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Item 7. Management’s Discussion and Analysis

2023-02-24 compared with 2022-02-25 · 173 added, 152 removed, 414 unchanged (44% of the section changed)

12 unchanged sentences

We additionally originate for sale or for investment purposes residential real estate loans on single family properties located primarily in our markets.

During the three months ended March 31, 2020, we ceased indirect auto loan originations, included in our consumer loan portfolio.

Our core profitability depends primarily on our net interest income.

1 unchanged sentence

Management manages the repricing characteristics of the Company's interest earning assets and interest bearing liabilities to protect net interest income from changes in market interest rates and changes in the shape of the yield curve.

Like most financial institutions, our net interest income is significantly affected by general and local economic conditions, particularly changes in market interest rates, and by governmental policies and actions of regulatory agencies.

Like most financial institutions, our net interest income is significantly affected by general and local economic conditions, particularly changes in market interest rates, including mostly recently significant changes as a result of inflation, and by governmental policies and actions of regulatory agencies.

Net interest income is additionally affected by changes in the volume and mix of interest earning assets, interest earned on these assets, the volume and mix of interest bearing liabilities and interest paid on these liabilities.

3 unchanged sentences

Net income is also affected by noninterest income and noninterest expense.

Noninterest income primarily consists of service charges and other fees and other income.

Noninterest income primarily consists of service charges and other fees, card revenue and other income.

Noninterest expense consists primarily of compensation and employee benefits, occupancy and equipment, data processing and professional services.

2 unchanged sentences

Data processing consists primarily of processing and network services related to the Bank’s core operating system, including the account processing system, electronic payments processing of products and services, internet and mobile banking channels and software-as-a-service providers.

Professional services consists primarily of third-party service providers such as auditors, consultants and lawyers.

Results of operations may also be significantly affected by general and local economic and competitive conditions, governmental policies and actions of regulatory authorities, especially changes resulting from the COVID-19 Pandemic and the governmental actions taken to address it.

Professional services consist primarily of third-party service providers such as auditors, consultants and lawyers.

Results of operations may also be significantly affected by general and local economic and competitive conditions, changes in accounting, tax and regulatory rules, governmental policies and actions of regulatory authorities, including changes resulting from the COVID-19 Pandemic and inflation and the governmental actions taken to address these issues.

Net income is also impacted by growth of operations through organic growth or acquisitions.

COVID-19 Pandemic Response

The Company maintains its commitment to supporting its community and customers during the COVID-19 Pandemic and remains focused on keeping its employees safe and the Bank running effectively to serve its customers.

As of December 31, 2021, nearly all Bank branches are open with normal hours and substantially all employees are expected to return to their go-forward working environments during the three months ended March 31, 2022.

The Bank will continue to monitor branch access and occupancy levels in relation to cases and close contact scenarios and follow governmental restrictions and public health authority guidelines.

Branch Consolidation Plan

The Company reduced the branch count to 49 from 61 branches at December 31, 2020, including the consolidation of

eight branches during the three months ended March 31, 2021 and four branches in October 2021.

The Company integrated these locations into other branches within its network.

These actions were the result of the Company’s increased focus on balancing physical locations and digital banking channels, driven by increased customer usage of online and mobile banking and a commitment to improve digital banking technology.

Results of Operations

Net income was $81.9 million, or $2.31 per diluted common share, for the year ended December 31, 2022 compared t o $98.0 million, or $2.73 per diluted common share, for the year ended December 31, 2021 .

Net income increased $51.5 million, or 110.5% , due primarily to a reversal o f provision for credit losses of $29.4 million during the year ended December 31, 2021 compared to a provision for credit losses of $36.1 million for the same period in 2020.

The Company’s efficiency ratio was 62.09% for the year ended December 31, 2021 compared to 62.52% for the year ended December 31, 2020.

Net income decreased $16.2 million, or 16.5% compared to December 31, 2021 primarily due to decreases in reversal of provision for credit losses of $27.9 million and a $5.0 million decrease in noninterest income.

These decreases were partially offset by an increase of $13.6 million in net interest income to $219.4 million during the year ended December 31, 2022 compared to $205.8 million during the year ended December 31, 2021, primarily as a result of rising market interest rates and changes in the mix of total interest earning assets including an increase in higher yielding taxable securities.

The Company’s efficiency ratio was 60.63% for the year ended December 31, 2022 compared to 62.09% for the same period in 2021 .

Average Balances, Yields and Rates Paid

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(1) Average balances are calculated using daily balances.

(2) Average loan receivable, net includes loans held for sale and loans classified as nonaccrual, which carry a zero yield.

Interest earned on loans receivable, net includes the amortization of net deferred loan fees of $28.4 million, $14.4 million and $776,000 for the years ended December 31, 2021, 2020, and 2019, respectively.

(2) Average loans receivable, net includes loans held for sale and loans classified as nonaccrual, which carry a zero yield.

Interest earned on loans receivable, net includes the amortization of net deferred loan fees of $7.4 million, $28.4 million and $14.4 million for the years ended December 31, 2022, 2021, and 2020, respectively.

(3) Yields on tax-exempt loans and securities have not been stated on a tax-equivalent basis.

1 unchanged sentence

One of the Company's key sources of earnings is net interest income.

