What changed in this filing

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Item 7. Management’s Discussion and Analysis

2023-02-22 compared with 2022-02-23 · 223 added, 224 removed, 629 unchanged (42% of the section changed)

1 unchanged sentence

Net income in 2022 was $103.8 million, up 8.4% from $95.7 million in 2021.

Net income for 2020 was 3.1% lower than $87.0 million in 2019.

Net income for 2021 was 13.5% higher than $84.3 million in 2020.

Diluted net income per common share was $4.04 in 2022, $3.74 in 2021 and $3.30 in 2020.

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The average equity to average assets ratio was 9.28% in 2022 compared to 10.96% in 2021 and 11.51% in 2020.

Net income in 2022 was positively impacted by a $24.8 million increase in net interest income.

Offsetting these positive impacts were a $5.9 million increase in noninterest expense, a $2.9 million decrease in noninterest income, and an $8.3 million increase in provision for credit losses.

Net income in 2021 was positively impacted by a $15.1 million increase in net interest income and a $13.7 million decrease in provision for credit losses.

Offsetting these positive impacts were a $13.1 million increase in noninterest expense and a $2.1 million decrease in noninterest income.

Net income in 2020 was $84.3 million, down 3.1% from $87.0 million in 2019 and up 4.9% from $80.4 million in 2018.

Diluted net income per common share was $3.30 in 2020 and $3.38 in 2019.

Return on average total assets was 1.55% in 2020 versus 1.76% in 2019.

Return on average total equity was 13.51% in 2020 versus 15.47% in 2019.

The dividend payout ratio, with respect to diluted earnings per share, was 36.36% in 2020 and 34.32% in 2019.

The average equity to average assets ratio was 11.51% in 2020 compared to 11.38% in 2019.

Net income in 2020 was positively impacted by an $8.0 million, or 5.1% increase, in net interest income and an $1.8 million, or 4.1% increase, in noninterest income.

Offsetting these positive impacts was an $11.5 million, or 356.6% increase, in the provision for credit losses and an $1.8 million, or 2.0%, increase in noninterest expense.

Total assets were $6.557 billion as of December 31, 2021 versus $5.830 billion as of December 31, 2020, an increase of $726.9 million or 12.5%.

This increase was primarily due to a $663.7 million increase in available-for-sale investment securities and an increase in short-term investments of $455.9 million.

The increase of investment securities reflects the deployment of $652 million in excess liquidity that resulted from deposit growth.

Deposit growth was impacted by PPP and economic stimulus.

Total average assets increased $729.0 million primarily due to a $434.4 million increase in available-for-sale investment securities and a $313.6 million increase in interest bearing deposits.

Total assets were $6.432 billion as of December 31, 2022 versus $6.557 billion as of December 31, 2021, a decrease of $125.0 million or 1.9%.

Early in 2022, the Company deployed $250.0 million of excess liquidity to the investment securities portfolio.

Loan growth of $422.6 million during 2022 was funded by cash and cash equivalents as well as deposits.

During the fourth quarter, deposit outflows from commercial and retail depositors contributed to the decline in deposits of $274.8 million during 2022.

Borrowings increased $222.0 million during 2022.

The increase was due to a $297.0 million increase in short-term borrowings at December 31, 2022, offset by the payoff of a $75.0 million long-term FHLB advance outstanding at December 31, 2021.

Total investment securities decreased $84.8 million during the year.

The decrease was driven primarily by a decrease in market value of available-for-sale securities as a result of the increased rate environment driven by the Federal Reserve's monetary tightening policy.

The decrease in fair value of available-for-sale investment securities was $236.9 million for the year 2022, from an unrealized gain position of $21.6 million at December 31, 2021 to an unrealized loss position of $215.3 million at December 31, 2022.

In addition, the Company elected to transfer securities from available-for-sale to held-to-maturity as an overall balance sheet management strategy in 2022.

The fair value of securities transferred during the second quarter of 2022 was $127.0 million, with $24.4 million in unrealized losses recorded in accumulated comprehensive income (loss) to be amortized over the remaining life of the securities transferred.

CRITICAL ACCOUNTING POLICIES

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The ultimate recovery of all loans is susceptible to future market factors beyond the Company’s control.

The level of credit loss provision is influenced by growth in the overall loan portfolio, emerging market risk, emerging concentration risk, commercial loan focus and large credit concentration, new industry lending activity, general economic conditions and historical loss analysis.

conditions and historical loss analysis.

In addition, management gives consideration to changes in the facts and circumstances of watch list credits, which includes the security position of the borrower, in determining the appropriate level of the credit loss provision.

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The Company has an established process to determine the adequacy of the allowance for credit losses that generally includes consideration of changes in the nature and volume of the loan portfolio and overall portfolio quality, along with current and forecasted economic conditions that may affect borrowers’ ability to repay.

Consideration is not limited to

these factors although they represent the most commonly cited factors.

Consideration is not limited to these factors although they represent the most commonly cited factors.

To determine the specific allocation levels for individual credits, management considers the current valuation of collateral and the amounts and timing of expected future cash flows as the primary measures.

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With respect to pools of similar loans, an appropriate level of general allowance is determined by portfolio segment using a probability of default-loss given default (“PD/LGD”) model, subject to a floor.

A default can be triggered by one of several different asset quality factors, including past due status, nonaccrual status, TDR status or if the loan has had a charge-off.

A default can be triggered by one of several different asset quality factors, including past due status, nonaccrual status, material modification to a borrower experiencing financial difficulty or if the loan has had a charge-off.

This PD is then combined with a LGD derived from historical charge-off data to construct a default rate.

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Commercial loans are subject to a dual standardized grading process administered by the credit administration function.

These grade assignments are performed independent of each other and a consensus is reached by credit administration and the loan review officer.

These grade assignments are performed independent of each other and a consensus is reached by credit administration and the loan officer.

Specific allowances are established in cases where management has identified significant conditions or circumstances related to an individual credit that indicate it should be evaluated on an individual basis.

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Due to the imprecise nature of estimating the allowance for credit losses, the Company’s allowance for credit losses includes an unallocated component.

The unallocated component of the allowance for credit losses incorporates the Company’s judgmental determination of potential expected losses that may not be fully reflected in other allocations, including factors such as the level of classified credits, economic uncertainties, industry trends impacting specific portfolio segments, broad portfolio quality trends, and trends in the composition of the Company’s large commercial loan portfolio and related large dollar exposures to individual borrowers.

The unallocated component of the allowance for credit losses incorporates the Company’s judgmental determination of potential expected losses that may not be fully reflected in other allocations.

As a practical expedient, the Company has elected to state accrued interest separately from loan principal balances on the consolidated balance sheet.

Additionally, when a loan is placed on non-accrual, interest payments are reversed through interest income.

For off balance sheet credit exposures outlined in the ASU at 326-20-30-11, it is the Company’s position that nearly all of the unfunded amounts on lines of credit are unconditionally cancellable, and therefore not subject to having a liability set up.

The allowance is inherently uncertain as it represents the Company’s expectation of the future collectability of loans in its portfolio;

actual collections may be greater than or less than expectations.

Actual collections may be impacted by wider economic conditions such as changes in the competitive environment or in the levels of business investment or consumer spending, or by the quality of borrowers’ management teams and the success of their strategy execution.

Actual collections may be impacted by wider economic conditions such as changes in the competitive environment or in the levels of business investment or consumer

spending, or by the quality of borrowers’ management teams and the success of their strategy execution.

Borrowers’ ability to repay may also change due to the effects of government monetary or fiscal policy, which could affect the level of demand for borrowers’ products or services.

The Company’s allowance for credit losses is subject to changes in the inputs to the model, including the following:

the numbers of delinquent loans, nonaccrual loans, troubled debt restructuring, or charge offs;

the number of delinquent loans, nonaccrual loans, material modification due to a borrower experiencing financial difficulty, or charge offs;

the levels of charge offs and recoveries;

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RESULTS OF OPERATIONS

In 2021 and 2020, the Company continued to grow loans and deposits organically, in its geographic footprint of northern Indiana and in central Indiana in the Indianapolis market.

In addition, during 2021 and 2020 the Company was an active participant in the PPP.

In 2022, the Company continued to grow loans organically in its geographic footprint of northern Indiana and in central Indiana in the Indianapolis market.

The Company had 52 branches as of December 31, 2022.

The Company’s profitability has been positively impacted by growth in loans and deposits and a reduction in provision for credit losses.

In addition, asset quality has remained stable.

The core banking contributions to noninterest income of loan, wealth management, and merchant card interchange fee income increased in 2021.

Overall, expense growth has reflected our continued investment in people, technology and our branch infrastructure.

The outlook for 2022 includes plans for continued organic loan growth and expanding our lending radius , a disciplined credit philosophy, continued investment in the Company in the form of staff additions, continued expansion in our geographic footprint, and continued investments in customer-facing technology and cybersecurity risk management tools.

The Company’s net interest income was positively affected by the monetary tightening policy of the Federal Reserve during 2022.

The rise in short-term interest rates and loan growth were the primary drivers of the 13.9% increase in net interest income for 2022.

The increase in net interest income was the primary driver for the 8.4% increase in net income of $8.1 million, as noninterest expense increased 5.7%, noninterest income decreased 6.4% and the provision for credit losses increased 770.5%.

