LAKELAND FINANCIAL CORP 10-Q

ITEM 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Net income in the first three months of 2023 was $24.3 million, which increased $636,000, or 2.7%, from $23.6 million for the comparable period of 2022 . Diluted income per common share was $0.94 in the first three months of 2023 , up 2.2% from $0.92 in the comparable period of 2022 . The increase in net income for 2023 was primarily due to growth in net interest income of $6.6 million, offset by an increase to the provision for credit losses of $3.9 million, a decrease in noninterest income of $373,000 and an increase in noninterest expense of $2.5 million . Pretax pre-provision earnings in the first three months of 2023 were $32.4 million, an increase of $3.8 million, or 13.3%, compared to $28.6 million for the comparable period of 2022. Pretax pre-provision earnings is a non-GAAP measure calculated by adding net interest income to noninterest income and subtracting noninterest expense. Annualized return on average total equity was 16.81% in the first three months of 2023 versus 14.04% in the comparable period of 2022 . Annualized return on average total assets was 1.54% in the first three months of 2023 versus 1.44% for the comparable period of 2022 . The Company's average equity to average assets ratio was 9.13% in the first three months of 2023 versus 10.26% in the comparable period of 2022 . Equity has been negatively impacted by unrealized losses from the available-for-sale investment securities portfolio, which are reported as a component of accumulated other comprehensive income (loss). The Company’s tangible common equity to tangible assets ratio, which is a non-GAAP financial measure, was 9.34% at March 31, 2023, compared to 9.22% at March 31, 2022 and 8.79% at December 31, 2022. Tangible equity and tangible assets have been impacted by declines in the market value of the company's available-for-sale investment securities portfolio. The market value decline is a result of rising interest rates caused by the tightening of monetary policy by the Federal Reserve beginning in March of 2022 to combat elevated levels of inflation affecting the U.S. economy. The rising interest rate environment has generated unrealized losses in the available-for-sale investment securities portfolio which are reflected in the company's reported accumulated other comprehensive income (loss). Unrealized losses from available-for-sale investment securities were $188.5 million as of March 31, 2023, compared to unrealized losses of $117.4 million at March 31, 2022 and improved from unrealized losses of $215.3 million at December 31, 2022. When excluding the impact of securities market value adjustments on tangible common equity and tangible assets, the Company's adjusted tangible common equity to adjusted tangible assets ratio, which is a non-GAAP financial measure, was 11.56% at March 31, 2023 compared to 10.44% at March 31, 2022 and 11.30% at December 31, 2022. Total assets were $6.412 billion as of March 31, 2023 versus $6.432 billion as of December 31, 2022, a decrease of $20.8 million. Balance sheet contraction was driven primarily by decreases in available-for-sale securities, noninterest bearing deposits and borrowings during the first three months of 2023. Available-for-sale securities decreased $77.2 million, noninterest bearing deposits decreased $188.7 million and total borrowings decreased $97.0 million. Offsetting these decreases were increases to short-term investments of $36.9 million, loans, net of the allowance for credit losses, of $45.9 million and interest bearing deposits of $245.8 million. Tota l equity increased by $33.1 million, or 5.8%, due primarily to an increase to accumulated other comprehensive income (loss) of $21.6 million. The increase in accumulated other comprehensive income (loss) was due to an improvement in available-for-sale securities fair market values during the first quarter of 2023 . The change in total equity was also impacted by net income of $24.3 million and dividends declared and paid of $0.46 per share, totaling $11.7 million. CRITICAL ACCOUNTING POLICIES The Company’s accounting policies are described in Note 1 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2022. Certain of the Company’s accounting policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Some of the facts and circumstances which could affect these judgments include changes in interest rates, in the performance of the economy or in the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for credit losses. See “Note 4 – Allowance for Credit Losses and Credit Quality” for more information on this critical accounting policy. 31 Table of Contents RESULTS OF OPERATIONS Overview Selected income statement information for the three months ended March 31, 2023 and 2022 is presented in the following table: Three Months Ended March 31, (dollars in thousands) 2023 2022 Income Statement Summary: Net interest income $ 51,519 $ 44,880 Provision for credit losses 4,350 417 Noninterest income 10,314 10,687 Noninterest expense 29,434 26,969 Other Data: Efficiency ratio (1) 47.60 % 48.53 % Diluted EPS $ 0.94 $ 0.92 Average Equity/Average Assets 9.13 % 10.26 % Tangible capital ratio (2) 9.34 % 9.22 % Adjusted tangible capital ratio (3) 11.56 % 10.44 % Net charge offs to average loans 0.49 % 0.06 % Net interest margin 3.54 % 2.93 % Noninterest income to total revenue 16.68 % 19.23 % Pretax pre-provision earnings (4) $ 32,399 $ 28,598 (1) Noninterest expense/net interest income plus noninterest income. (2) Non-GAAP financial measure. The Company believes that disclosing non-GAAP financial measures provides investors with information useful to understanding the Company’s financial performance. Additionally, these non-GAAP measures are used by management for planning and forecasting purposes, including measures based on “tangible common equity,” which is “total equity” excluding intangible assets, net of deferred tax, and “tangible assets,” which is “total assets” excluding intangible assets, net of deferred tax. The tangible capital ratio is calculated