There are several factors that affect net interest income, including, but not limited to, the volume, pricing, mix and maturity of interest earning assets and interest bearing liabilities;

There are several factors that affect net interest income, including, but not limited to, the volume, pricing, mix and maturity of interest earning assets and interest bearing

the volume of noninterest earning assets, noninterest bearing demand deposits, other noninterest bearing liabilities and stockholders' equity;

1 unchanged sentence

and asset quality.

The following table provides the changes in net interest income due to changes in average asset and liability balances (volume), changes in average rates (rate) and changes attributable to the combined effect of volume and interest rates allocated proportionately to the absolute value of changes due to volume and changes due to interest rates:

Market rates impact the results of the Company's net interest income, including the significant increases in the federal funds target rate by the Federal Reserve in response to inflation during 2022.

The following table provides the federal funds target rate history and changes from each period since December 31, 2021 :

Change Date Rate (%) Rate Change (%)

December 31, 2021 0.00% - 0.25% N/A

March 17, 2022 0.25% - 0.50% 0.25 %

May 5, 2022 0.75% - 1.00% 0.50 %

June 16, 2022 1.50% - 1.75% 0.75 %

July 28, 2022 2.25% - 2.50% 0.75 %

September 22, 2022 3.00% - 3.25% 0.75 %

November 3, 2022 3.75% - 4.00% 0.75 %

December 15, 2022 4.25% - 4.50% 0.50 %

The following table provides the changes in net interest income for the periods indicated due to changes in average asset and liability balances (volume), changes in average rates (rate) and changes attributable to the combined effect of volume and interest rates allocated proportionately to the absolute value of changes due to volume and changes due to interest rates:

2022 Compared to 2021

Increase (Decrease) Due to changes in 2020 Compared to 2019

Increase (Decrease) Due to changes in

Volume Rate Total Volume Rate Total

(Dollars in thousands) (Dollars in thousands)

Volume Yield/Rate Total % Change

(Dollars in thousands)

Interest Earning Assets:

14 unchanged sentences

Net interest income $ 3,192 $ 10,404 $ 13,596 6.6 %

Net interes t income increased $4.8 million, or 2.4%, to $205.8 million for the year ended December 31, 2021 compared to $201.0 million for 2020 due primarily to the Bank decreasing deposit rates following decreases in short-term market interest rates and secondarily due to an increase in the yield of loans receivable, net, predominately from higher amortization of deferred SBA PPP loan fees recognized from forgiven SBA PPP loans and higher recoveries of interest and fees on loans classified as nonaccrual.

These factors increasing net interest income were offset partially by a decrease in average loans receivable, net and a decrease in the yield on taxable securities.

Net interest margin decreased due primarily to the significant increase in low-yielding average interest earning deposits to average total earning assets of 18.7% during the year ended December 31, 2021 compared to 5.7% for the same period in 2020, reducing the yield on interest earning assets for 2021.

The following table presents the loan yield and the impacts of SBA PPP loans and the incremental accretion on purchased loans on this financial measure for the periods presented below:

Year Ended December 31,

2021 Compared to 2020

Increase (Decrease) Due to changes in

Volume Yield/Rate $ %

(Dollars in thousands)

Interest Earning Assets:

Loans receivable, net $ (6,934) $ 4,349 $ (2,585) (1.3) %

Taxable securities 2,566 (2,615) (49) (0.3)

Nontaxable securities 159 81 240 6.6

Interest earning deposits 1,278 (373) 905 128.7

Total interest income $ (2,931) $ 1,442 $ (1,489) (0.7) %

Interest Bearing Liabilities:

Certificates of deposit $ (1,082) $ (2,782) $ (3,864) (68.1) %

Savings accounts 100 (259) (159) (30.2)

2021 Compared to 2020

Increase (Decrease) Due to changes in

Volume Yield/Rate $ %

(Dollars in thousands)

Interest bearing demand and money market accounts 803 (2,885) (2,082) (34.3)

Total interest bearing deposits (179) (5,926) (6,105) (49.8)

Junior subordinated debentures 12 (160) (148) (16.6)

Securities sold under agreement to repurchase 75 (95) (20) (12.5)

FHLB advances and other borrowings (4) (4) (8) (100.0)

Total interest expense $ (96) $ (6,185) $ (6,281) (47.1) %

Net interest income $ (2,835) $ 7,627 $ 4,792 2.4 %

Total interest income increased $14.6 million, or 6.9%, to $227.5 million for the year ended December 31, 2022 compared to $212.8 million for the year ended December 31, 2021.

The increase in total interest income was primarily due to an increase in average balances of taxable securities and secondarily due to increased yields on interest earning assets, offset partially by a $15.6 million decrease in interest earned on loans receivable, net resulting from a decrease in deferred SBA PPP loan fees recognized.

SBA PPP interest and fee income decreased $26.9 million, or 83.8%, to $5.2 million for the year ended December 31, 2022 compared to $32.1 million for the year ended December 31, 2021 due to a decline in the volume of forgiven SBA PPP loans.

The following table presents the loan yield and the impacts of SBA PPP loans and the incremental accretion on acquired loans on this financial measure for the periods presented below:

Year Ended December 31,

Loan yield (GAAP) 4.52 % 4.54 %

Exclude impact from SBA PPP loans (0.09) % (0.20) %

Exclude impact from incremental accretion on purchased loans (0.07) % (0.08) %

Loan yield excluding SBA PPP loans and incremental accretion on purchased loans (non-GAAP) 4.27 % 4.52 %

(1) For additional information, see the "Reconciliations of Non-GAAP Measures" section below.

