What changed in this filing

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Item 2. Management’s Discussion and Analysis

2023-08-02 compared with 2023-05-03 · 258 added, 152 removed, 395 unchanged (51% of the section changed)

54 unchanged sentences

The Bank specializes in providing lending and deposit related services to small businesses nationwide.

The Bank identifies and extends lending to credit-worthy borrowers within specified industries, also called verticals, through expertise within those industries, and more broadly to select borrowers outside of those industries.

A significant portion of the loans originated by the Bank are guaranteed by the SBA under the 7(a) Loan Program and the U.S.

Department of Agriculture’s (“USDA”) Rural Energy for America Program (“REAP”), Water and Environmental Program (“WEP”), Business & Industry (“B&I”) and Community Facilities loan programs.

These loans are to small businesses and professionals with what the Bank believes are lower risk characteristics.

Industries, or “verticals,” on which the Bank focuses its lending efforts are carefully selected.

The Bank also lends more broadly to select borrowers outside of those verticals.

The Company’s wholly owned material subsidiaries are the Bank, Government Loan Solutions (“GLS”), Live Oak Grove, LLC (“Grove”), Live Oak Ventures, Inc.

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Performance Summary

Three months ended March 31, 2023 compared with three months ended March 31, 2022

For the three months ended March 31, 2023, the Company reported net income of $398 thousand, or $0.01 per diluted share, compared to net income of $34.5 million, or $0.76 per diluted share, for the first quarter of 2022.

Three months ended June 30, 2023 compared with three months ended June 30, 2022

For the three months ended June 30, 2023, the Company reported net income of $17.5 million, or $0.39 per diluted share, compared to net income of $97.0 million, or $2.16 per diluted share, for the second quarter of 2022.

The decrease in net income was largely due to the following items:

• Provision for loan and lease credit losses increased $17.2 million, compared to $1.8 million for the first quarter of 2022.

The level of provision expense in the first quarter of 2023 was primarily the result of continued growth of the loan and lease portfolio combined with portfolio trends and changes in the macroeconomic outlook;

• Decreased net gains on sales of loans of $10.8 million, or 51.5%, the result of lower loan sale volume and comparatively lower premiums in the first quarter of 2023;

• The net loss on loans accounted for under the fair value option of $4.5 million, increased by $5.0 million, from a net gain of $516 thousand in the first quarter of 2022;

• Increased noninterest expense of $13.2 million, or 20.2%, principally comprised of salaries and employee benefits up $6.3 million, or 16.3%, and other expense up $3.5 million largely a product of $2.8 million in increased levels of reserves on unfunded commitments driven by refinements in estimation assumptions.

Key factors partially offsetting the decrease in net income for the first quarter of 2023 were:

• Increase in net interest income of $4.2 million, or 5.4%, predominately from increases in volume for the total loan and lease portfolio, partially mitigated by a decrease in the net interest margin arising from an increase in interest-bearing liabilities combined with average cost of funds outpacing the average yield on interest-earning assets;

• A net gain on loan servicing asset revaluation of $356 thousand compared to a net loss of $1.6 million in the first quarter of 2022, resulting in a positive change of $1.9 million, or 122.7%;

• Increased management fee income of $2.0 million, or 133.3%;

• Decrease in equity method investment income of $121.1 million, largely driven by the second quarter of 2022 gain of $120.5 million related to the Company's sale of its investment in Finxact, Inc.

• Provision for loan and lease credit losses increased by $7.8 million to $13.0 million, compared to $5.3 million for the second quarter of 2022.

The level of provision expense in the second quarter of 2023 was primarily the result of continued growth of the loan and lease portfolio combined with portfolio trends largely comprised of specific reserve increases in two impaired loans.

Key factors partially offsetting the decrease in net income for the second quarter of 2023 were:

• Increase in net interest income of $4.4 million, or 5.5%, predominately from increases in variable interest-earning assets following the first quarter of 2023 Federal Reserve rate increases combined with increased levels of cash, investments and the total loan and lease portfolio, partially mitigated by a decrease in the net interest margin arising from an increase in interest-bearing liabilities combined with average cost of funds outpacing the average yield on interest-earning assets;

• The net loss on loan servicing asset revaluation decreased $5.8 million, or 67.3%, to $2.8 million compared to a net loss of $8.7 million in the second quarter of 2022;

• Increased net gains on sales of loans of $5.2 million, or 91.9%, principally the result of a higher volume of loan sales in the second quarter of 2023;

• The net gain on loans accounted for under the fair value option of $1.7 million, improved by $6.2 million, from a net loss of $4.5 million in the second quarter of 2022;

• Decreased contributions and donations expense of $5.5 million, principally related to a special 2022 charitable donation of $5.0 million made in connection with the above discussed Finxact gain;

• Decreased income tax expense of $23.8 million, or 94.3%, principally related to above discussed decrease in net income.

Six months ended June 30, 2023 compared with six months ended June 30, 2022

For the six months ended June 30, 2023, the Company reported net income of $17.9 million, or $0.40 per diluted share, compared to net income of $131.5 million, or $2.92 per diluted share, for the first half of 2022.

The decrease in net income was largely due to the following items:

• Decrease in equity method investment income of $121.9 million, principally a product of the above discussed Finxact gain of $120.5 million in the second quarter of 2022;

• Provision for loan and lease credit losses increased by $24.9 million, to $32.0 million, compared to $7.1 million for the first half of 2022.

The level of provision expense in the first half of 2023 was primarily the result of continued growth of the loan and lease portfolio combined with portfolio trends and changes in the macroeconomic outlook;

• Decreased net gains on sales of loans of $5.6 million, or 21.2%, principally the result of comparatively negative market premiums in the first half of 2023;

• Increased FDIC insurance expense of $4.3 million, or 104.6%, largely a product of rate increases effective in 2023 combined with the ongoing growth of Live Oak Banking Company.

Key factors partially offsetting the decrease in net income for the first half of 2023 were:

• Increase in net interest income of $8.6 million, or 5.5%, principally the result of the above discussed drivers of the quarter over quarter increase;

• A net loss on loan servicing asset revaluation of $2.5 million compared to a net loss of $10.2 million in the first half of 2022, resulting in a positive change of $7.8 million, or 75.8%;

• Decreased contributions and donations expense of $6.2 million, principally related to a special 2022 charitable donation of $5.0 million discussed above related to the 2022 Finxact gain;

• Decreased income tax expense of $29.0 million, or 86.2%, principally related to above discussed decrease in net income.

Net Interest Income and Margin

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Due to the nature of a branchless bank and the relatively low overhead required for deposit gathering, the rates that the Bank offers are generally above the industry average.

Three months ended March 31, 2023 compared with three months ended March 31, 2022

For the three months ended March 31, 2023, net interest income increased $4.2 million, or 5.4%, to $82.0 million compared to $77.8 million for the three months ended March 31, 2022.

This increase was principally due to the growth in the held for investment loan and lease portfolio outpacing growth in interest-bearing liabilities combined with an increase in average cost of funds which exceeded the increase in average yield on interest-earning assets.

Three months ended June 30, 2023 compared with three months ended June 30, 2022

For the three months ended June 30, 2023, net interest income increased $4.4 million, or 5.5%, to $84.3 million compared to $79.9 million for the three months ended June 30, 2022.

This increase was principally due to the growth in the held for investment loan and lease portfolio outpacing growth in interest-bearing liabilities offset by an increase in average cost of funds which exceeded the increase in average yield on interest-earning assets.

Excluding PPP loan impacts, comprised of amortization of net deferred fees combined with a 1% annualized interest rate less the related interest expense from funding activity, net interest income increased by $5.5 million.