by excluding the balance of goodwill, net of deferred taxes. See reconciliation on the next page. (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. Pretax pre-provision earnings is calculated by adding net interest income to noninterest income and subtracting noninterest expense. Management believes this is an important measure because it may enable investors to identify the trends in the Company's earnings exclusive of the effects of tax and provision expense, which may vary significantly from period to period. See reconciliation on the next page. 32 Table of Contents A reconciliation of non-GAAP measures is provided below (in thousands, except for per share data). As of and For The Three Months Ended March 31, (dollars in thousands) 2023 2022 Total Equity $ 602,006 $ 609,102 Less: Goodwill (4,970) (4,970) Plus: Deferred Tax Assets Related to Goodwill 1,167 1,167 Tangible Common Equity (A) 598,203 605,299 AOCI Market Value Adjustment 166,612 92,751 Adjusted Tangible Common Equity (C) 764,815 698,050 Total Assets $ 6,411,529 $ 6,572,259 Less: Goodwill (4,970) (4,970) Plus: Deferred Tax Assets Related to Goodwill 1,167 1,167 Tangible Assets (B) 6,407,726 6,568,456 Market Value Adjustment 210,901 117,406 Adjusted Tangible Assets (D) 6,618,627 6,685,862 Ending Common Shares Issued (E) 25,607,663 25,527,896 Tangible Book Value per Common Share (A/E) $ 23.36 $ 23.71 Tangible Capital Ratio (A/B) 9.34 % 9.22 % Adjusted Tangible Capital Ratio (C/D) 11.56 % 10.44 % Net Interest Income $ 51,519 $ 44,880 Noninterest Income 10,314 10,687 Noninterest Expense (29,434) (26,969) Pretax Pre-Provision Earnings $ 32,399 $ 28,598 Net Income Net income was $24.3 million in the first three months of 2023 , an increase of $636,000, or 2.7%, versus net income of $23.6 million in the first three months of 2022 . The increase in net income for 2023 was primarily due to growth in net interest income of $6.6 million, or 14.8%, offset by a decrease to the provision for credit losses of $3.9 million, a decrease to noninterest income of $373,000, or 3.5%, and an increase to noninterest expense of $2.5 million, or 9.1%. 33 Table of Contents N et Interest Income The following table sets forth consolidated information regarding average balances and rates: Three Months Ended March 31, 2023 2022 (fully tax equivalent basis, dollars in thousands) Average Balance Interest Yield (1)/ Rate Average Balance Interest Yield (1)/ Rate Earning Assets Loans: Taxable (2)(3) $ 4,667,867 $ 69,542 6.04 % $ 4,278,894 $ 39,735 3.77 % Tax exempt (1) 57,560 1,126 7.93 22,032 213 3.92 Investments: Securities (1) 1,250,189 8,956 2.91 1,514,024 9,108 2.44 Short-term investments 2,242 22 3.98 2,143 1 0.11 Interest bearing deposits 89,718 942 4.26 574,982 245 0.17 Total earning assets $ 6,067,576 $ 80,588 5.39 % $ 6,392,075 $ 49,302 3.13 % Less: Allowance for credit losses (73,266) (68,051) Nonearning Assets Cash and due from banks 76,578 71,905 Premises and equipment 58,319 59,309 Other nonearning assets 282,873 196,705 Total assets $ 6,412,080 $ 6,651,943 Interest Bearing Liabilities Savings deposits $ 392,567 $ 71 0.07 % $ 408,314 $ 75 0.07 % Interest bearing checking accounts 2,757,120 21,402 3.15 2,642,003 1,862 0.29 Time deposits: In denominations under $100,000 180,502 642 1.44 198,257 346 0.71 In denominations over $100,000 494,873 2,803 2.30 633,947 798 0.51 Miscellaneous short-term borrowings 241,870 2,783 4.67 26 0 0.00 Long-term borrowings and subordinated debentures 0 0 0.00 75,000 73 0.40 Total interest bearing liabilities $ 4,066,932 $ 27,701 2.76 % $ 3,957,547 $ 3,154 0.32 % Noninterest Bearing Liabilities Demand deposits 1,662,530 1,966,117 Other liabilities 97,014 45,587 Stockholders' Equity 585,604 682,692 Total liabilities and stockholders' equity $ 6,412,080 $ 6,651,943 Interest Margin Recap Interest income/average earning assets 80,588 5.39 49,302 3.13 % Interest expense/average earning assets 27,701 1.85 3,154 0.20 % Net interest income and margin $ 52,887 3.54 % $ 46,148 2.93 % (1) Tax exempt income was converted to a fully taxable equivalent basis at a 21 percent tax rate. The tax equivalent rate for tax exempt loans and tax exempt securities acquired after January 1, 1983 included the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) adjustment applicable to nondeductible interest expenses. Taxable equivalent basis adjustments were $1.37 million and $1.27 million in the three-month periods ended March 31, 2023 and March 31, 2022, respectively. (2) Loan fees, which are immaterial in relation to total taxable loan interest income for the three months ended March 31, 2023 and 2022, are included as taxable loan interest income . (3) Nonaccrual loans are included in the average balance of taxable loans. 34 Table of Contents Net interest income increased $6.6 million, or 14.8%, to $51.5 million for the three months ended March 31, 2023, compared with $44.9 million for the first three months of 2022 . Growth in average loans and an improvement in loan yields were the primary drivers behind the $31.3 million increase in tax-equivalent interest income between the two quarters. An improvement in yields in securities and cash and cash equivalents also contributed to the increase in net interest income. Interest expense, which increased by $24.5 million, partially offset the positive impact of increased loan and securities interest income, driven by increased funding costs from deposits and borrowings. Average earning assets declined by $324.5 million, due primarily to a reduction in investment securities of $263.8 million and a decrease in demand deposits of $303.6 million. Offsetting the contraction in average deposits was an increase in average short-term borrowings of $241.8 million, offset by a decrease in average long-term borrowings of $75.0 million. Average loans outstanding increased $424.5 million to $4.725 billion during the three months ended March 31, 2023, compared to $4.301 billion during the same period of 2022 . The earning asset contraction was offset by a decrease in deposits. Average total deposits decreased $361.0 million to $5.488 