Exclude impact from incremental accretion on acquired loans (0.04) % (0.07) %

Loan yield excluding SBA PPP loans and incremental accretion on acquired loans (non-GAAP) 4.39 % 4.27 %

(1) For additional information, see the "Reconciliations of Non-GAAP Measures."

The impact to loan yield from recoveries of interest and fees on loans classified as nonaccrual was three basis points during the year ended December 31, 2022 compared to seven basis points during the same period in 2021.

Total interest expense increased $1.0 million, or 14.6%, to $8.1 million for the year ended December 31, 2022 compared to $7.0 million for the year ended December 31, 2021 due primarily to an increase in average rates paid on deposit accounts as a result of upward market pressure and an increase in average rates paid on junior subordinated debentures as a result of rising market interest rates.

The net interest margin increased 12 basis points to 3.35% for the year ended December 31, 2022 compared to 3.23% for the year ended December 31, 2021.

The increase in net interest margin was due primarily to increases in average yields on total interest earning assets as a result of increases in market interest rates and the change in the mix of total interest earning assets to higher yielding assets, including an increase in higher yielding taxable securities.

This was partially offset by an increase in the average cost of interest bearing liabilities as a result of upward market pressure related to deposit rates.

Provision for Credit Losses Overview

The ACL on unfunded commitments is included on the Consolidated Statements of Financial Condition within accrued expenses and other liabilities.

The following table presents the provision for credit losses for the periods indicated:

Year Ended December 31,

(In thousands)

Provision for credit losses on loans $ (27,298) $ 35,433

Provision for credit losses on unfunded commitments (2,074) 673

Provision for credit losses $ (29,372) $ 36,106

The reversal of provision for credit losses recognized during the year ended December 31, 2021 was due primarily to improvements in forecasted economic indicators used to calculate credit losses during the year ended December 31, 2021 compared to the worsening of economic indicators during the year ended December 31, 2020 stemming from the onset of the COVID-19 Pandemic.

The aggregate of the provision for credit losses on loans and the provision for credit losses on unfunded commitments is presented on the Consolidated Statements of Income as the "(Reversal of) provision for credit losses." The ACL on unfunded commitments is included on the Consolidated Statements of Financial Condition within "Accrued expenses and other liabilities."

The following table presents the reversal of provision for credit losses for the periods indicated:

Year Ended December 31, Change

2022 2021 $ %

(Dollars in thousands)

Reversal of provision for credit losses on loans $ (563) $ (27,298) $ 26,735 (97.9) %

Reversal of provision for credit losses on unfunded commitments (863) (2,074) 1,211 (58.4)

Reversal of provision for credit losses $ (1,426) $ (29,372) $ 27,946 (95.1) %

The reversal of provision for credit losse s recognized during the year ended December 31, 2022 was due primarily to a $3.4 million reduction in the ACL on loans individually evaluated for losses offset partially by an increase related to the growth in balances of collectively evaluated loans.

The reversal of provision for credit losses recognized during the year ended December 31, 2021 was due substantially to continued improvements in the economic forecast at December 31, 2021 as compared to the forecast at December 31, 2020.

Noninterest Income Overview

The following table presents the change in the key components of noninterest income for the periods indicated:

Year Ended December 31,

2021 2020 Change % Change

Year Ended December 31, Change

2022 2021 $ %

(Dollars in thousands)

Service charges and other fees $ 10,390 $ 9,207 $ 1,183 12.8 %

Gain on sale of investment securities, net 29 1,518 (1,489) (98.1)

Card revenue 8,885 8,325 560 6.7

Gain (loss) on sale of investment securities, net (256) 29 (285) (982.8)

Gain on sale of loans, net 633 3,644 (3,011) (82.6)

1 unchanged sentence

Bank owned life insurance income 3,747 2,520 1,227 48.7

2,520 4,319 (1,799) (41.7)

Gain on sale of other assets, net 469 4,405 (3,936) (89.4)

1 unchanged sentence

Total noninterest income $ 29,591 $ 34,615 $ (5,024) (14.5) %

Nonintere st income decreased due primarily to lower bank owned life insurance income as the year ended December 31, 2020 included the recognition of death benefits of $1.9 million and lower other income as last year included trust income of $1.6 million, including a termination fee of $651,000 from the divestiture of our trust department.

Additionally, noninterest income was lower due to reduced gain on sale of investment securities due to fewer sales, a decrease in gain on sale of loans due primarily to lower sales volume of secondary market mortgage loans and a decline in interest rate swap fees due to fewer executions of interest rate swap contracts.

Partially offsetting these decreases was an increase in gain on sale of other assets, net for the year ended December 31, 2021, including a $2.7 million gain from the sale and leaseback of the Company's headquarters in Olympia, Washington.

Nonintere st income decreased due primarily to lower gain on sale of other assets, net and lower gain on sale of loans, net.

The decrease in the gain on sale of other assets, net, was due to a higher gain on sale of branches held for sale recognized during the year ended December 31, 2021 as a result of branch consolidations.

The decrease in gain on sale of loans, net was due to a decline in origination and sales volumes as a result of the higher interest rate environment.

These decreases were partially offset by an increase in bank owned life insurance income due to the recognition of a death benefit of $1.0 million during year ended December 31, 2022 as well as increases in service charges and other fees and card revenue reflecting increased customer transactions as businesses reopened in our market areas.