Average interest-earning assets increased by $1.75 billion, or 22.3%, to $9.61 billion for the first quarter of 2023, compared to $7.85 billion for the first quarter of 2022, while the yield on average interest-earning assets increased one hundred-sixty basis points to 6.39%.

The cost of funds on interest-bearing liabilities for the first quarter of 2023 increased two hundred-thirty basis points to 3.11%, and the average balance of interest-bearing liabilities increased by $1.53 billion, or 20.3%, over the first quarter of 2022.

The increase in average interest-bearing liabilities was also largely driven by funding for significant loan originations and growth.

Average interest-earning assets increased by $2.03 billion, or 24.6%, to $10.27 billion for the second quarter of 2023, compared to $8.25 billion for the second quarter of 2022, while the yield on average interest-earning assets increased one hundred-eighty basis points to 6.63%.

The cost of funds on interest-bearing liabilities for the second quarter of 2023 increased two hundred-sixty basis points to 3.59%, and the average balance of interest-bearing liabilities increased by $1.69 billion, or 21.6%, over the second quarter of 2022.

The increase in average interest-bearing liabilities was largely driven by funding for significant loan originations and growth as well as maintenance of the Company's target liquidity profile.

This increase was muted by a $95.0 million reduction in average borrowings largely related to Paycheck Protection Program Liquidity Facility, or PPPLF, repayments in 2022.

As indicated in the rate/volume table below, the overall increase discussed above is reflected in increased interest income of $58.6 million outpacing growth in interest expense of $54.4 million for the first quarter of 2023 compared to the first quarter of 2022.

For the first quarter of 2023 compared to the first quarter of 2022, net interest margin decreased from 4.02% to 3.46%.

During 2022 and through March of 2023, the Federal Reserve increased the federal funds upper target rate by 425 basis points and 50 basis points, respectively, to 5.00%.

In March 2023, the Federal Reserve released its most current federal funds target rate midpoint projections which implied an increase of the median Federal Funds rate to 5.1% by the end of 2023 and a decrease of approximately 75 basis points to 4.3% by the end of 2024.

As indicated in the rate/volume table below, the overall increase discussed above is reflected in increased interest income of $70.5 million outpacing growth in interest expense of $66.1 million for the second quarter of 2023 compared to the second quarter of 2022.

The net interest margin decreased from 3.89% for the second quarter of 2022 to 3.29% for the second quarter of 2023.

Six months ended June 30, 2023 compared with six months ended June 30, 2022

For the six months ended June 30, 2023, net interest income increased $8.6 million, or 5.5%, to $166.3 million compared to $157.7 million for the six months ended June 30, 2022.

Average interest-earning assets increased by $1.94 billion, or 24.1%, to $9.99 billion for the first half of 2023, compared to $8.05 billion for the first half of 2022, while the yield on average interest-earning assets increased one hundred-sixty-seven basis points to 6.48%.

The cost of funds on interest-bearing liabilities for the first half of 2023 increased two hundred-forty-six basis points to 3.36%, and the average balance of interest-bearing liabilities increased by $1.61 billion, or 21.0%, over the first half of 2022.

The increase in average interest-bearing liabilities was largely driven by funding for significant loan originations and growth as well as maintenance of the Company's target liquidity profile.

This increase was muted by a $99.4 million reduction in average borrowings largely related to Paycheck Protection Program Liquidity Facility, or PPPLF, repayments in 2022.

As indicated in the rate/volume table below, the overall increase discussed above is reflected in increased interest income of $129.1 million outpacing growth in interest expense of $120.5 million for the first half of 2023 compared to the first half of 2022.

The net interest margin decreased from 3.95% for the first half of 2022 to 3.36% for the first half of 2023.

During the first half of 2023, the Federal Reserve increased the federal funds upper target rate by 75 basis points.

Subsequently, on July 26, 2023 the Federal Reserve further increased the federal funds upper target rate by 25 basis points, to 5.50%.

In June 2023, the Federal Reserve released its most current federal funds target rate midpoint projections which implied an increase of the median Federal Funds rate to 5.6% by the end of 2023 and a decrease of approximately 100 basis points to 4.6% by the end of 2024.

There can be no assurance that any further increases in the Federal Funds rate will occur, and if they do, the amount and timing of actual increases are subject to change.

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Loan fees are included in interest income on loans.

Three Months Ended March 31,

Three Months Ended June 30,

Balance Interest Average

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(1) Average loan and lease balances include non-accruing loans and leases.

Six Months Ended June 30,

Interest Average

Interest-earning assets:

Interest-earning balances in other banks $ 530,205 $ 12,040 4.58 % $ 276,114 $ 1,027 0.75 %

Federal funds sold 69,629 1,624 4.70 43,897 202 0.93

Investment securities 1,220,028 16,050 2.65 905,403 7,445 1.66

Loans held for sale 538,385 24,139 9.04 1,117,360 31,152 5.62

Loans and leases held for investment (1)

7,636,343 267,275 7.06 5,708,084 152,203 5.38

Total interest-earning assets 9,994,590 321,128 6.48 8,050,858 192,029 4.81

Allowance for credit losses on loans and leases

(101,457) (62,649)

Noninterest-earning assets 496,925 616,486

Total assets $ 10,390,058 $ 8,604,695

Interest-bearing liabilities:

Interest-bearing checking $ 161,626 $ 4,239 5.29 % $ — $ — — %

Savings 4,242,763 78,181 3.72 3,750,838 12,378 0.67

Money market accounts 117,753 321 0.55 92,272 110 0.24

Certificates of deposit 4,664,536 69,857 3.02 3,633,547 20,637 1.15

Total deposits 9,186,678 152,598 3.35 7,476,657 33,125 0.89

Borrowings 97,920 2,211 4.55 197,369 1,191 1.22

Total interest-bearing liabilities 9,284,598 154,809 3.36 7,674,026 34,316 0.90

Noninterest-bearing deposits 191,489 91,373

Noninterest-bearing liabilities 72,467 53,841

Shareholders' equity 841,504 785,455

Total liabilities and shareholders' equity

$ 10,390,058 $ 8,604,695

Net interest income and interest rate spread

$ 166,319 3.12 % $ 157,713 3.91 %

Net interest margin 3.36 % 3.95 %

Ratio of average interest-earning assets to average interest-bearing liabilities

107.65 % 104.91 %

(1) Average loan and lease balances include non-accruing loans and leases.

Rate/Volume Analysis.

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For purposes of this table, increases or decreases attributable to changes in both rate and volume that cannot be segregated have been allocated proportionally based on the changes due to rate and the changes due to volume.

Three Months Ended March 31,

Increase (Decrease) Due to

Rate Volume Total

Three Months Ended June 30, Six Months Ended June 30,

2022 2023 vs.

Increase (Decrease) Due to Increase (Decrease) Due to

Rate Volume Total Rate Volume Total

Interest income:

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Provision for Loan and Lease Credit Losses

The provision for loan and lease credit losses represents the amount necessary to be charged against the current period’s earnings to maintain the ACL on loans and leases at a level that the Company believes is appropriate in relation to the estimated losses inherent in the loan and lease portfolio.

The provision for loan and lease credit losses represents the amount necessary to be charged against the current period’s earnings to maintain the allowance for credit losses (“ACL”) on loans and leases at a level that the Company believes is appropriate in relation to the estimated losses inherent in the loan and lease portfolio.

Losses inherent in loan relationships are mitigated if a portion of the loan is guaranteed by the SBA or USDA.

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The Company believes that its focus on compliance with regulations and guidance from the SBA and USDA are key factors to managing this risk.

For the first quarter of 2023, there was a provision for loan and lease credit losses of $19.0 million compared to $1.8 million for the same period in 2022, an increase of $17.2 million.

The increase in provision expense as compared to the first quarter of 2022 was primarily the result of loan growth, combined with portfolio trends and changes in the macroeconomic outlook.