Asset quality metrics remained stable with watch list loans as a percentage of total loans at a historic low of 3.42%.

Fee based lines of business including treasury management services, commercial loan fees, interchange fee income and merchant interchange fee income positively contributed to growth in noninterest income.

Overall, expense growth has reflected the Company's continued investment in people, technology and our branch infrastructure.

The outlook for 2023 includes plans for continued loan growth, disciplined credit philosophy, continued investments in human capital, enhancements to the Lake City Bank digital platform, and targeted expansion of our branch network in the Indianapolis market with two new offices planned in the next 18 months.

Selecte d income statement information for the years ended December 31, 2022, 2021 and 2020 is presented in the following table.

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Tangible capital ratio (2) 8.79 % 10.70 % 11.21 %

Net charge-offs (recoveries) to average loans 0.09 % 0.09 % 0.03 %

Adjusted tangible capital ratio (3) 11.30 % 10.47 % 10.78 %

Net charge-offs to average loans 0.10 % 0.09 % 0.09 %

Net interest margin 3.40 % 3.07 % 3.19 %

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(3) Non-GAAP financial measure.

Calculated by removing the fair market value adjustment impact of the available-for-sale investment securities portfolio from tangible equity and tangible assets.

Management believes this is an important measure because it provides better comparability to prior periods.

See reconciliation on the next page.

(4) Non-GAAP financial measure.

Calculated by subtracting the impact PPP loans had on average earnings assets, loan interest income, average interest bearing liabilities, and interest expense.

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A reconciliation of these non-GAAP financial measures is provided below (dollars in thousands, except per share data).

31, 2022 Dec.

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Tangible Common Equity 565,084 701,112 653,390

AOCI Market Value Adjustment 188,154 (17,056) (29.182)

Adjusted Tangible Common Equity 753,238 684,056 653,361

Assets $ 6,432,371 $ 6,557,323 $ 5,830,435

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Tangible Assets 6,428,568 6,553,529 5,826,641

Securities Market Value Adjustment 238,170 (21,589) (36,939)

Adjusted Tangible Assets 6,666,738 6,531,940 5,789,702

Ending Common Shares Issued 25,536,026 25,488,508 25,424,307

Tangible Book Value Per Common Share $ 22.13 $ 27.50 $ 25.70

Tangible Capital Ratio 10.70 % 11.21 % 12.02 %

Tangible Common Equity/Tangible Assets 8.79 % 10.70 % 11.21 %

Adjusted Tangible Common Equity/Adjusted Tangible Assets 11.30 % 10.47 % 10.78 %

Net Interest Income $ 202,887 $ 178,088 $ 163,008

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Net income was $103.8 million in 2022, an increase of $8.1 million, or 8.4%, versus net income of $95.7 million in 2021.

The increase in net income from 2021 to 2022 was primarily due to an increase in net interest income of $24.8 million, or 13.9%.

Offsetting the increase in net interest income, noninterest expense increased $5.9 million, or 5.7%, noninterest income decreased $2.9 million, or 6.4%, and the provision for credit losses increased $8.3 million, or 770.5%.

Net interest income for 2022 included $772,000 in PPP interest and fee income compared to $14.9 million for 2021.

The increase in provision expense for 2022 was driven primarily by the downgrade of a single commercial relationship that occurred in late December 2022.

The remaining increase in provision was driven by loan growth during the year.

Net income was $95.7 million in 2021, an increase of $11.4 million, or 13.5%, versus net income of $84.3 million in 2020.

The increase in net income from 2020 to 2021 was primarily due to an increase in net interest income of $15.1 million, or 9.3%, and a decrease in the provision for credit losses of $13.7 million, or 92.7%.

Noninterest expense increased $13.1 million, or 14.3%, and noninterest income decreased $2.1 million, or 4.5%.

Net interest income for 2021 included $14.9 million in PPP interest and fee income compared to $12.8 million for 2020.

The decrease in provision expense for 2021 was driven by improved economic conditions, which were supported by government stimulus programs and accommodative FOMC monetary policy.

Net income was $84.3 million in 2020, a decrease of $2.7 million, or 3.1%, versus net income of $87.0 million in 2019.

The decrease in net income from 2019 to 2020 was primarily due to an increase in the provision for credit losses of $11.5 million, or 356.6%, as well as an increase of $1.8 million, or 2.0%, in noninterest expense.

Net interest income increased $8.0 million, or 5.1%, and noninterest income increased $1.8 million, or 4.1%.

Net interest income for 2021 included $14.9 million in PPP interest and fee income.

The increase in provision for credit losses was driven by the potential negative impact to the Company's borrowers due to the economic impact of the COVID-19 pandemic.

The decrease in provision expense for 2021 was driven by improved economic conditions, which were supported by government stimulus programs and accommodative Federal Reserve Board's Federal Open Market Committee ("FOMC") monetary policy.

Net Interest Income

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Tax exempt (3) 35,576 2,094 5.89 14,638 594 4.06 18,478 813 4.40

Available-for-sale 1,068,325 25,582 2.39 633,956 17,830 2.81 603,580 17,930 2.97

Securities 1,432,287 38,882 2.71 1,068,325 25,582 2.39 633,956 17,830 2.81

Short-term investments 2,266 30 1.32 2,254 2 0.09 25,046 67 0.27

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Net loan fees attributable to PPP loans were $692,000, $12.5 million and $9.0 million for the years ended December 31, 2022, 2021 and 2020, respectively.

All other loan fees were immaterial in relation to total taxable loan interest income for the periods presented.

(2) Nonaccrual loans are included in the average balance of taxable loans.

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Tax exempt 1,141 359 1,500 (158) (61) (219)

Available-for-sale 10,724 (2,972) 7,752 879 (979) (100)

Securities 9,552 3,748 13,300 10,724 (2,972) 7,752

Short-term investments 0 28 28 (37) (28) (65)

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The tax equivalent rate for tax exempt loans and tax exempt securities acquired after January 1, 1983 included the TEFRA adjustment applicable to nondeductible interest expense.

Net interest income increased by $15.1 million to $178.1 million in 2021 compared to 2020, primarily due to a $721.8 million, or 13.9%, increase in average earning assets, driven by a $434.4 million increase in average available-for-sale investment securities and a $313.6 million increase in interest bearing deposits.

The yield on average earning assets decreased 44 basis points to 3.33% in 2021 from 3.77% in 2020.

The net interest margin decreased to 3.07% in 2021 versus 3.19% in 2020 , driven by continued margin compression and excess liquidity on the Company's balance sheet.

The net interest margin decreased to 3.19% in 2020 versus 3.38% in 2019, driven by the Federal Reserve Bank decreasing the target Federal Funds

Rate by 225 basis points since the second half of 2019, inclusive of two emergency cuts during March 2020, in response to the economic challenges from the COVID-19 pandemic.

Growth in the commercial loan portfolio accounted for most of the growth in loans.

Management believes that the growth in the loan portfolio, excluding the PPP loan program, will likely continue in a measured and prudent fashion as a result of our continued strategic focus on commercial and industrial lending, as well as commercial real estate lending.

Average total loans were flat at $4.421 billion at December 31, 2021 compared to $4.424 billion at December 31, 2020.

Average total loans, excluding PPP loans, were $4.183 billion at December 31, 2021 and represented growth of $135.5 million, or 3.3%, during 2021.

Loan growth, excluding PPP loans, was slower in 2021 and 2020 as compared to prior years due to excess liquidity on our customers' balance sheets and a slowdown in demand for manufacturing and industrial loans.

The utilization of commercial lines of credit has dropped in 2021 and 2020, due to softened loan demand, to 42% at December 31, 2021 from 43% at December 31, 2020 and 46% at December 31, 2019.

However, available lines of credit have increased by a record $557 million to $4.101 billion at December 31, 2021 compared to $3.544 billion at December 31, 2020.

Management believes that tepid loan demand has impacted the decrease in commercial line utilization and believes its organic growth strategy of continued expansion in its current geographic footprint and in Indianapolis will provide continued loan growth opportunities.

During 2021 a reduction in average loans of $3.4 million, growth in average available-for-sale investment securities of $434.4 million and growth in average short-term investments and interest bearing deposits of $290.8 million was funded through an increase in deposits.

Average demand deposits increased $361.3 million in 2021 and average interest bearing deposit accounts increased $345.4 million.

The increase in deposits for 2021 resulted from excess liquidity on our customers’ balance sheets resulting from a combination of PPP and economic stimulus.

As a result of this excess liquidity on the Company's balance sheet, management deployed $652 million into the available-for-sale investment securities portfolio during 2021.

Net interest income increased by $24.8 million to $202.9 million in 2022 compared to 2021, partially due to a $216.5 million, or 3.7%, increase in average earning assets.

The increase in average assets was primarily driven by a $364.0 million increase in average investment securities offset by a decrease in interest bearing deposits.

The yield on average earning assets increased 67 basis points to 4.00% in 2022 from 3.33% in 2021.

The higher earning asset yields and cost of funds were driven by the 425 basis points increase to the target Federal Funds rate implemented by the Federal Reserve Board beginning in 2022 to combat elevated levels of inflation affecting the U.S.

The target Federal Funds rate increased from a zero-bound range of 0.00% - 0.25% in March 2022 to a range of 4.25% - 4.50% at December 31, 2022.

