Committee (“ALCO”) monitors sources and uses of funds and modifies asset and liability positions as liquidity requirements change. This process, combined with our ability to raise funds in money and capital markets and through private placements, provides flexibility in managing the exposure to liquidity risk.
Immediate liquid resources are available in cash, which is primarily on deposit with the Federal Reserve Bank of San Francisco (the “FRB”). As of September 30, 2020 and December 31, 2019, cash and cash equivalents were $0.8 billion and $0.7 billion, respectively. Potential sources of liquidity also include investment securities in our available-for-sale portfolio. The estimated fair value of our available-for-sale investment securities were $5.7 billion and $4.1 billion as of September 30, 2020 and December 31, 2019, respectively. As of September 30, 2020 and December 31, 2019, we maintained our excess liquidity primarily in collateralized mortgage obligations issued by Ginnie Mae, Fannie Mae and Freddie Mac. As of September 30, 2020, our available-for-sale investment securities portfolio was comprised of securities with a weighted average life of approximately 4.3 years. These funds offer substantial resources to meet either new loan demand or to help offset reductions in our deposit funding base. Liquidity is further enhanced by our ability to pledge loans to access secured borrowings from the FHLB and the FRB. As of September 30, 2020, we had borrowing capacity of $2.0 billion from the FHLB and $1.0 billion from the FRB based on the amount of collateral pledged. As of December 31, 2019, we had borrowing capacity of $1.7 billion from the FHLB and $596.8 million from the FRB based on the amount of collateral pledged.
Our core deposits have historically provided us with a long-term source of stable and relatively lower cost of funding. Our core deposits, defined as all deposits exclusive of time deposits exceeding $250,000, totaled $17.4 billion and $15.1 billion as of September 30, 2020 and December 31, 2019, respectively, which represented 92% of our total deposits as of both September 30, 2020 and December 31, 2019. These core deposits are normally less volatile, often with customer relationships tied to other products offered by the Company, however, deposit levels could decrease if interest rates increase significantly or if corporate customers increase investing activities and reduce deposit balances.
The Company’s routine funding requirements are expected to consist primarily of general corporate needs and capital to be returned to our shareholders. We expect to meet these obligations from dividends paid by the Bank to the Parent. Additional sources of liquidity available to us include selling residential real estate loans in the secondary market, short- and long-term borrowings and the issuance of long-term debt and equity securities. At the start of the pandemic, we increased our liquidity position through additional public time deposits in anticipation of a surge in funding needs due to our participation in the PPP and other additional liquidity needs. While our public time deposits have since decreased from the second quarter of 2020, we have continued to maintain strong levels of liquidity as of September 30, 2020.
Investment Securities
Table 13 presents the estimated fair value of our available-for-sale investment securities portfolio as of September 30, 2020 and December 31, 2019:
Investment Securities
Table 13
September 30,
December 31,
(dollars in thousands)
2020
2019
U.S. Treasury and government agency debt securities
$
144,956
$
29,888
Government-sponsored enterprises debt securities
—
101,439
Mortgage-backed securities:
Residential - Government agency
193,948
291,209
Residential - Government-sponsored enterprises
431,842
399,492
Commercial - Government agency
751,922
—
Commercial - Government-sponsored enterprises
498,273
101,719
Collateralized mortgage obligations:
Government agency
2,085,976
2,381,278
Government-sponsored enterprises
1,585,966
770,619
Total available-for-sale securities
$
5,692,883
$
4,075,644
73
Table of Contents
Table 14 presents the maturity distribution at amortized cost and weighted-average yield to maturity of our available-for-sale investment securities portfolio as of September 30, 2020:
Maturities and Weighted-Average Yield on Securities (1)
Table 14
1 Year or Less
After 1 Year - 5 Years
After 5 Years - 10 Years
Over 10 Years
Total
Weighted
Weighted
Weighted
Weighted
Weighted
Average
Average
Average
Average
Average
Fair
(dollars in millions)
Amount
Yield
Amount
Yield
Amount
Yield
Amount
Yield
Amount
Yield
Value
As of September 30, 2020
Available-for-sale securities
U.S. Treasury and government agency debt securities
$
—
—
%
$
38.3
0.82
%
$
3.3
1.01
%
$
100.8
1.38
%
$
142.4
1.23
%
$
145.0
Mortgage-backed securities (2) :
Residential - Government agency
—
—
188.8
2.39
—
—
—
—
188.8
2.39
193.9
Residential - Government-sponsored enterprises
—
—
378.5
2.38
38.8
1.40
—
—
417.3
2.29
431.8
Commercial - Government agency
—
—
497.5
2.21
136.9
1.68
103.5
1.32
737.9
1.99
751.9
Commercial - Government-sponsored enterprises
—
—
41.9
2.27
377.9
1.64
67.0
1.68
486.8
1.70
498.3
Collateralized mortgage obligations (2) :
Government agency
97.5
1.96
1,825.1
1.62
125.0
1.25
—
—
2,047.6
1.62
2,086.0
Government-sponsored enterprises
69.5
2.17
830.8
1.61
663.5
1.42
—
—
1,563.8
1.56
1,586.0
Total available-for-sale securities as of September 30, 2020
$
167.0
2.05
%
$
3,800.9
1.81
%
$
1,345.4
1.49
%
$
271.3
1.43
%
$
5,584.6
1.72
%
$
5,692.9
(1) Weighted-average yields were computed on a fully taxable-equivalent basis.
(2) Maturities for mortgage-backed securities and collateralized mortgage obligations anticipate future prepayments.
The fair value of our available-for-sale investment securities portfolio was $5.7 billion as of September 30, 2020, an increase of $1.6 billion or 40% compared to December 31, 2019. Our available-for-sale investment securities are carried at fair value with changes in fair value reflected in other comprehensive income or through the Provision.
As of September 30, 2020, we maintained all of our investment securities in the available-for-sale category recorded at fair value in the unaudited interim consolidated balance sheets, with $3.7 billion invested in collateralized mortgage obligations issued by Ginnie Mae, Fannie Mae and Freddie Mac. Our available-for-sale portfolio also included $1.9 billion in mortgage-backed securities issued by Ginnie Mae, Freddie Mac, Fannie Mae and municipal housing authorities and $145.0 million in debt securities issued by the U.S Treasury and government agencies (US International Development Finance Corporation bonds).
We continually evaluate our investment securities portfolio in response to established asset/liability management objectives, changing market conditions that could affect profitability and the level of interest rate risk to which we are exposed. These evaluations may cause us to change the level of funds we deploy into investment securities and change the composition of our investment securities portfolio.
We conduct a regular assessment of our investment securities portfolio to determine whether any securities are impaired. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security is compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and the ACL is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through the ACL is recognized in other comprehensive income. For the three and nine months ended September 30, 2020, we did not record any credit losses related to our investment securities portfolio.
Gross unrealized gains in our investment securities portfolio were $111.7 million and $19.0 million as of September 30, 2020 and December 31, 2019, respectively. Gross unrealized losses in our investment securities portfolio were $3.4 million and $24.0 million as of September 30, 2020 and December 31, 2019, respectively. The increase in unrealized gains in our investment securities portfolio was primarily due to lower market interest rates as of September 30, 2020, relative to December 31, 2019, resulting in a higher valuation. The increase in unrealized gain positions was primarily related to our mortgage-backed securities and collateralized mortgage obligations, the fair values of which are sensitive to changes in market interest rates.
We are required to hold non-marketable equity securities, comprised of FHLB stock, as a condition of our membership in the FHLB system. Our FHLB stock is accounted for at cost, which equals par or redemption value. As of September 30, 2020 and December 31, 2019, we held FHLB stock of $18.1 million and $34.1 million, respectively, which is recorded as a component of other assets in our unaudited interim consolidated balance sheets.
74
Table of Contents
See “Note 2. Investment Securities” contained in our unaudited interim consolidated financial statements for more information on our investment securities portfolio.
Loans and Leases
Table 15 presents the composition of our loan and lease portfolio by major categories as of September 30, 2020 and December 31, 2019:
Loans and Leases
Table 15
September 30,
December 31,
(dollars in thousands)
2020
2019
Commercial and industrial
$
3,170,262
$
2,743,242
Commercial real estate
3,461,085
3,463,953
Construction
662,871
519,241
Residential:
Residential mortgage
3,669,051
3,768,936
Home equity line
864,789
893,239
Total residential
4,533,840
4,662,175
Consumer
1,425,934
1,620,556
Lease financing
245,977
202,483
Total loans and leases
$
13,499,969
$
13,211,650
Total loans and leases were $13.5 billion as of September 30, 2020, an increase of $288.3 million or 2% from December 31, 2019 with increases in commercial and industrial loans, construction loans and lease financing. The increase in total loans and leases was primarily due to our participation in the PPP which had a total amortized cost basis of $920.2 million as of September 30, 2020. While we have not experienced declines in our loan portfolio in the third quarter, it is possible that the effects of COVID-19 on the economy could result in less demand for our loan products.
Commercial and industrial loans are made primarily to corporations, middle market and small businesses for the purpose of financing equipment acquisition, expansion, working capital and other general business purposes. We also offer a variety of automobile dealer flooring lines to our customers in Hawaii and California to assist with the financing of their inventory. Commercial and industrial loans were $3.2 billion as of September 30, 2020, an increase of $427.0 million or 16% from December 31, 2019. This increase was primarily due to PPP loans totaling $920.2 million, offset by decreases in our Shared National Credits and dealer flooring portfolios during the nine months ended September 30, 2020.