billion during the three months ended March 31, 2023, compared to $5.849 billion for the same period of 2022 . The decrease in average deposits was driven by a decrease in average noninterest bearing deposits, which decreased $303.6 million, or 15.4%, from $1.967 billion for the three months ended March 31, 2022, to $1.663 billion for the same period of 2023. Offsetting the contraction in average deposits was an increase in average short-term borrowings of $241.8 million, offset by a decrease in average long-term borrowings of $75.0 million. The tax equivalent net interest margin was 3.54 % for the three months ended March 31, 2023, compared to 2.93% during the first three months of 2022, representing a 61 basis point expansion between the two quarters. The net interest margin expansion was driven by a 475 basis point increase to the target Federal Funds rate implemented by the Federal Reserve through a series of rate increases beginning in March of 2022. The target Federal Funds rate increased from a zero-bound range of 0.00%-0.25% in March 2022 to a range of 4.75%-5.00% at March 31, 2023. The impact of the higher interest rate increased earning asset yields by 226 basis points to 5.39% for the first quarter of 2023, up from 3.13% for the first quarter of 2022. However, this increase was offset by an increase in the company's funding costs as excess customer liquidity was utilized and the competition for deposits increased throughout the industry. Interest expense as a percentage of average earning assets increased to 1.85% for the first quarter of 2023 from a historical low of 0.20% for the first quarter of 2022, an increase of 165 basis points . Cost of funds may continue to rise throughout 2023 as a result of market competition for deposits. Provision for Credit Losses The Company recorded provision for credit losses expense of $4.4 million for the three months ended March 31, 2023 compared to provision expense of $417,000 during the comparable period of 2022 . The increase in provision during the first quarter of 2023 compared to the first quarter of 2022 was primarily attributable to increases in the qualitative and environmental risk factors for certain segments of the Company's loan portfolio that could be impacted by higher borrowing costs and the potential economic weakness in the Company's markets. Net charge-offs were $5.7 million during the three month period ended March 31, 2023 compared to net recoveries of $664,000 during the comparable period of 2022 . The increase in charge offs in the first quarter of 2023 compared to the first quarter of 2022 was the result of a further charge off of $5.5 million attributable to a single commercial customer. The $10.7 million credit was downgraded in late December 2022, and a partial charge off of $3.7 million was recognized at that time. The remaining $7.0 million was placed on nonaccrual status pending additional due diligence and financial analysis related to the borrower's debt service capacity. During the first quarter of 2023, the outlook for repayment of the loan weakened significantly and resulted in the additional charge off of $5.5 million. The charge off amount was fully allocated in the allowance for credit losses. Additional factors considered by management included key loan quality metrics, including reserve coverage of nonperforming loans and economic conditions in the Company’s markets, and changes in the facts and circumstances of watch list credits, which includes the security position of the borrower. Management’s overall view on current credit quality was also a factor in the determination of the provision for credit losses. The Company’s management continues to monitor the adequacy of the provision based on loan levels, asset quality, economic conditions and other factors that may influence the assessment of the collectability of loans. 35 Table of Contents Noninterest Income Noninterest income categories for the three-month period ended March 31, 2023 and 2022 are shown in the following table: Three Months Ended March 31, (dollars in thousands) 2023 2022 Dollar Change Percent Change Wealth advisory fees $ 2,200 $ 2,287 $ (87) (3.8) % Investment brokerage fees 534 519 15 2.9 Service charges on deposit accounts 2,630 2,809 (179) (6.4) Loan and service fees 2,846 2,889 (43) (1.5) Merchant card fee income 877 815 62 7.6 Bank owned life insurance income (loss) 691 (83) 774 (932.5) Interest rate swap fee income 0 50 (50) (100.0) Mortgage banking income (loss) (99) 509 (608) (119.4) Net securities gains 16 0 16 100.0 Other income 619 892 (273) (30.6) Total noninterest income $ 10,314 $ 10,687 $ (373) (3.5) % Noninterest income to total revenue 16.7 % 19.2 % The Company's noninterest income decreased $373,000, or 3.5%, to $10.3 million for the three months ended March 31, 2023 compared to $10.7 million in the prior year period. The decrease in noninterest income was primarily driven by a decline in mortgage banking income of $608,000, from reduced levels of mortgage financing activity because of the increased rate environment. Additionally, a decrease in other income of $273,000, or 30.6%, and decreased service charges on deposit accounts of $179,000, or 6.4%, contributed to the decrease in noninterest income. The decrease in other income was the result of less income from partnership investments during the comparable quarters and the decrease in service charges on deposit accounts was primarily the result of increased earning credit rating for commercial depositors related to commercial treasury management fees. Offsetting these decreases was an increase in bank owned life insurance income of $774,000. Bank owned life insurance income benefited by improved market performance of the company's variable life insurance policies, which track to the overall performance of the equity markets. In addition, increased general account bank owned life insurance income resulted from the purchase of insurance policies during the fourth quarter of 2022. Noninterest Expense Noninterest expense categories for the three-month period ended March 31, 2023 and 2022 are