Noninterest Expense Overview

The following table presents changes in the key components of noninterest expense for the periods indicated:

Year Ended December 31,

2021 2020 Change % Change

Year Ended December 31, Change

2022 2021 $ %

(Dollars in thousands)

6 unchanged sentences

Federal deposit insurance premium 2,015 2,106 (91) (4.3)

Other real estate owned, net — (145) 145 (100.0)

Year Ended December 31,

2021 2020 Change % Change

(Dollars in thousands)

Amortization of intangible assets 2,750 3,111 (361) (11.6)

1 unchanged sentence

Total noninterest expense $ 150,966 $ 149,269 $ 1,697 1.1 %

Noninterest expen se increased slightly due primari ly to an increase in data processing expense as the Bank continues to invest in technology.

Additionally, noninterest expense increased due to compensation and employee benefits primarily as a result of severance payments following a strategic reduction in force and an increase in accrual for incentive payments.

The increase in noninterest expense was offset partially by lower professional services expense due to costs incurred during the year ended December 31, 2020 related to the launch of the new mobile and online commercial banking platform "Heritage Direct" last year and secondarily due to t he decrease in ot her expense from lower branch consolidation costs recognized during the year ended December 31, 2021 compared to the same period in 2020.

Noninterest expense increased due primarily to an increase in compensation and employee benefits as a result of an increase in the number of full-time equivalent employees including the addition of commercial and relationship banking teams in the second quarter of 2022 and an increase in salaries and wages due to upward market pressure.

This increase was offset partially by a decrease in professional services, which were elevated during the year ended December 31, 2021 due to costs associated with our participation in the SBA PPP, as well as a decrease in marketing expenses due to less activity.

Income Tax Expense Overview

The following table presents the income tax expense and related metrics and the change for the periods indicated:

Year Ended December 31,

2021 2020 Change % Change

December 31, Change

2022 2021 $ %

(Dollars in thousands)

2 unchanged sentences

Effective income tax rate 17.7 % 18.6 % (0.9) % (4.8) %

Inco me tax expense and the effective income tax rate both increased due primarily to higher pre-tax income , which decreased the impact of favorable permanent tax items such as tax-exempt investments, investments in bank owned life insurance and low-income housing tax credits, and secondarily due to a provision in the CARES Act, which permitted the Company to recognize a $1.0 million benefit from net operating losses related to prior acquisitions during the year ended December 31, 2020 .

Additionally, the Bank's New Market Tax Credit was fully utilized during the seven year period ending December 31, 2020 and the related entiti es were dissolved in May 2021.

In 2021, the Bank formed HBCDE, LLC which was certified as a Community Development Entity by the Department of the Treasury Community Development Financial Institutions Fund in September 2021.

The newly created entity is expected to commence funding eligible loans during the year ended December 31, 2022 and apply for New Market Tax Credits in future years.

Income tax expense and the effective income tax rate both decreased due primarily to lower pre-tax income, which increased the impact of favorable permanent tax items such as tax-exempt investments, investments in bank owned life insurance and LIHTC.

Financial Condition Overview

The table below provides a comparison of the changes in the Company's financial condition for the periods indicated:

December 31, 2021 December 31, 2020 Change % Change

December 31, 2022 December 31, 2021 $ %

(Dollars in thousands)

12 unchanged sentences

Total assets $ 6,980,100 $ 7,432,412 $ (452,312) (6.1) %

December 31, 2021 December 31, 2020 Change % Change

(Dollars in thousands)

Liabilities and Stockholders' Equity

Deposits $ 5,907,420 $ 6,394,290 $ (486,870) (7.6) %

Deposits held for sale 17,420 — 17,420 100.0

Total Deposits 5,924,840 6,394,290 (469,450) (7.3)

Junior subordinated debentures 21,473 21,180 293 1.4

4 unchanged sentences

Retained earnings 345,346 293,238 52,108 17.8

Accumulated other comprehensive income, net 9,396 25,018 (15,622) (62.4)

Accumulated other comprehensive (loss) income, net (99,850) 9,396 (109,246) (1,162.7)

Total stockholders' equity 797,893 854,432 (56,539) (6.6)

Total liabilities and stockholders' equity $ 6,980,100 $ 7,432,412 $ (452,312) (6.1) %

Total assets increased due primarily to increases in cash and cash equivalents and total investment securities due primarily to the significant increase in total deposits, which is discussed in more detail in the "Deposit Activities Overview" section below.

The increase in total assets was offset partially by a decrease in loans receivable, net, which is discussed in more detail in the "Lending Activities Overview" section below.

Total assets decreased due primarily to a decrease in cash and cash equivalents reflecting deployment of excess liquidity into purchases of higher yielding investment securities and loans.

Total liabilities and stockholders' equity decreased due primarily to a decrease in deposits as well as a decrease in AOCI following an increase in market interest rates during the year ended December 31, 2022, which negatively impacted the fair value of our investment securities available for sale portfolio at December 31, 2022.

The changes are discussed in more detail in the sections below.

Investment Activities Overview

4 unchanged sentences

The following table provides information regarding our investment securities at the dates indicated:

December 31, 2021 December 31, 2020

December 31, 2022 December 31, 2021 Change

Total Balance % of

Total Change % Change

(Dollars in thousands)

13 unchanged sentences

Total investment securities $ 2,097,839 100.0 % $ 1,277,728 100.0 % $ 820,111 64.2 %

Total investment securities increased due primarily to purchases of $756.4 million, offset partially by maturities, calls and payments of investment securities of $255.9 million.