Commercial real estate loans are secured by first mortgages on commercial real estate at loan to value (“LTV”) ratios generally not exceeding 75% and a minimum debt service coverage ratio of 1.20 to 1. The commercial properties are predominantly apartments, neighborhood and grocery anchored retail, industrial, office, and to a lesser extent, specialized properties such as hotels. The primary source of repayment for investor property is cash flow from the property and for owner occupied property is the operating cash flow from the business. Commercial real estate loans were $3.5 billion as of September 30, 2020, a decrease of $2.9 million or less than 1% from December 31, 2019.
Construction loans are for the purchase or construction of a property for which repayment will be generated by the property. Loans in this portfolio are primarily for the purchase of land, as well as for the development of commercial properties, single family homes and condominiums. We classify loans as construction until the completion of the construction phase. Following completion of the construction phase, if a loan is retained by the Bank, the loan is reclassified to the commercial real estate or residential real estate classes of loans. Construction loans were $662.9 million as of September 30, 2020, an increase of $143.6 million or 28% from December 31, 2019. The increase in construction loans stemmed from various disbursements of project loans during the nine months ended September 30, 2020.
Residential real estate loans are generally secured by 1-4 unit residential properties and are underwritten using traditional underwriting systems to assess the credit risks and financial capacity and repayment ability of the consumer. Decisions are primarily based on LTV ratios, debt-to-income (“DTI”) ratios, liquidity and credit scores. LTV ratios generally do not exceed 80%, although higher levels are permitted with mortgage insurance. We offer fixed rate mortgage products and variable rate mortgage products with interest rates that are subject to change every year after the first, third, fifth or tenth year, depending on the product and are based on LIBOR. Variable rate residential mortgage loans are underwritten at fully-indexed interest rates. We generally do not offer interest-only, payment-option facilities, Alt-A loans or any product with negative amortization. Residential real estate loans were $4.5 billion as of September 30, 2020, a decrease of $128.3 million or 3%
75
Table of Contents
from December 31, 2019. Our portfolio of residential real estate loans declined due to the sale of $132.0 million in residential mortgages originated for investment during the nine months ended September 30, 2020.
Consumer loans consist primarily of open- and closed-end direct and indirect credit facilities for personal, automobile and household purchases as well as credit card loans. We seek to maintain reasonable levels of risk in consumer lending by following prudent underwriting guidelines, which include an evaluation of personal credit history, cash flow and collateral values based on existing market conditions. Consumer loans were $1.4 billion as of September 30, 2020, a decrease of $194.6 million or 12% from December 31, 2019. The decrease in consumer loans was primarily due to decreases in credit card balances and indirect automobile loans.
Lease financing consists of commercial single investor leases and leveraged leases. Underwriting of new lease transactions is based on our lending policy, including but not limited to an analysis of customer cash flows and secondary sources of repayment, including the value of leased equipment, the guarantors’ cash flows and/or other credit enhancements. No new leveraged leases are being added to the portfolio and all remaining leveraged leases are running off. Lease financing was $246.0 million as of September 30, 2020, an increase of $43.5 million or 22% from December 31, 2019. The increase in lease financing was due to portfolio growth in our commercial single investor leases.
See “Note 3. Loans and Leases” and “Note 4. Allowance for Credit Losses” contained in our unaudited interim consolidated financial statements and the discussion in “Analysis of Financial Condition — Allowance for Credit Losses” of this MD&A for more information on our loan and lease portfolio.
The Company’s loan and lease portfolio includes adjustable-rate loans, primarily tied to Prime and LIBOR, hybrid-rate loans, for which the initial rate is fixed for a period from one year to as much as ten years, and fixed rate loans, for which the interest rate does not change through the life of the loan. Table 16 presents the recorded investment in our loan and lease portfolio as of September 30, 2020 by rate type:
Loans and Leases by Rate Type
Table 16
September 30, 2020
Adjustable Rate
Hybrid
Fixed
(dollars in thousands)
Prime
LIBOR
Treasury
Other
Total
Rate
Rate
Total
Commercial and industrial
$
202,729
$
1,580,855
$
—
$
67,019
$
1,850,603
$
31,983
$
1,287,676
$
3,170,262
Commercial real estate
32,825
2,135,042
333
900,409
3,068,609
107,822
284,654
3,461,085
Construction
35,091
504,753
32
31,533
571,409
981
90,481
662,871
Residential:
Residential mortgage
18,672
171,253
92,095
58,191
340,211
376,847
2,951,993
3,669,051
Home equity line
352,317
—
10,256
—
362,573
502,172
44
864,789
Total residential
370,989
171,253
102,351
58,191
702,784
879,019
2,952,037
4,533,840
Consumer
295,312
16,262
1,429
132
313,135
1,491
1,111,308
1,425,934
Lease financing
—
—
—
—
—
—
245,977
245,977
Total loans and leases
$
936,946
$
4,408,165
$
104,145
$
1,057,284
$
6,506,540
$
1,021,296
$
5,972,133
$
13,499,969
% by rate type at September 30, 2020
7
%
33
%
1
%
8
%
49
%
7
%
44
%
100
%
76
Table of Contents
Tables 17 and 18 present the geographic distribution of our loan and lease portfolio as of September 30, 2020 and December 31, 2019:
Geographic Distribution of Loan and Lease Portfolio
Table 17
September 30, 2020
U.S.
Guam &
Foreign &
(dollars in thousands)
Hawaii
Mainland (1)
Saipan
Other
Total
Commercial and industrial
$
1,850,652
$
1,067,337
$
205,193
$
47,080
$
3,170,262
Commercial real estate
2,246,115
814,164
400,588
218
3,461,085
Construction
303,217
353,296
6,358
—
662,871
Residential:
Residential mortgage
3,548,042
2,417
118,592
—
3,669,051
Home equity line
833,609
161
31,019
—
864,789
Total residential
4,381,651
2,578
149,611
—
4,533,840
Consumer
1,056,122
19,373
348,805
1,634
1,425,934
Lease financing
85,745
145,250
14,982
—
245,977
Total Loans and Leases
$
9,923,502
$
2,401,998
$
1,125,537
$
48,932
$
13,499,969
Percentage of Total Loans and Leases
73%
18%
8%
1%
100%
(1) For secured loans and leases, classification as U.S. Mainland is made based on where the collateral is located. For unsecured loans and leases, classification as U.S. Mainland is made based on the location where the majority of the borrower's business operations are conducted.
Geographic Distribution of Loan and Lease Portfolio
Table 18
December 31, 2019
U.S.
Guam &
Foreign &
(dollars in thousands)
Hawaii
Mainland (1)
Saipan
Other
Total
Commercial and industrial
$
1,270,997
$
1,285,340
$
140,929
$
45,976
$
2,743,242
Commercial real estate
2,289,626
768,314
405,720
293
3,463,953
Construction
261,089
253,577
4,575
—
519,241
Residential:
Residential mortgage
3,642,251
2,708
123,977
—
3,768,936
Home equity line
861,079
78
32,082
—
893,239
Total residential
4,503,330
2,786
156,059
—
4,662,175
Consumer
1,202,762
22,521
393,045
2,228
1,620,556
Lease financing
85,842
110,630
6,011
—
202,483
Total Loans and Leases
$
9,613,646
$
2,443,168
$
1,106,339
$
48,497
$
13,211,650
Percentage of Total Loans and Leases
73%
18%
8%
1%
100%
(1) For secured loans and leases, classification as U.S. Mainland is made based on where the collateral is located. For unsecured loans and leases, classification as U.S. Mainland is made based on the location where the majority of the borrower's business operations are conducted.
Our lending activities are concentrated primarily in Hawaii. However, we also have lending activities on the U.S. mainland, Guam and Saipan. Our commercial lending activities on the U.S. mainland include automobile dealer flooring activities in California, participation in the Shared National Credits Program and selective commercial real estate projects based on existing customer relationships. Our lease financing portfolio includes commercial leveraged and single investor lease financing activities both in Hawaii and on the U.S. mainland. However, no new leveraged leases are being added to the portfolio and all remaining leveraged leases are running off. Our consumer lending activities are concentrated primarily in Hawaii and, to a smaller extent, in Guam and Saipan.
77
Table of Contents
Table 19 presents certain contractual loan maturity categories and sensitivities of those loans to changes in interest rates as of September 30, 2020:
Maturities for Selected Loan Categories (1)
Table 19
September 30, 2020
Due in One
Due After One
Due After
(dollars in thousands)
Year or Less
to Five Years
Five Years
Total
Commercial and industrial
$
902,911
$
2,029,418
$
237,933
$
3,170,262
Construction
302,925
287,762
72,184
662,871
Total Selected Loans
$
1,205,836
$
2,317,180
$
310,117
$
3,833,133
Total of loans with:
Adjustable interest rates
$
1,116,965
$
1,087,884
$
217,163
$
2,422,012
Hybrid interest rates
618
24,627
7,719
32,964
Fixed interest rates
88,253
1,204,669
85,235
1,378,157
Total Selected Loans
$
1,205,836
$
2,317,180
$
310,117
$
3,833,133
(1) Based on contractual maturities.