shown in the following tables: Three Months Ended March 31, 2023 (dollars in thousands) 2023 2022 Dollar Change Percent Change Salaries and employee benefits $ 16,063 $ 14,392 $ 1,671 11.6 % Net occupancy expense 1,572 1,629 (57) (3.5) Equipment costs 1,438 1,411 27 1.9 Data processing fees and supplies 3,452 3,081 371 12.0 Corporate and business development 1,431 1,219 212 17.4 FDIC insurance and other regulatory fees 795 439 356 81.1 Professional fees 2,121 1,559 562 36.0 Other expense 2,562 3,239 (677) (20.9) Total noninterest expense $ 29,434 $ 26,969 $ 2,465 9.1 % Efficiency ratio 47.6 % 48.5 % 36 Table of Contents The Company's noninterest expense increased by $2.5 million, or 9.1%, to $29.4 million for the three months ended March 31, 2023, from $27.0 million for the three months ended March 31, 2022. Salaries and employee benefits expense contributed $1.7 million, or 11.6%, of the increase in noninterest expense primarily as a result of increased salaries and wages and health insurance expense. Variable compensation expense, which is tied to market performance of the company's variable bank owned life insurance policies, increased due to improved market performance and also contributed to the increase in salaries and employee benefits expense. Additionally, professional fees increased $562,000, or 36.0%, data processing fees and supplies increased $371,000, or 12.0%, FDIC insurance and other regulatory fees increased $356,000, or 81.1%, and corporate and business development expense increased $212,000, or 17.4%. The increase in professional fees was a result of increased interest charges associated with the bank's swap collateral positions as well as continued investment in technology solutions for our retail and commercial digital applications. This increased investment in technology was also primarily responsible for the increase in data processing fees and supplies expense. The increase to FDIC insurance and other regulatory fees was caused by a blanket increase to the assessment rate used by the FDIC to calculate insurance premiums, effective during the first quarter of 2023. Corporate and business development expense was impacted by increased spending for advertising and other corporate and business development activities. These increases were offset by a decrease to other expense of $677,000, or 20.9%, driven by a decrease in accruals pertaining to ongoing legal matters between the two periods. See "Note 11 – Loss Contingencies" for additional details. The Company's efficiency ratio was 47.6% for the three months ended March 31, 2023 compared to 48.5% for the first three months of 2021. The Company's income tax expense decreased $768,000, or 16.9%, in the three months ended March 31, 2023 compared to the same period in 2022. The effective tax rate was 13.4% in the three months ended March 31, 2023, compared to 16.1% for the comparable period of 2022. The year-to-date effective tax rate is reduced by income from tax-advantaged sources such as f ederally tax exempt municipal bond interest income as w ell as a tax benefit from stock-based compensation vesting of shares for plan participants. FINANCIAL CONDITION Overview Total assets were $6.412 billion as of March 31, 2023 versus $6.432 billion as of December 31, 2022, a decrease of $20.8 million. Balance sheet contraction was driven primarily by decreases in available-for-sale securities, noninterest bearing deposits and borrowings during the first three months of 2023. Available-for-sale securities decreased $77.2 million, noninterest bearing deposits decreased $188.7 million and total borrowings decreased $97.0 million. Offsetting these decreases were increases to short-term investments of $36.9 million, loans, net of the allowance for credit losses, of $45.9 million and interest bearing deposits of $245.8 million. Uses of Funds Total Cash and Cash Equivalents Total cash and cash equivalents increased by $23.2 million, or 17.8%, to $153.5 million at March 31, 2023, from $130.3 million at December 31, 2022. Cash and cash equivalents include short-term investments. The increase in cash and cash equivalents at March 31, 2023 was driven by an increase in interest bearing short-term investment accounts of $36.9 million, or 74.8%, offset by a decrease in cash and due from banks of $13.7 million, or 16.9%. These fluctuations are reflective of a normalization of activity as excess levels of liquidity experienced throughout 2021 and 2022 have decreased through deployments of cash to the investment securities portfolio and utilization of excess cash balances by deposit customers. 37 Table of Contents Investment Portfolio The amortized cost and the fair value of securities as of March 31, 2023 and December 31, 2022 were as follows: March 31, 2023 December 31, 2022 (dollars in thousands) Amortized Cost Fair Value Amortized Cost Fair Value Available-for-Sale U.S Treasury securities $ 3,363 $ 3,352 $ 3,057 $ 3,034 U.S government sponsored agencies 153,928 127,995 156,184 126,961 Mortgage-backed securities: residential 561,865 484,462 578,175 492,308 State and municipal securities 577,603 492,472 663,367 563,225 Total available-for-sale $ 1,296,759 $ 1,108,281 $ 1,400,783 $ 1,185,528 Held-to-Maturity State and municipal securities $ 128,651 $ 115,533 $ 128,242 $ 111,029 Total Investment Portfolio $ 1,425,410 $ 1,223,814 $ 1,529,025 $ 1,296,557 At March 31, 2023 and December 31, 2022, there were no holdings of securities of any one issuer, other than the U.S. government agencies and government sponsored entities, in an amount greater than 10% of stockholders’ equity. Management is aware that, as interest rates rise, any unrealized loss in the available-for-sale investment securities portfolio will increase, and as interest rates fall the unrealized gain in the investment portfolio will rise. Since the majority of the bonds in the investment portfolio are fixed-rate, with only a few adjustable-rate bonds, we would expect our investment portfolio to follow this market value pattern. This is taken into consideration when evaluating the gain or loss of investment securities