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Item 7A. Quantitative and Qualitative Disclosures About Market Risk

2022-03-16 compared with 2021-03-15 · 74 added, 91 removed, 1 unchanged (99% of the section changed)

Quantitative and Qualitative Disclosures about Market Risk

Risk Management

The Company has adopted risk management policies and procedures, which aim to ensure the proper control and management of all risk factors inherent in the operation of the Company, most importantly credit risk, interest rate risk and liquidity risk.

These risk factors are not mutually exclusive.

It is recognized that any product or service offered by the Company may expose the Company to one or more of these risk factors.

Credit risk is the risk to earnings or capital arising from an obligor’s failure to meet the terms of any contract or otherwise fail to perform as agreed.

Credit risk is found in all activities where success depends on counterparty, issuer, or borrower performance.

Credit risk in the investment portfolio and correspondent bank accounts is addressed through defined limits in the Company’s policy statements.

In addition, certain securities carry insurance to enhance credit quality of the bond.

In order to control credit risk in the loan & lease portfolio the Company has established credit management policies and procedures that govern both the approval of new loans & leases and the monitoring of the existing portfolio.

The Company manages and controls credit risk through comprehensive underwriting and approval standards, dollar limits on loans & leases to one borrower, and by restricting loans & leases made primarily to its principal market area where management believes it is best able to assess the applicable risk.

Additionally, management has established guidelines to ensure the diversification of the Company’s credit portfolio such that even within key portfolio sectors such as real estate or agriculture, the portfolio is diversified across factors such as location, building type, crop type, etc.

However, as a financial institution that assumes credit risks as a principal element of its business, credit losses will be experienced in the normal course of business.

The allowance for credit losses is maintained at a level considered by management to be adequate to provide for risks inherent in the loan & lease portfolio.

The allowance is increased by provisions charged to operating expense and reduced by net charge-offs.

The Company’s methodology for assessing the appropriateness of the allowance is applied on a regular basis and considers all loans & leases.

The systematic methodology consists of three parts.

Part 1 - includes a detailed analysis of the loan & lease portfolio in two phases.

The first phase is conducted in accordance with the “Receivables” topic of the FASB ASC.

Individual loans & leases are reviewed to identify them for impairment.

A loan or lease is impaired when principal and interest are deemed uncollectible in accordance with the original contractual terms of the loan or lease.

Impairment is measured as either the expected future cash flows discounted at each loan’s or lease’s effective interest rate, the fair value of the loan’s or lease’s collateral if the loan or lease is collateral dependent, or an observable market price of the loan or lease, if one exists.

Upon measuring the impairment, the Company will ensure an appropriate level of allowance is present or established.

Central to the first phase of the analysis of the loan & lease portfolio is the risk rating system.

The originating credit officer assigns each borrower an initial risk rating, which is based primarily on a thorough analysis of that borrower’s financial position in conjunction with industry and economic trends.

Approvals are made based upon the amount of inherent credit risk specific to the transaction and are reviewed for appropriateness by senior credit administration personnel.

Credits are monitored by credit administration personnel for deterioration in a borrower’s financial condition, which would impact the ability of the borrower to perform under the contract.

Risk ratings are adjusted as necessary.

Risk ratings are reviewed by both the Company’s independent third-party credit examiners and bank examiners from the DFPI and FDIC.

Based on the risk rating system, specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicates that the loan or lease is impaired and there is a probability of loss.

Management performs a detailed analysis of these loans & leases, including, but not limited to, cash flows, appraisals of the collateral, conditions of the marketplace for liquidating the collateral, and assessment of the guarantors.

Management then determines the inherent loss potential and allocates a portion of the allowance for losses as a specific allowance for each of these credits.

The second phase is conducted by segmenting the loan & lease portfolio by risk rating and into groups of loans & leases with similar characteristics in accordance with the “Contingency” topic of the FASB ASC.

In this second phase, groups of loans & leases with similar characteristics are reviewed and the appropriate allowance factor is applied based on the historical average charge-off rate for each particular group of loans or leases.