Credit Quality
We perform an internal loan review and grading or scoring procedures on an ongoing basis. The review provides management with periodic information as to the quality of the loan portfolio and effectiveness of our lending policies and procedures. The objective of the loan review and grading or scoring procedures is to identify, in a timely manner, existing or emerging credit quality issues so that appropriate steps can be initiated to avoid or minimize future losses.
For purposes of managing credit risk and estimating the ACL, management has identified three portfolio segments (commercial, residential and consumer) that we use to develop our systematic methodology to determine the ACL. The categorization of loans for the evaluation of credit risk is specific to our credit risk evaluation process and these loan categories are not necessarily the same as the loan categories used for other evaluations of our loan portfolio. See “Note 4. Allowance for Credit Losses” contained in our unaudited interim consolidated financial statements for more information about our approach to estimating the ACL.
78
Table of Contents
The following tables and discussion address non-performing assets, loans and leases that are 90 days past due but are still accruing interest, impaired loans and loans modified in a TDR.
Non-Performing Assets and Loans and Leases Past Due 90 Days or More and Still Accruing Interest
Table 20 presents information on our non-performing assets and accruing loans and leases past due 90 days or more as of September 30, 2020 and December 31, 2019:
Non-Performing Assets and Accruing Loans and Leases Past Due 90 Days or More
Table 20
September 30,
December 31,
(dollars in thousands)
2020
2019
Non-Performing Assets
Non-Accrual Loans and Leases
Commercial Loans:
Commercial and industrial
$
725
$
32
Commercial real estate
7,067
30
Construction
2,043
—
Total Commercial Loans
9,835
62
Residential Loans:
Residential mortgage
7,798
5,406
Total Residential Loans
7,798
5,406
Total Non-Accrual Loans and Leases
17,633
5,468
Other Real Estate Owned ("OREO")
—
319
Total Non-Performing Assets
$
17,633
$
5,787
Accruing Loans and Leases Past Due 90 Days or More
Commercial Loans:
Commercial and industrial
$
1,938
$
1,429
Commercial real estate
1,307
1,013
Construction
100
2,367
Total Commercial Loans
3,345
4,809
Residential Loans:
Residential mortgage
—
74
Home equity line
4,503
2,995
Total Residential Loans
4,503
3,069
Consumer
2,897
4,272
Total Accruing Loans and Leases Past Due 90 Days or More
$
10,745
$
12,150
Restructured Loans on Accrual Status and Not Past Due 90 Days or More
$
9,726
$
14,493
Total Loans and Leases
$
13,499,969
$
13,211,650
Ratio of Non-Accrual Loans and Leases to Total Loans and Leases
0.13
%
0.04
%
Ratio of Non-Performing Assets to Total Loans and Leases and OREO
0.13
%
0.04
%
Ratio of Non-Performing Assets and Accruing Loans and Leases Past Due 90 Days or More to Total Loans and Leases and OREO
0.21
%
0.14
%
Table 21 presents the activity in Non-Performing Assets (“NPAs”) for the nine months ended September 30, 2020:
Non-Performing Assets
Table 21
Nine Months Ended September 30,
(dollars in thousands)
2020
Balance at beginning of period
$
5,787
Additions
51,146
Reductions
Payments
(6,890)
Return to accrual status
(567)
Sales of other real estate owned
(766)
Transfers to loans held for sale
(14,566)
Charge-offs/write-downs
(16,511)
Total Reductions
(39,300)
Balance at end of period
$
17,633
79
Table of Contents
The level of NPAs represents an indicator of the potential for future credit losses. NPAs consist of non-accrual loans and leases and other real estate owned. Changes in the level of non-accrual loans and leases typically represent increases for loans and leases that reach a specified past due status, offset by reductions for loans and leases that are charged-off, paid down, sold, transferred to held for sale classification, transferred to other real estate owned or are no longer classified as non-accrual because they have returned to accrual status as a result of continued performance and an improvement in the borrower’s financial condition and loan repayment capabilities.
Total NPAs were $17.6 million as of September 30, 2020, an increase of $11.8 million from December 31, 2019. The ratio of our NPAs to total loans and leases and other real estate owned was 0.13% as of September 30, 2020, an increase of 9 basis points from December 31, 2019. The increase in total NPAs was primarily due to a $7.0 million increase in commercial real estate non-accrual loans, a $2.4 million increase in residential mortgage non-accrual loans and a $2.0 million increase in construction non-accrual loans.
As of September 30, 2020, commercial real estate non-accrual loans were $7.1 million, an increase of $7.0 million from December 31, 2019. This increase was primarily due to additions of $15.9 million in commercial real estate loans, partially offset by transfers to loans held for sale of $5.3 million and $2.7 million in charge-offs. The additions in commercial real estate non-accruals loans during the year was primarily due to the impact of COVID-19 and the shut-down of the tourism industry in Hawaii.
As of September 30, 2020, commercial and industrial non-accrual loans were $0.7 million, an increase of $0.7 million from December 31, 2019. This increase was primarily due to additions in commercial and industrial loans totaling $28.6 million, partially offset by transfers to loans held for sale of $9.3 million, $13.4 million in charge-offs and $5.3 million in payments. The additions in commercial and industrial non-accruals loans during the year was primarily due to the impact of COVID-19 and the shut-down of the tourism industry in Hawaii.
As of September 30, 2020, construction non-accrual loans were $2.0 million, an increase of $2.0 million or 100% from December 31, 2019. This increase was primarily due to the addition of one construction non-accrual loan of $2.2 million, partially offset by a $0.4 million charge-off.
As of September 30, 2020, residential mortgage non-accrual loans were $7.8 million, an increase of $2.4 million or 44% from December 31, 2019. As of September 30, 2020, our residential mortgage non-accrual loans were comprised of 41 loans with a weighted average current LTV ratio of 55%.
Other real estate owned represents property acquired as the result of borrower defaults on loans. Other real estate owned is recorded at fair value, less estimated selling costs, at the time of foreclosure. On an ongoing basis, properties are appraised as required by market conditions and applicable regulations. As of September 30, 2020, there were no other real estate owned. As of December 31, 2019, other real estate owned was $0.3 million which was comprised of two residential real estate properties.
Loans and Leases Past Due 90 Days or More and Still Accruing Interest. Loans and leases in this category are 90 days or more past due, as to principal or interest, and are still accruing interest because they are well secured and in the process of collection.
Loans and leases past due 90 days or more and still accruing interest were $10.7 million as of September 30, 2020, a decrease of $1.4 million or 12% as compared to December 31, 2019. Construction and consumer loans that were past due 90 days or more and still accruing interest decreased by $2.3 million and $1.4 million, respectively, during the nine months ended September 30, 2020. This was partially offset by increases of $1.5 million and $0.5 million in home equity lines and commercial and industrial loans, respectively, that were past due 90 days or more and still accruing interest during the nine months ended September 30, 2020.
Impaired Loans. A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. For a loan that has been modified in a TDR, the contractual terms of the loan agreement refers to the contractual terms specified by the original loan agreement, not the contractual terms specified by the modified loan agreement.
80
Table of Contents
Impaired loans were $28.2 million and $20.6 million as of September 30, 2020 and December 31, 2019, respectively. These impaired loans had a related ACL of $2.2 million and $0.2 million as of September 30, 2020 and December 31, 2019, respectively. The increase in impaired loans during the nine months ended September 30, 2020 was primarily due to increases in commercial real estate and construction loans of $7.0 million and $1.8 million, respectively, partially offset by decreases in commercial and industrial loans and residential mortgage loans of $0.8 million and $0.5 million, respectively. The decrease in the impaired loans balance includes charge-offs and paydowns. For the three months ended September 30, 2020 and 2019, we recorded charge-offs of $0.1 million and $0.5 million, respectively, related to our total impaired loans. For the nine months ended September 30, 2020 and 2019, we recorded charge-offs of $16.5 million and $0.5 million, respectively, related to our total impaired loans. Our impaired loans are considered in management’s assessment of the overall adequacy of the ACL.
If interest due on the balances of all non-accrual loans as of September 30, 2020 had been accrued under the original terms, approximately $0.3 million and $0.9 million in additional interest income would have been recorded during the three and nine months ended September 30, 2020, respectively, compared to nil and $0.1 million in additional interest income that would have been recorded for the same periods in 2019. Actual interest income recorded on these loans was $0.1 million and $0.2 million, respectively, for the three and nine months ended September 30, 2020, compared to $0.4 million and $1.3 million, respectively, for the same periods in 2019.
COVID-19 Financial Hardship Relief Programs
Certain borrowers have been unable to meet their contractual payment obligations because of the adverse effects of COVID-19. To help mitigate these effects, we have been offering various relief programs to assist customers who are experiencing financial hardship due to COVID-19. For example, for certain residential mortgage and commercial loans, various relief options were available on a case-by-case basis, including payment deferrals for up to six months. For certain consumer loans, loan assistance was being offered in the form of payment deferrals for up to three months, which extended the term of the loan by the number of months deferred, and interest continued to accrue on the principal balance. The short-term modifications for payment deferrals, extensions of repayment terms, or delays in payment described above that are insignificant and made on a good faith basis in response to borrowers impacted by COVID-19 who were current prior to any relief are not required to be accounted for and disclosed as TDRs under GAAP. Please see “Note 4. Allowance for Credit Losses” in the notes to our unaudited interim consolidated financial statements for further discussion on short-term modifications.