Additionally, net interest margin during the year ended December 31, 2022 was positively impacted by the recognition of nonaccrual interest resulting from the interest recovery of two nonaccrual commercial borrowers during the fourth quarter of 2022.

The interest recovery was from

two loans placed on nonaccrual status in 2009 and 2021.

The $1.9 million of nonaccrual interest income was recognized into loan interest income and contributed 3 basis points to the Company's net interest margin during 2022.

The net interest margin increased to 3.40% in 2022 versus 3.07% in 2021.

The net interest margin decreased to 3.07% in 2021 versus 3.19% in 2020, driven by margin compression from the lower interest rate environment and excess liquidity on the Company's balance sheet.

During 2022, average loans increased $6.1 million and average investment securities increased $364.0 million.

The growth in average assets and average investment securities was funded by a reduction of interest bearing deposits of $153.5 million, growth in interest bearing liabilities of $151.7 million and growth in average demand deposits of $171.6 million.

The increase in average deposits for 2022 resulted from excess liquidity on our customers’ balance sheets resulting from a combination of PPP and economic stimulus.

As a result of this excess liquidity on the Company's balance sheet, management deployed an additional $250 million into the available-for-sale investment securities portfolio during 2022, bringing total excess liquidity deployment to the investment securities portfolio of $902 million since the beginning of 2021.

The utilization of commercial and retail lines of credit remained unchanged at 42% in 2022 and 2021 and down from 43% at December 31, 2020.

However, available lines of credit have increased by a record $651 million to $4.752 billion at December 31, 2022 compared to $4.101 billion at December 31, 2021, or 16% growth.

While overall line usage as a percentage of total line availability remained unchanged, management remains encouraged because of the healthy expansion in overall line availability due to strong demand for traditional working capital from our commercial and industrial client base as well as continued development activity within our commercial real estate markets.

Provision for Credit Losses

On December 27, 2020, President Trump signed into law the Consolidated Appropriations Act, 2021.

This law extended relief for troubled debt restructurings and provided the opportunity to further delay CECL adoption originally provided under the CARES Act.

The Company elected to defer adoption of CECL until January 1, 2021.

Prior to this, provision expense was recorded under the incurred loss methodology.

The day one impact of the adoption was an increase in the allowance for credit losses of $9.1 million, with an offset, net of taxes, to beginning stockholders' equity.

The Company recorded a provision for credit losses of $9.4 million in 2022 compared to $1.1 million in 2021 and $14.8 million in 2020.

The lower provision in 2021 was driven by improvement in the financial condition and outlook of the Company's borrowers.

The increased provision in 2022 was driven by provision expense of $7.0 million related to the downgrade of a single $10.7 million commercial relationship.

The remainder of the increase was due to growth in the overall loan portfolio.

The Company’s allowance for credit losses as of December 31, 2022 was $72.6 million compared to $67.8 million as of December 31, 2021 and $61.4 million as of December 31, 2020.

The allowance for credit losses represented 1.54% of total loans as of December 31, 2022 versus 1.58% at December 31, 2021 and 1.32% at December 31, 2020.

CECL adoption included a one-time increase to the allowance for credit losses of $9.1 million.

The company’s credit loss reserve to total loans, excluding PPP loans, was 1.54% at December 31, 2022 compared to 1.59% at December 31, 2021 and 1.45% at December 31, 2020.

PPP loans are guaranteed by the United States SBA and have not been allocated for within the allowance for credit losses.

Net charge-offs of $3.8 million, or 0.09% of average loans, and net charge-offs of $4.0 million, or 0.09% of average loans, were recorded in 2021 and 2020, respectively.

Net charge-offs of $4.5 million, or 0.10%, and $3.8 million, or 0.09%, of average loans, were recorded in 2022 and 2021, respectively.

The charge offs for 2022 and 2021 resulted primarily from a single commercial credit each year.

Management believes the charge offs were one-off instances and are not reflective of deteriorating trends in the loan portfolio.

The Company’s management continues to monitor the adequacy of the provision based on loan levels, asset quality, economic conditions including the impact of the COVID-19 pandemic and other factors that may influence the assessment of the collectability of loans.

Management believes the charge offs were isolated instances that were negatively impacted by unique circumstances resulting from the pandemic and are not reflective of deteriorating trends in the loan portfolio.

The Company’s management continues to monitor the adequacy of the provision based on loan levels, asset quality, economic conditions including inflation and the resulting impact on the interest rate environment, and other factors that may influence the assessment of the collectability of loans.

The Company adopted CECL on January 1, 2021.

Prior to this date, provision expense was recorded under the incurred loss methodology.

The day one impact of the adoption was an increase in the allowance for credit losses of $9.1 million, with an offset, net of taxes, to stockholders' equity.

Noninterest Income

The following table presents changes in the components of noninterest income for the years ended December 31.

The following table presents changes in the components of noninterest income for the years ended December 31, 2020, 2021 and 2022.

% Change From

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Noninterest income was $41.9 million in 2022 versus $44.7 million in 2021, a decrease of $2.9 million, or 6.4%.

Market value declines impacted the overall decrease in noninterest income.

Bank owned life insurance income for the year ended December 31, 2022 decreased by $2.0 million, primarily due to declines in the market value of variable life insurance policies that are tied to the equity markets.

A reduction of market value of $950,000 was recorded during 2022 compared to market value gains of $1.1 million for 2021.

The valuation changes to the variable life insurance policies are offset by similar changes to the deferred compensation expense that is recognized in salary and employee benefits.

Excluding the impact of the variable life insurance policy market value changes, noninterest income was $42.8 million for the year ended December 31, 2022, compared to $43.7 million for the year-ended December 31, 2021, a decline of $840,000, or 2.1%.

In addition, other income decreased $851,000, mortgage banking income decreased by $785,000, gains on securities sales decreased by $776,000 and interest rate swap fee income decreased by $456,000.

Notably, fee-based noninterest income increased by a cumulative $2.0 million primarily due to volume, including improvements in service charges on deposit accounts of $987,000, or 9.3%, merchant and interchange fee income of $537,000, or 17.8%, investment brokerage fees of $343,000, or 17.4%, and loan and service fees of $292,000, or 2.4%.

Wealth advisory fees declined by $114,000, or 1.3%, and were negatively impacted by market value declines of 8.0% in trust assets from $2.5 billion at December 31, 2021 to $2.3 billion at December 31, 2022.

Noninterest income was $44.7 million in 2021 compared to $46.8 million in 2020, a decrease of $2.1 million, or 4.5%.

The decrease was primarily driven by a $4.1 million decrease in interest rate swap fees generated from commercial lending transactions, as well as a $2.5 million decrease in mortgage banking income.

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The carrying value of mortgage servicing rights was negatively impacted by increased prepayment speeds, resulting from the low interest rate environment.

Offsetting these decreases were an increase in loan service fees of $1.8 million, an increases in wealth advisory and investment brokerage fees of $1.6 million, an increase in merchant and interchange fees of $615,000, and an increase in service charges on deposit accounts of $498,000.

The increases in fee income were driven by growth in fee-based businesses including from the wealth advisory group, merchant services, debit card interchange and institutional services areas due to higher transaction volumes and increased economic activity.

Noninterest income was $46.8 million in 2020 versus $45.0 million in 2019 , an increase of $1.8 million, or 4.1% higher.

The increase was primarily driven by a record $3.4 million increase in interest rate swap fees generated from commercial lending transactions, as well as a $2.3 million increase in mortgage banking income.

Noninterest income was also positively impacted by increase in wealth advisory fees due to continued growth of client relationships.

Offsetting these increases was a decrease in service charges on deposit accounts driven primarily by lower treasury management fees as well as reduced levels of overdraft fee income.

Offsetting these decreases were an increase in loan service fees of $1.8 million, an increase in wealth advisory and investment brokerage fees of $1.6 million, an increase in merchant and interchange fees of $615,000, and an increase in service charges on deposit accounts of $498,000.

The increases in fee income were driven by growth in fee-based business including from the wealth advisory group, merchant services, debit card interchange and institutional services areas due to higher transaction volumes and increased economic activity.

Noninterest Expense

The following table presents changes in the components of noninterest expense for the years ended December 31.

The following table presents changes in the components of noninterest expense for the years ended December 31, 2020, 2021 and 2022.

% Change From

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Total noninterest expense $ 110,210 $ 104,287 $ 91,205 5.7 % 14.3 %

Noninterest expense increased by $5.9 million, or 5.7%, for the year ended December 31, 2022, to $110.2 million compared to $104.3 million for the year ended December 31, 2021.

The increase was due primarily to an increase of $4.2 million in other expense caused by accruals for ongoing legal matters of $3.5 million.

See "Note 1 – Summary of Significant Accounting Policies" for additional details regarding loss contingencies.

Corporate and business development expense increased $936,000, or 22.0%, driven by increased corporate development spending, advertising expense and charitable and foundation contributions, including contributions associated with the Company's sesquicentennial celebration.

Salaries and benefits expense increased $648,000, or 1.1%.

Offsetting these increases was a decrease in professional fees of $581,000, or 8.2%, due to a decrease in legal expense incurred during the year.

FDIC insurance and other regulatory fee expense decreased by $243,000, or 10.8%, due to declining deposits and reduced total assets of the Company.