Part 2 - considers qualitative internal and external factors that may affect a loan or lease’s collectability, is based upon management’s evaluation of various conditions, the effects of which are not directly measured in the determination of the historical and specific allowances.

The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments.

The conditions evaluated in connection with the second element of the analysis of the allowance include, but are not limited to the following conditions that existed as of the balance sheet date:

general economic and business conditions affecting the key service areas of the Company;

credit quality trends (including trends in collateral values, delinquencies and non-performing loans & leases);

loan & lease volumes, growth rates and concentrations;

loan & lease portfolio seasoning;

specific industry and crop conditions;

recent loss experience;

duration of the current business cycle.

Part 3 - An unallocated allowance generally occurs due to the imprecision in estimating and allocating allowance balances associated with macro factors such as:

(1) economic conditions in the Central Valley;

and (2) the long-term risks associated with the availability of water in the Central Valley.

Management reviews all of these conditions in discussion with the Company’s senior credit officers.

To the extent that any of these conditions is evidenced by a specifically identifiable impaired credit or portfolio segment as of the evaluation date, management’s estimate of the effect of such condition may be reflected as a specific allowance applicable to such credit or portfolio segment.

Where any of these conditions is not evidenced by a specifically identifiable impaired credit or portfolio segment as of the evaluation date, management’s evaluation of the inherent loss related to such condition is reflected in the second element of the allowance or in the unallocated allowance.

Management believes, that based upon the preceding methodology, and using information currently available, the allowance for credit losses at December 31, 2020 was adequate.

No assurances can be given that future events may not result in increases in delinquencies, non-performing loans & leases, or net loan & lease charge-offs that would require increases in the provision for credit losses and thereby adversely affect the results of operations.

Interest Rate Risk

The mismatch between maturities of interest sensitive assets and liabilities results in uncertainty in the Company’s earnings and economic value and is referred to as interest rate risk.

The Company does not attempt to predict interest rates and positions the balance sheet in a manner, which seeks to minimize, to the extent possible, the effects of changing interest rates.

The Company measures interest rate risk in terms of potential impact on both its economic value and earnings.

The methods for governing the amount of interest rate risk include:

(1) analysis of asset and liability mismatches (Gap analysis);

(2) the utilization of a simulation model;

and (3) limits on maturities of investment, loan & lease, and deposit products, which reduces the market volatility of those instruments.

The Gap analysis measures, at specific time intervals, the divergence between earning assets and interest bearing liabilities for which repricing opportunities will occur.

A positive difference, or Gap, indicates that earning assets will reprice faster than interest-bearing liabilities.

This will generally produce a greater net interest margin during periods of rising interest rates and a lower net interest margin during periods of declining interest rates.

Conversely, a negative Gap will generally produce a lower net interest margin during periods of rising interest rates and a greater net interest margin during periods of decreasing interest rates.

The interest rates paid on deposit accounts do not always move in unison with the rates charged on loans & leases.

In addition, the magnitude of changes in the rates charged on loans & leases is not always proportionate to the magnitude of changes in the rate paid for deposits.

Consequently, changes in interest rates do not necessarily result in an increase or decrease in the net interest margin solely as a result of the differences between repricing opportunities of earning assets or interest bearing liabilities.

The Company also utilizes the results of a dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes.

The sensitivity of the Company’s net interest income is measured over a rolling one-year horizon.

The simulation model estimates the impact of changing interest rates on interest income from all interest earning assets and the interest expense paid on all interest bearing liabilities reflected on the Company’s balance sheet.

This sensitivity analysis is compared to policy limits, which specify a maximum tolerance level for net interest income exposure over a one-year horizon assuming no balance sheet growth, given a 200 basis point upward and a 100 basis point downward shift in interest rates.

A shift in rates over a 12-month period is assumed.

Results that exceed policy limits, if any, are analyzed for risk tolerance and reported to the Board with appropriate recommendations.

At December 31, 2020, the Company’s estimated net interest income sensitivity to changes in interest rates, as a percent of net interest income was a slight decrease in net interest income of .03% if rates increase by 200 basis points and a decrease in net interest income of 0.2% if rates decline 100 basis points.