Loans and leases held for investment at historical cost were $7.22 billion as of March 31, 2023, increasing by $2.08 billion, or 40.5%, compared to March 31, 2022.

Excluding PPP loans and net unearned fees on those loans, the balance in loans and leases held for investment at historical cost was $7.21 billion at March 31, 2023, an increase of $2.20 billion, or 44.0%, over March 31, 2022.

Net charge-offs for loans and leases carried at historical cost were $6.7 million, or 0.38% of average quarterly loans and leases held for investment, carried at historical cost, on an annualized basis, for the three months ended March 31, 2023, compared to net charge-offs of $2.4 million, or 0.19%, for the three months ended March 31, 2022.

The increase in net charge-offs for the first three months of 2023 was primarily isolated to two relationships.

Net charge-offs are a key element of historical experience in the Company's estimation of the allowance for credit losses on loans an d leases.

In addition, nonperforming loans and leases not guaranteed by the SBA or USDA, excluding $8.2 million and $4.5 million accounted for under the fair value option at March 31, 2023 and 2022, respectively, totaled $22.0 million, which was 0.30% of the held for investment loan and lease portfolio carried at historical cost at March 31, 2023, compared to $19.5 million, or 0.38% of loans and leases held for investment carried at historical cost at March 31, 2022.

For the second quarter of 2023, there was a provision for loan and lease credit losses of $13.0 million compared to $5.3 million for the same period in 2022, an increase of $7.8 million.

For the first six months of 2023, there was a provision for loan and lease credit losses of $32.0 million compared to $7.1 million for the same period in 2022, an increase of $24.9 million.

The increase in provision expense as compared to the second quarter of 2022 and first six months of 2022 was primarily the result of loan growth, combined with portfolio trends and changes in the macroeconomic outlook.

Loans and leases held for investment at historical cost were $7.39 billion as of June 30, 2023, increasing by $2.07 billion, or 38.7%, compared to June 30, 2022.

Net charge-offs for loans and leases carried at historical cost were $1.2 million, or 0.06% of average quarterly loans and leases held for investment, carried at historical cost, on an annualized basis, for the three months ended June 30, 2023, compared to net charge-offs of $2.5 million, or 0.19%, for the three months ended June 30, 2022.

For the six months ended June 30, 2023 , net charge-offs totaled $7.8 million compared to $4.8 million for the six months ended June 30, 2022 , an increase of $3.0 million, or 62.2%.

The increase in net charge-offs for the first half of 2023 was primarily isolated to two relationships.

Net charge-offs are a key element of historical experience in the Company's estimation of the allowance for credit losses on loans and leases.

In addition, nonperforming loans and leases not guaranteed by the SBA or USDA, excluding $8.6 million and $3.6 million accounted for under the fair value option at June 30, 2023 and 2022, respectively, totaled $44.9 million, which was 0.61% of the held for investment loan and lease portfolio carried at historical cost at June 30, 2023, compared to $12.0 million, or 0.22% of loans and leases held for investment carried at historical cost at June 30, 2022.

The increase in total nonperforming loans and leases not guaranteed and carried at historical cost was principally isolated to two large relationships.

Noninterest Income

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In addition, the loan servicing revaluation is significantly impacted by changes in market rates and other underlying assumptions such as prepayment speeds and default rates.

Net (loss) gain on loans accounted for under the fair value option is also significantly impacted by changes in market rates, prepayment speeds and inherent credit risk.

Net gain (loss) on loans accounted for under the fair value option is also significantly impacted by changes in market rates, prepayment speeds and inherent credit risk.

Other less consistent elements of noninterest income include gains and losses on investments.

The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.

Three Months Ended March 31, 2023/2022 Increase (Decrease)

Three Months Ended June 30, 2023/2022 Increase (Decrease)

2023 2022 Amount Percent

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Net gains on sales of loans 10,804 5,630 5,174 91.9

Net (loss) gain on loans accounted for under the fair value option (4,529) 516 (5,045) (977.7)

Equity method investments income (loss) (2,952) (2,124) (828) (39.0)

Net gain (loss) on loans accounted for under the fair value option 1,728 (4,461) 6,189 138.7

Equity method investments (loss) income (2,055) 119,056 (121,111) (101.7)

Equity security investments gains (losses), net 121 1,655 (1,534) (92.7)

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Total noninterest income $ 24,156 $ 128,529 $ (104,373) (81.2) %

For the three months ended March 31, 2023, noninterest income decreased by $13.1 million, or 40.1%, compared to the three months ended March 31, 2022.

The decrease over the prior year is the result of a decrease in net gains on sales of loans of $10.8 million combined with an incremental $5.0 million net loss on loans accounted for under the fair value option.

Partially offsetting the decrease over the prior year was the net gain on servicing asset revaluation incrementally increasing $1.9 million combined with $2.0 million more in management fee income generated by Canapi Advisors.

Six Months Ended June 30, 2023/2022 Increase (Decrease)

2023 2022 Amount Percent

Noninterest income

Loan servicing revenue $ 13,067 $ 12,833 $ 234 1.8 %

Loan servicing asset revaluation (2,475) (10,237) 7,762 75.8

Net gains on sales of loans 20,979 26,607 (5,628) (21.2)

Net gain (loss) on loans accounted for under the fair value option (2,801) (3,945) 1,144 29.0

Equity method investments (loss) income (5,007) 116,932 (121,939) (104.3)

Equity security investments gains (losses), net 198 1,611 (1,413) (87.7)

Lease income 5,070 5,013 57 1.1

Management fee income 6,738 4,046 2,692 66.5

Other noninterest income 7,966 8,337 (371) (4.5)

Total noninterest income $ 43,735 $ 161,197 $ (117,462) (72.9) %

For the three months ended June 30, 2023, noninterest income decreased by $104.4 million, or 81.2%, compared to the three months ended June 30, 2022.

The decrease over the prior year is primarily a result of the $120.5 million Finxact gain included in equity method investment income in the second quarter of 2022.

Partially offsetting the decrease over the second quarter of 2022 was lower losses of $5.8 million related to the servicing asset revaluation, an increase in net gains on sales of loans of $5.2 million, combined with an incremental $6.2 million net gain on loans accounted for under the fair value option.

For the six months ended June 30, 2023, noninterest income decreased by $117.5 million, or 72.9%, compared to the six months ended June 30, 2022.

The decrease over the prior year is primarily a result of the above mentioned Finxact gain in the second quarter of 2022 combined with a decrease in net gains on sales of loans of $5.6 million.

Partially offsetting the decrease over the prior year to date period was lower losses of $7.8 million related to the servicing asset revaluation combined with a $2.7 million increase in management fee income generated by Canapi Advisors.

Canapi Advisors is included in the Company's Fintech segment.

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These components are key drivers of the Company's noninterest income.

Three Months Ended March 31, For years ended December 31,

Three months ended June 30, Three months ended March 31,

2023 2022 2023 2022

Amount of loans and leases originated $ 861,033 $ 959,635 $ 1,030,882 $ 865,063

Guaranteed portions of loans sold 245,074 68,818 167,826 219,703

Outstanding balance of guaranteed loans sold (1)

2,808,200 2,681,079 2,695,757 2,786,403

Six Months Ended June 30, For years ended December 31,

2023 2022 2022 2021 2020 2019

Amount of loans and leases originated

$ 1,891,915 $ 1,824,698 $ 4,007,621 $ 4,480,725 $ 4,450,198 $ 2,001,886

Guaranteed portions of loans sold

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The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as adequate compensation for servicing, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses, with the prepayment speed being one of the most sensitive assumptions.