Additionally, we transferred $244.8 million of investment securities available for sale to investment securities held to maturity in order to mitigate market price volatility and its impact to AOCI within stockholders' equity.

Total investment securities increased due primarily to purchases to deploy excess liquidity into higher yielding, longer duration assets.

Purchases of investment securities available for sale were offset partially by a $139.1 million decrease in the fair value of these investment securities as a result of an increase in market interest rates resulting in an unrealized loss at December 31, 2022 of $128.6 million compared to an unrealized gain at December 31, 2021 of $10.5 million.

The following table provides the weighted average yield at December 31, 2022 calculated based upon the fair values of our investment securities available for sale and held to maturity and excluding any income tax benefits of tax-exempt bonds:

13 unchanged sentences

Total $ 34,862 1.98 % $ 445,268 3.14 % $ 361,903 2.64 % $ 489,410 2.69 % $ 1,331,443 2.81 %

In one year or less After one year through five years After five years through ten years After ten years Total

Value Yield Fair

(Dollars in thousands)

Investment securities held to maturity:

6 unchanged sentences

The Bank originates a wide variety of loans with a focus on commercial business loans.

In addition to originating loans, the Bank may also acquire loans through pool purchases, participation purchases and syndicated loan purchases.

The following table provides information about our loan portfolio by type of loan at the dates indicated:

December 31, 2021 December 31, 2020

Amortized Cost % of Loans Receivable Amortized Cost % of Loans Receivable Change % Change

December 31, 2022 December 31, 2021 Change

Amortized Cost % of Loans Receivable Amortized Cost % of Loans Receivable $ %

(Dollars in thousands)

13 unchanged sentences

Total $ 4,050,858 100.0 % $ 3,815,662 100.0 % $ 235,196 6.2 %

Loans receivable decreased due primarily to a decrease in SBA PPP loans as a result of forgiveness payments received from the SBA in excess of SBA PPP originations and elevated prepayments of commercial and industrial loans.

Additionally, the consumer loan portfolio decreased due partially to continued runoff of the indirect auto loan portfolio following the cessation of this business line during the three months ended March 31, 2020.

Offsetting these decreases was an increase in CRE loans which includes the transfer of several completed projects from real estate construction and land development loans.

SBA Paycheck Protection Program

The Bank has supported its community and customers during the COVID-19 Pandemic through its participation in the SBA's PPP.

The SBA PPP ended on May 31, 2021.

The Bank earns 1% interest on these loans as well as a fee from the SBA to cover processing costs, which is amortized over the life of the loan and recognized fully at payoff or forgiveness.

The Bank began processing loan forgiveness applications and receiving SBA PPP forgiveness payments during the three months ended December 31, 2020.

Loans receivable increased due primarily to higher loan demand as well as increased utilization of commercial and industrial lines of credit and a decline in loan prepayments.

The increase in residential real estate loans included $139.0 million of purchased residential real estate loans.

This increase was offset partially by repayments of SBA PPP loans and a decrease in consumer loans due primarily to repayments of $54.4 million in indirect loans as the Bank ceased indirect auto loan originations in 2020.

Composition of loans receivable by contractual maturity and interest type

6 unchanged sentences

Owner-occupied CRE 34,181 188,922 650,447 63,490 937,040

In one year or less After one year through five years After five years through 15 years After 15 years Total

(In thousands)

Non-owner occupied CRE 57,977 454,566 1,041,298 32,791 1,586,632

28 unchanged sentences

Under these derivative contract arrangements, the Bank effectively earns a variable rate of interest based on the one-month LIBOR plus a margin, except for interest rate swap contracts on construction loans that earn fixed rates until the end of the construction period and the variable rate swap becomes effective.

Loans classified as nonaccrual and performing TDR and nonperforming assets

The following table provides information about our nonaccrual loans, performing TDR loans and nonperforming assets for the dates indicated:

2021 December 31, 2020 Change % Change

As of December 31, 2022, there were $389.0 million of loans in our portfolio tied to LIBOR.

To mitigate the uncertainty surrounding the LIBOR transition, the Bank has been utilizing specific contract language in new loan agreements beginning in 2021 that provides for changes in the index used to calculate the loan's interest rate.

Additionally, effective January 25, 2021, the Bank agreed to adhere to the Interbank Offered Rate Fallbacks Protocol as published by the International Swaps and Derivatives Association, Inc recommended by the Alternative Reference Rates Committee.

Nonaccrual loans, accruing loans past due 90 days or more performing TDR loans and nonperforming assets

The following table provides information about our nonaccrual loans, accruing loans past due 90 days or more, performing TDR loans and nonperforming assets for the dates indicated:

2022 December 31, 2021 $ %

(Dollars in thousands)

1 unchanged sentence

Commercial business $ 5,869 $ 23,107 $ (17,238) (74.6) %

2022 December 31, 2021 $ %

Residential real estate

17 unchanged sentences

The following table provides the changes in nonaccrual loans during the periods indicated:

Year Ended December 31,

2021 2020 Change % Change

Year Ended December 31, Change

2022 2021 $ %

(In thousands)

4 unchanged sentences

Charge-offs (171) (1,190) 1,019 (85.6)

Transfer to OREO — (270) 270 (100.0)

Balance, end of period $ 5,906 $ 23,754 $ (17,848) (75.1) %

The decrease in nonaccrual loans during the year ended December 31, 2021 was due primarily to payoffs, including a payoff of an agricultural business relationship of $10.7 million, which was initially classified as nonaccrual during the three months ended September 30, 2019, and the return to accrual status of an owner-occupied CRE relationship of $7.0 million.