in the portfolio and the potential for an allowance for credit losses. Purchases of securities available-for-sale totaled $4.0 million in the first three months of 2023. The purchases consisted of U.S. Treasury securities and mortgage-backed securities issued by government sponsored entities. Investment securities represented 19.3% of total assets on March 31, 2023, compared to 20.4% of total assets on December 31, 2022. The ratio of investment securities as a percentage of total assets remains elevated over historical levels of approximately 14%. The increase in this ratio resulted from the deployment of excess liquidity during 2021 and 2022 to the investment securities portfolio as an earning asset alternative of excess balance sheet liquidity stemming from increased levels of core deposits from government stimulus programs. The Company expects the investment securities portfolio to represent a lower percentage of total assets over time as proceeds from pay downs, sales and maturities of these investment securities are used to fund loan portfolio growth and for other general liquidity purposes. Paydowns from prepayments and scheduled payments of $13.0 million were received in the first three months of 2023, and the amortization of premiums, net of the accretion of discounts, was $1.2 million. Maturities and calls of securities totaled $6.1 million in the first three months of 2023. Sales of available-for-sale investment securities totaled $87.5 million in the first three months of 2023 and resulted in net gains of $16,000. No allowance for credit losses was recognized for available-for-sale or held-to-maturity securities as of March 31, 2023 and December 31, 2022. The fair value of the available-for-sale investment securities portfolio as of March 31, 2023 included net unrealized losses of $188.5 million compared to net unrealized losses of $215.3 million as of December 31, 2022. Unrealized losses in the available-for-sale investment securities portfolio resulted from the declines in market values of the investment securities. These declines were driven by the rising interest rate environment as a result of the Federal Reserve's monetary tightening policy to combat elevated levels of inflation affecting the U.S. economy. The investment portfolio is managed by a third-party firm to provide for an appropriate balance between liquidity, credit risk, interest rate risk management and investment return and to limit the Company’s exposure to credit risk in the investment securities portfolio. The Company does not trade or invest in or sponsor certain unregistered investment companies defined as hedge funds and private equity funds under what is commonly referred to as the “Volcker Rule” of the Dodd-Frank Wall Street Reform and Consumer Protection Act. 38 Table of Contents Real Estate Mortgage Loans Held-for-Sale Real estate mortgage loans held-for-sale increased by $151,000, or 42.3%, to $508,000 at March 31, 2023, from $357,000 at December 31, 2022. The balance of 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 conforming qualifying mortgage loans it originates on the secondary market. Proceeds from sales of residential mortgages totaled $672,000 in the first three months of 2023 compared to $18.1 million in the first three months of 2022. Management expects the volume of loans originated for sale in the secondary market to remain at reduced levels due to the rise in mortgage rates. Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of loans serviced for others were $355.9 million and $364.3 million as of March 31, 2023 and December 31, 2022, respectively. Loan Portfolio The loan portfolio by portfolio segment as of March 31, 2023 and December 31, 2022 is summarized as follows: (dollars in thousands) March 31, 2023 December 31, 2022 Current Period Change Commercial and industrial loans $ 1,459,618 30.7 % $ 1,493,049 31.7 % $ (33,431) Commercial real estate and multi-family residential loans 2,265,756 47.5 2,179,094 46.2 86,662 Agri-business and agricultural loans 392,982 8.3 432,088 9.2 (39,106) Other commercial loans 132,284 2.8 113,593 2.4 18,691 Consumer 1-4 family mortgage loans 417,916 8.8 407,566 8.6 10,350 Other consumer loans 89,734 1.9 88,075 1.9 1,659 Subtotal, gross loans 4,758,290 100.0 % 4,713,465 100.0 % 44,825 Less: Allowance for credit losses (71,215) (72,606) 1,391 Net deferred loan fees (3,362) (3,069) (293) Loans, net $ 4,683,713 $ 4,637,790 $ 45,923 Total loans, excluding real estate mortgage loans held-for-sale and deferred fees, increased by $44.8 million to $4.758 billion at March 31, 2023 from $4.713 billion at December 31, 2022. The increase was primarily driven by originations of loans concentrated in the commercial real estate and multi-famly residential, other commercial, and consumer 1-4 family mortgage loans categories and was offset by paydowns in commercial and industrial loans and the agri-business and agricultural loans segments, the latter of which traditionally experiences seasonal fluctuations in activity. The following table summarizes the Company’s non-performing assets as of March 31, 2023 and December 31, 2022: (dollars in thousands) March 31, 2023 December 31, 2022 Nonaccrual loans $ 17,715 $ 16,964 Loans past due over 90 days and still accruing 25 123 Total nonperforming loans 17,740 17,087 Other real estate owned 100 100 Repossessions 82 37 Total nonperforming assets $ 17,922 $ 17,224 Individually analyzed loans $ 18,188 $ 31,327 Nonperforming loans to total loans 0.37 % 0.36 % Nonperforming assets to total assets 0.28 % 0.27 % Total nonperforming assets increased by $698,000, or 4.1%, to $17.9 million during the three month period ended March 31, 2023. The ratio of nonperforming assets to total assets increased from 0.27% at December 31, 2022 to 0.28% at March 31, 2023. 39 Table of Contents A loan is individually analyzed when full payment under the original loan terms is not expected. The analysis for smaller loans that are similar in nature and which are not in nonaccrual or modified status, such as residential mortgage, consumer, and credit card loans, is determined based on the class of loans. 