Noninterest expense increased by $13.1 million, or 14.3%, to $104.3 million for the year ended December 31, 2021 as compared to $91.2 million for 2020.

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Corporate and business development expenses increased as the 2021 economy re-opened, and client events and contributions increased in 2021.

Noninterest expense was $91.2 million in 2020 versus $89.4 million in 2019, an increase of $1.8 million, or 2.0%.

Data processing fees increased $1.5 million in 2020 primarily due to the Company's continued investment in customer focused, technology-based solutions and ongoing cybersecurity and data management enhancements.

FDIC insurance and other regulatory fees increased $1.1 million due to the expiration of insurance assessment credits and growth of the balance sheet.

Professional fees increased by $670,000 primarily due to higher legal expenses, increased fees to accounting firms and professional fees for innovative project implementations.

Salaries and employee benefits increased primarily due to an increase in staffing at revenue producing and risk management areas as well as higher health insurance expenses.

Offsetting these increases were decreases in corporate and business development as the COVID-19 pandemic forced the cancellation and postponement of events, in-person trainings and face-to-face customer and prospect meetings due to COVID-19 safety protocols.

The Company spent approximately $640,000 since the pandemic began on personal protective equipment, protective barriers and enhanced social distancing measures for the safety of bank customers and employees.

As previously disclosed, in the third quarter of 2019, t he Bank discovered potentially fraudulent activity by a former treasury management client involving multiple banks.

The former client subsequently filed several related bankruptcy cases, captioned In re Interlogic Outsourcing, Inc., et al ., which are pending in the United States Bankruptcy Court for the Western District of Michigan.

On April 27, 2021, the bankruptcy court entered an order approving an amended plan of liquidation, which was filed by the former client, other debtors and bankruptcy plan proponents, and approving the consolidation of the assets in the aforementioned cases under the Khan IOI Consolidated Estate Trust.

On August 9, 2021, the liquidating trustee for the bankruptcy estates filed a complaint against the Bank and the Company, and has agreed to stay prosecution of the action through March 31, 2022.

The action is focused on a series of business transactions among the client, related entities, and the Bank, which the liquidating trustee alleges are voidable under applicable federal bankruptcy and state law.

The complaint also addresses treatment of the Bank’s claims filed in the bankruptcy cases.

Based on current information, we have determined that a material loss is neither probable nor estimable at this time, and the Bank and the Company intend to vigorously defend themselves against all allegations asserted in the complaint.

Future noninterest expense may continue to be impacted due to the COVID-19 pandemic.

For example, continued economic reopening and growth may impact balance sheet growth and resulting revenue growth which could increase the amount the Company pays in incentive-based compensation.

In addition, prolonged supply chain disruptions, labor availability shortages and increased infection rates due to COVID-19 variants could halt the economic recovery and resulting elevated provision expense which may reduce net income and diluted earnings per share, a key performance metric that impacts incentive-based compensation targets.

The Company recognized income tax expense in 2022 of $21.3 million, compared to $21.7 million in 2021 and $19.5 million in 2020.

The effective tax rate in 2021 was 18.5% compared to 18.8% in 2020, and 18.9% in 2019.

The effective tax rate was 17.1% in 2022, compared to 18.5% in 2021 and 18.8% in 2020.

The effective tax rate declined due to the Indiana Financial Institution Tax rate being 5.0% in 2022, 5.5% in 2021 and 6.0% in 2020 as well as an increase in tax-free interest income from municipal securities and loans during 2022 and 2021.

For a detailed analysis of the Company’s income taxes see "Note 12 – Income Taxes".

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Dividend payout ratio is computed by dividing dividends declared per common share by earnings per diluted common share for each indicated fiscal year.

Refer to the "Financial Condition - Loan Portfolio", "Financial Condition - Sources of Funds" and "Risk Management - Loan Portfolio" sections of this MD&A and to the Notes to Consolidated Financial Statements of this Form 10-K for the other required disclosures.

FINANCIAL CONDITION

Total assets of the Company were $6.557 billion as of December 31, 2021, an increase of $726.9 million, or 12.5%, when compared to $5.830 billion as of December 31, 2020.

Total loans, excluding PPP loans, increased by $24.5 million, or 0.6%, as of December 31, 2021 from $4.237 billion at December 31, 2020.

Total loans outstanding decreased by $361.3 million, or 7.8%, to $4.288 billion at December 31, 2021 from $4.649 billion at December 31, 2020.

Total assets of the Company were $6.432 billion as of December 31, 2022, a decrease of $125.0 million, or 1.9%, when compared to $6.557 billion as of December 31, 2021.

Total loans, excluding PPP loans, increased by $447.2 million, or 10.5%, to $4.709 billion as of December 31, 2022 from $4.262 billion at December 31, 2021.

Total loans outstanding increased by $422.6 million, or 9.9%, to $4.710 billion at December 31, 2022 from $4.288 billion at December 31, 2021.

PPP loans outstanding were $1.5 million as of December 31, 2022, compared to $26.2 million at December 31, 2021.

The company received PPP forgiveness proceeds and borrowers' repayment of $709.5 million from the SBA for loans since the program's inception.

Cash and cash equivalents increased by $433.3 million and available-for-sale securities increased by $663.7 million.

Funding for the investment securities portfolio and organic loan growth came from a $698.6 million increase in total deposits as well as a $54.1 million increase in retained earnings, offset by an $10.5 million decrease in total borrowings.

Total deposits decreased $274.8 million, from $5.735 billion at December 31, 2021, to $5.461 billion at December 31, 2022, as retail and commercial depositors utilized excess liquidity on their balance sheets.

Deposits contracted $274.8 million in 2022 and $203.5 million of that decrease occurred during the fourth quarter.

The $553.0 million decrease in cash and cash equivalents was utilized to fund $447.2 million in net organic loan growth during 2022.

Additionally, the Company deployed $250.0 million for the purchase of available-for-sale investment securities during the first quarter of 2022.

In mid 2022, the Company elected to utilize principal and interest cash flows from the investment securities portfolio to supplement liquidity for funding loans.

Cash flows from the investment securities portfolio provided $114.0 million of liquidity during 2022.

In addition, the Company utilized short-term borrowings of $297.0 million to offset deposit outflows.

Uses of Funds

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See "Note 2 – Securities" for more information on these investments.

On April 1, 2022, the Company elected to transfer $151.4 million in net book value of municipal bonds from the available-for-sale securities portfolio to held-to-maturity as an overall balance sheet management strategy.

The fair value of these securities transferred was $127.0 million.

Purchases of securities available-for-sale totaled $315.3 million in 2022, $835.0 million in 2021 and $216.5 million in 2020.

Growth of the investment portfolio during the past three years serves to provide liquidity for the Company and provide longer duration as an offset to the short duration of the loan portfolio.

The Company deployed $652 million in excess liquidity into the investment securities portfolio during 2021 and $100 million in 2020 in order to preserve net interest income in the current rate and economic environment.

Growth of the investment portfolio during the past three years served to provide an earning asset alternative for excess balance sheet liquidity stemming from increased levels of core deposits as a result of the U.S.

government's COVID-19 pandemic stimulus programs.

The Company deployed $250 million of excess liquidity to the investment securities portfolio during 2022, $652 million in 2021 and $100 million in 2020 to preserve net interest margin prior to the Federal Reserve Board's tightening cycle, which began in March of 2022.

Investment securities represented 20% of total assets on December 31, 2022 compared to 21% on December 31, 2021 and 13% on December 31, 2020.

Management expects the investment portfolio as a percent of total assets to normalize once core loan growth demand increases and investment security repayments are deployed into loan growth.

Management expects the investment securities portfolio as a percentage of assets to decrease over time and return to historical levels of approximately 14% as the proceeds from paydowns and maturities of these investment securities are used to fund future loan portfolio growth.

Securities sales totaled $25.3 million in 2022, $14.0 million in 2021 and $8.0 million in 2020.

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Maturities and calls of securities totaled $9.3 million , $24.7 million and $7.6 million in 2022, 2021 and 2020, respectively.

No provision for allowance for credit loss was recorded in connection with the investment securities portfolio in 2021, and n o other-than-temporary impairment was recognized in 2020 or 2019.

No provision for allowance for credit loss was recorded in connection with the investment securities portfolio in 2022 or 2021, and n o other-than-temporary impairment was recognized in 2020.

The investment portfolio is managed to provide for an appropriate balance between liquidit y, credit risk and investment return and to limit the Company’s exposure to risk to an acceptable level.

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residential 4,960 3.40 % 6,579 3.32 % 36,979 2.51 % 443,790 2.12 %

Mortgage-backed securities:

commercial 523 2.48 % 0 0.00 % 0 0.00 % 0 0.00 %

State and municipal securities 1,386 3.60 % 5,070 4.44 % 51,228 3.43 % 616,570 3.02 %

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Real Estate Mortgage Loans Held For Sale

Real estate mortgages held for sale decreased by $3.7 million to $7.5 million at December 31, 2021 from $11.2 million at December 31, 2020 as a result of reduced mortgage refinancing demand compared to refinancing activity during 2020.

Real estate mortgages held for sale decreased by $7.1 million to $357,000 at December 31, 2022 from $7.5 million at December 31, 2021 as a result of reduced mortgage refinancing demand caused by the rising interest rate environment.