81
Table of Contents
Table 22 presents information on our loans and leases that received payment deferrals under our COVID-19 financial hardship relief programs as of September 30, 2020:
Loans and Leases that Received Payment Deferrals under COVID-19 Financial Hardship Relief Programs
Table 22
September 30, 2020
Number of Loans
Amortized
(dollars in thousands)
and Leases
Cost Basis
Loans and Leases that Received Payment Deferrals under COVID-19 Financial Hardship Relief Programs
Commercial and industrial
1,206
$
809,778
Commercial real estate
429
1,196,376
Construction
39
62,383
Lease financing
58
9,927
Residential mortgage
1,585
684,281
Consumer
17,091
259,350
Total Loans and Leases that Received Payment Deferrals under COVID-19 Financial Hardship Relief Programs
20,408
$
3,022,095
Total Loans and Leases
$
13,499,969
Ratio of Loans and Leases that Received Payment Deferrals under COVID-19 Financial Hardship Relief Programs to Total Loans and Leases
22.4
%
In addition to the relief programs described above, we have been also participating in the PPP offered by the SBA. The PPP is intended to help small businesses impacted by the COVID-19 pandemic by providing “fully forgivable” loans for up to $10 million to cover up to 24 weeks of payroll expenses, including employee benefits, and can also be used to make mortgage interest, rent and utility payments. PPP loans have a fixed interest rate of one percent per annum and a maturity date of up to five years, with the ability to prepay the loan in full without penalty. The first payment is deferred for 10 months or until compensation is received for forgiven amounts, and interest will continue to accrue during the initial deferment period. The borrower may apply with the Bank for loan forgiveness of the amount due on the loan in an amount equal to payroll, employee benefits, mortgage interest, rent and utility costs incurred during the 24-week period, subject to limitations, in accordance with the PPP and CARES Act. Because the purpose of the PPP is to help small businesses keep their workers employed and paid, if the business spends less than 60% of loan proceeds on payroll costs, uses the loan proceeds for non-payroll costs that are not related to mortgage interest, rent or utility payments, or significantly reduces its employee count or compensation levels without qualifying for other exceptions, a portion of the loan will not be forgiven, and the business will be required to repay that portion of the loan to the Bank over the remaining term of the loan.
82
Table of Contents
Table 23 presents information on our PPP loans outstanding as of September 30, 2020 to borrowers operating in industries we consider to be the most impacted by the COVID-19 pandemic (“high impact industries”) and all other industries:
PPP Loans Outstanding to Borrowers by Industry
Table 23
September 30, 2020
Number
Amortized
(dollars in thousands)
of Loans
Cost Basis
PPP Loans Outstanding to Borrowers by Industry
High Impact Industries:
Food service
599
$
111,971
Automobile dealers
77
64,228
Retail
517
60,101
Hospitality/Hotel
95
57,045
Transportation
166
35,774
Total PPP Loans Outstanding to Borrowers Operating in High Impact Industries
1,454
329,119
All other industries (1)
4,561
591,049
Total PPP Loans Outstanding (2)
6,015
$
920,168
Total Loans and Leases
$
13,499,969
Ratio of PPP Loans Outstanding to Borrowers Operating in High Impact Industries to Total Loans and Leases
2.4
%
Ratio of PPP Loans Outstanding to Total Loans and Leases
6.8
%
(1) "All other industries" represent borrowers that received PPP loans that did not operate in the five high impact industries listed above, which is primarily comprised of the construction, health care, and professional services industries.
(2) Outstanding loan balances are reported net of deferred loan costs and fees of $2.0 million and $22.2 million, respectively, at September 30, 2020.
Loans Modified in a Troubled Debt Restructuring
Table 24 presents information on loans whose terms have been modified in a TDR as of September 30, 2020 and December 31, 2019:
Loans Modified in a Troubled Debt Restructuring
Table 24
September 30,
December 31,
(dollars in thousands)
2020
2019
Commercial and industrial
$
3,470
$
4,919
Commercial real estate
665
692
Total commercial
4,135
5,611
Residential mortgage
6,764
10,487
Total
$
10,899
$
16,098
Loans modified in a TDR were $10.9 million as of September 30, 2020, a decrease of $5.2 million or 32% from December 31, 2019. This decrease was primarily due to decreases in residential mortgage loans of $3.7 million and commercial and industrial loans of $1.4 million. As of September 30, 2020, $9.7 million or 89% of our loans modified in a TDR were performing in accordance with their modified contractual terms and were on accrual status.
Generally, loans modified in a TDR are returned to accrual status after the borrower has demonstrated performance under the modified terms by making six consecutive timely payments. See “Note 4. Allowance for Credit Losses” contained in our unaudited interim consolidated financial statements for more information and a description of the modification programs that we currently offer to our customers.
As noted above, we have begun to provide our borrowers with opportunities to defer payments, or portions thereof. In the absence of intervening factors, such short-term modifications made on a good faith basis are not categorized as troubled debt restructurings, nor are loans granted payment deferrals related to COVID-19 reported as past due or placed on non-accrual status (provided the loans were not past due or on non-accrual status prior to the deferral).
83
Table of Contents
Allowance for Credit Losses for Loans and Leases & Reserve for Unfunded Commitments
We adopted the provisions of Accounting Standards Update (“ASU”) No. 2016-13, Financial Instruments – Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments on January 1, 2020. This guidance changes the accounting for credit losses from an “incurred loss” model, which estimates a loss allowance based on current known and inherent losses within a loan portfolio to an “expected loss” model, which estimates a loss based on losses expected to be recorded over the life of the loan portfolio.
Effective January 1, 2020, we recorded a pre-tax cumulative effect adjustment to increase the ACL by $0.8 million and to increase the reserve for unfunded commitments by $16.3 million. The Company’s ACL under CECL is significantly more dependent on the quantitative model and less on the qualitative assessment, compared to the previous incurred loss model. The increase in the ACL was primarily related to our indirect auto, commercial real estate and consumer loan products. This was partially offset by the decrease in the ACL related to our commercial and industrial, home equity lines and residential real estate loan products. These directional changes were predominantly due to differences between the loss emergence periods previously used under the incurred loss methodology and the remaining life of the loan as required under CECL. The large increase to our reserve for unfunded commitments was primarily due to an increase in utilization rates estimated using our CECL methodology.
Table 25 presents an analysis of our ACL for the periods indicated:
Allowance for Credit Losses
Table 25
Three Months Ended September 30,
Nine Months Ended September 30,
(dollars in thousands)
2020
2019
2020
2019
Balance at Beginning of Period
$
192,120
$
138,535
$
130,530
$
141,718
Adjustment to Adopt ASC Topic 326
—
—
770
—
After Adoption of ASC Topic 326
192,120
138,535
131,300
141,718
Loans and Leases Charged-Off
Commercial Loans:
Commercial and industrial
(598)
(514)
(14,773)
(2,514)
Commercial real estate
—
—
(2,723)
—
Construction
—
—
(379)
—
Lease financing
—
—
—
(24)
Total Commercial Loans
(598)
(514)
(17,875)
(2,538)
Residential Loans:
Residential mortgage
—
(7)
(14)
(7)
Home equity line
—
—
(8)
—
Total Residential Loans
—
(7)
(22)
(7)
Consumer
(4,238)
(8,015)
(21,742)
(24,118)
Total Loans and Leases Charged-Off
(4,836)
(8,536)
(39,639)
(26,663)
Recoveries on Loans and Leases Previously Charged-Off
Commercial Loans:
Commercial and industrial
1,699
241
2,019
303
Commercial real estate
—
30
—
93
Construction
30
—
170
—
Total Commercial Loans
1,729
271
2,189
396
Residential Loans:
Residential mortgage
27
368
179
704
Home equity line
16
57
146
156
Total Residential Loans
43
425
325
860
Consumer
3,148
2,269
7,687
7,103
Total Recoveries on Loans and Leases Previously Charged-Off
4,920
2,965
10,201
8,359
Net Loans and Leases Recovered (Charged-Off)
84
(5,571)
(29,438)
(18,304)
Provision for Credit Losses - Loans and Leases
3,672
—
94,014
9,550
Balance at End of Period
$
195,876
$
132,964
$
195,876
$
132,964
Average Loans and Leases Outstanding
$
13,559,367
$
13,032,349
$
13,569,119
$
13,105,086
Ratio of Net Loans and Leases Charged-Off to Average Loans and Leases Outstanding (1)
-
%
0.17
%
0.29
%
0.19
%
Ratio of Allowance for Credit Losses for Loans and Leases to Loans and Leases Outstanding
1.45
%
1.04
%
1.45
%
1.04
%
(1) Annualized for the three and nine months ended September 30, 2020 and 2019.