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 flows or at the fair value of collateral if repayment is expected solely from the collateral. Total individually analyzed loans decreased by $13.1 million, or 41.9%, to $18.2 million at March 31, 2023 from $31.3 million at December 31, 2022. Loans are charged against the allowance for credit losses when management believes that the principal is uncollectible. Subsequent recoveries, if any, are credited to the allowance. The allowance is an amount that management believes will be adequate to absorb current expected credit losses relating to specifically identified loans based on an evaluation of the loans by management, as well as other current expected losses in the loan portfolio. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans and current economic conditions that may affect the borrower’s ability to repay. Management also considers trends in adversely classified loans based upon a monthly review of those credits. General allowance is determined after considering the following factors: application of loss percentages using a probability of default/loss given default approach subject to a floor, emerging market risk, commercial loan focus and large credit concentrations, new industry lending activity and current economic conditions. Federal regulations require insured institutions to classify their own assets on a regular basis. The regulations provide for three categories of classified loans: Substandard, Doubtful and Loss. The regulations also contain a Special Mention category. Special Mention applies to loans that do not currently expose an insured institution to a sufficient degree of risk to warrant classification as Substandard, Doubtful or Loss but do possess credit deficiencies or potential weaknesses deserving management’s close attention. The Company’s policy is to establish a specific allowance for credit losses for any assets where management has identified conditions or circumstances that indicate an asset is nonperforming. If an asset or portion, thereof is classified as a loss, the Company’s policy is to either establish specified allowances for credit losses in the amount of 100% of the portion of the asset classified loss or charge-off such amount. At March 31, 2023, the allowance for credit losses was 1.50% of total loans outstanding, versus 1.54% of total loans outstanding at December 31, 2022. At March 31, 2023, management believed the allowance for credit losses was at a level commensurate with the overall risk exposure of the loan portfolio. However, if economic conditions deteriorate, 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 credit losses is a subjective process. The Company has a relatively high percentage of commercial and commercial real estate loans, which are extended to businesses with a broad range of revenue and within a wide variety of industries. Traditionally, this type of lending may have more credit risk than other types of lending because of the size and diversity of the credits. The Company manages this risk by utilizing relatively 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. The Company has limited exposure to commercial office space borrowers. Loans totaling $33.6 million for this sector represent 0.71% of total loans at March 31, 2023. As of March 31, 2023, based on management’s review of the loan portfolio, the Company had 59 credit relationships totaling $174.9 million on the classified loan list versus 58 credit relationships totaling $161.0 million as of December 31, 2022. The increase in classified loans for the first three months of 2023 resulted primarily from borrower risk rating downgrades of pass rated loans to the non-individually analyzed portion of the watch list. As of March 31, 2023, the Company had $142.6 million of assets classified as Special Mention, $32.3 million classified as Substandard, $0 classified as Doubtful and $0 classified as Loss as compared to $115.7 million, $45.3 million, $0 and $0, respectively, at December 31, 2022. Watch list loans as a percentage of total loans increased to 3.68% as of March 31, 2023, up from a historical low at 3.42% as of December 31, 2022. Allowance estimates are developed by management after taking into account actual loss experience adjusted for current economic conditions and a reasonably supportable forecast period. The Company has annual discussions regarding this methodology with regulatory authorities. Allowance estimates are considered a prudent measurement of the risk in the Company’s loan portfolio based upon loan segment. In accordance with applicable accounting guidance, the allowance is based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability 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. 40 Table of Contents The allowance for credit losses decreased $1.4 million, from $72.6 million at December 31, 2022 to $71.2 million at March 31, 2023. The decrease was a result of net charge offs recorded during the quarter of $5.7 million, offset by provision expense of $4.4 million. Of the $5.7 million in net charge offs, $5.5 million was attributable to the previously described deteriorated commercial relationship which was reserved for in the allowance for credit losses. The increased provision expense recorded during the first quarter of 2023 was primarily attributable to increases in the qualitative and environmental risk factors for certain segments of the Company's loan portfolio that could be impacted by higher borrowing costs and the potential economic weakness in the Company's markets. As the bulk of the Company’s lending activity is concentrated in the commercial loan portfolio, which can result in overall asset quality being influenced by a small number of credits, management has historically considered growth and portfolio composition when determining credit loss allocations. Sources of Funds The Company's sources of funds include a diversified deposit base gathered throughout the Company's footprint and includes approximately 130,000 commercial, retail and public funds deposit