This asset category is subject to a high degree of variability depending on, among other things, recent mortgage loan rates and the timing of loan sales into the secondary market.

The Company generally sells almost all of the mortgage loans it originates in the secondary market.

The Company generally sells almost all of the conforming mortgage loans it originates in the secondary market.

Proceeds from sales totaled $36.5 million in 2022, $126.4 million in 2021 and $114.2 million in 2020.

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Total Loans 100.00 % 100.00 % 100.00 %

In 2021, net loan balances decreased by $367.7 million to $4.220 billion, which excludes approximately $119.4 million in loans originated for sale.

PPP loans of $26.2 million are included in non-working capital loans of commercial and industrial loans at December 31, 2021.

In 2020, net loan balances increased by $572.6 million to $4.588 billion, which excludes approximately $117.6 million in loans originated for sale.

PPP loans of $412.0 million were included in non-working capital loans of commercial and industrial loans at December 31, 2020.

In 2019, net loan balances increased by $148.9 million to $4.015 billion, which excludes approximately $66.0 million in loans originated for sale.

The mix of loan types within the Company’s portfolio continued a trend toward a higher percentage of the total loan portfolio being in commercial loans.

This higher percentage of commercial loans to the total portfolio was a result of the Company’s long standing strategic plan that is focused on organic expansion and growth in commercial loans.

Commercial and industrial loans together with owner occupied commercial real estate loans represent 49.6% and 52.4% of total loans as of December 31, 2021 and 2020, respectively.

The owner-occupied commercial real estate loans tend to represent the real estate holding of our commercial and industrial loan customers.

Another significant loan segment are loans to the agri-business sector.

During 2021, the Bank ranked as the third largest agricultural lender in the State of Indiana.

In 2022, net loan balances increased by $417.7 million to $4.638 billion, and excludes approximately $28.7 million in loans originated for sale.

In 2021, net loan balances decreased by $367.7 million to $4.220 billion, and excluded approximately $119.4 million in loans originated for sale.

In 2020, net loan balances increased by $572.6 million to $4.588 billion, and excluded approximately $117.6 million in loans originated for sale.

PPP loans of $1.5 million, $26.2 million and $412.0 million were included in non-working capital loans of commercial and industrial loans at December 31, 2022, 2021 and 2020, respectively.

The mix of The Company's loan portfolio consists primarily of commercial loans and the Bank's lending focus is on the commercial sector of the Lake City Bank footprint.

Owner occupied commercial real estate loans represent in many instances the buildings and factories of our commercial and industrial borrowers.

Commercial and industrial loans together with owner occupied commercial real estate loans represented 47.8% and 49.6% of total loans as of December 31, 2022 and 2021, respectively.

Loans to the agriculture and agri-business sector of our Indiana footprint represent a significant loan segment of the overall loan portfolio.

This loan segment is well diversified with loans to corn, soybean, poultry, dairy, swine, beef and egg growers.

The residential construction and land development loans class included construction loans totaling $12.0 million and $3.3 million as of December 31, 2022 and 2021.

Declines in consumer loans during 2021 resulted from paydowns due to borrower excess liquidity generated from mortgage refinancing activity and government stimulus programs.

The Bank generally sells conforming mortgage loans which it originates on the secondary market.

Increases in consumer loans during 2022 resulted from an increased focus on indirect lending to consumers and the introduction of a new adjustable rate mortgage product.

The Bank generally sells conforming mortgage loans, which it originates locally, into the secondary market.

These loans generally represent mortgage loans that are made to clients with long-term or substantial relationships with the Bank on terms consistent with secondary market requirements.

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Based upon the table above, all loans due after one year which have a predetermined interest rate and loans due after one year which have floating or adjustable interest rates as of December 31, 2022 amounted to $1.729 billion and $1.622 billion, respectively.

Paycheck Protection Program

During 2020 and the first half of 2021, the Bank funded PPP loans totaling $735.6 million for its customers through the PPP programs.

In addition, the Bank processed forgiveness applications for PPP loans representing 97% of loans originated.

As of December 31, 2021, PPP loans outstanding, net of deferred fees, totaled $26.2 million;

$3.8 million from PPP round one and $22.3 million from PPP round two.

As of December 31, 2021, the SBA has approved forgiveness of, or borrowers repaid, $709.5 million in PPP loans;

$566.7 million for PPP loans originated during round one and $142.8 million for PPP loans originated during round two.

As of December 31, 2021, the Bank had submitted additional PPP forgiveness applications on behalf of customers in the amount of $8.3 million that were awaiting SBA approval.

December 31, 2021

Originated Forgiven / Repaid Outstanding (1)

Number Amount Number Amount Number Amount

PPP Round 1 2,409 $ 570,500 2,390 $ 566,682 19 $ 3,818

PPP Round 2 1,192 165,142 1,117 142,809 75 22,333

Total 3,601 $ 735,642 3,507 $ 709,491 94 $ 26,151

Bank Owned Life Insurance

Bank owned life insurance increased by $10.8 million to $108.4 million at December 31, 2022 and by $2.4 million to $97.7 million at December 31, 2021 from $95.2 million at December 31, 2020.

The increase during 2021 was primarily due to investment returns on the life insurance policies of pre-existing life insurance policies.

The increase during 2022 was primarily due to the purchase of additional life insurance policies on officers of the Bank.

Bank owned life insurance provides investment income from the securities the life insurance is invested in and offsets benefit plan expenses for participants covered by insurance.

The increase during 2021 was primarily due to investment returns on the life insurance policies of pre-existing life insurance policies.

Bank owned life insurance investment income is used as an offset to the cost of life insurance purchased by the Bank as a benefit for bank officers.

Sources of Funds

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Total time certificates of deposit $ 455,427 $ 170,759 $ 626,186 100.00 %

Total deposits increased by $698.6 million to $5.735 billion, comparing December 31, 2021 to December 31, 2020.

The increase in deposits consisted of growth of $703.6 million in core deposit combined with a decrease of $5.0 million in brokered deposits.

Total deposit growth was led by an increase of $321.9 million, or 16.6%, in commercial deposits.

In addition, retail deposits increased by $259.5 million, or 13.5%, while public funds deposits increased by $122.2 million, or 10.5%.

PPP loan proceeds to borrowers and government stimulus to consumers impacted the increase in deposit during 2021 as loan proceeds and stimulus payments were deposited into customer checking and savings accounts at the Bank.

Proceeds from the sale of customer businesses also contributed to the increase of deposits during 2021.

Total deposits increased by $903.0 million to $5.037 billion, comparing December 31, 2020 to December 31, 2019.

The growth in deposits consisted of $1.002 billion in core deposit growth offset by a decrease of $98.5 million in brokered deposits.

Total deposits decreased by $274.8 million to $5.461 billion, at December 31, 2022 compared to December 31, 2021.

The decrease in deposits was attributable to a decrease in core deposits.

Total deposit contraction was led by a decrease of $243.7 million, or 11.2%, in retail deposits.

In addition, commercial deposits decreased $176.3 million, or 7.8%, while public funds deposits increased by $145.2 million, or 11.3%.

The decrease in deposits during 2022 reflects the normalization of excess liquidity in our customer's deposit accounts and occurred primarily during the fourth quarter of 2022.

Rising inflation is considered a contributor to the decline in deposits during 2022 after the surge in deposits experienced during 2020 and 2021 from PPP funding and COVID-related stimulus programs.

Total deposits increased by $698.6 million to $5.735 billion, at December 31, 2021 compared to December 31, 2020.

The growth in deposits consisted of $703.6 million in core deposit growth offset by a decrease of $5.0 million in brokered deposits.

Total deposit growth was led by an increase of $321.9 million, or 16.6%, in commercial deposits.

In addition, retail deposits increased by $259.5 million, or 13.5%, while public funds deposits increased by $122.2 million, or 10.5%.

The growth in deposits in 2020 resulted from increased deposit balances from new and existing customers, as well as a decreased utilization of brokered deposits.

Deposit growth was impacted by excess liquidity on customer balance sheets resulting from PPP loans, due to both economic stimulus payments made to retail customers and an increase in savings rates.

Core deposit growth enabled the Company to reduce reliance on wholesale funding during 2020 and 2021.

PPP loan proceeds to borrowers and government stimulus to consumers impacted the increase in deposits during 2021 as loan proceeds and other stimulus payments were deposited into customer checking and savings accounts at the Bank.

Proceeds from the sale of customer businesses also contributed to the increase in deposits during 2021.

As previously noted, 26% of the Company’s deposit base is attributable to public fund entities which primarily represent customers in the Company’s geographic footprint.

A majority of public fund balances represent customers with operating accounts at the Bank.

A shift in funding away from public fund deposits could require the Company to execute alternative funding plans under the Contingency Funding Plan discussed in further detail under “Liquidity Risk” below.

The following table presents total deposits by portfolio segment as of December 31, 2022, 2021 and 2020:

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FHLB Advances and Other Borrowings

During 2022, average total short-term borrowings increased by $6.2 million to $6.6 million, as the Company's excess liquidity position normalized after experiencing a reduction in cash and short-term investments.

Ending balances of short-term and miscellaneous borrowings increased to $297.0 million at December 31, 2022, from $0 at December 31, 2021.

Average total long-term borrowings decreased by $42.9 million to $32.1 million, due to the repayment of a $75.0 million long-term, putable FHLB advance.

