What changed in this filing

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Item 2. Management’s Discussion and Analysis

2023-11-03 compared with 2023-08-02 · 177 added, 173 removed, 480 unchanged (42% of the section changed)

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government may take to avoid exceeding the debt ceiling, and uncertainties surrounding the debt ceiling and the federal budget;

• changes in political and economic conditions;

• changes in political and economic conditions, including any prolonged U.S.

government shutdown;

• the impact of heightened regulatory scrutiny of financial products and services, primarily led by the Consumer Financial Protection Bureau and various state agencies;

43 unchanged sentences

Performance Summary

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:

• 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.

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

For the three months ended September 30, 2023, the Company reported net income of $39.8 million, or $0.88 per diluted share, compared to net income of $42.9 million, or $0.96 per diluted share, for the third quarter of 2022.

The decrease in net income was principally due to the lower equity method investment income of $30.2 million, largely driven by the third quarter of 2022 gain of $28.4 million related to the Company's sale of its investment in Payrailz, LLC (“Payrailz”).

To a lesser extent, the decrease was also influenced by a $5.0 million negative change in net loss on loans accounted for under the fair value option.

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

• Increase in net interest income of $5.5 million, or 6.6%, driven by increases in loan volumes, partially mitigated by a decrease in 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;

• Decreased provision for loan and lease credit losses of $3.9 million to $10.3 million, compared to $14.2 million for the third quarter of 2022.

The provision expense in the third quarter of 2023 was primarily the result of continued growth of the loan and lease portfolio combined with specific reserve changes on individually evaluated loans and charge-off related impacts;

• On July 1, 2023, the Company changed the valuation techniques used to estimate the fair value of its servicing rights and loans measured at fair value as a result of rising interest rates and their impacts on market conditions.

These revisions were made to provide estimates which the Company believes are more representative of fair value.

These estimate changes were implemented as of July 1, 2023 and resulted in one-time adjustments on that date to increase the estimated value of the servicing asset by $13.7 million and loans measured at fair value by $1.3 million, or a total impact to noninterest income of $15.0 million.

All comparative balances and changes between periods discussed herein related to the servicing asset and loans measured at fair value are inclusive of these one-time adjustments.

During the third quarter of 2023, the net gain on loan servicing asset revaluation increased by $12.7 million (inclusive of the one-time adjustment discussed above), to $11.3 million for the quarter, compared to a net loss of $1.3 million in the third quarter of 2022.

• Increased net gains on sales of loans of $3.4 million, or 36.7%, principally the result of a higher volume of loan sales in the third quarter of 2023;

• Decreased impairment charges of $7.7 million, arising from a third quarter of 2022 renewable energy tax credit investment.

Nine months ended September 30, 2023 compared with nine months ended September 30, 2022

For the nine months ended September 30, 2023, the Company reported net income of $57.7 million, or $1.28 per diluted share, compared to net income of $174.4 million, or $3.88 per diluted share, for the nine months ended September 30, 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:

• Decrease in equity method investment income of $152.1 million, principally a product of the above discussed Payrailz gain combined with 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 $21.1 million, to $42.3 million, compared to $21.3 million for the first nine months of 2022.

The level of provision expense in the first nine months of 2023 was primarily the result of continued growth of the loan and lease portfolio combined with specific reserve changes on individually evaluated loans and charge-off related impacts;

• The net loss on loans accounted for under the fair value option of $3.4 million, increased by $3.8 million (inclusive of the one-time adjustment discussed above) from a net gain of $475 thousand in the first nine months of 2022, principally the result of negative market trends;

• Increased levels of noninterest expense related to advertising and marketing up $3.4 million, or 51.2%, technology expense up $3.9 million, or 19.8%, and FDIC insurance expense up $5.7 million, or 84.1%.

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

• Increase in net interest income of $14.1 million, or 5.8%, 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;

• A net gain on loan servicing asset revaluation of $8.9 million (inclusive of the one-time adjustment discussed above) compared to a net loss of $11.6 million in the first nine months of 2022, resulting in a positive change of $20.4 million.

This increase was principally driven by the above discussed third quarter of 2023 change in estimate;

• Decreased levels of noninterest expense related to professional services expense down $4.6 million, or 49.5%, combined with declines in renewable energy tax credit investment impairment of $7.7 million and contributions and donations expense of $6.4 million;

• Decreased income tax expense of $27.6 million, or 78.4%, principally related to above discussed decrease in net income.

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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 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.