For the three months ended March 31, 2023, there was a net gain on loan servicing asset revaluation of $356 thousand, compared to a net loss of $1.6 million for the three months ended March 31, 2022, resulting in a positive change of $1.9 million, or 122.7%.

The increase in the net gain on valuation of the servicing asset compared to the first quarter of 2022 was principally the result of positive movements in market pricing during the first three months of 2023 as compared to negative market changes within the first quarter of 2022.

For the three months ended June 30, 2023, there was a net loss on loan servicing asset revaluation of $2.8 million, compared to a net loss of $8.7 million for the three months ended June 30, 2022, resulting in a positive comparative quarter change of $5.8 million, or 67.3%.

For the six months ended June 30, 2023, there was a net loss on loan servicing asset revaluation of $2.5 million compared to $10.2 million for the six months ended June 30, 2022, resulting in a positive change of $7.8 million, or 75.8%.

The increase in the valuation of the servicing asset compared to the second quarter and first half of 2022 was principally the result of negative market trends in 2022 outpacing those experienced in 2023.

Net Gains on Sales of Loans:

For the three months ended March 31, 2023, net gains on sales of loans decreased $10.8 million, or 51.5%, compared to the three months ended March 31, 2022.

The volume of guaranteed loans sold decreased $51.9 million, or 23.6%, for the three months ended March 31, 2023 to $167.8 million from $219.7 million in the three months ended March 31, 2022.

The average net gain on loan sale premium decreased from 109% to 106% in the first quarters of 2022 and 2023, respectively.

The decrease in net gains on sales of loans was principally the result of lower loan sale volume and comparatively lower premiums in the first quarter of 2023.

Accordingly, these market trends influenced the Company's level of appetite for loan sales during periods of weaker premiums in the current year.

Net (Loss) Gain on Loans Accounted for Under the Fair Value Option :

For the three months ended March 31, 2023, the Company had a net loss on loans accounted for under the fair value option of $4.5 million compared to a net gain of $516 thousand for the first quarter of 2022, a negative change of $5.0 million.

The carrying amount of loans accounted for under the fair value option at March 31, 2023 and 2022 was $467.0 million (all classified as held for investment) and $625.7 million ($25.1 million classified as held for sale and $600.6 million classified as held for investment), respectively, a decrease of $158.7 million, or 25.4% .

The incremental net loss on loans accounted for under the fair value option during first quarter of 2023 compared to the first quarter of 2022 was largely the result of negative market impacts related to rising interest rates.

For the three months ended June 30, 2023, net gains on sales of loans increased $5.2 million, or 91.9%, compared to the three months ended June 30, 2022.

The volume of guaranteed loans sold increased $176.3 million, or 256.1%, for the three months ended June 30, 2023 to $245.1 million from $68.8 million in the three months ended June 30, 2022.

For the six months ended June 30, 2023, net gains on sales of loans decreased $5.6 million, or 21.2%, compared to the six months ended June 30, 2022.

For the six months ended June 30, 2023, the volume of guaranteed loans sold increased $124.4 million, or 43.1%, to $412.9 million from $288.5 million for the six months ended June 30, 2022.

The average net gain on loan sale premium decreased from 108% to 105% in the second quarters of 2022 and 2023, respectively, and decreased from 109% to 106% in the first halves of 2022 and 2023, respectively.

The increase in net gains on sales of loans over the second quarter of 2022 was principally the result of higher loan sale volume while the decrease over the first half of 2022 was principally related to the effect of weaker premiums outpacing heightened levels of sales volume.

Net Gain (Loss) on Loans Accounted for Under the Fair Value Option :

For the three months ended June 30, 2023, the Company had a net gain on loans accounted for under the fair value option of $1.7 million compared to a net loss of $4.5 million for the second quarter of 2022, a positive change of $6.2 million, or 138.7%.

For the six months ended June 30, 2023 , the Company had a net loss on loans accounted for under the fair value option of $2.8 million compared to a net loss of $3.9 million for the same period of 2022 , a positive change of $1.1 million, or 29.0%.

The carrying amount of loans accounted for under the fair value option at June 30, 2023 and 2022 was $441.8 million (all classified as held for investment) and $554.1 million ($23.5 million classified as held for sale and $530.6 million classified as held for investment), respectively, a decrease of $112.3 million, or 20.3% .

The incremental net gain on loans accounted for under the fair value option compared to both prior periods was largely the result of moderating interest rate impacts in 2023 combined with a continued decline in the size of the underlying principal balance of the portfolio.

Noninterest Expense

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The following table shows the components of noninterest expense and the related dollar and percentage changes for the periods presented.

Three Months Ended March 31, 2023/2022 Increase (Decrease)

Three Months Ended June 30, 2023/2022 Increase (Decrease)

2023 2022 Amount Percent

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Total noninterest expense $ 76,457 $ 80,879 $ (4,422) (5.5) %

Total noninterest expense for the three months ended March 31, 2023, increased $13.2 million, or 20.2%, compared to the same period in 2022.

The increase in noninterest expense for the comparable three month period was largely driven by various components, as discussed below.

Six Months Ended June 30, 2023/2022 Increase (Decrease)

2023 2022 Amount Percent

Noninterest expense

Salaries and employee benefits $ 87,831 $ 84,783 $ 3,048 3.6 %

Total personnel expense for the three months ended March 31, 2023 increased by $6.3 million, or 16.3%, compared to the same period in 2022.

The increase in salaries and employee benefits was principally related to continued investment in human resources to support strategic and growth initiatives.

Total full-time equivalent employees increased from 842 at March 31 , 2022, to 968 at March 31 , 2023.

Salaries and employee benefits expense included $6.2 million and $5.0 million of stock-based compensation for the three months ended March 31, 2023 and 2022, respectively.

Non-employee expenses:

Travel expense 5,181 4,255 926 21.8

Professional services expense 2,923 6,779 (3,856) (56.9)

Advertising and marketing expense 6,612 4,030 2,582 64.1

Occupancy expense 4,130 5,100 (970) (19.0)

Technology expense 15,734 11,815 3,919 33.2

Equipment expense 7,841 7,600 241 3.2

Other loan origination and maintenance expense 7,369 6,135 1,234 20.1

Renewable energy tax credit investment impairment 69 50 19 38.0

FDIC insurance 8,464 4,136 4,328 104.6

Contributions and donations — 6,238 (6,238) (100.0)

Other expense 9,265 5,672 3,593 63.3

Total non-employee expenses 67,588 61,810 5,778 9.3

Total noninterest expense $ 155,419 $ 146,593 $ 8,826 6.0 %

Total noninterest expense for the three and six months ended June 30, 2023, decreased $4.4 million, or 5.5%, and increased $8.8 million, or 6.0%, respectively, compared to the same periods in 2022.

The changes in noninterest expense for the comparable three and six month period was largely driven by various components, as discussed below.

Salaries and employee benefits :

Total personnel expense for the three and six months ended June 30, 2023 decreased by $3.2 million, or 6.9%, and increased $3.0 million, or 3.6%, respectively, compared to the same periods in 2022.

The decrease in salaries and employee benefits over the second quarter of 2022 was largely the product of lower levels in bonus accruals while the increase over the first half of 2022 is principally related to continued investment in human resources to support strategic and growth initiatives.

Total full-time equivalent employees increased from 891 at June 30, 2022, to 984 at June 30, 2023 .

Salaries and employee benefits expense included $6.3 million and $12.5 million of stock-based compensation for the three and six months ended June 30, 2023, respectively, compared to $5.1 million and $10.0 million for the three and six months ended June, 30, 2022, respectively.

Expenses related to the employee stock purchase program, stock grants, stock option compensation and restricted stock expense are all considered stock-based compensation.

Professional service expense:

For the three months ended March 31, 2023, professional service expenses decreased $1.9 million, or 66.8%, compared to the same period in 2022 .