The FHLB excercised its putable option during the second quarter of 2022 .

During 2021, average total short-term borrowings decreased by $33.9 million to $408,000, primarily due to lower short-term FHLB borrowings and lower usage of the Company's holding company line of credit.

Ending balances of short-term and miscellaneous borrowings decreased $10.5 million during 2021 to $0.

Ending balances of short-term and miscellaneous borrowings decreased by $10.5 million during 2021 to $0.

The decrease was due to the payoff of the Company's holding company line of credit which was used in connection with its share repurchase activity during 2020.

The holding company's line repayment was funded by a dividend from the Bank.

There was no share repurchase activity during 2021.

Short-term FHLB borrowings are used to fund short-term balance sheet growth due to the flexible nature of the financial instrument and allow the Company to prudently fund commercial or retail loans when opportunities are presented.

Average total long-term borrowings increased by $12.7 million to $75.0 million, due to a $75.0 million long-term FHLB borrowing taken in 2020 that was outstanding for all of 2021.

During 2020, average total short-term borrowings decreased by $27.0 million to $34.3 million, primarily due to the payoff of outstanding short-term FHLB borrowings.

During 2020, the Company utilized $10.5 million of the holding company's $30.0 million revolving line of credit in connection with its share repurchase activity.

Average total long-term borrowings increased by $31.5 million to $62.3 million, primarily due to a $75.0 million long-term FHLB borrowing offset by the repayment of the Company's subordinated debentures in December 2019.

The Company believes that a strong, appropriately managed capital position is critical to support continued growth of loans and earnings.

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The Company also had a Tier 1 leverage ratio of 11.50% and a tangible equity ratio of 8.79%.

See Note 16 – Capital Requirements for more information.

When excluding the impact of accumulated other comprehensive income (loss) on tangible common equity, the Company's adjusted tangible common equity to adjusted tangible assets was 11.30%.

See "Note 15 – Capital Requirements and Restrictions on Retained Earnings" for more information.

The ability to maintain these ratios is a function of the balance between net income and a prudent dividend policy.

Total stockholders’ equity increased by 7.3% to $704.9 million as of December 31, 2021 from $657.2 million as of December 31, 2020.

Total stockholders’ equity decreased by 19.3% to $568.9 million as of December 31, 2022 from $704.9 million as of December 31, 2021.

The Company earned $103.8 million in 2022 and $95.7 million in 2021.

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The Company declared cash dividends of $1.36 per share in 2021, which decreased equity by $34.7 million.

The change in accumulated other comprehensive income in 2021

was due to changes in the fair values of available-for-sale securities and the defined benefit pension which decreased equity by $11.7 million in 2021 compared to an increase of $15.7 million in 2020.

Total stockholder's equity has been impacted by declines in the market value of the Company's available-for-sale investment securities portfolio.

The market value decline, resulting from rising interest rates during 2022, has generated unrealized losses in the available-for-sale portfolio.

Unrealized losses from the available-for-sale investment securities portfolio are recorded, net of tax, in accumulated other comprehensive income (loss) in the statement of stockholders' equity.

Changes in the fair value of available-for-sale securities and the defined benefit pension plan negatively impacted equity by $205.0 million in 2022 compared to a decrease of $11.7 million in 2021.

The impact to equity due to other comprehensive income (loss) is not included in regulatory capital.

In addition, during March of 2020 the Company repurchased 289,101 shares of its common stock for $10.0 million.

RISK MANAGEMENT

The Company, with the oversight of the Corporate Risk Committee of the Board, has developed a company-wide risk management program intended to help identify, manage and mitigate the various business risks the Company is exposed to.

The Company, with the oversight of the Corporate Risk Committee of the board of directors, has developed a company-wide risk management program intended to help identify, manage and mitigate the various business risks it faces.

Following is a discussion addressing the risks identified as most significant to the Company – Credit, Liquidity, Interest Rate and Market Risk.

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The Company’s investment portfolio consists of U.S.

treasuries, government agencies and municipal bonds subject to an investment security policy that is approved annually by the Board.

treasuries, government agencies and municipal bonds subject to an investment security policy that is approved annually by the board of directors.

During 2022, purchases in the securities portfolio consisted of primarily municipal bonds, agency securities and mortgage-backed securities.

As of December 31, 2021, the Company’s investment in U.S government sponsored mortgage-backed securities represented approximately 35% of total securities consisting of Collateralized Mortgage Obligations, Commercial Mortgage-Backed Securities and mortgage pools issued by Ginnie Mae, Fannie Mae and Freddie Mac.

As of December 31, 2022, the Company’s investment in U.S government sponsored mortgage-backed securities represented approximately 38% of total investment securities fair value consisting of Collateralized Mortgage Obligations, Commercial Mortgage-Backed Securities and mortgage pools issued by Ginnie Mae, Fannie Mae and Freddie Mac.

Ginnie Mae, Fannie Mae and Freddie Mac securities are each guaranteed by their respective agencies as to principal and interest.

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As of December 31, 2022, all mortgage-backed securities were performing in a manner consistent with management’s expectations at time of purchase.

Municipal securities represent 55% of total securities as of December 31, 2021 and were rated investment grade at the time of purchase and continue to be rated investment grade.

Municipal securities represent 52% of total investment securities fair value as of December 31, 2022 and were rated investment grade at the time of purchase and continue to be rated investment grade.

The Company uses analytics provided by its third party portfolio advisor to evaluate and monitor credit risk for all investments on a quarterly basis.

Based upon these analytics as of December 31, 2021, the securities in the available-for-sale portfolio had approximately a 4.6 year effective duration.

Based upon these analytics as of December 31, 2022, the securities in the combined available-for-sale and held-to-maturity portfolios had an effective duration of approximately 6.5 years.

The analysis indicated a negative 17.98% change in market value in the event of a 300 basis point upward, instantaneous rate shock and an approximate positive 6.54% change in market value in the event of a 100 basis point downward, instantaneous rate shock.

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The Company manages this risk by utilizing conservative credit structures, by adjusting its pricing to the perceived risk of each individual credit and by diversifying the portfolio by customer, product, industry and market area and by obtaining personal loan guarantees.

There were no loan concentrations within industries, which exceeded ten percent of total loans, except commercial real estate and manufacturing.

Commercial real estate was $1.955 billion, or 45.6% , of total loans and manufacturing wa s $438.8 mil lion, or 10.2%, of total loans at December 31, 2021.

There were no loan concentrations within industries, which exceeded ten percent of total loans, except commercial real estate.

Commercial real estate was $2.179 billion, or 46.2% , of total loans at December 31, 2022.

The owner occupied commercial real estate portfolio generally represents the financing of factories and operational facilities for the Bank's commercial and industrial borrowers.

The Company’s in-house lending limit was raised from $30.0 million to $40.0 million during 2020.

The Company’s in-house lending limit is $40.0 million.

M anufacturing loans are included in the commercial and industrial loans total and are well diversified by industry.

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Nonperforming loans to total loans 0.36 % 0.35 %

(1) Includes nonaccrual troubled debt restructured loans.

(1) Includes nonaccrual troubled debt restructured loans at December 31, 2021.

Nonperforming assets of the Company include nonperforming loans (as indicated above), nonaccrual investments and other real estate owned and repossessions, the total of which amounted to $17.2 million and $15.3 million at December 31, 2022 and 2021, respectively.

Nonperforming loans increased by $3.0 million during 2021, due primarily to the downgrade of one commercial loan relationship.

The relationship is a shared national credit participation of $5.2 million to a commercial borrower that operates grain elevators and handles feed processing and merchandising of agriculture products.

Loans to this borrower are secured by a blanket lien on all assets, including buildings, inventory, accounts receivable and equipment.

This loan is current on interest and principal payments through December 2021.

As of December 31, 2021, management believed that there were no significant foreseeable losses relating to nonperforming assets, except as discussed below.

Loans for which the borrower appears to be unable or unwilling to repay its debt in full or on time and the collateral is insufficient to cover all principal and accrued interest, will be reclassified as nonperforming loans to the extent they are unsecured, on or before the date when the loan becomes 90 days delinquent, with the exception of small dollar other consumer loans which are not placed on nonaccrual status since these loans are charged-off when they have been delinquent from 90 to

180 days, and when the related collateral, if any, is not sufficient to offset the indebtedness.

Nonperforming loans increased by $2.0 million during 2022, due primarily to one commercial relationship, partially offset by paydowns and upgrades.

During the fourth quarter 2022, the Company downgraded a single $10.7 million commercial relationship that the Bank became aware of in early 2023.

As a result of the deterioration of this credit, $3.7 million of the balance was charged off with the remaining $7.0 million placed on nonaccrual status.

The relationship was downgraded due to the severe impact on the business caused by the improving conditions related to the COVID-19 pandemic.

The borrower is a manufacturer of name brand home and commercial cleaning and disinfecting products that are sold through third party firms to regional and national grocery and retail chains.

Demand for these products substantially declined during 2022 as the pandemic subsided.

As a result, the borrower's largest customer encountered financial challenges, precipitated by the dramatic decline in demand for these products, and ceased operations.

The credit is supported by an unlimited personal guarantee of the business owner and the Bank

is actively working with the borrower to structure a long-term repayment plan.