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

For the three months ended September 30, 2023, net interest income increased $5.5 million, or 6.6%, to $89.4 million compared to $83.9 million for the three months ended September 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 $6.6 million.

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 $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 $1.85 billion, or 21.4%, to $10.52 billion for the third quarter of 2023, compared to $8.66 billion for the third quarter of 2022, while the yield on average interest-earning assets increased 150 basis points to 6.81%.

The cost of funds on interest-bearing liabilities for the third quarter of 2023 increased 217 basis points to 3.72%, and the average balance of interest-bearing liabilities increased by $1.58 billion, or 19.3%, over the third quarter of 2022.

As indicated in the rate/volume table below, the overall increase discussed above is reflected in increased interest income of $64.8 million outpacing growth in interest expense of $59.3 million for the third quarter of 2023 compared to the third quarter of 2022.

The net interest margin decreased from 3.84% for the third quarter of 2022 to 3.37% for the third quarter of 2023.

Nine months ended September 30, 2023 compared with nine months ended September 30, 2022

For the nine months ended September 30, 2023, net interest income increased $14.1 million, or 5.8%, to $255.7 million compared to $241.6 million for the nine months ended September 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.

Average interest-earning assets increased by $1.91 billion, or 23.2%, to $10.17 billion for the nine months ended September 30, 2023, compared to $8.26 billion for the nine months ended September 30, 2022, while the yield on average interest-earning assets increased 161 basis points to 6.60%.

The cost of funds on interest-bearing liabilities for the nine months ended September 30, 2023 increased 236 basis points to 3.49%, and the average balance of interest-bearing liabilities increased by $1.60 billion, or 20.4%, over the nine months ended September 30, 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 $78.0 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 $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.

As indicated in the rate/volume table below, the overall increase discussed above is reflected in increased interest income of $193.9 million outpacing growth in interest expense of $179.7 million for the first nine months of 2023 compared to the first nine months of 2022.

The net interest margin decreased from 3.91% for the nine months ended September 30, 2022 to 3.36% for the nine months ended September 30, 2023.

During the nine months ended September 30, 2023, the Federal Reserve increased the federal funds upper target rate by 100 basis points.

In September 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 50 basis points to 5.1% 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 June 30,

Three Months Ended September 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,

Nine Months Ended September 30,

Interest Average

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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 June 30, Six Months Ended June 30,

Three Months Ended September 30, Nine Months Ended September 30,

2022 2023 vs.

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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 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.

For the third quarter of 2023, there was a provision for loan and lease credit losses of $10.3 million compared to $14.2 million for the same period in 2022, a decrease of $3.9 million.

For the nine months ended September 30, 2023, there was a provision for loan and lease credit losses of $42.3 million compared to $21.3 million for the same period in 2022, an increase of $21.1 million.

The increase in provision expense as compared to the third quarter of 2022 and the nine months ended September 30, 2022 was primarily the result of loan growth, combined with specific reserve changes on individually evaluated loans and charge-off related impacts.

Loans and leases held for investment at historical cost were $7.79 billion as of September 30, 2023, increasing by $1.45 billion, or 22.9%, compared to September 30, 2022.

Net charge-offs for loans and leases carried at historical cost were $9.1 million, or 0.48% of average quarterly loans and leases held for investment, carried at historical cost, on an annualized basis, for the three months ended September 30, 2023, compared to net charge-offs of $1.7 million, or 0.12%, for the three months ended September 30, 2022.

The increase in net charge-offs was primarily related to a single borrower relationship of which a significant portion was reserved for in the second quarter of 2023.

For the nine months ended September 30, 2023 , net charge-offs totaled $16.9 million compared to $6.6 million for the nine months ended September 30, 2022 , an increase of $10.4 million, or 158.1%.

The increase in net charge-offs for the first nine-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 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.

In addition, nonperforming loans and leases not guaranteed by the SBA or USDA, excluding $6.5 million and $2.7 million accounted for under the fair value option at September 30, 2023 and 2022, respectively, totaled $33.3 million, which was 0.43% of the held for investment loan and lease portfolio carried at historical cost at September 30, 2023, compared to $14.3 million, or 0.23% of loans and leases held for investment carried at historical cost at September 30, 2022.

The increase in total nonperforming loans and leases not guaranteed and carried at historical cost was largely comprised of one large relationship.

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 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.

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.