The decrease compared to the prior period was due to an insurance recovery of $1.3 million in the current quarter related to previously expensed legal fees.

Professional services expense:

For the three and six months ended June 30, 2023, professional services expense decreased $2.0 million, or 49.9%, and $3.9 million, or 56.9%, respectively, compared to the same periods in 2022 .

The decrease compared to the prior periods was due to lower levels of legal fees combined with an insurance recovery of $1.3 million in the first quarter of 2023 related to previously expensed legal fees.

Advertising and marketing expense :

For the three months ended March 31, 2023, advertising and marketing expense increased $1.9 million, or 108.4%, compared to the same period in 2022.

This increase was largely driven by continued investment in the Company’s lending and deposit market growth.

For the six months ended June 30, 2023, advertising and marketing expense increased $2.6 million, or 64.1%, compared to the same period in 2022.

The increase over the first half of 2022 was largely driven by continued investment in the Company’s lending and deposit market growth.

Technology expense :

For the three months ended March 31, 2023, technology expense increased $1.7 million, or 27.7%, compared to the same period in 2022.

For the three and six months ended June 30, 2023, technology expense increased $2.2 million, or 38.9%, and $3.9 million, or 33.2%, respectively, compared to the same periods in 2022.

This increase was primarily related to enhanced investments in the Company’s technology resources.

FDIC insurance:

For the three months ended March 31, 2023, FDIC insurance increased $1.4 million, or 72.6%, compared to the same period in 2022.

This increase is largely a product of the Bank's continued growth.

For the three and six months ended June 30, 2023, FDIC insurance increased $2.9 million, or 133.9%, and $4.3 million, or 104.6%, respectively, compared to the same periods in 2022.

This increase is largely the result of rate increases effective in 2023 combined with the ongoing growth of Live Oak Banking Company.

Contributions and donations:

For the three and six months ended June 30, 2023, contributions and donations decreased $5.5 million, and $6.2 million, respectively, compared to the same periods in 2022.

The decrease is principally related to a special charitable donation during the second quarter of 2022 of $5.0 million made in connection with the earlier discussed Finxact gain.

Other expense:

For the three months ended March 31, 2023, other expense increased $3.5 million, compared to the same period in 2022, largely related to $2.8 million in increased levels of reserves on unfunded commitments.

For the six months ended June 30, 2023, other expense increased $3.6 million, or 63.3%, compared to the same period in 2022, largely related to $2.9 million in increased levels of reserves on unfunded commitments.

This increase in the reserve for unfunded commitments was largely a result of refinements to the estimation assumptions in the first quarter of 2023.

Income Tax Expense

For the three months ended March 31, 2023, income tax expense was $3.2 million compared to $8.4 million for the first quarter of 2022, and the Company’s effective tax rates were 89.0% and 19.6%, respectively.

The lower level of income tax expense for the first quarter of 2023 as compared to the same period in 2022 was principally the result of decreased pretax income while the higher effective tax rate was principally the product of discrete items in the first quarter of 2023 related to stock compensation.

For the three months ended June 30, 2023, income tax expense was $1.4 million compared to $25.3 million for the second quarter of 2022, and the Company’s effective tax rates were 7.5% and 20.7%, respectively.

For the six months ended June 30, 2023, income tax expense was $4.6 million compared to $33.7 million for the first half of 2022, and the Company’s effective tax rates were 20.6% and 20.4%, respectively.

The lower level of income tax expense for the second quarter and the first half of 2023 as compared to the same periods in 2022 was principally the result of decreased pretax income combined with increased tax credits.

Results of Segment Operations

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Net income (loss) by operating segment is presented below:

Three Months Ended March 31,

Three Months Ended June 30, Six Months Ended June 30,

2023 2022 2023 2022

Banking $ 19,623 $ 3,755 $ 22,011 $ 41,595

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Consolidated net income $ 17,544 $ 97,039 $ 17,942 $ 131,548

For the three months ended March 31, 2023, net income decreased $35.5 million, or 93.7%, compared to the same period of 2022.

Key factors influencing this decrease are discussed below.

The provision for loan and lease credit losses for the three months ended March 31, 2023, increased $17.2 million.

For the three and six months ended June 30, 2023, net income increased $15.9 million and decreased $19.6 million, respectively, compared to the same periods of 2022.

Key factors influencing these changes are discussed below.

For the three and six months ended June 30, 2023, net interest income increased $4.1 million, or 5.1%, and $8.1 million, or 5.1%, respectively, compared to the same periods of 2022.

See above section captioned “Net Interest Income and Margin” as it is principally related to the Banking segment.

The provision for loan and lease credit losses for the three and six months ended June 30, 2023, increased $7.8 million and $24.9 million, respectively, compared to the same periods of 2022.

See the analysis of provision for loan and lease credit losses included in the above section captioned “Provision for Loan and Lease Credit Losses” as it is entirely related to the Banking segment.

For the three months ended March 31, 2023, noninterest income decreased $14.9 million, or 46.8%, compared to the same period of 2022.

For the three and six months ended June 30, 2023, noninterest income increased $16.3 million and $1.4 million, respectively, compared to the same periods of 2022.

The increase for the three month comparative period was principally driven by lower losses related to the loan servicing asset revaluation, increased net gains on sales of loans and an incremental gain on loans accounted for under the fair value option.

See the analysis of these categories of noninterest income included in the above section captioned “Noninterest Income” for additional discussion.

For the three months ended March 31, 2023, noninterest expense increased $13.1 million, or 21.3%, compared to same period of 2022.

For the three and six months ended June 30, 2023, noninterest expense decreased $4.9 million, or 6.3%, and increased $8.2 million, or 5.9%, respectively, compared to same periods of 2022.

See the analysis of these categories of noninterest expense included in the above section captioned “Noninterest Expense” for additional discussion.

For the three months ended March 31, 2023, income tax expense decreased $5.8 million, or 63.7%, compared to the same period of 2022.

This decrease relative to the Bank for both comparative periods is discussed in the above section captioned “ Income Tax Expense.

For the three months ended March 31, 2023, net loss decreased by $1.4 million, compared to same period of 2022.

The primary factor influencing the decrease in net loss was an increase in noninterest income of $1.8 million compared to the same period of 2022.

This increase was principally due to a $2.0 million increase in management fee income earned by Canapi Advisors.

There were two funds receiving advisory services in the first quarter of 2022 compared to four funds in the first quarter of 2023.

For the three and six months ended June 30, 2023, income tax expense increased $1.7 million and decreased $4.1 million, respectively, compared to the same periods of 2022.

The decrease compared to the six months ended June 30, 2022 is principally due to lower levels of pretax income.

For the three and six months ended June 30, 2023, net income decreased by $95.4 million and $94.0 million, respectively, compared to same periods of 2022.

The primary factor influencing this decrease compared to both prior periods is the $120.5 million Finxact gain included in equity method investment income in the second quarter of 2022.

Partially offsetting the decrease over the first half of 2022 was a $2.7 million increase in management fee income earned by Canapi Advisors combined with lower levels of income tax expense as a result decreased pretax income in 2023.

Discussion and Analysis of Financial Condition

March 31, 2023 vs.

June 30, 2023 vs.

December 31, 2022

Total assets at March 31, 2023 were $10.36 billion, an increase of $508.8 million, or 5.2%, compared to total assets of $9.86 billion at December 31, 2022.

Total assets at June 30, 2023 were $10.82 billion, an increase of $963.7 million, or 9.8%, compared to total assets of $9.86 billion at December 31, 2022.

The growth in total assets was principally driven by the following:

• Growth in total loans and leases held for investment and held for sale of $321.5 million resulting from strong origination activity in the first three months of 2023 and holding loans available for sale for longer periods of time before sale, as discussed more fully below.