The Bank recovered $1.5 million of interest and fees on loans related to the payoff of the agricultural business relationship.

Additionally, the volume of additions to the nonaccrual loan classification decreased to $1.5 million during the year ended December 31, 2021 compared to $33.0 million last year which contributed to the lower ending balance of loans classified as nonaccrual.

The decrease in nonaccrual loans improved the Bank's credit quality ratios.

Nonaccrual loans decreased $17.8 million, or 75.1%, to $5.9 million due primarily to ongoing collection efforts, including the partial payoff of two large commercial and industrial loan relationships totaling $1.9 million and the transfer of six commercial business loan relationships totaling $10.2 million back to accrual status.

The Bank also sold a pool of 14 nonaccrual loans totaling $1.0 million during the year ended December 31, 2022.

Allowance for Credit Losses on Loans Overview

4 unchanged sentences

ACL on loans at the beginning of the period $ 42,361 $ 70,185 $ (27,824) (39.6) %

Impact of CECL Adoption — 1,822 (1,822) (100.0)

Adjusted ACL on loans, beginning of period 70,185 37,993 32,192 84.7

Commercial business (316) (1,276) 960 (75.2)

At or For the Years Ended December 31,

2022 2021 Change % Change

(Dollars in thousands)

Residential real estate

(30) — (30) 100.0

Real estate construction and land development — (1) 1 (100.0)

6 unchanged sentences

Total recoveries 2,081 1,420 661 46.5

Net charge-offs (526) (3,241) 2,715 (83.8)

Provision for credit losses on loans (27,298) 35,433 (62,731) (177.0)

Net recoveries (charge-offs) 1,188 (526) 1,714 (325.9)

(Reversal of) provision for credit losses on loans (563) (27,298) 26,735 (97.9)

ACL on loans at the end of period $ 42,986 $ 42,361 $ 625 1.5 %

4 unchanged sentences

ACL on loans to nonaccrual loans 727.84 178.33 549.51 308.1

ACL on loans to nonperforming assets 727.84 % 178.33 % 549.51 % 308.1 %

Average balances outstanding during the period:

4 unchanged sentences

Total $ 3,893,852 $ 4,237,969 $ (344,117) (8.1) %

Net charge-offs (recoveries) during the period to average balances outstanding during the period:

Net (recoveries) charge-offs during the period to average balances outstanding during the period:

Commercial business (0.02) % 0.01 % (0.03) % (300) %

Residential real estate — — — n/a

Residential real estate 0.01 — 0.01 0.01

Real estate construction and land development (0.16) (0.01) (0.15) 1500

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(2) Average balances exclude the ACL on loans and loans held for sale, but include loans classified as nonaccrual.

The ACL on loans decreased due primarily to a reversal of prov ision for credit losses on loans recorded during the year ended December 31, 2021 following improvements in the economic forecast used in the CECL model at December 31, 2021 as compared to the economic forecast at December 31, 2020 .

The ACL on loans increased due primarily to net recoveries offset partially by a reversal of provision for credit losses.

The reversal of provision for credit losses of $563,000 was due primarily to a reduction of loans individually evaluated for losses and as a result, their related ACL of $3.4 million, offset by an increase in ACL on loans collectively evaluated due to loan growth.

There were also improvements in the economic forecast used in the CECL model at December 31, 2022 as compared to the economic forecast at December 31, 2021.

T he economic forecast at December 31, 2022 considered the potential impact of inflation and potential recession;

however, the December 31, 2021 considered a more significant impact as a result of COVID-19 and related variants.

The following table presents the ACL on loans by loan portfolio segment at the indicated dates:

December 31, 2021 December 31, 2020

December 31, 2022 December 31, 2021 Change

ACL on loans Percent of

Change % Change

(Dollars in thousands)

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The following table summarizes the Company's deposits at the dates indicated:

December 31, 2021 December 31, 2020

Balance Percent of Total Balance Percent of Total Change % Change

December 31, 2022 December 31, 2021 Change

Percent of Total Balance Percent of Total $ %

(Dollars in thousands)

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Total deposits $ 5,924,840 100.0 % $ 6,394,290 100.0 % $ (469,450) (7.3) %

Total deposits increased due primarily to proceeds from SBA PPP loans originated during the year ended December 31, 2021 which were deposited directly into the customers' deposit accounts.

Total deposits includes uninsured deposits of $2.68 billion and $2.17 billion at December 31, 2021 and 2020, respectively, calculated in accordance with FDIC guidelines.

(1) Deposit balances includes deposits held for sale at December 31, 2022.

Total deposits decreased due primarily to competitive pricing pressures and customers moving excess funds to alternative higher yielding investments, utilization of funds received through the SBA PPP and investment in property and equipment by commercial deposit customers.

A portion of these balances were transferred to assets under management by the Bank's Wealth Management department.

The Bank entered into a purchase and sale agreement with a third party to sell and transfer assets, deposits and other liabilities of its branch in Ellensburg during the three months ended September 30, 2022.

As a result of entering into this purchase and sale agreement, $17.4 million in deposits are classified as held for sale.

The lower of amortized cost or fair value adjustment upon transferring these deposits to held for sale was not material.