Offsetting the increase to nonperforming assets caused by the placement of this credit on nonaccrual status were payoffs to other nonaccrual notes during 2022.

Loans for which the borrower appears to be unable or unwilling to repay its debt in full or on time, and the collateral is insufficient to cover all principal and accrued interest, will be reclassified as nonperforming to the extent they are unsecured, on or before the date when the loan becomes 90 days delinquent, with the exception of small dollar other consumer loans which are not placed on nonaccrual status since these loans are charged-off when they have been delinquent from 90 to 180 days, and when the related collateral, if any, is not sufficient to offset the indebtedness.

When a loan is classified as a nonaccrual loan, interest on the loan is no longer accrued, all unpaid accrued interest is reversed and interest income is subsequently recorded only to the extent cash payments are received.

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A loan is individually analyzed when full payment under the original loan terms is not expected.

Reserves are evaluated in total for smaller-balance loans of similar nature not in nonaccrual or troubled debt restructured status such as residential mortgage, consumer, and credit card loans, and on an individual loan basis for other loans.

Reserves are evaluated in total for smaller-balance loans of similar nature not in nonaccrual status such as residential mortgage, consumer, and credit card loans, and on an individual loan basis for other loans including material modifications made to borrowers experiencing financial difficulty.

If a loan is individually analyzed, a portion of the allowance may be allocated so that the loan is reported, net, at the present value of estimated future cash flow or at the fair value of collateral if repayment is expected solely from the collateral.

Total nonperforming loans were $15.1 million, or 0.35% of total loans, at year end 2021 versus $12.1 million, or 0.26% of total loans, at year end 2020.

Total nonperforming loans were $17.1 million, or 0.36% of total loans, at December 31, 2022 versus $15.1 million, or 0.35% of total loans, at December 31, 2021.

There were 39 loans totaling $31.3 million classified as individually analyzed as of December 31, 2022 versus 34 loans totaling $25.6 million at the end of 2021.

The increase in individually analyzed loans during 2021 resulted primarily from the downgrade of one commercial loan relationship.

Loans to this borrower are secured by a blanket lien on all assets, including buildings, inventory, accounts receivable and equipment.

This loan is current on interest and principal payments through December 2021.

Loans renegotiated as troubled debt restructurings are those loans for which either the contractual interest rate has been reduced below market rates and/or other concessions to market terms are granted to the borrower because of a deterioration in the financial condition of the borrower which results in the inability of the borrower to meet the terms of the loan.

The increase in individually analyzed loans during 2022 resulted primarily from the downgrade of the previously described $10.7 million commercial loan relationship placed on nonaccrual status.

The credit is supported by an unlimited personal guarantee of the business owner and the Bank is actively working with the borrower to structure a long-term repayment plan.

Paydowns and upgrades of other individually analyzed loans offset the increase to individually analyzed loans for the year ended December 31, 2022.

Loans renegotiated as modifications to borrowers experiencing financial difficulty are those loans for which either the contractual interest rate has been reduced below market rates and/or other concessions to market terms are granted to the borrower because of a deterioration in the financial condition of the borrower which results in the inability of the borrower to meet the terms of the loan.

No loans received a material modification as a result of borrower financial difficulty during the year ended December 31, 2022.

Prior to January 1, 2022, loans renegotiated as troubled debt restructurings are those for which either the contractual interest rate has been reduced below market rates and/or other concessions to market terms are granted to the borrower because of a deterioration in the financial condition of the borrower which results in the inability of the borrower to meet the terms of the loan.

As of December 31, 2021, there were 27 loans totaling $11.3 million renegotiated as troubled debt restructurings of which $217,000 wer e modified in 2021.

Of these loans, $6.2 million w ere included in nonaccrual loans in the previous table and the remaining $5.1 million w ere performing under their modified terms.

As of December 31, 2020, there were 31 loans totaling $11.7 million renegotiated as troubled debt restructurings of which $5.5 million were modified in 2020.

Of these loans, $ 6.5 million were included in nonaccrual loans in the previous table and the remaining $5.2 million were performing under their modified terms.

The Company has no commitments to lend additional funds to any of the borrowers.

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Total loans (excluding PPP loans) 1.54 % 1.59 % 1.45 %

Nonperforming loans 449.13 % 507.42 % 270.58 %

Ratio of allowance for credit losses to nonperforming loans 424.91 % 449.13 % 507.42 %

The following is a summary of the allocation for credit losses as of December 31, 2022 and 2021.

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Total allowance for credit losses $ 72,606 $ 67,773

At December 31, 2021, the allowance for credit losses was 1.58% of total loans outstanding, versus 1.32% of total loans outstanding at December 31, 2020 under the incurred loss model.

At December 31, 2022, the allowance for credit losses was 1.54% of total loans outstanding, versus 1.58% of total loans outstanding at December 31, 2021.

The allowance for credit losses was 1.54% of total loans outstanding, excluding PPP loans of $1.5 million, as of December 31, 2022 versus 1.59% of total loans outstanding, excluding PPP loans of $26.2 million, as of December 31, 2021.

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Management believes the allowance for credit losses is at a level commensurate with the overall risk exposure of the loan portfolio.

However, if economic conditions fail to recover or continue to deteriorate due to the COVID-19 pandemic or the current economic environment, certain borrowers may experience difficulty and the level of nonperforming loans, charge-offs and delinquencies could rise and require increases in the allowance for credit losses.

The process of identifying expected credit losses is a subjective process.

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These amounts represent outstanding balances, excluding deferred fees and costs.

The decrease in classified loans during 2021 reflects the improved economic outlook some of the Company’s borrowers are experiencing, particularly in the hotel and entertainment industries as the economy continues to reopen.

The decrease in classified loans during 2022 reflects the continued strengthening of the Company’s asset quality to historically strong levels and is reflective of the resilience of the Company's borrowers despite recent economic challenges presented by disruptions to the supply chain, the availability of labor, and elevated levels of inflation.

As of December 31, 2022, the Company had $ 115.7 million of assets classified as Special Mention , $45.3 million classified as Substandard, $0 classified as Doubtful and $0 classified as Loss as compared to $176.6 million, $57.9 million, $0 and $0, respectively, at December 31, 2021.

The balances reported in "Note 4 – Allowance for Credit Losses and Credit Quality" include deferred fees and costs.

Included in the classified loan amounts for December 31, 2021 above were the following troubled debt restructured loans:

13 mortgage loans totaling $1.2 million with total allocations of $209,000 and 7 commercial loans totaling $3.9 million with total allocations of $1.6 million.

Included in the classified loan amounts for December 31, 2020 above were the following troubled debt restructured loans:

There were no material modifications to borrowers experiencing financial difficulty performed during 2022 included in the classified loan amounts for December 31, 2022.

Included in the classified loan amounts for December 31, 2021 were the following troubled debt restructured loans:

13 mortgage loans totaling $1.2 million with total allocations of $209,000, and 7 commercial loans totaling $3.9 million with total allocations of $1.6 million.

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Allowance estimates are considered a prudent measurement of the risk in the Company's loan portfolio based upon loan segment.

In accordance with CECL accounting guidance, the allowance is based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the reported amounts.

In accordance with accounting guidance, the allowance is based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the reported amounts.

For a more thorough discussion of the allowance for credit losses methodology see the "Critical Accounting Policies" section of this Item 2.

The allowance for credit losses increased 10.4%, or $6.4 million, from $61.4 million at December 31, 2020 to $67.8 million at December 31, 2021 due to the day one impact of the adoption of CECL which increased the allowance for credit losses by $9.1 million.

Pooled loan allocations increased $8.9 million from $50.2 million at December 31, 2020 to $58.7 million at December 31, 2021.

The unallocated component of the allowance for credit losses was $450,000 at December 31, 2021, which decreased from $3.1 million reported at December 31, 2020, and decreased primarily due to changes in methodology as a result of the adoption of the CECL standard.

The unallocated component of the allowance for credit losses incorporates the Company’s judgmental determination of expected losses that may not be fully reflected in other allocations, including factors such as the level of classified credits, economic uncertainties, industry trends impacting specific portfolio segments, broad portfolio quality trends and trends in the composition of the Company’s large commercial loan portfolio and related large dollar exposures to individual borrowers.

The allowance for credit losses increased 7.1%, or $4.8 million, from $67.8 million at December 31, 2021 to $72.6 million at December 31, 2022 due primarily to provision expense of $7.0 million recorded in the fourth quarter related to the previously described commercial loan placed on nonaccrual status.

Pooled loan allocations decreased $492,000 from $58.7 million at December 31, 2021 to $58.2 million at December 31, 2022.

The unallocated component of the allowance for credit losses was $554,000 at December 31, 2022, which increased from $450,000 reported at December 31, 2021 .

The unallocated component of the allowance for credit losses incorporates the Company’s judgmental determination of expected losses that may not be fully reflected in other allocations.

The Company has experienced growth in total loans, excluding PPP loans, over the last several years with organic growth exclusive of PPP loans of $447.2 million, or 10.5%, from December 31, 2021 to December 31, 2022.

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Watch list loans represent 3.42% of total loans at December 31, 2022 compared to 5.47% at December 31, 2021.

Watch list loans excluding PPP loans, were 5.50% of total loans at December 31, 2021 compared to 6.75% at December 31, 2020.