Total originations during the first quarter of 2023 were $1.03 billion.

• Investment securities available-for-sale increased $135.0 million during the first three months of 2023, from $1.01 billion at December 31, 2022, to $1.15 billion at March 31, 2023, an increase of 13.3%.

The increase was largely the result of liquidity and balance sheet management.

At March 31, 2023, the investment portfolio was comprised of U.S.

government agencies, U.S.

government-sponsored entity mortgage-backed securities, municipal bonds and other debt securities.

Cash and cash equivalents, comprised of cash and due from banks and federal funds sold, was $463.2 million at March 31, 2023, an increase of $46.6 million, or 11.2%, compared to $416.6 million at December 31, 2022.

This change principally reflects strategically increased liquidity in response to the recent banking crisis.

Loans held for sale decreased $21.3 million, or 3.8%, during the first three months of 2023, from $554.6 million at December 31, 2022, to $533.3 million at March 31, 2023.

The decrease in loans held for sale was principally due to the impact of market conditions in a rising rate environment which has influenced management's intent to hold a greater portion of loans as held for investment.

Loans and leases held for investment increased $342.8 million, or 4.7%, during the first three months of 2023, from $7.34 billion at December 31, 2022, to $7.69 billion at March 31, 2023.

• Cash and cash equivalents, comprised of cash and due from banks and federal funds sold, combined with investment securities available-for-sale was $1.94 billion at June 30, 2023, an increase of $509.9 million, or 35.6%, compared to $1.43 billion at December 31, 2022.

This increase reflects growing deposit levels combined with strategic maintenance of the Company's liquidity profile.

• Growth in total loans and leases held for investment and held for sale of $461.4 million resulting from strong origination activity in the first six months of 2023 and holding loans available for sale for longer periods of time before sale, as discussed more fully below.

Total originations during the first half of 2023 were $1.89 billion.

Loans held for sale decreased $30.8 million, or 5.6%, during the first six months of 2023, from $554.6 million at December 31, 2022, to $523.8 million at June 30, 2023.

Loans and leases held for investment increased $492.2 million, or 6.7%, during the first six months of 2023, from $7.34 billion at December 31, 2022, to $7.84 billion at June 30, 2023.

The increase was primarily the result of the above-mentioned loan originations in 2023 combined with increased levels of loans retained as held for investment.

Total deposits were $9.42 billion at March 31, 2023, an increase of $537.1 million, or 6.0%, from $8.88 billion at December 31, 2022.

The increase in total deposits from the prior period was to support growth in the loan and lease portfolio, as well as enhance the Company’s liquidity profile in response to the recent banking crisis.

In addition, the Company began offering the IntraFi Insured Cash Sweep product in the first quarter of 2023 whereby depositors have access to FDIC insurance in excess of $250 thousand.

At March 31, 2023 the Bank’s total uninsured deposits were approximately $1.4 billion, or 14.5% of total deposits.

Borrowings decreased to $30.8 million at March 31, 2023 from $83.2 million at December 31, 2022.

Total deposits were $9.88 billion at June 30, 2023, an increase of $994.2 million, or 11.2%, from $8.88 billion at December 31, 2022.

The increase in total deposits from the prior period was to support growth in the loan and lease portfolio combined with strong deposit inflows.

At June 30, 2023, the Bank’s total uninsured deposits were approximately $1.4 billion, or 14.3%, of total deposits.

Borrowings decreased to $28.3 million at June 30, 2023, from $83.2 million at December 31, 2022.

This decrease was principally due to paying off the Company’s Fed Funds line of credit in the first quarter of 2023.

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Regulatory Impact of Asset Growth

As of March 31, 2023, the Company and the Bank each first exceeded $10 billion in total assets.

As of March 31, 2023, the Company and the Bank each had total assets of $10.36 billion and $10.25 billion, respectively.

In the first quarter of 2023, the Company and the Bank each first exceeded $10 billion in total assets.

As of June 30, 2023, the Company and the Bank each had total assets of $10.82 billion and $10.72 billion, respectively.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) and its implementing regulations impose various additional requirements on bank holding companies and banks with $10 billion or more in total consolidated assets.

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The Volcker Rule also places restrictions on proprietary trading, which could impact certain hedging activities.

Community banks are excluded from the restrictions of the Volcker Rule if (i) the community bank, and every entity that controls it, has total consolidated assets equal to or less than $10 billion and (ii) trading assets and liabilities of the community bank, and every entity that controls it, are equal to or less than five percent of its total consolidated assets.

The Company and the Bank will no longer be eligible for this exemption upon exceeding $10 billion in total consolidated assets.

Limits on Interchange Fees.

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2022-02 on January 1, 2023, as described more fully in Note 2 in the accompanying Unaudited Condensed Consolidated Financial Statements, the prior period discussed below has been adjusted to exclude previously disclosed troubled debt restructurings for comparative purposes.

Nonperforming assets, excluding loans measured at fair value, at March 31, 2023 were $85.7 million, which represented a $12.3 million, or 16.8%, increase from December 31, 2022.

These nonperforming assets at March 31, 2023 were comprised of $85.7 million in nonaccrual loans and leases.

At March 31, 2023, there were no foreclosed assets.

Of the $85.7 million of nonperforming assets, $63.7 million carried a government guarantee, leaving an unguaranteed exposure of $22.0 million in total nonperforming assets at March 31, 2023.

Nonperforming assets, excluding loans measured at fair value, at June 30, 2023 were $111.2 million, which represented a $37.8 million, or 51.5%, increase from December 31, 2022.

These nonperforming assets at June 30, 2023 were all nonaccrual loans and leases.

At June 30, 2023, there were no foreclosed assets.

Of the $111.2 million of nonperforming assets, $66.3 million carried a government guarantee, leaving an unguaranteed exposure of $44.9 million in total nonperforming assets at June 30, 2023.

This represents an increase of $26.1 million, or 139.0%, from an unguaranteed exposure of $18.8 million at December 31, 2022.

The following table provides information with respect to nonperforming assets, excluding loans measured at fair value, at the dates indicated.

March 31, 2023 (1)

June 30, 2023 (1)

December 31, 2022 (1)

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(1) Excludes loans measured at fair value.

March 31, 2023 (1)

June 30, 2023 (1)

December 31, 2022 (1)

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(1) Excludes loans measured at fair value.

Total nonperforming assets, including loans measured at fair value, at March 31, 2023 were $141.3 million, which represented a $20.9 million, or 17.4%, increase from December 31, 2022.

Of the $141.3 million of nonperforming assets, $109.4 million carried a government guarantee, leaving an unguaranteed exposure of $31.9 million in total nonperforming assets at March 31, 2023.

Total nonperforming assets, including loans measured at fair value, at June 30, 2023 were $168.8 million, which represented a $48.4 million, or 40.2%, increase from December 31, 2022.

Of the $168.8 million of nonperforming assets, $113.2 million carried a government guarantee, leaving an unguaranteed exposure of $55.6 million in total nonperforming assets at June 30, 2023.

This represents an increase of $29.5 million, or 113.4%, from an unguaranteed exposure of $26.0 million at December 31, 2022.

See the below discussion related to the change in potential problem and impaired loans and leases for management’s overall observations regarding growth in total nonperforming loans and leases.

As a percentage of the Bank’s total capital, nonperforming loans and leases, excluding loans measured at fair value, represented 10.4% at March 31, 2023, compared to 9.0% at December 31, 2022.

Adjusting the ratio to include only the unguaranteed portion of nonperforming loans and leases at historical cost to reflect management’s belief that the greater magnitude of risk resides in this portion, the ratios at both March 31, 2023 and December 31, 2022 were 2.7% and 2.3%, respectively.