84
Table of Contents
Tables 26 and 27 present the allocation of the ACL by loan and lease category, in both dollars and as a percentage of total loans and leases outstanding as of September 30, 2020 and December 31, 2019:
Allocation of the Allowance for Credit Losses by Loan and Lease Category
Table 26
September 30,
December 31,
(dollars in thousands)
2020
2019
Commercial and industrial
$
21,271
$
28,975
Commercial real estate
51,733
22,325
Construction
4,934
4,844
Lease financing
4,051
424
Total commercial
81,989
56,568
Residential mortgage
42,217
29,303
Home equity line
7,601
9,876
Total residential
49,818
39,179
Consumer
64,069
34,644
Unallocated
—
139
Total Allowance for Credit Losses for Loans and Leases
$
195,876
$
130,530
Allocation of the Allowance for Credit Losses by Loan and Lease Category
Table 27
September 30,
December 31,
2020
2019
Allocated
Loan
Allocated
Loan
ACL as
category as
ACL as
category as
(as a percentage of total loans
% of loan or
% of total
% of loan or
% of total
and leases outstanding)
lease category
loans and leases
lease category
loans and leases
Commercial and industrial
0.67
%
23.48
%
1.06
%
20.76
%
Commercial real estate
1.49
25.64
0.64
26.22
Construction
0.74
4.91
0.93
3.93
Lease financing
1.65
1.82
0.21
1.53
Total commercial
1.09
55.85
0.82
52.44
Residential mortgage
1.15
27.18
0.78
28.53
Home equity line
0.88
6.41
1.11
6.76
Total residential
1.10
33.59
0.84
35.29
Consumer
4.49
10.56
2.14
12.27
Total
1.45
%
100.00
%
0.99
%
100.00
%
As of September 30, 2020, the ACL was $195.9 million or 1.45% of total loans and leases outstanding, compared with an ACL of $130.5 million or 0.99% of total loans and leases outstanding as of December 31, 2019. The level of the ACL was commensurate with the adverse impacts that COVID-19 is having on the Hawaii and global economy.
Net recoveries of loans and leases were $0.1 million for the three months ended September 30, 2020 compared to net charge-offs of $5.6 million or 0.17% of total average loans and leases, on an annualized basis, for the three months ended September 30, 2019. Net recoveries in our commercial lending portfolio were $1.1 million for the three months ended September 30, 2020 compared to net charge-offs of $0.2 million for the three months ended September 30, 2019. Net recoveries in our residential lending portfolio were nil and $0.4 million for the three months ended September 30, 2020 and 2019, respectively. Net charge-offs in our consumer lending portfolio were $1.1 million and $5.7 million for the three months ended September 30, 2020 and 2019, respectively. Net charge-offs in our consumer portfolio segment include those related to credit cards, automobile loans, installment loans and small business lines of credit and reflect the inherent risk associated with these loans.
Net charge-offs of loans and leases were $29.4 million, or 0.29% of total average loans and leases on an annualized basis, for the nine months ended September 30, 2020 compared to $18.3 million or 0.19% of total average loans and leases, on an annualized basis, for the nine months ended September 30, 2019. Net charge-offs in our commercial lending portfolio were $15.7 million and $2.1 million for the three months ended September 30, 2020 and 2019, respectively. The increase in net charge-offs in our commercial lending portfolio was primarily due to $16.0 million in charge-offs related to several loans that have been adversely impacted by the shut-down of the tourism industry in Hawaii. Net recoveries in our residential lending portfolio were $0.3 million and $0.9 million for the nine months ended September 30, 2020 and 2019, respectively. Our net
85
Table of Contents
recovery position in this portfolio segment is largely attributable to rising real estate prices in Hawaii. Net charge-offs in our consumer lending portfolio were $14.1 million and $17.0 million for the nine months ended September 30, 2020 and 2019, respectively. Net charge-offs in our consumer portfolio segment include those related to credit card, automobile loans, installment loans and small business lines of credit and reflect the inherent risk associated with these loans.
The increase in the ACL during the third quarter of 2020 was primarily due to the adverse economic impact that COVID-19 is having and is expected to continue to have on the global, national and local economies. Business closures and the ripple effect it has had and will continue to have on unemployment filings is expected to impact the ability of our borrowers to continue to remain current on their loans and leases. As noted earlier, a significant number of our customers (primarily individuals and small businesses) have taken advantage of payment deferral programs in assisting them while they may be temporarily unemployed or while their businesses have closed. We continue to monitor the impact of COVID-19 on our tourism industry and the re-opening of the Hawaii economy under new guidelines. Once these measures are relaxed, we expect that local consumption of goods and services will begin to resume over an extended period of time. Additionally, effective October 15, 2020, while the State of Hawaii has begun to allow passengers from the U.S. mainland with an approved negative COVID-19 test within 72 hours prior to arrival in the State of Hawaii to bypass the state’s mandatory 14-day self-quarantine requirement, the timing and extent of the return of air travel and the recovery of the Hawaii tourism industry is highly uncertain and is dependent upon the number of cases declining around the globe.
As of September 30, 2020, the higher allocation of our ACL to our commercial and consumer portfolio segments and the lower allocation to our residential portfolio segment (which is secured by real estate), is primarily due to expected credit losses related to COVID-19 and the impact that it will have on the Hawaii economy, local businesses and our customers. See “Note 4. Allowance for Credit Losses” contained in our unaudited interim consolidated financial statements for more information on the ACL.
Goodwill
Goodwill was $995.5 million as of both September 30, 2020 and December 31, 2019. Our goodwill originated from the acquisition of the Company by BNP Paribas in December of 2001. Goodwill generated in that acquisition was recorded on the balance sheet of the Bank as a result of push down accounting treatment, and remains on our consolidated balance sheets.
The Company’s policy is to assess goodwill for impairment at the reporting unit level on an annual basis or between annual assessments if a triggering event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Impairment is the condition that exists when the carrying amount of a reporting unit exceeds its fair value. The continued adverse effect of the COVID-19 pandemic prompted the Company to perform an interim assessment of its goodwill for impairment during the third quarter of 2020. The Company performed an assessment of the criteria included in Accounting Standards Codification Topic 350, Intangibles – Goodwill and Other , and based on such assessment, the Company concluded that there was no impairment in our goodwill for the three and nine months ended September 30, 2020. Future events, including the ongoing impacts of the COVID-19 pandemic, that could cause a significant decline in our expected future cash flows or a significant adverse change in our business or the business climate may necessitate taking charges in future reporting periods related to the impairment of our goodwill.
Other Assets
Other assets were $606.7 million as of September 30, 2020, an increase of $116.1 million or 24% from December 31, 2019. This increase was primarily due to a $96.4 million increase in interest rate swap agreements and a $39.9 million increase in prepaid assets.
Deposits
Deposits are the primary funding source for the Bank and are acquired from a broad base of local markets, including both individual and corporate customers. We obtain funds from depositors by offering a range of deposit types, including demand, savings, money market and time.
86
Table of Contents
Table 28 presents the composition of our deposits as of September 30, 2020 and December 31, 2019:
Deposits
Table 28
September 30,
December 31,
(dollars in thousands)
2020
2019
Demand
$
6,908,270
$
5,880,072
Savings
5,994,687
4,998,933
Money Market
3,379,985
3,055,832
Time
2,614,820
2,510,157
Total Deposits (1)
$
18,897,762
$
16,444,994
(1) Public deposits were $1.8 billion as of September 30, 2020, an increase of $745.7 million compared to December 31, 2019.
Total deposits were $18.9 billion as of September 30, 2020, an increase of $2.5 billion or 15% from December 31, 2019. The increase in deposit balances stemmed primarily from a $1.0 billion increase in demand deposit balances, a $545.4 million increase in public savings deposit balances and a $450.4 million increase in non-public savings deposit balances. We increased our liquidity position in anticipation of a surge in funding needs, primarily due to our participation in the PPP.
Short-term and Long-term Borrowings
As of September 30, 2020 there were no short-term borrowings as the remaining short-term FHLB fixed-rate advance matured in July 2020. As of December 31, 2019 short-term borrowings were $400.0 million with a weighted average interest rate of 2.84%.
Long-term borrowings were $200.0 million as of both September 30, 2020 and December 31, 2019. The Company’s long-term borrowings included $200.0 million in FHLB fixed-rate advances with a weighted average interest rate of 2.73% and maturity dates ranging from 2023 to 2024. Long-term borrowings mature in excess of one year from the unaudited interim consolidated balance sheet date.
As of September 30, 2020 and December 31, 2019, the available remaining borrowing capacity with the FHLB was $2.0 billion and $1.7 billion, respectively. The FHLB fixed-rate advances and remaining borrowing capacity were secured by residential real estate loan collateral as of September 30, 2020 and December 31, 2019.
Pension and Postretirement Plan Obligations
We have a noncontributory qualified defined benefit pension plan, an unfunded supplemental executive retirement plan, a directors’ retirement plan (a non-qualified pension plan for eligible directors) and a postretirement benefit plan providing life insurance and healthcare benefits that we offer to our directors and employees, as applicable. The noncontributory qualified defined benefit pension plan, the unfunded supplemental executive retirement plan and the directors’ retirement plan are all frozen to new participants. On March 11, 2019, the Company’s board of directors approved an amendment to the SERP to freeze the SERP. As a result of such amendment, effective July 1, 2019, there are no new accruals of benefits, including service accruals. To calculate annual pension costs, we use the following key variables: (1) size of the employee population, length of service and estimated compensation increases; (2) actuarial assumptions and estimates; (3) expected long-term rate of return on plan assets; and (4) discount rate.
Pension and postretirement benefit plan obligations, net of pension plan assets, were $122.2 million as of September 30, 2020, a nominal increase from December 31, 2019. This increase was primarily due to net periodic benefit costs for the nine months ended September 30, 2020 of $6.5 million, offset by payments of $6.3 million.
See “Note 16. Noninterest Income and Noninterest Expense” contained in our unaudited interim consolidated financial statements for more information on our pension and postretirement benefit plans.