accounts. While the traditional base of core deposits represents the primary source of funding for the Company, the Company has access to a robust array of other liquidity sources, including secured borrowings available from the Federal Home Loan Bank, the Federal Reserve Bank Discount Window and the Federal Reserve Bank Term Funding Program. In addition, the Company has access to unsecured borrowing capacity through long established relationships within the brokered deposit markets, Federal Funds lines from correspondent bank partners and Insured Cash Sweep (ICS) one-way buy funds available from the Intrafi network. As of March 31, 2023, the Company had access to $3.03 billion in unused liquidity available from these aggregate sources compared to $2.99 billion at December 31, 2022. The average daily deposits and borrowings together with average rates paid on those deposits and borrowings for the three months ended March 31, 2023 and 2022 are summarized in the following table: Three months ended March 31, 2023 2022 (dollars in thousands) Balance Rate Balance Rate Noninterest bearing demand deposits $ 1,662,530 0.00 % $ 1,966,117 0.00 % Savings and transaction accounts: Savings deposits 392,567 0.07 408,314 0.07 Interest bearing demand deposits 2,757,120 3.15 2,642,003 0.29 Time deposits: . Deposits of $100,000 or more 494,873 2.30 633,947 0.51 Other time deposits 180,502 1.44 198,257 0.71 Total deposits $ 5,487,592 1.84 % $ 5,848,638 0.21 % FHLB advances and other borrowings 241,870 4.67 75,026 0.39 Total funding sources $ 5,729,462 1.96 % $ 5,923,664 0.22 % Average total deposits were $5.488 billion for the first quarter of 2023, a decrease of $361.0 million, or 6.2%, from the first quarter of 2022. Average total borrowings were $241.9 million for the first quarter of 2023, an increase of $166.8 million from the first quarter of 2023. Deposits and Borrowings As of March 31, 2023, total deposits increased by $57.1 million, or 1.0%, from December 31, 2022. Core deposits, which excludes brokered deposits, decreased by $93.5 million, or 1.7%, to $5.357 billion as of March 31, 2023 from $5.451 billion as of December 31, 2022. Total brokered deposits were $160.7 million at March 31, 2023 compared to $10.0 million at December 31, 2022. 41 Table of Contents The following table summarizes deposit composition at March 31, 2023 and December 31, 2022: (dollars in thousands) March 31, 2023 Percentage of Total December 31, 2022 Percentage of Total Current Period Change Retail $ 1,894,707 34.3 % $ 1,934,787 35.4 % $ (40,080) Commercial 2,105,512 38.2 2,085,934 38.2 19,578 Public funds 1,356,851 24.6 1,429,872 26.2 (73,021) Core deposits $ 5,357,070 97.1 % $ 5,450,593 99.8 % $ (93,523) Brokered deposits 160,658 2.9 10,027 0.2 150,631 Total deposits $ 5,517,728 100.0 % $ 5,460,620 100.0 % $ 57,108 Commercial, retail and public funds deposit composition remained stable between March 31, 2023 and December 31, 2022. On March 31, 2023 and December 31, 2022, commercial deposits represented 38% of total deposits. Retail deposits represented 34% at March 31, 2023 versus 35% at December 31, 2022. Public Funds deposits represented 25% at March 31, 2023 versus 26% at December 31, 2022. Commercial deposits grew $19.6 million, or 0.9%, from $2.086 billion at December 31, 2022; retail deposits contracted $40.1 million, or 2.1%, from $1.935 billion at December 31, 2022; and public funds deposits contracted $73.0 million, or 5.1%, from $1.430 billion at December 31, 2022. Commercial checking accounts increased in number of accounts and balances since year end and average balances per account remain elevated above pre-pandemic levels. Retail checking accounts have increased, but balances have declined. Average retail checking account balances per account have declined modestly but remain elevated above pre-pandemic levels. Public Fund accounts are unchanged, but balances have decreased. Average public fund checking account balances are lower on a linked quarter basis but remain elevated as compared to pre-pandemic levels. Uninsured deposits, not covered by FDIC deposit insurance or the Indiana Public Deposit Insurance Fund (PDIF), were 29% of total deposits as of March 31, 2023, versus 30% as of December 31, 2022. Deposits not insured by FDIC Insurance coverage (including the public fund deposits that are covered by the PDIF) were 54% as of March 31, 2023, versus 56% at December 31, 2022. As of March 31, 2023, and December 31, 2022, 98% of deposit accounts have deposit balances less than $250,000 and 2% of accounts have deposit balances greater than $250,000. Utilization of other sources of liquidity totaled $360.7 million at March 31, 2023, compared to $307.0 million at December 31, 2022, an increase of $53.7 million, or 17.5%. Brokered deposits of $160.7 million at March 31, 2023 drove the increase up $150.6 million from $10.0 million at December 31, 2022. Total borrowings decreased $97.0 million, or 32.7%, from $297.0 million at December 31, 2022 to $200.0 million at March 31, 2023, driven by a decrease in Federal Funds purchased of $22.0 million, and a decrease in FHLB advances of $75.0 million, or 27.3%. Capital As of March 31, 2023, total stockholders’ equity was $602.0 million, an increase of $33.1 million, or 5.8%, from $568.9 million at December 31, 2022. Net income of $24.3 million increased equity. In addition, an increase of $21.6 million in accumulated other comprehensive income (loss), primarily driven by a net increase in the fair value of available-for-sale securities, contributed to the increase. Dividends declared and paid of $0.46 per share, or $11.7 million, offset the increase to total stockholders' equity. The impact on equity for other comprehensive income (loss) is not included in regulatory capital. The banking regulators have established guidelines for leverage capital requirements, expressed in terms of Tier 1, or core capital, as a percentage of average assets, to measure the soundness of a financial institution. In addition, banking regulators have established risk-based capital guidelines for U.S. banking organizations. As of March 31, 2023, the Company's capital levels remained characterized as “well-capitalized”. 