As of March 31, 2023, and December 31, 2022, potential problem (also referred to as criticized) and classified loans and leases, excluding loans measured at fair value, totaled $504.2 million and $424.7 million, respectively.

As a percentage of the Bank’s total capital, nonperforming loans and leases, excluding loans measured at fair value, represented 12.8% at June 30, 2023, compared to 9.0% at December 31, 2022.

Adjusting the ratio to include only the unguaranteed portion of nonperforming loans and leases at historical cost to reflect management’s belief that the greater magnitude of risk resides in this portion, the ratios at both June 30, 2023 and December 31, 2022 were 5.2% and 2.3%, respectively.

As of June 30, 2023, and December 31, 2022, potential problem (also referred to as criticized) and classified loans and leases, excluding loans measured at fair value, totaled $556.6 million and $424.7 million, respectively.

The following is a discussion of these loans and leases.

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Loans and Leases Held for Investment and Credit Quality in the Company’s 2022 Form 10-K.

At March 31, 2023 , the portion of criticized and classified loans and leases guaranteed by the SBA or USDA totaled $218.3 million and total portfolio unguaranteed exposure risk was $285.9 million, or 6.4% of total held for investment unguaranteed exposure carried at historical cost.

At June 30, 2023 , the portion of criticized and classified loans and leases guaranteed by the SBA or USDA totaled $227.1 million and total portfolio unguaranteed exposure risk was $329.5 million, or 7.0% of total held for investment unguaranteed exposure carried at historical cost.

This compares to the December 31, 2022 portion of criticized and classified loans and leases guaranteed by the SBA or USDA which totaled $195.8 million and total portfolio unguaranteed exposure risk was $228.9 million, or 5.5% of total held for investment unguaranteed exposure carried at historical cost.

As of March 31, 2023 , loans and leases carried at historical cost within the following verticals comprise the largest portion of the total potential problem and classified loans and leases:

Sponsor Finance at 12.8% (principally related to Search Fund Lending), Wine and Craft Beverage at 11.3%, Senior Housing at 11.0%, General Lending at 10.7%, Healthcare at 6.2%, Hotels at 5.0%, Senior Care at 4.6% and Fitness Centers at 4.2%.

As of June 30, 2023 , loans and leases carried at historical cost within the following verticals comprise the largest portion of the total potential problem and classified loans and leases:

Wine and Craft Beverage at 12.3%, Senior Housing at 12.2%, Sponsor Finance at 12.1% (principally related to Search Fund Lending), General Lending at 10.1%, Healthcare at 5.0%, Senior Care at 4.7%, Fitness Centers at 4.6%, Hotels at 4.6%, Venture Banking at 4.4% and Agriculture at 4.0%.

As of December 31, 2022 , loans and leases carried at historical cost within the following verticals comprise the largest portion of the total potential problem and classified loans and leases:

Wine and Craft Beverage at 11.5%, General Lending at 10.3%, Senior Housing at 10.2%, Sponsor Finance at 7.8%, Healthcare at 6.4%, Hotels at 5.9%, Fitness Centers at 5.1%, Agriculture at 4.5% and Senior Care at 4.0%.

Of the above listed verticals, Senior Housing and Sponsor Finance are within the Company’s Specialty Lending division while Hotels are within the Energy & Infrastructure division, the remainder of the above listed verticals are within the Small Business Banking division.

The majority of the $79.5 million increase in potential problem and classified loans and leases in the first three months of 2023 was comprised of several relationships that did not have a government guarantee.

Of the above listed verticals, Senior Housing, Sponsor Finance and Venture Banking are within the Company’s Specialty Lending division while Hot els are within the Energy & Infrastructure division, the remainder of the above listed verticals are within the Small Business Banking division.

The majority of the $131.9 million increase in potential problem and classified loans and leases in the first six months of 2023 was comprised of several relationships that did not have a government guarantee.

The Company believes that its underwriting and credit quality standards have remained high and continues to consider changing economic conditions in a rising interest rate environment.

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Credit personnel will review the request to determine if the customer is stressed and how the event has impacted the ability of the customer to repay the loan or lease long term.

At March 31, 2023, the Company had a total of $21.1 million in loans modified in the first quarter of 2023 to borrowers experiencing financial difficulty, all of which remained current with $4.2 million on principal payment deferral.

Management endeavors to be proactive in its approach to identify and resolve problem loans and leases and is focused on working with the borrowers and guarantors of these loans and leases to provide loan and lease modifications when warranted.

At June 30, 2023, the Company had a total of $21.7 million in loans modified in the first half of 2023 to borrowers experiencing financial difficulty, all of which remained current with $4.5 million on principal payment deferral.

Management endeavors to be proactive in its approach to identify and resolve p roblem loans and leases and is focused on working with the borrowers and guarantors of these loans and leases to provide loan and lease modifications when warranted.

Management implements a proactive approach to identifying and classifying loans and leases as special mention (also referred to as criticized), Risk Grade 5.

At March 31, 2023, and December 31, 2022, Risk Grade 5 loans and leases, excluding lo ans measured at fair value, totaled $370.8 million and $286.5 million, respectively, for a quarter over quarter increase of $84.3 million.

The increase in Risk Grade 5 loans and leases, exclusive of loans measured at fair value, during the first quarter of 2023 was principally confined to seven verticals:

Sponsor Finance ($32.3 million or 38.3%, principally related to Search Fund Lending ), Bioenergy ($13.5 million or 16.0%), Senior Housing ($12.2 million or 14.4%), Venture Banking ($11.8 million or 14.0%), Wine and Craft Beverage ($8.4 million or 10.0%), Conventional Financing ($6.6 million or 7.8%) and Senior Care ($6.0 million or 7.2%).

The increase in criticized loans in 2023 was related to a small number of large relationships within four mature verticals.

At June 30, 2023, and December 31, 2022, Risk Grade 5 loans and leases, excluding lo ans measured at fair value, totaled $404.3 million and $286.5 million, respectively, for a six month increase of $117.8 million.

The increase in Risk Grade 5 loans and leases, exclusive of loans measured at fair value, during the first half of 2023 was principally confined to eight verticals:

Sponsor Finance ($35.9 million or 30.4%, principally related to Search Fund Lending ), Wine and Craft Beverage ($19.7 million or 16.7%), Venture Banking ($17.1 million or 14.5%), Bioenergy ($13.5 million or 11.4%), Senior Housing ($12.5 million or 10.6%), Conventional Financing ($10.3 million or 8.7%), General Lending ($6.4 million or 5.4%), and Senior Care ($6.1 million or 5.2%).

Of the above listed verticals, Sponsor Finance, Senior Housing, Venture Banking and Conventional Financing are within the Company’s Specialty Lending division while Bioenergy is within the Energy & Infrastructure division, the remainder of the above listed verticals are within the Small Business Banking division.

At March 31, 2023, approximately 99.6% of loans and leases classified as Risk Grade 5 are performing with no relationships having payments past due more than 30 days.

At June 30, 2023, approximately 97.5% of loans and leases classified as Risk Grade 5 are performing with no relationships having payments past due more than 30 days.

While the level of nonperforming assets fluctuates in response to changing economic and market conditions, in light of the relative size and composition of the loan and lease portfolio and management’s degree of success in resolving problem assets, management believes that a proactive approach to early identification and intervention is critical to successfully managing a small business loan portfolio.

As government payment assistance began to expire toward the end of 2020, borrowers with continuing difficulties arising from the pandemic were provided additional relief through payment deferrals.

At March 31, 2023, the Company had $6.6 million in unguaranteed loans on SBA payment assistance.

At June 30, 2023, the Company had $9.5 million in unguaranteed loans on SBA payment assistance.

Management monitors these borrowers closely and has observed financial conditions continuing to improve.