87
Table of Contents
Foreign Activities
Cross-border outstandings are defined as loans (including accrued interest), acceptances, interest-bearing deposits with other banks, other interest-bearing investments and any other monetary assets which are denominated in dollars or other non-local currency. As of September 30, 2020, there were no aggregate cross-border outstandings in countries which amounted to 0.75% to 1% of our total consolidated assets. As of December 31, 2019, aggregate cross-border outstandings in countries which amounted to 0.75% to 1% of our total consolidated assets were approximately $174.7 million to Japan and $162.1 million to Canada. There were no cross-border outstandings in excess of 1% of our total consolidated assets as of both September 30, 2020 and December 31, 2019.
Capital
The bank regulators currently use a combination of risk-based ratios and a leverage ratio to evaluate capital adequacy. The Company and the Bank are subject to the federal bank regulators’ final rules implementing Basel III and various provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Capital Rules”.)
The Capital Rules, among other things impose a capital measure called “Common Equity Tier 1” (“CET1”), to which most deductions/adjustments to regulatory capital must be made. In addition, the Capital Rules specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting certain specified requirements.
Under the Capital Rules, the minimum capital ratios are as follows:
● 4.5% CET1 capital to risk-weighted assets,
● 6.0% Tier 1 capital (that is, CET1 capital plus Additional Tier 1 capital) to risk-weighted assets,
● 8.0% Total capital (that is, Tier 1 capital plus Tier 2 capital) to risk-weighted assets, and
● 4.0% Tier 1 capital to average quarterly assets.
The Capital Rules also require a 2.5% capital conservation buffer designed to absorb losses during periods of economic stress. The capital conservation buffer is composed entirely of CET1, on top of these minimum risk weighted asset ratios, effectively resulting in minimum ratios of (i) 7% CET1 to risk-weighted assets, (ii) 8.5% Tier 1 capital to risk-weighted assets, and (iii) 10.5% total capital to risk-weighted assets.
As of September 30, 2020, the Company’s capital levels remained characterized as “well capitalized” under the Capital Rules. Our regulatory capital ratios, calculated in accordance with the Capital Rules, are presented in Table 29 below. There have been no conditions or events since September 30, 2020 that management believes have changed either the Company’s or the Bank’s capital classifications.
Regulatory Capital
Table 29
September 30,
December 31,
(dollars in thousands)
2020
2019
Stockholders' Equity
$
2,733,934
$
2,640,258
Less:
Goodwill
995,492
995,492
Accumulated other comprehensive income (loss), net
51,254
(31,749)
Common Equity Tier 1 Capital and Tier 1 Capital
$
1,687,188
$
1,676,515
Add:
Qualifying allowance for credit losses and reserve for unfunded commitments
173,191
131,130
Total Capital
$
1,860,379
$
1,807,645
Risk-Weighted Assets
$
13,808,018
$
14,110,799
Key Regulatory Capital Ratios
Common Equity Tier 1 Capital Ratio
12.22
%
11.88
%
Tier 1 Capital Ratio
12.22
%
11.88
%
Total Capital Ratio
13.47
%
12.81
%
Tier 1 Leverage Ratio
7.91
%
8.79
%
88
Table of Contents
The tier 1 leverage ratio decreased 88 basis points from 8.79% at December 31, 2019 to 7.91% at September 30, 2020. This decrease primarily stemmed from increases in the average balances of investment securities, loans and leases and interest bearing deposits.
Total stockholders’ equity was $2.7 billion as of September 30, 2020, an increase of $93.7 million or 4% from December 31, 2019. The increase in stockholders’ equity was primarily due to earnings for the period of $124.0 million and a net unrealized gain in the fair value of our investment securities of $83.1 million. This was partially offset by dividends declared and paid to the Company’s stockholders of $101.3 million and the cumulative effect adjustment of a change in an accounting principle of $12.5 million during the nine months ended September 30, 2020.
In October 2020, the Company’s Board of Directors declared a quarterly cash dividend of $0.26 per share on our outstanding shares. The dividend will be paid on December 4, 2020 to shareholders of record at the close of business on November 23, 2020.
Off-Balance Sheet Arrangements and Guarantees
Off-Balance Sheet Arrangements
We hold interests in several unconsolidated variable interest entities (“VIEs”). These unconsolidated VIEs are primarily low income housing tax credit investments in partnerships and limited liability companies. Variable interests are defined as contractual ownership or other interest in an entity that change with fluctuations in an entity’s net asset value. The primary beneficiary consolidates the VIE. Based on our analysis, we have determined that the Company is not the primary beneficiary of these entities. As a result, we do not consolidate these VIEs.
Guarantees
We sell residential mortgage loans on the secondary market, primarily to Fannie Mae or Freddie Mac. The agreements under which we sell residential mortgage loans to Fannie Mae or Freddie Mac contain provisions that include various representations and warranties regarding the origination and characteristics of the residential mortgage loans. Although the specific representations and warranties vary among investors, insurance or guarantee agreements, they typically cover ownership of the loan, validity of the lien securing the loan, the absence of delinquent taxes or liens against the property securing the loan, compliance with loan criteria set forth in the applicable agreement, compliance with applicable federal, state and local laws and other matters. As of both September 30, 2020 and December 31, 2019, the unpaid principal balance of our portfolio of residential mortgage loans sold was $2.3 billion. The agreements under which we sell residential mortgage loans require delivery of various documents to the investor or its document custodian. Although these loans are primarily sold on a non-recourse basis, we may be obligated to repurchase residential mortgage loans or reimburse investors for losses incurred if a loan review reveals that underwriting and documentation standards were potentially not met in the origination of those loans. Upon receipt of a repurchase request, we work with investors to arrive at a mutually agreeable resolution. Repurchase demands are typically reviewed on an individual loan by loan basis to validate the claims made by the investor to determine if a contractually required repurchase event has occurred. We manage the risk associated with potential repurchases or other forms of settlement through our underwriting and quality assurance practices and by servicing mortgage loans to meet investor and secondary market standards. For the nine months ended September 30, 2020, there was one repurchase of a residential mortgage loan of $0.3 million and there was one pending repurchase of a residential mortgage loan of $0.5 million.
In addition to servicing loans in our portfolio, substantially all of the loans we sell to investors are sold with servicing rights retained. We also service loans originated by other mortgage loan originators. As servicer, our primary duties are to: (1) collect payments due from borrowers; (2) advance certain delinquent payments of principal and interest; (3) maintain and administer any hazard, title or primary mortgage insurance policies relating to the mortgage loans; (4) maintain any required escrow accounts for payment of taxes and insurance and administer escrow payments; and (5) foreclose on defaulted mortgage loans, or loan modifications or short sales. Each agreement under which we act as servicer generally specifies a standard of responsibility for actions taken by the Company in such capacity and provides protection against expenses and liabilities incurred by the Company when acting in compliance with the respective servicing agreements. However, if we commit a material breach of obligations as servicer, we may be subject to termination if the breach is not cured within a specified period following notice. The standards governing servicing and the possible remedies for violations of such standards vary by investor. These standards and remedies are determined by servicing guides issued by the investors as well as the contract provisions established between the investors and the Company. Remedies could include repurchase of an affected loan. For
89
Table of Contents
the nine months ended September 30, 2020, we had no repurchase requests related to loan servicing activities, nor were there any pending repurchase requests as of September 30, 2020.
Although to date repurchase requests related to representation and warranty provisions and servicing activities have been limited, it is possible that requests to repurchase mortgage loans may increase in frequency as investors more aggressively pursue all means of recovering losses on their purchased loans. However, as of September 30, 2020, management believes that this exposure is not material due to the historical level of repurchase requests and loss trends and thus has not established a liability for losses related to mortgage loan repurchases. As of September 30, 2020, 97% of our residential mortgage loans serviced for investors were current. We maintain ongoing communications with investors and continue to evaluate this exposure by monitoring the level and number of repurchase requests as well as the delinquency rates in loans sold to investors.
Contractual Obligations
Our contractual obligations have not changed materially since previously reported as of December 31, 2019.
Future Application of Accounting Pronouncements
For a discussion of the expected impact of accounting pronouncements recently issued but not adopted by us as of September 30, 2020, see “Note 1. Organization and Basis of Presentation — Recent Accounting Pronouncements” to the unaudited interim consolidated financial statements for more information.
Risk Governance and Quantitative and Qualitative Disclosures About Market Risk
Managing risk is an essential part of successfully operating our business. Management believes that the most prominent risk exposures for the Company are credit risk, market risk, liquidity risk management, capital management and operational risk. See “Analysis of Financial Condition — Liquidity” and “—Capital” sections of this MD&A for further discussions of liquidity risk management and capital management, respectively.
Credit Risk
Credit risk is the risk that borrowers or counterparties will be unable or unwilling to repay their obligations in accordance with the underlying contractual terms. We manage and control credit risk in the loan and lease portfolio by adhering to well-defined underwriting criteria and account administration standards established by management. Written credit policies document underwriting standards, approval levels, exposure limits and other limits or standards deemed necessary and prudent. Portfolio diversification at the obligor, industry, product, and/or geographic location levels is actively managed to mitigate concentration risk. In addition, credit risk management includes an independent credit review process that assesses compliance with commercial, real estate and consumer credit policies, risk ratings and other critical credit information. In addition to implementing risk management practices that are based upon established and sound lending practices, we adhere to sound credit principles. We understand and evaluate our customers’ borrowing needs and capacity to repay, in conjunction with their character and history.