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 June 30, 2023/2022 Increase (Decrease)

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

2023 2022 Amount Percent

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Net gains on sales of loans 12,675 9,275 3,400 36.7

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

Net (loss) gain on loans accounted for under the fair value option (568) 4,420 (4,988) (112.9)

Equity method investments (loss) income (1,034) 29,136 (30,170) (103.5)

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

Equity security investments (losses) gains, net (783) 876 (1,659) (189.4)

Lease income 2,498 2,516 (18) (0.7)

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Total noninterest income $ 37,891 $ 57,724 $ (19,833) (34.4) %

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

Nine Months Ended September 30, 2023/2022 Increase (Decrease)

2023 2022 Amount Percent

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Net gains on sales of loans 33,654 35,882 (2,228) (6.2)

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

Net (loss) gain on loans accounted for under the fair value option (3,369) 475 (3,844) (809.3)

Equity method investments (loss) income (6,041) 146,068 (152,109) (104.1)

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

Equity security investments (losses) gains, net (585) 2,487 (3,072) (123.5)

Lease income 7,568 7,529 39 0.5

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Total noninterest income $ 81,626 $ 218,921 $ (137,295) (62.7) %

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.

As mentioned earlier, balances herein for the three and nine-month periods ended September 30, 2023 are inclusive of positive one-time change in estimate adjustments of $13.7 million for the loan servicing asset revaluation and $1.3 million for the net loss on loans accounted for under the fair value option

For the three months ended September 30, 2023, noninterest income decreased by $19.8 million, or 34.4%, compared to the three months ended September 30, 2022.

The decrease over the prior year is primarily a result of the $28.4 million Payrailz gain included in equity method investment income in the third quarter of 2022.

To a lesser extent, the decrease was also influenced by a $5.0 million negative change in net losses on loans accounted for under the fair value option.

Partially offsetting the decrease over the third quarter of 2022 was a $12.7 million incremental net gain related to the servicing asset revaluation and an increase in net gains on sales of loans of $3.4 million.

For the nine months ended September 30, 2023, noninterest income decreased by $137.3 million, or 62.7%, compared to the nine months ended September 30, 2022.

The decrease over the prior year is primarily a result of the aggregate $148.9 million in Finxact and Payrailz gains included in equity method investments income in the first nine months of 2022.

To a lesser extent, the decrease was also influenced by a $3.8 million negative change in net losses on loans accounted for under the fair value option, decreased net gains on loan sales of $2.2 million and decreased equity security investments gains of $3.1 million.

Partially offsetting the decrease over the prior year to date period was an increased net gain of $20.4 million related to the servicing asset revaluation combined with a $3.1 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 June 30, Three months ended March 31,

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

2023 2022 2023 2022 2023 2022

3 unchanged sentences

2,909,343 2,671,705 2,808,200 2,681,079 2,695,757 2,786,403

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

Nine Months Ended September 30, For years ended December 31,

2023 2022 2022 2021 2020 2019

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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 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.

For the three months ended September 30, 2023, there was a net gain on loan servicing asset revaluation of $11.3 million, compared to a net loss of $1.3 million for the three months ended September 30, 2022, resulting in a positive comparative quarter change of $12.7 million.

For the nine months ended September 30, 2023, there was a net gain on loan servicing asset revaluation of $8.9 million compared to a net loss of $11.6 million for the nine months ended September 30, 2022, resulting in a positive change of $20.4 million, or 176.6%.

The increase in the valuation of the servicing asset compared to the three and nine months ended September 30, 2022 was principally the result of the previously discussed change in valuation techniques used to estimate the fair value of servicing rights with a one-time positive adjustment of $13.7 million as a result of rising interest rates and their impacts on market conditions.

Net Gains on Sales of Loans:

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.

For the three months ended September 30, 2023, net gains on sales of loans increased $3.4 million, or 36.7%, compared to the three months ended September 30, 2022.

The volume of guaranteed loans sold increased $77.5 million, or 52.3%, for the three months ended September 30, 2023 to $225.6 million from $148.1 million in the three months ended September 30, 2022.

For the nine months ended September 30, 2023, net gains on sales of loans decreased $2.2 million, or 6.2%, compared to the nine months ended September 30, 2022.

For the nine months ended September 30, 2023, the volume of guaranteed loans sold increased $201.9 million, or 46.2%, to $638.5 million from $436.6 million for the nine months ended September 30, 2022.

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

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

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

For the three months ended September 30, 2023, the Company had a net loss on loans accounted for under the fair value option of $568 thousand compared to a net gain of $4.4 million for the third quarter of 2022, a negative change of $5.0 million, or 112.9%.