Watch list loans excluding PPP loans reached a historic low of 3.42% of total loans at December 31, 2022 compared to 5.50% at December 31, 2021.

This reflects a more comparable ratio to prior periods, as PPP loans are fully guaranteed by the SBA and have not been allocated for within the allowance for credit losses calculation.

The reduction in watchlist loans resulted primarily from upgrades of $62.3 million and payoffs of $2.4 million.

The reduction in watch list loans resulted primarily from upgrades of $19.3 million and payoffs of $43.2 million .

The Company's continued growth strategy promotes diversification among industries as well as continued focus on the enforcement of a disciplined credit culture and a conservative portion in loan work-out situations.

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The cash flow from the securities portfolio is expected to provide approximately $115.6 million of potential contingent funding in 2023.

During 2021, the Company experienced excess levels of liquidity as a result of strong core deposit growth.

Management expects the excess liquidity to dissipate over time as depositors utilize the excess funds.

During 2022, the Company's liquidity levels normalized as commercial and retail depositors utilized liquidity that had built up in their accounts during 2020 and 2021.

Management expects future liquidity needs to be met by a combination of proceeds from paydowns, calls and maturities from the investment securities portfolio, deposit growth and borrowings.

The Company has approval of $3.292 billion in secondary funding sources available as of December 31, 2022, of which $307.0 million was utilized.

The Company had $350.0 million of availability in federal funds lines with eleven correspondent banks, none of which was drawn on as of December 31, 2021.

The Company has Board approval to borrow up to $800.0 million at the FHLB, but, given the Company’s current collateral structure and outstanding borrowings as of December 31, 2021, the Company could have only borrowed up to $227.8 million under this authority based on utilization of $75.0 million of advances at December 31, 2021.

The Company also has additional collateral that could be pledged to the FHLB of $544.9 million as of December 31, 2021 to generate additional liquidity.

Further, the Company had available capacity at the Federal Reserve Bank of Chicago of up to $616.5 million given its current collateral structure at the Federal Reserve Bank discount window program and the terms of these facilities at December 31, 2021, with no balances outstanding at December 31, 2021.

The Company had $350.0 million of availability in federal funds lines with eleven correspondent banks, of which $22.0 million was drawn on as of December 31, 2022.

The Company has board of directors approval to borrow up to $800.0 million at the FHLB, but given the Company’s current collateral structure and outstanding borrowings as of December 31, 2022, the Company could have only borrowed up to $66.5 million under this authority.

The Company has additional collateral that could be pledged to the FHLB of $486.2 million as of December 31, 2022 to generate additional liquidity.

Further, the Company had available capacity at the Federal Reserve Bank of Chicago of up to $758.3 million given its current collateral structure at the Federal Reserve Bank discount window program and the terms of that facility at December 31, 2022, with no balances outstanding at December 31, 2022.

The Company also has established relationships in the brokered time deposit and brokered money market sectors, as well as the IntraFi Network CD Option One-Way Buy program, to access these funds when desired with settlement of funds in one to two weeks’ time.

Additionally, the Bank has entered agreements with IntraFi Network relative to their Insured Cash Sweep One-Way Buy program.

As of December 31, 2021, the total amount available to the Bank via this program was $100.0 million, of which $10.0 million was drawn on.

As of December 31, 2022, the total amount available to the Bank via this program was $100.0 million, of which $10.0 million was drawn.

The Bank is also a member of the American Financial Exchange (AFX) where overnight fed funds purchased can be obtained from other banks on the exchange that have approved the Bank for an unsecured, overnight line.

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As of December 31, 2022, the total amount approved for the Bank via AFX banks was $319.0 million and none was outstanding at year end.

The Company had all of its securities in the available-for-sale portfolio at December 31, 2021, allowing the Company maximum flexibility to sell securities to meet funding demands.

Management believes the majority of the securities in the available- for-sale portfolio are of high quality and marketable.

The Company had 91% of its securities in the available-for-sale portfolio at December 31, 2022, allowing the Company extensive flexibility to sell securities to meet funding demands.

The remaining portion of investments securities were designated as held-to-maturity.

Management believes the majority of the securities in investment portfolio are of high quality and marketable.

Approximately 48% of this portfolio is comprised of U.S.

government agency securities or mortgage-backed securities directly or indirectly backed by the U.S.

At December 31, 2022, 93% of municipal securities owned by the Company were AAA or AA rated with a diversified geography of state issuer.

In addition, the Company has historically sold the majority of its originated mortgage loans on the secondary market to reduce interest rate risk and to create an additional source of funding.

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The CFP specifically considers liquidity at the Bank and the Company level.

The CFP identifies the potential funding sources at the Bank level, which includes the FHLB, the Federal Reserve Bank, brokered deposits, one-way buy products via the IntraFi Network (CD Option and ICS) and Fed Funds.

The CFP also addresses the Bank’s ability to liquidate its securities portfolio.

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Government and its agencies, particularly the Federal Reserve Board.

During the entirety of 2021 the Federal Reserve Board’s Federal Open Market Committee (“FOMC”) kept the target federal funds rate at a range of 0% to .25%.

There has been no movement in the target federal funds rate since March 2020.

The Committee announced and implemented in late 2021 the beginning of their bond taper process relative to their purchases of treasury and mortgage-backed securities;

this tapering is now expected to conclude in early 2022.

The FOMC statement released for the meeting in December 2021 was relatively positive with the Fed suggesting the economy continues to strengthen and characterized the labor markets as solid, while they did also note that risks to the economic outlook remain including from new variants of the COVID-19 virus.

The updated economic projections released at the December meeting project three quarter point rates increases in 2022, another three in 2023 and two more in 2024.

Additionally, the longer run Fed median forecast for the federal funds rate was left unchanged at 2.50%.

The combined result of the decrease in the yield on earning assets offset by a decrease in the cost of funding earning assets led to decrease in the net interest margin from 3.19% for 2020 to 3.07% for 2021 given the Company’s asset sensitive balance sheet.

The Company’s yield on earning assets decreased 44 basis points during 2021 as assets repriced at lower rates due to the low rate environment and competitive markets for commercial loan pricing and excess liquidity was deployed into the investment portfolio.

During 2022 the FOMC increased the target federal funds rate a total of 425 basis points through seven rate moves.

Commencing in March 2022, rate increases were implemented at every remaining FOMC meeting for the year.

The combined effect of these actions increased the target federal funds rate to a range of 4.25% to 4.50%.

The FOMC statement released for the meeting in December 2022 repeated their commitment to lowering inflation to 2% and to further tightening, while also noting modest economic growth, strong employment growth and an unemployment rate that remains low.

The FOMC anticipates that ongoing increases to the target range will be appropriate to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time.

The updated economic projections released at the December meeting project the median federal funds rate rising to 5.1% in 2023 before easing to 4.1% in 2024.

Additionally, the longer run median forecast for the federal funds rate was left unchanged at 2.50%.

The combined result of the increase in the yield on earning assets offset by an increase in the cost of funding earning assets led to increase net interest margin from 3.07% for 2021 to 3.40% for 2022 given the Company’s asset sensitive balance sheet.

The Company’s yield on earning assets increased 67 basis points during 2022 as assets repriced at higher rates primarily due to the FOMC rate increases noted above and a significantly higher yield curve as when compared to 2021.

The commercial loan portfolio represents 89% of the total loan portfolio.

Approximately 69% of the commercial loan portfolio are variable rate loans which are primarily indexed to 30 day LIBOR, Prime and FHLB indices.

The rate paid on deposit accounts and purchased funds decreased 35 basis points for 2021 mainly due to time deposit repricing and decreased rates paid on public fund accounts, including transactional accounts and time deposit accounts, as these accounts are typically more sensitive to interest rates.

The realized decrease in the rate paid on deposit accounts and purchased funds was benefited by an increase in the average balance of non-interest bearing demand deposit accounts for 2021 verses 2020, which was largely influenced by PPP Round 2 loan proceeds deposited into borrower checking and savings accounts at the Bank, as well as an overall increase in the savings rate and continued economic stimulus payments.

Future changes in the net interest margin will be dependent upon multiple factors including further actions by the FOMC during 2022 in response to the continued COVID-19 pandemic, inflation, economic conditions and geopolitical concerns, the results of any of the administration’s changes to economic policy and laws, competitive pressures in the various markets served, and changes in the structure of the balance sheet as a result of changes in customer demands for products and services.

Approximately 67% of the commercial loan portfolio are variable rate loans which are primarily indexed to Prime, 1 Month Term SOFR, 1 Month LIBOR and FHLB indices.

The rate paid on deposit accounts and purchased funds increased 36 basis points for 2022 mainly due to increased rates paid on public fund transactional accounts as these accounts are typically more sensitive to interest rates.

The realized increase in the rate paid on deposit accounts and purchased funds was lessened by an increase in the average balance of non-interest bearing demand deposit accounts for 2022 verses 2021, primarily in commercial deposit accounts.

Future changes in the net interest margin will be dependent upon multiple factors including further actions by the FOMC during 2023 in response to inflation, economic conditions and geopolitical concerns, the results of any of the administration’s changes to economic policy and laws, competitive pressures in the various markets served, and changes in the structure of the balance sheet as a result of changes in customer demands for products and services.

In general, we expect loans to reprice quicker than deposits in a rising and falling rate environment as quantified in the sensitivity to market rates table in Item 7A.

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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