Management has identified three categories of loans that we use to develop our systematic methodology to determine the Allowance: commercial, residential and consumer.
Commercial lending is further categorized into four distinct classes based on characteristics relating to the borrower, transaction and collateral. These classes are: commercial and industrial, commercial real estate, construction and lease financing. Commercial and industrial loans are primarily for the purpose of financing equipment acquisition, expansion, working capital and other general business purposes by medium to larger Hawaii based corporations, as well as U.S. mainland and international companies. Commercial and industrial loans are typically secured by non-real estate assets whereby the collateral is trading assets, enterprise value or inventory. As with many of our customers, our commercial and industrial loan customers are heavily dependent on tourism, government expenditures and real estate values. Commercial real estate loans are secured by real estate, including but not limited to structures and facilities to support activities designated as retail, health care, general office space, warehouse and industrial space. Our Bank’s underwriting policy generally requires that net cash flows from the property be sufficient to service the debt while still maintaining an appropriate amount of reserves. Commercial real estate loans in Hawaii are characterized by having a limited supply of real estate at commercially attractive locations, long delivery time frames for development and high interest rate sensitivity. Our construction lending portfolio consists primarily of land loans, single family and condominium development loans. Financing of construction loans is
90
Table of Contents
subject to a high degree of credit risk given the long delivery time frames for such projects. Construction lending activities are underwritten on a project financing basis whereby the cash flows or lease rents from the underlying real estate collateral or the sale of the finished inventory is the primary source of repayment. Market feasibility analysis is typically performed by assessing market comparables, market conditions and demand in the specific lending area and general community. We require presales of finished inventory prior to loan funding. However, because this analysis is typically performed on a forward looking basis, real estate construction projects typically present a higher risk profile in our lending activities. Lease financing activities include commercial single investor leases and leveraged leases used to purchase items ranging from computer equipment to transportation equipment. Underwriting of new leasing arrangements typically includes analyzing customer cash flows, evaluating secondary sources of repayment, such as the value of the leased asset, the guarantors’ net cash flows as well as other credit enhancements provided by the lessee.
Residential lending is further categorized into the following classes: residential mortgages (loans secured by 1-4 family residential properties and home equity loans) and home equity lines of credit. Our Bank’s underwriting standards typically require LTV ratios of not more than 80%, although higher levels are permitted with accompanying mortgage insurance. First mortgage loans secured by residential properties generally carry a moderate level of credit risk, with an average loan size of approximately $355,000. Residential mortgage loan production is added to our loan portfolio or is sold in the secondary market, based on management’s evaluation of our liquidity, capital and loan portfolio mix as well as market conditions. Changes in interest rates, the economic environment and other market factors have impacted, and will likely continue to impact, the marketability and value of collateral and the financial condition of our borrowers which impacts the level of credit risk inherent in this portfolio, although we remain in a supply constrained housing environment in Hawaii. Geographic concentrations exist for this portfolio as nearly all residential mortgage loans and home equity lines of credit are for residences located in Hawaii, Guam or Saipan. These island locales are susceptible to a wide array of potential natural disasters including, but not limited to, hurricanes, floods, tsunamis and earthquakes. We offer home equity lines of credit with variable rates; fixed rate lock options may be available post-closing. All lines are underwritten at 2% over the fully indexed rate. Our procedures for underwriting home equity lines of credit include an assessment of an applicant’s overall financial capacity and repayment ability. Decisions are primarily based on repayment ability via debt-to-income ratios, LTV ratios and an evaluation of credit history.
Consumer lending is further categorized into the following classes of loans: credit cards, automobile loans and other consumer-related installment loans. Consumer loans are either unsecured or secured by the borrower’s personal assets. The average loan size is generally small and risk is diversified among many borrowers. We offer a wide array of credit cards for business and personal use. In general, our customers are attracted to our credit card offerings on the basis of price, credit limit, reward programs and other product features. Credit card underwriting decisions are generally based on repayment ability of our borrower via DTI ratios, credit bureau information, including payment history, debt burden and credit scores, such as FICO, and analysis of financial capacity. Automobile lending activities include loans and leases secured by new or used automobiles. We originate the majority of our automobile loans and leases on an indirect basis through selected dealerships. Our procedures for underwriting automobile loans include an assessment of an applicant’s overall financial capacity and repayment ability, credit history and the ability to meet existing obligations and payments on the proposed loan or lease. Although an applicant’s creditworthiness is the primary consideration, the underwriting process also includes a comparison of the value of the collateral security to the proposed loan amount. We require borrowers to maintain full coverage automobile insurance on automobile loans and leases, with the Bank listed as either the loss payee or additional insured. Installment loans consist of open and closed end facilities for personal and household purchases. We seek to maintain reasonable levels of risk in installment lending by following prudent underwriting guidelines which include an evaluation of personal credit history and cash flow.
In addition to geographic concentration risk, we also monitor our exposure to industry risk. While the Bank, our customers and our results of operations could be adversely impacted by events affecting the tourism industry, we also monitor our other industry exposures, including, but not limited to, our exposures in the oil, gas and energy industries. As of September 30, 2020 and December 31, 2019, we did not have material exposures to customers in the oil, gas and energy industries.
Market Risk
Market risk is the potential of loss arising from changes in interest rates, foreign exchange rates, equity prices and commodity prices, including the correlation among these factors and their volatility. When the value of an instrument is tied to such external factors, the holder faces market risk. We are exposed to market risk primarily from interest rate risk, which is defined as the risk of loss of net interest income or net interest margin because of changes in interest rates.
91
Table of Contents
The potential cash flows, sales or replacement value of many of our assets and liabilities, especially those that earn or pay interest, are sensitive to changes in the general level of interest rates. In the banking industry, changes in interest rates can significantly impact earnings and the safety and soundness of an entity.
Interest rate risk arises primarily from our core business activities of extending loans and accepting deposits. This occurs when our interest earning loans and interest bearing deposits mature or reprice at different times, on a different basis or in unequal amounts. Interest rates may also affect loan demand, credit losses, mortgage origination volume, pre- payment speeds and other items affecting earnings.
Many factors affect our exposure to changes in interest rates, such as general economic and financial conditions, customer preferences, historical pricing relationships and repricing characteristics of financial instruments. Our earnings are affected not only by general economic conditions, but also by the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve. The monetary policies of the Federal Reserve can influence the overall growth of loans, investment securities and deposits and the level of interest rates earned on assets and paid for liabilities.
Market Risk Measurement
We primarily use net interest income simulation analysis to measure and analyze interest rate risk. We run various hypothetical interest rate scenarios and compare these results against a measured base case scenario. Our net interest income simulation analysis incorporates various assumptions, which we believe are reasonable but which may have a significant impact on results. These assumptions include: (1) the timing of changes in interest rates, (2) shifts or rotations in the yield curve, (3) re-pricing characteristics for market rate sensitive instruments on and off-balance sheet, (4) differing sensitivities of financial instruments due to differing underlying rate indices and (5) varying loan prepayment speeds for different interest rate scenarios. Because of limitations inherent in any approach used to measure interest rate risk, simulation results are not intended as a forecast of the actual effect of a change in market interest rates on our results but rather as a means to better plan and execute appropriate asset liability management strategies to manage our interest rate risk.
Table 30 presents, for the twelve months subsequent to September 30, 2020 and December 31, 2019, an estimate of the changes in net interest income that would result from ramps (gradual changes) and shocks (immediate changes) in market interest rates, moving in a parallel fashion over the entire yield curve, relative to the measured base case scenario. Ramp scenarios assume interest rates move gradually in parallel across the yield curve relative to the base case scenario. Shock scenarios assume an immediate and sustained parallel shift in interest rates across the entire yield curve, relative to the base case scenario. The base case scenario assumes that the balance sheet and interest rates are generally unchanged. We evaluate the sensitivity by using a static forecast, where the balance sheets as of September 30, 2020 and December 31, 2019 are held constant.
Net Interest Income Sensitivity Profile - Estimated Percentage Change Over 12 Months
Table 30
Static Forecast
Static Forecast
September 30, 2020
December 31, 2019
Ramp Change in Interest Rates (basis points)
+100
5.9
%
4.0
%
+50
3.0
1.9
(50)
(1.7)
(2.3)
(100)
(2.4)
(4.4)
Immediate Change in Interest Rates (basis points)
+100
11.2
%
8.9
%
+50
5.7
4.4
(50)
(2.9)
(4.9)
(100)
(3.8)
(9.6)
The table above shows the effects of a simulation which estimates the effect of a gradual and immediate sustained parallel shift in the yield curve of −100, −50, +50 and +100 basis points in market interest rates over a twelve-month period on our net interest income.
92
Table of Contents
Currently, our interest rate profile is such that we project net interest income will benefit from higher interest rates as our assets would reprice faster and to a greater degree than our liabilities, while in the case of lower interest rates, our assets would reprice downward and to a greater degree than our liabilities.