The estimated sensitivity does not necessarily represent a Company forecast and the results may not be indicative of actual changes to the Company’s net interest income.

These estimates are based upon a number of assumptions including:

the nature and timing of interest rate levels including yield curve shape;

prepayments on loans & leases and securities;

pricing strategies on loans & leases and deposits;

replacement of asset and liability cash flows;

and other assumptions.

While the assumptions used are based on current economic and local market conditions, there is no assurance as to the predictive nature of these conditions including how customer preferences or competitor influences might change.

Liquidity Risk

Liquidity risk is the risk to earnings or capital resulting from the Company’s inability to meet its obligations when they come due without incurring unacceptable losses.

It includes the ability to manage unplanned decreases or changes in funding sources and to recognize or address changes in market conditions that affect the Company’s ability to liquidate assets or acquire funds quickly and with minimum loss of value.

The Company endeavors to maintain a cash flow adequate to fund operations, handle fluctuations in deposit levels, respond to the credit needs of borrowers, and to take advantage of investment opportunities as they arise.

The Company’s principal operating sources of liquidity include (see “Item 8.

Financial Statements and Supplementary Data – Consolidated Statements of Cash Flows”) cash and cash equivalents, cash provided by operating activities, principal payments on loans & leases, proceeds from the maturity or sale of investments, and growth in deposits.

To supplement these operating sources of funds the Company maintains Federal Funds credit lines of $118 million and repurchase lines of $112 million with major banks.

As of December 31, 2020, the Company has additional borrowing capacity of $630.5 million with the Federal Home Loan Bank and $438 million with the Federal Reserve Bank.

Borrowings under these lines are collateralized with loans or securities that have been accepted for pledging at the FHLB and FRB.

At December 31, 2020, the Company had available sources of liquidity, which included cash and cash equivalents and unpledged investment securities available-for-sale of approximately $583.4 million, which represents 13% of total assets.

Market risk is the risk of loss in a financial instrument arising from adverse changes in market prices and rates, foreign currency exchange rates, commodity prices and equity prices.

Our market risk arises primarily

from interest rate risk inherent in our lending and deposit taking activities.

Management actively monitors and manages our interest rate risk exposure.

We do not have any market-risk sensitive instruments entered into for trading purposes.

our interest-rate sensitivity by matching the re-pricing opportunities on our earning assets to those on our funding liabilities.

Management uses various asset/liability strategies to manage the re-pricing characteristics of our assets and liabilities designed to ensure that exposure to interest rate fluctuations is limited within our guidelines

of acceptable levels of risk-taking.

Hedging strategies, including the terms and pricing of loans and deposits, and managing the deployment of our securities, are used to reduce mismatches in interest rate re-pricing opportunities of portfolio assets

and their funding sources.

Our Asset Liability Management Committee (“ALCO”), which is comprised of members of the Board of Directors and executive officers, manages market risk.

ALCO monitors interest rate risk by analyzing the potential impact

on net interest income from potential changes in interest rates, and considers the impact of alternative strategies or changes in balance sheet structure.

ALCO manages our balance sheet in part to maintain the potential impact of changes in interest

rates on net interest income within acceptable ranges despite changes in interest rates.

Our exposure to interest rate risk is reviewed on at least a quarterly basis by ALCO.

Interest rate risk exposure is measured using interest rate sensitivity analysis to determine our change in net interest income in

the event of hypothetical changes in interest rates.

If potential changes to net interest income resulting from hypothetical interest rate changes are not within risk tolerances determined by ALCO, and approved by the full Board of Directors,

Management may make adjustments to the Company’s asset and liability mix to bring interest rate risk levels within the board approved limits.

Net Interest Income Simulation.

In order to measure interest rate risk, we used a simulation model to project changes in net interest income that result from forecasted changes

in interest rates.

This analysis calculates the difference between net interest income forecasted using a rising and a falling interest rate scenario and a net interest income forecast using a base market interest rate derived from the current

treasury yield curve.

The income simulation model includes various assumptions regarding the re-pricing relationships for each of our products.

