FIVE STAR BANCORP 10-Q

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk Market risk is the risk of loss from adverse changes in market prices and rates. As a financial institution, the Company experiences market risk arising primarily from interest rate risk inherent in lending and deposit-taking activities. Because the interest rates on the Company’s assets and liabilities do not necessarily change at the same speed or rate as market interest rates, sudden and/or substantial changes in interest rates may adversely impact our earnings. In particular, the Company’s financial results are sensitive to significant changes in the treasury yield curve, the Federal Funds rate, and the Wall Street Prime Index. The Company’s total interest income was $47.5 million for the three months ended March 31, 2024 and $174.4 million for the year ended December 31, 2023. As market interest rates that serve as reference indices for our variable rate loans and investment securities have continued to increase, our total interest income has grown. Our total interest expense was $20.8 million for the three months ended March 31, 2024 and $63.5 million for the year ended December 31, 2023. As rates paid on borrowed funds are correlated with short-term interest rates, the cost associated with our borrowings generally increases in a rising rate environment. Overall, our net interest income was $26.7 million for the three months ended March 31, 2024 and $110.9 million for the year ended December 31, 2023. Economic value of equity (“EVE”) measures our long-term earnings exposure from changes in market rates of interest. EVE is defined as the present value of assets minus the present value of liabilities at a point in time for a given set of market rate assumptions. An increase in EVE due to a specified rate change indicates an improvement in the long-term earnings capacity of the balance sheet, assuming that the rate change remains in effect over the life of the current balance sheet. As of March 31, 2024, the Company carried a slightly higher balance of liabilities than assets that will reprice in the event that interest rates fall. As such, we generally expect the Company to benefit from a declining rate environment. Our policies and procedures provide management with guidelines for effective funds management, and we have established a measurement system for monitoring our net interest rate sensitivity position. This is overseen and adjusted as needed by our Management Asset Liability Committee (“MALCO”) on a monthly basis and our Director Asset Liability Committee (“ALCO”) on a quarterly basis. We have historically managed our sensitivity position within our established guidelines. With the intent of stabilizing or increasing net interest income, management typically deploys the Company’s excess liquidity and seeks to migrate certain earning assets into higher-yielding categories (from investment securities into loans, for example). However, in situations where deposit balances contract, management relies upon various borrowing facilities and/or the use of brokered deposits. The Company monitors the impact of interest rate risk on EVE by reviewing and managing assets and liabilities with varying interest rate risks, such as cash and time deposits. Assets and liabilities are subject to fluctuations at each measurement date based on the composition of the balance sheet at each measurement date. EVE results are compared to previous periods and established policies on a quarterly basis. As of March 31, 2024, the overnight Federal Funds rate, the rate used in the interest rate shock scenarios listed below, was 5.33%. The scenarios presented assume that interest rates change instantaneously (“shock”) and that there are no significant changes in the structure of the Company’s balance sheet over the twelve months being measured. The following table summarizes the estimated effect on net interest income and EVE from changing interest rates as measured against a flat rate (no interest rate change) instantaneous parallel shock scenario over a twelve month period utilizing an interest sensitivity (GAP) analysis based on the Company’s specific mix of interest-earning assets and interest-bearing liabilities as of March 31, 2024 and December 31, 2023. March 31, 2024 December 31, 2023 Change in Interest Rates Estimated Change in NII (as % of NII) Estimated Change in EVE (as % of EVE) Estimated Change in NII (as % of NII) Estimated Change in EVE (as % of EVE) (in basis points) +300 (shock) (14.62) % (19.52) % (13.73) % (22.17) % +200 (shock) (9.64) % (13.37) % (9.02) % (15.23) % +100 (shock) (4.79) % (6.72) % (4.63) % (7.90) % + 0 (flat) — % — % — % — % -100 (shock) 4.69 % 7.05 % 4.43 % 8.09 % -200 (shock) 9.44 % 13.57 % 8.93 % 14.76 % -300 (shock) 14.36 % 20.19 % 13.72 % 22.38 % 60 The computation of the prospective effects of hypothetical interest rate changes requires numerous assumptions, which are based upon our experience and published industry experience. Such assumptions may not necessarily reflect the manner or timing in which our interest-earning assets and interest-bearing liabilities respond to changes in market rates. Because these assumptions are inherently uncertain, actual results will differ from simulated results.