Under the static balance sheet forecast as of September 30, 2020, our net interest income sensitivity profile is more sensitive in higher interest rate scenarios and less sensitive in lower interest rate scenarios as compared to similar forecasts as of December 31, 2019. The sensitivity impacts described above are primarily due to holding a larger federal funds position and market interest rates being lower as of September 30, 2020 as compared with December 31, 2019. A larger federal funds position has the effect of magnifying the impact of higher interest rate scenarios. Lower market interest rates have the effect of higher prepayments on loans and investment securities and reinvestments which occur at lower rates. Because market interest rates have been approaching an interest rate floor, this dampens the impact of the lower interest rate scenarios for both ramp and shock scenarios.
The comparisons above provide insight into the potential effects of changes in interest rates on net interest income. The Company believes that its approach to interest rate risk has appropriately considered its susceptibility to both rising and falling rates and has adopted strategies which minimize the impact of such risks.
We also have longer term interest rate risk exposures which may not be appropriately measured by net interest income simulation analysis. We use market value of equity (“MVE”) sensitivity analysis to study the impact of long-term cash flows on earnings and capital. MVE involves discounting present values of all cash flows of on-balance sheet and off-balance sheet items under different interest rate scenarios. The discounted present value of all cash flows represents our MVE. MVE analysis requires modifying the expected cash flows in each interest rate scenario, which will impact the discounted present value. The amount of base case measurement and its sensitivity to shifts in the yield curve allow management to measure longer term repricing option risk in the balance sheet.
Limitations of Market Risk Measures
The results of our simulation analyses are hypothetical, and a variety of factors might cause actual results to differ substantially from what is depicted. For example, if the timing and magnitude of interest rate changes differ from those projected, our net interest income might vary significantly. Non parallel yield curve shifts such as a flattening or steepening of the yield curve or changes in interest rate spreads would also cause our net interest income to be different from that depicted. An increasing interest rate environment could reduce projected net interest income if deposits and other short-term liabilities re-price faster than expected or faster than our assets re-price. Actual results could differ from those projected if we grow assets and liabilities faster or slower than estimated, if we experience a net outflow of deposits or if our mix of assets and liabilities otherwise changes. For example, while we maintain relatively high levels of liquidity, a faster than expected withdrawal of deposits out of the bank may cause us to seek higher cost sources of funding. Actual results could also differ from those projected if we experience substantially different prepayment speeds in our loan portfolio than those assumed in the simulation analyses. Finally, these simulation results do not consider all the actions that we may undertake in response to potential or actual changes in interest rates, such as changes to our loan, investment, deposit, funding or hedging strategies.
Market Risk Governance
We seek to achieve consistent growth in net interest income and capital while managing volatility arising from changes in market interest rates. The objective of our interest rate risk management process is to increase net interest income while operating within acceptable limits established for interest rate risk and maintaining adequate levels of funding and liquidity.
To manage the impact on net interest income, we manage our exposure to changes in interest rates through our asset and liability management activities within guidelines established by our ALCO and approved by our board of directors. The ALCO has the responsibility for approving and ensuring compliance with the ALCO management policies, including interest rate risk exposures. The objective of our interest rate risk management process is to maximize net interest income while operating within acceptable limits established for interest rate risk and maintaining adequate levels of funding and liquidity.
Through review and oversight by the ALCO, we attempt to engage in strategies that neutralize interest rate risk as much as possible. Our use of derivative financial instruments, as detailed in “Note 12. Derivative Financial Instruments” to the unaudited interim consolidated financial statements, has generally been limited. This is due to natural on balance sheet hedges arising out of offsetting interest rate exposures from loans and investment securities with deposits and other interest-bearing liabilities. In particular, the investment securities portfolio is utilized to manage the interest rate exposure and sensitivity to
93
Table of Contents
within the guidelines and limits established by the ALCO. We utilize natural and offsetting economic hedges in an effort to reduce the need to employ off-balance sheet derivative financial instruments to hedge interest rate risk exposures. Expected movements in interest rates are also considered in managing interest rate risk. Thus, as interest rates change, we may use different techniques to manage interest rate risk.
Management uses the results of its various simulation analyses to formulate strategies to achieve a desired risk profile within the parameters of our capital and liquidity guidelines.
Operational Risk
Operational risk is the risk of loss arising from inadequate or failed processes, people or systems, external events (such as natural disasters), or compliance, reputational or legal matters, including the risk of loss resulting from fraud, litigation and breaches in data security. Operational risk is inherent in all of our business ventures and the management of that risk is important to the achievement of our objectives. We have a framework in place that includes the reporting and assessment of any operational risk events, and the assessment of our mitigating strategies within our key business lines. This framework is implemented through our policies, processes and reporting requirements. We measure and report operational risk using the seven operational risk event types projected by the Basel Committee on Banking Supervision in Basel II: (1) external fraud; (2) internal fraud; (3) employment practices and workplace safety; (4) clients, products and business practices; (5) damage to physical assets; (6) business disruption and system failures; and (7) execution, delivery and process management. Our operational risk review process is also a core part of our assessment of material new products or activities.
Critical Accounting Policies
Our interim consolidated financial statements were prepared in accordance with GAAP and follow general practices within the industries in which we operate. The most significant accounting policies we follow are presented in “Note 1. Organization and Summary of Significant Accounting Policies” in the notes to the consolidated financial statements included in our Form 10-K for the year ended December 31, 2019. Application of these principles requires us to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. Most accounting policies are not considered by management to be critical accounting policies. Several factors are considered in determining whether or not a policy is critical in the preparation of the consolidated financial statements. These factors include among other things, whether the policy requires management to make difficult, subjective and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or using different assumptions. The accounting policies which we believe to be most critical in preparing our consolidated financial statements are those that are related to the determination of the ACL, fair value estimates, pension and postretirement benefit obligations and income taxes. An updated discussion of the ACL is presented below as a result of our adoption of the CECL standard on January 1, 2020.
Allowance for Credit Losses
Management's evaluation of the adequacy of the ACL is often the most critical of accounting estimates for a financial institution. Our determination of the amount of the ACL is a critical accounting estimate as it requires significant reliance on the accuracy of credit risk ratings on individual borrowers, the use of estimates and significant judgment as to the amount and timing of expected future cash flows on impaired loans, significant reliance on estimated loss rates on portfolios and consideration of our quantitative and qualitative evaluation of macro-economic factors and trends. While our methodology in establishing the ACL attributes portions of the ACL to the commercial, residential real estate and consumer portfolio segments, the entire ACL is available to absorb credit losses in the total loan and lease portfolio.
The ACL is a valuation account that is deducted from the amortized cost basis of loans and leases to present the net amount expected to be collected from loans and leases. Loans and leases are charged-off against the ACL when management believes the uncollectibility of a loan or lease balance is confirmed. Expected recoveries do not exceed the aggregate of amounts previously charged-off and expected to be charged-off. Changes in the ACL and, therefore, in the related Provision, can materially affect net income. In applying the judgment and review required to determine the ACL, management considers changes in economic conditions, customer behavior, and collateral value, among other factors. From time to time, economic factors or business decisions may affect the composition and mix of the loan and lease portfolio, causing management to increase or decrease the ACL.
The following are some of the significant judgments and inherent limitations which affect the estimate of the ACL:
94
Table of Contents
● The Accuracy of Internal Credit Risk Ratings, Monitoring of Loans Past Due and Delinquency Trends. The ACL related to our commercial portfolio segment is generally most sensitive to the accuracy of internal credit risk ratings assigned to each borrower. Commercial loan risk ratings are evaluated based on each situation by experienced senior credit officers and are subject to periodic review by an independent internal team of credit specialists.
● Data. We have applied considerable judgments about the sufficiency and applicability of our internal data to provide an accurate view of historical loss information. For each of our portfolio segments we have examined between 8 and 12 years of historical data. For many of our residential real estate and consumer loan classes, we have assumed that the historical loss period observed is sufficient to capture a full credit loss cycle and that the credit loss exposures observed over this historical loss period are representative of those for which we will be making estimates of future expected credit losses under CECL. In making this assumption, we have relied on the fact that the historical loss period incorporated the most recent observed recessionary period as well as the subsequent period of sustained recovery and growth.
● Reasonable and Supportable Forecast Period. For contractual periods which extend beyond the one-year reasonable and supportable forecast period, management elected an immediate reversion to the mean approach. Management will continue to assess whether a one-year reasonable and supportable forecast period is appropriate. Changes to the economic environment and uncertainty with regards to the timing and extent of an economic recovery may result in management decreasing or increasing the current reasonable and supportable forecast period.
● Qualitative Adjustments to the Reasonable and Supportable Forecast Period. The Bank’s economic forecast team meets to discuss possible qualitative adjustments that should be considered in estimating the ACL. These qualitative adjustments could be attributable to forecasted levels of employment, visitor arrivals and spending, interest rates and real estate prices. Various economic forecasts ranging from mild, medium to severe are evaluated to forecast losses over the reasonable and supportable forecast period. Such qualitative adjustments are highly subjective and are a result of significant management judgment and estimation.
● Identification and Measurement of Individually Assessed Loans, including Loans Modified in a TDR. Our experienced senior credit officers may consider a loan impaired based on their evaluation of current information and events, including loans modified in a TDR. The measurement of impairment is typically based on an analysis of the present value of expected future cash flows. The development of these expectations requires significant management judgment and estimation.
See “Note 1. Organization and Basis of Presentation” and “Note 4. Allowance for Credit Losses” in the notes to the interim consolidated financial statements for more information on the ACL.
95
Table of Contents
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See “Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risk Governance and Quantitative and Qualitative Disclosures About Market Risk.”
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.