Allowance for Credit Losses on Loans and Leases

The ACL of $96.6 million at December 31, 2022, increased by $11.7 million, or 12.1%, to $108.2 million at March 31, 2023.

The ACL as a percentage of loans and leases held for investment at historical cost amounted to 1.4% and 1.5% at December 31, 2022 and March 31, 2023, respectively.

The increase in the ACL during the first three months of 2023 was primarily the result of loan growth, combined with portfolio trends and changes in the macroeconomic outlook.

The ACL of $96.6 million at December 31, 2022, increased by $23.6 million, or 24.4%, to $120.1 million at June 30, 2023.

The ACL as a percentage of loans and leases held for investment at historical cost amounted to 1.4% and 1.6% at December 31, 2022 and June 30, 2023, respectively.

The increase in the ACL during the first six months of 2023 was primarily the result of loan growth, combined with portfolio trends and changes in the macroeconomic outlook.

See also the above section captioned “Provision for Loan and Lease Credit Losses” in “Results of Operations” for related information.

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This increase was comprised of a $11.5 million increase in unguaranteed exposure combined with a $29.7 million increase in the guaranteed portion of past due loans compared to December 31, 2022.

At March 31, 2023 and December 31, 2022, total held for investment unguaranteed loans and leases past due as a percentage of total held for investment unguaranteed loans and leases, inclusive of loans measured at fair value, was 0.6% and 0.7%, respectively.

Total unguaranteed loans and leases past due were comprised of $21.0 million carried at historical cost, a decrease of $160 thousand, and $8.7 million measured at fair value, an decrease of $909 thousand, as of March 31, 2023 compared to December 31, 2022.

At June 30, 2023 and December 31, 2022, total held for investment unguaranteed loans and leases past due as a percentage of total held for investment unguaranteed loans and leases, inclusive of loans measured at fair value, was 0.9% and 0.7%, respectively.

Total unguaranteed loans and leases past due were comprised of $35.8 million carried at historical cost, an increase of $14.6 million, and $11.8 million measured at fair value, an increase of $2.2 million, as of June 30, 2023 compared to December 31, 2022.

Management continues to actively monitor and work to improve asset quality.

Management believes the ACL of $108.2 million at March 31, 2023 is appropriate in light of the risk inherent in the loan and lease portfolio.

Management believes the ACL of $120.1 million at June 30, 2023 is appropriate in light of the risk inherent in the loan and lease portfolio.

Management’s judgments are based on numerous assumptions about current and expected events that it believes to be reasonable, but which may or may not be valid.

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Additional information on the ACL is presented in Note 5.

Loans and Leases Held for Investment and Credit Quality of the condensed consolidated financial statements in this report.

Loans and Leases Held for Investment and Credit Quality of the Unaudited Condensed Consolidated Financial Statements in this report.

Liquidity Management

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and (d) availability under lines of credit.

At March 31, 2023, the total amount of these four items was $4.24 billion, or 40.9% of total assets compared to 40.7% of total assets, at December 31, 2022.

At June 30, 2023, the total amount of these four items was $4.59 billion, or 42.4% of total assets compared to 40.7% of total assets, at December 31, 2022.

Loans and other assets are funded by loan sales, wholesale deposits and core deposits.

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Additionally, the Company maintains a guaranteed loan portfolio that is also a contingent liquidity source, whether via pledging to the Federal Reserve Discount Window or through liquidation.

At March 31, 2023, none of the investment securities portfolio was pledged to secure public deposits or pledged to retail repurchase agreements, leaving $1.15 billion available to pledge as collateral.

At June 30, 2023, none of the investment securities portfolio was pledged to secure public deposits or pledged to retail repurchase agreements, leaving $1.13 billion available to pledge as collateral.

Contractual Obligations

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One method used to manage interest rate sensitivity is to measure, over various time periods, the interest rate sensitivity positions, or gaps.

As of March 31, 2023, the balance sheet’s total cumulative gap position was 5.8%, for further information, see Item 3.

As of June 30, 2023, the balance sheet’s total cumulative gap position was 5.0%.

For further information, see Item 3.

Quantitative and Qualitative Disclosures About Market Risk.

The interest rate gap method, however, addresses only the magnitude of asset and liability repricing timing differences as of the report date and does not address earnings, market value, changes in account behaviors based on the interest rate environment, nor growth.

Therefore, management also uses an earnings simulation model to prepare, on a regular basis, earnings projections based on a range of instantaneous parallel interest rate shocks applied to a static balance sheet to measure interest rate risk.

As of March 31, 2023, the Company’s interest rate risk profile under the instantaneous parallel interest rate shock scenarios shifted from asset-sensitive to slightly liability-sensitive.

As of June 30, 2023, the Company’s interest rate risk profile under the instantaneous parallel interest rate shock scenarios applied to a static balance sheet is slightly asset-sensitive.

For more information, see Item 3.

Quantitative and Qualitative Disclosures About Market Risk.

A liability-sensitive position means that net interest income will generally move in the opposite direction as interest rates.

For instance, if interest rates increase, net interest income can be expected to decrease, and if interest rates decrease, net interest income can be expected to increase.

An asset-sensitive position means that net interest income will generally move in the same direction as interest rates.

For instance, if interest rates increase, net interest income can be expected to increase, and if interest rates decrease, net interest income can be expected to decrease.

The Company attempts to mitigate interest rate risk by match funding assets and liabilities with similar rate instruments.

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Note that the Company regularly models various forecasted rate projections with non-parallel shifts that are reflective of potential current rate environment outcomes.

Under these scenarios, the Company’s interest rate risk profile may increase in liability sensitivity, decrease in liability sensitivity, or depending on the scenario and timing of anticipated rate changes, may transition back to an asset-sensitive interest rate risk profile.

Regular, robust modeling of various interest rate outcomes allows the Company to properly assess and manage potential risks from various rate shifts.

Under these scenarios, the Company’s interest rate risk profile may increase in asset sensitivity, decrease in asset sensitivity, or depending on the scenario and timing of anticipated rate changes, may transition to a liability-sensitive interest rate risk profile.

The Company believes that regular modeling of various interest rate outcomes allows it to assess and manage potential risks from various rate shifts.

The maintenance of appropriate levels of capital is a management priority and is monitored on a regular basis.

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to provide financial flexibility to support future growth and client needs;

comply with relevant laws, regulations, and supervisory guidance;

to comply with relevant laws, regulations, and supervisory guidance;

to achieve optimal ratings for the Company and its subsidiaries;

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Risk-based capital ratios, which include Tier 1 Capital, Total Capital and Common Equity Tier 1 Capital, are calculated based on regulatory guidance related to the measurement of capital and risk-weighted assets.

Capital amounts and ratios as of March 31, 2023 and December 31, 2022, are presented in the table below.

Capital amounts and ratios as of June 30, 2023, and December 31, 2022, are presented in the table below.

Actual Minimum Capital

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Amount Ratio Amount Ratio Amount Ratio

Consolidated - March 31, 2023

Consolidated - June 30, 2023

Common Equity Tier 1 (to Risk-Weighted Assets) $ 911,721 11.55 % $ 355,139 4.50 % N/A N/A

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Tier 1 Capital (to Average Assets) 911,721 8.46 430,986 4.00 N/A N/A

Bank - March 31, 2023

Bank - June 30, 2023

Common Equity Tier 1 (to Risk-Weighted Assets) $ 770,449 10.14 % $ 342,051 4.50 % $ 494,074 6.50 %

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• Valuation of servicing assets;

• Income taxes

Changes in these estimates, that are likely to occur from period to period, or the use of different estimates that the Company could have reasonably used in the current period, would have a material impact on the Company’s financial position, results of operations or liquidity.

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-Q

Item 2. Management’s Discussion and Analysis