Many of our assets are floating rate loans, which are assumed to re-price immediately, and to the same

extent as the change in market rates according to their contracted index.

Some loans and investment vehicles include the opportunity of prepayment (embedded options), and accordingly the simulation model uses national indexes to estimate these prepayments and assumes the reinvestment of the

proceeds at current yields.

Our non-term deposit products re-price more slowly, usually changing less than the change in market rates and at our discretion.

This analysis indicates the impact of changes in net interest income for the given set of rate changes and assumptions.

It assumes the balance sheet grows modestly, but that its structure will remain similar to the

structure as of the period presented.

It does not account for all factors that affect this analysis, including changes by management to mitigate the effect of interest rate changes or secondary impacts such as changes to our credit risk profile as

interest rates change.

Furthermore, loan prepayment-rate estimates and spread relationships change regularly.

Interest rate changes create changes in actual loan prepayment rates that will differ from the market estimates incorporated in

this analysis.

Changes that vary significantly from the assumptions may have significant effects on our net interest income.

For the rising and falling interest rate scenarios, the base market interest rate forecast was increased or decreased, on an instantaneous and sustained basis, by 100 basis points.

As of the periods presented, our net

interest margin exposure related to these hypothetical changes in market interest rates was within the current guidelines established by us.

Our simulation model highlights the fact that our balance sheet is asset sensitive, which means that our net

interest income rises in a rising interest rate environment.

The ratio of variable to fixed-rate loans in our loan portfolio, the ratio of short-term (maturing at a given time within 12 months) to long-term loans, and the ratio of our demand, money market and savings deposits to

CDs (and their time periods), are the primary factors affecting the sensitivity of our net interest income to changes in market interest rates.

Our short-term loans are typically priced at prime plus a margin, and our long-term loans are typically

priced based on a FHLB index for comparable maturities, plus a margin.

The composition of our rate-sensitive assets or liabilities is subject to change and could result in a more unbalanced position that would cause market rate changes to have a

greater impact on our net interest margin.

Gap Analysis.

Another way to measure the impact that future changes in interest rates will have on net interest income is through a cumulative gap measure.

The gap represents

the net position of assets and liabilities subject to re-pricing in specified periods.

A gap analysis highlights the distribution of re-pricing opportunities of our interest earning assets and interest-bearing liabilities, the interest rate

sensitivity gap (that is, interest rate sensitive assets less interest rate sensitive liabilities), cumulative interest earning assets and interest bearing liabilities, the cumulative interest rate sensitivity gap, the ratio of cumulative interest

earning assets to cumulative interest-bearing liabilities and the cumulative gap as a percentage of total assets and total interest earning assets as of the periods presented.

The analysis also sets forth the time periods during which interest

earning assets and interest bearing liabilities will mature or may re-price in accordance with their contractual terms.

The interest rate relationships between the re-priceable assets and re-priceable liabilities are not necessarily constant and may

be affected by many factors, including the behavior of clients in response to changes in interest rates.

This table should, therefore, be used only as a guide as to the possible effect changes in interest rates might have on our net interest

Our gap analysis also highlights the asset sensitivity of our balance sheet.

Gap analysis has certain limitations.

Measuring the volume of re-pricing or maturing assets and liabilities does not always measure the full impact on the portfolio value of equity or net interest income.

does not account for rate caps on products, dynamic changes such as increasing prepayment speeds as interest rates decrease, basis risk, embedded options or the benefit of no-rate funding sources.

The relation between product rate re-pricing and

market rate changes (basis risk) is not the same for all products.

The majority of interest earning assets generally re-price along with a movement in market rates, while non-term deposit rates in general move more slowly and usually incorporate only

a fraction of the change in market rates.

Products categorized as non-rate sensitive, such as our non-interest bearing demand deposits, in the gap analysis behave like long-term fixed rate funding sources.

Management uses income simulation, net interest income

rate shocks and market value of portfolio equity as its primary interest rate risk management tools.

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

What changed 10-K

Item 7A. Quantitative and Qualitative Disclosures About Market Risk