42 Table of Contents The actual capital amounts and ratios of the Company and the Bank as of March 31, 2023 and December 31, 2022, are presented in the table below. Capital ratios for March 31, 2023 are preliminary until the Call Report and FR Y-9C are filed. Actual Minimum Required For Capital Adequacy Purposes For Capital Adequacy Purposes Plus Capital Conservation Buffer Minimum Required to Be Well Capitalized Under Prompt Corrective Action Regulations (dollars in thousands) Amount Ratio Amount Ratio Amount Ratio Amount Ratio As of March 31, 2023: Total Capital (to Risk Weighted Assets) Consolidated $ 832,907 15.21 % $ 438,191 8.00 % $ 575,126 N/A N/A N/A Bank $ 810,361 14.83 % $ 437,037 8.00 % $ 573,611 10.50 % $ 546,296 10.00 % Tier I Capital (to Risk Weighted Assets) Consolidated $ 764,316 13.95 % $ 328,643 6.00 % $ 465,578 N/A N/A N/A Bank $ 741,948 13.58 % $ 327,778 6.00 % $ 464,352 8.50 % $ 437,037 8.00 % Common Equity Tier 1 (CET1) Consolidated $ 764,316 13.95 % $ 246,483 4.50 % $ 383,417 N/A N/A N/A Bank $ 741,948 13.58 % $ 245,833 4.50 % $ 382,407 7.00 % $ 355,092 6.50 % Tier I Capital (to Average Assets) Consolidated $ 764,316 11.56 % $ 264,374 4.00 % $ 264,374 N/A N/A N/A Bank $ 741,948 11.25 % $ 263,730 4.00 % $ 263,730 4.00 % $ 329,663 5.00 % As of December 31, 2022: Total Capital (to Risk Weighted Assets) Consolidated $ 821,008 15.07 % $ 435,786 8.00 % $ 571,969 N/A N/A N/A Bank $ 801,044 14.74 % $ 434,758 8.00 % $ 570,620 10.50 % $ 543,448 10.00 % Tier I Capital (to Risk Weighted Assets) Consolidated $ 752,751 13.82 % $ 326,840 6.00 % $ 463,023 N/A N/A N/A Bank $ 732,966 13.49 % $ 326,069 6.00 % $ 461,930 8.50 % $ 434,758 8.00 % Common Equity Tier 1 (CET1) Consolidated $ 752,751 13.82 % $ 245,130 4.50 % $ 381,313 N/A N/A N/A Bank $ 732,966 13.49 % $ 244,551 4.50 % $ 380,413 7.00 % $ 353,241 6.50 % Tier I Capital (to Average Assets) Consolidated $ 752,751 11.50 % $ 261,859 4.00 % $ 261,859 N/A N/A N/A Bank $ 732,966 11.22 % $ 261,222 4.00 % $ 261,222 4.00 % $ 326,527 5.00 % 43 Table of Contents FORWARD-LOOKING STATEMENTS This document (including information incorporated by reference) contains, and future oral and written statements of the Company and its management may contain, forward-looking statements, within the meaning of such term in the federal securities law. Forward-looking statements are not historical facts and are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “project,” “possible,” “continue,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events. The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain and, accordingly, the reader is cautioned not to place undue reliance on any forward-looking statement made by the Company. Actual results could differ materially from those addressed in the forward-looking statements as a result of numerous factors, including, without limitation: • the effects of future economic, business and market conditions and changes, including prevailing interest rates and the rate of inflation; • governmental monetary and fiscal policies and the impact the current economic environment will have on these; • the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities and other interest sensitive assets and liabilities; • changes in borrowers’ credit risks and payment behaviors; • the failure of assumptions and estimates used in our reviews of our loan portfolio, underlying the establishment of reserves for possible credit losses, our analysis of our capital position and other estimates; • the effects of disruption and volatility in capital markets on the value of our investment portfolio; • the effects of competition from a wide variety of local, regional, national and other providers of financial, investment and insurance services; • the risks related to the recent failures of Silicon Valley Bank and Signature Bank, including the effects on FDIC premiums, increased regulation, and increased deposit volatility; • the timing and scope of any legislative and regulatory changes, including changes in banking, securities and tax laws and regulations and their application by our regulators; • changes in the scope and cost of FDIC insurance, the state of Indiana’s Public Deposit Insurance Fund and other coverages; • changes in the prices, values and sales volumes of residential and commercial real estate; • the risk of labor availability, trade policy and tariffs, as well as supply chain constraints could impact loan demand from the manufacturing sector; • changes in the availability and cost of credit and capital in the financial markets; • the outcome of pending litigation and other claims we may be subject to from time to time; • the anticipated phase out of most LIBOR tenors by mid-2023 and establishment of a new reference rate or rates; • risk of cyber-security attacks that could result in damage to the Company's or third-party service providers' networks or data of the Company; • changes in technology or products that may be more difficult or costly, or less effective than anticipated; • the effects of any employee or customer fraud; • the risks of mergers, acquisitions and divestitures, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and possible failures to achieve expected gains, revenue growth and/or expense savings from such transactions; • changes in accounting policies, rules and practices; 44 Table of Contents • the effects of war or other conflicts, acts of terrorism or other catastrophic events, including storms, droughts, tornados and flooding, that may affect general economic conditions, including agricultural production and demand and prices for agricultural goods and land used for agricultural purposes, generally and in our markets; and • the risks noted in the Risk Factors discussed under Item 1A of Part 1 of our Annual Report on Form 10-K for the year ended December 31, 2022, as well as other risks and uncertainties set forth from time to time in the Company’s other filings with the SEC. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.