The sale is expected to be completed during the second quarter of 2023;

however, the completion of this sale depends on many factors including regulatory approval.

Total deposits include uninsured deposits of $2.37 billion and $2.68 billion at December 31, 2022 and 2021, respectively, calculated in accordance with FDIC guidelines.

The Bank does not hold any foreign deposits.

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Stockholders' Equity Overview

The Company’s stockholders' equity to assets ratio was 11.5% as of December 31, 2021 and 12.4% as of December 31, 2020.

The Company’s stockholders' equity to assets ratio was 11.4% and 11.5% at December 31, 2022 and December 31, 2021.

The following table provides the changes to stockholders' equity during the periods indicated:

Year Ended December 31,

2021 2020 Change % Change

Year Ended December 31, Change

2022 2021 $ %

(In thousands)

Balance, beginning of period $ 854,432 $ 820,439 $ 33,993 4.1 %

Cumulative effect from change in accounting policy (1)

— (5,615) 5,615 (100.0)

Net income 81,875 98,035 (16,160) (16.5)

Dividends declared (29,767) (29,197) (570) 2.0

Year Ended December 31,

2021 2020 Change % Change

(In thousands)

Other comprehensive income, net of tax (15,622) 14,640 (30,262) (206.7)

Repurchase of common stock (22,889) (19,119) (3,770) 19.7

Other 3,666 3,681 (15) (0.4)

Other comprehensive loss, net of tax (109,246) (15,622) (93,624) 599.3

Common stock repurchased (3,196) (22,889) 19,693 (86.0)

Stock-based compensation expense 3,795 3,666 129 3.5

Balance, end of period $ 797,893 $ 854,432 $ (56,539) (6.6) %

(1) Effective January 1, 2020, the Bank adopted ASU 2016-13, Financial Instruments - Credit Losses .

The Company repurchased 904,972 and 795,700 shares of its common stock under the Company's stock repurchase plans during the year ended December 31, 2021 and 2020, respectively.

The repurchases represented approximately 2.5% and 2.2% of the Company's stock outstanding at the beginning of each year.

The Company has historically paid cash dividends to its common shareholders.

Payments of future cash dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including our business, operating results and financial condition, capital requirements, current and anticipated cash needs, plans for expansion, any legal or contractual limitation on our ability to pay dividends and other relevant factors.

Dividends on common stock from the Company depend substantially upon receipt of dividends from the Bank, which is the Company’s predominant source of income.

On January 26, 2022, the Company’s board of directors declared a regular quarterly dividend of $0.21 per common share payable on February 23, 2022 to shareholders of record on February 9, 2022.

Stockholder's equity decreased due primarily to a decrease in AOCI as a result of an increase in other comprehensive loss, net of tax, following increases in market interest rates during the year ended December 31, 2022, which negatively impacted the fair value of our investment securities available for sale.

AOCI has no effect on our regulatory capital ratios as the Company opted to exclude it from our common equity tier 1 capital.

Cash dividends and stock repurchases also contributed to the decrease in stockholders' equity, partly offset by net income earned during the year ended December 31, 2022.

The Company repurchased 100,090 and 904,972 shares of its common stock under the Company's stock repurchase plan during the years ended December 31, 2022 and December 31, 2021, respectively.

Liquidity and Capital Resources

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We maintain sufficient cash and cash equivalents and investment securities to meet short-term liquidity needs and actively monitor our long-term liquidity position to ensure the availability of capital resources for contractual obligations, strategic loan growth objectives and to fund operations.

Our funding strategy has been to acquire non-maturity deposits from our retail accounts, acquire noninterest bearing demand deposits from our commercial customers and use our borrowing availability to

fund growth in assets.

We may also acquire brokered deposits when the cost of funds is advantageous to other funding sources.

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Management believes the capital sources are adequate to meet all reasonably foreseeable short-term and intermediate-term cash requirements.

Critical Accounting Policies

Critical Accounting Estimates

Critical accounting estimates are those estimates made in accordance with generally accepted accounting principles that involve a significant level of estimation uncertainty and have had or are reasonably likely to have a material impact on the financial condition or results of operations of the registrant.

The Company considers its critical accounting estimates to be as follows:

ACL on Investment Securities

Investment securities issued by the U.S.

government and its agencies are either explicitly or implicitly guaranteed by the U.S.

government, highly rated by major credit rating agencies and have a long history of no credit losses and therefore management concluded any declines in fair value were attributable to changes in interest rates relative to where these investments fall within the yield curve and individual characteristics.

The remainder of investment securities available for sale were issued by municipal or corporate issuers.

Management examined the combination of credit ratings, at the individual security level, and an analysis of historical defaults by credit rating for municipal and corporate securities since 1970 and determined the probability and magnitude of loss was insignificant.

Management's reliance on credit ratings and an analysis of historical defaults is subjective and these historical inputs may not be suitable predictors of future performance.

Unanticipated changes in the credit ratings or the historical defaults could have a significant impact on our financial condition and results of operations.

For additional information regarding the ACL on investment securities, see Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements and Note (2) Investment Securities of the Notes to Consolidated Financial Statements included in Item 8.

Financial Statements And Supplementary Data.

Management's estimate of the ACL on loans relies on the identification, stratification and separate estimates of loss for loans individually evaluated for loss and loans collectively evaluated for loss.

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The Company performed its annual goodwill impairment test during the fourth quarter of 2022 and determined, based on a qualitative assessment utilizing the Company's market capitalization, that it is more likely than not that the fair value of the reporting unit exceeded the carrying value, such that the Company's goodwill was not considered impaired for the year ended December 31, 2022.

Changes in the economic environment, operations of the reporting unit or other adverse events, including as a result of COVID-19, could result in future impairment charges which could have a material adverse impact on the Company’s operating results.

Changes in the economic environment, operations of the reporting unit or other adverse events, could result in future impairment charges which could have a material adverse impact on the Company’s operating results.

For additional information regarding goodwill, see Note (1) Description of Business, Basis of Presentation, Significant Accounting Policies and Recently Issued Accounting Pronouncements and Note (7) Goodwill and Other Intangible Assets of the Notes to Consolidated Financial Statements included in Item 8.

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This Form 10-K contains certain financial measures not presented in accordance with GAAP in addition to financial measures presented in accordance with GAAP.

The Company has presented these non-GAAP financial measures in this Form 10-K because it believes that they provide useful and comparative information to assess trends in the Company’s performance and asset quality and to facilitate comparison of its performance with the performance of its peers.

The Company has presented these non-GAAP financial measures in this Form 10-K because it believes they provide useful and comparative information to assess trends in the Company’s performance and asset quality and to facilitate comparison of its performance with the performance of its peers.

These non-GAAP measures have inherent limitations, are not required to be uniformly applied and are not audited.

They should not be considered in isolation or as a substitute for financial measures presented in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.

Reconciliations of the GAAP and non-GAAP financial measures are presented in the tables below.

The Company believes presenting loan yield excluding the effect of discount accretion on purchased loans is useful in assessing the impact of acquisition accounting on loan yield as the effect of loan discount accretion is expected to decrease as the acquired loans mature or roll off its balance sheet.

Incremental accretion on purchased loans represents the amount of interest income recorded on purchased loans in excess of the contractual stated interest rate in the individual loan notes due to incremental accretion of purchased discount or premium.

Reconciliations of the GAAP and non-GAAP financial measures are presented below.

The Company believes presenting loan yield excluding the effect of discount accretion on acquired loans is useful in assessing the impact of acquisition accounting on loan yield as the effect of loan discount accretion is expected to decrease as the acquired loans mature or roll off its balance sheet.

Incremental accretion on acquired loans represents the amount of interest income recorded on acquired loans in excess of the contractual stated interest rate in the individual loan notes due to incremental accretion of purchased discount or premium.

Purchased discount or premium is the difference between the contractual loan balance and the fair value of acquired loans at the acquisition date, or as modified by the adoption of ASU 2016-13.

The purchased discount is accreted into income over the remaining life of the loan.

The impact of incremental accretion on loan yield will change during any period based on the volume of prepayments, but it is expected to decrease over time as the balance of the purchased loans decreases.

Similarly, presenting loan yield excluding the effect of SBA PPP loans is useful in assessing the impact of these special program loans that are anticipated to substantially decrease within a short time frame.

Year Ended December 31,

(Dollars in thousands)

Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans:

The impact of incremental accretion on loan yield will change during any period based on the volume of prepayments, but it is expected to decrease over time as the balance of the acquired loans decreases.

Similarly, presenting loan yield excluding the effect of SBA PPP loans is useful in assessing the impact of these special program loans that have substantially decreased within a short time frame.

Loan yield, excluding SBA PPP Loans and Incremental Accretion on Acquired Loans, annualized:

Interest and fees on loans (GAAP) $ 174,275 $ 189,832

Exclude SBA PPP loan interest and fees (32,109) (19,472)

Exclude incremental accretion on purchased loans (2,638) (3,446)

Exclude interest and fees on SBA PPP loans (5,215) (32,109)

Exclude incremental accretion on acquired loans (1,436) (2,638)

Adjusted interest and fees on loans (non-GAAP) $ 167,624 $ 155,085

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Adjusted average loans receivable, net (non-GAAP) $ 3,815,071 $ 3,632,042

Loan yield (GAAP) 4.54 % 4.44 %

Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans (non-GAAP) 4.27 % 4.52 %

The Company considers presenting the ratio of ACL on loans to loans receivable, excluding SBA PPP loans, to be a useful measurement in evaluating the adequacy of the Company's ACL on loans as the balance of SBA PPP loans is significant to the loan portfolio, and since SBA PPP loans are guaranteed by the SBA, the Company has not provided an ACL on loans for SBA PPP loans.

Loan yield, annualized (GAAP) 4.52 % 4.54 %

Loan yield, excluding SBA PPP loans and incremental accretion on acquired loans, annualized (non-GAAP) 4.39 % 4.27 %

The Company considers presenting the ratio of ACL on loans to loans receivable, excluding SBA PPP loans, to be a useful measurement in evaluating the adequacy of the Company's ACL on loans as the balance of SBA PPP loans was significant to the loan portfolio during the year ended December 31, 2021, and since SBA PPP loans are guaranteed by the SBA, the Company has not provided an ACL on loans for SBA PPP loans.

2022 December 31,

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ACL on Loans to Loans Receivable, excluding SBA PPP Loans:

Allowance for credit losses on loans $ 42,361 $ 70,185

Allowance for credit losses on loans (GAAP) $ 42,986 $ 42,361

Loans receivable (GAAP) $ 4,050,858 $ 3,815,662

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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 7. Management’s Discussion and Analysis