For the nine months ended September 30, 2023, the Company had a net loss on loans accounted for under the fair value option of $3.4 million compared to a net gain of $475 thousand for the same period of 2022, a negative change of $3.8 million, or 809.3%.

The carrying amount of loans accounted for under the fair value option at September 30, 2023 and 2022 was $410.1 million (all classified as held for investment) and $512.2 million (all classified as held for investment), respectively, a decrease of $102.1 million, or 19.9%.

The incremental net loss on loans accounted for under the fair value option compared to both prior periods was largely the result of negative market trends between the comparative periods.

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 June 30, 2023/2022 Increase (Decrease)

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

2023 2022 Amount Percent

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Total noninterest expense $ 74,262 $ 83,048 $ (8,786) (10.6) %

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

Nine Months Ended September 30, 2023/2022 Increase (Decrease)

2023 2022 Amount Percent

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Total noninterest expense $ 229,681 $ 229,641 $ 40 — %

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.

Total noninterest expense for the three and nine months ended September 30, 2023, decreased $8.8 million, or 10.6%, and increased $40 thousand, respectively, compared to the same periods in 2022.

The changes in noninterest expense for the comparable three and nine month periods were 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.

Total personnel expense for the nine months ended September 30, 2023 increased $2.5 million, or 2.0%, respectively, compared to the same period in 2022.

The increase over the first nine months of 2022 is principally related to continued investment in human resources to support strategic and growth initiatives.

Total full-time equivalent employees increased from 940 at September 30, 2022, to 956 at September 30, 2023.

Salaries and employee benefits expense included $12.7 million of stock-based compensation for the nine months ended September 30, 2023, compared to $15.1 million for the nine months ended September 30, 2022.

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

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.

For the nine months ended September 30, 2023, professional services expense decreased $4.6 million, or 49.5%, compared to the same period in 2022 .

This decrease 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 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.

For the nine months ended September 30, 2023, advertising and marketing expense increased $3.4 million, or 51.2%, compared to the same period in 2022.

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

Technology expense :

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.

For the nine months ended September 30, 2023, technology expense increased $3.9 million, or 19.8%, compared to the same period in 2022.

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

Renewable energy tax credit investment impairment:

For the three and nine months ended September 30, 2023, impairment charges decreased by $7.7 million, compared to the same periods in 2022.

This decrease was the result of a new renewable energy tax credit investment in the third quarter of 2022.

FDIC insurance:

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.

For the nine months ended September 30, 2023, FDIC insurance increased $5.7 million, or 84.1%, compared to the same period 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 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.

For the nine months ended September 30, 2023, contributions and donations decreased $6.4 million, compared to the same period in 2022.

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

Income Tax Expense

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.

For the three months ended September 30, 2023, income tax expense was $3.0 million compared to $1.5 million for the three months ended September 30, 2022, and the Company’s effective tax rates were 6.9% and 3.4%, respectively.

For the nine months ended September 30, 2023, income tax expense was $7.6 million compared to $35.2 million for the nine months ended September 30, 2022, and the Company’s effective tax rates were 11.6% and 16.8%, respectively.

The higher level of income tax expense for the third quarter of 2023 as compared to the third quarter of 2022 was was primarily the result of higher than anticipated investment tax credits in the third quarter of 2022 related to renewable energy investments, arising from the impacts of the passage of the Inflation Reduction Act of 2022 combined with higher than expected costs at that time, as a result of the inflationary environment.

The decrease in income tax expense for first nine months of 2023 compared to the same period in 2022 was primarily due to decreased pretax income during the current period.

Results of Segment Operations

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

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

Three Months Ended September 30, Nine Months Ended September 30,

2023 2022 2023 2022

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Consolidated net income $ 39,793 $ 42,868 $ 57,735 $ 174,416

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.

For the three and nine months ended September 30, 2023, net income increased $24.9 million and $5.3 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.

For the three and nine months ended September 30, 2023, net interest income increased $5.3 million, or 6.2%, and $13.4 million, or 5.5%, 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.

The provision for loan and lease credit losses for the three and nine months ended September 30, 2023, decreased $3.9 million, and increased $21.1 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 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.

For the three and nine months ended September 30, 2023, noninterest income increased $8.5 million, or 31.0%, and $9.8 million, or 15.3%, respectively, compared to the same periods of 2022.

The increase for the three and nine month comparative periods was principally driven by an incremental net gain on the loan servicing asset revaluation.

Also contributing to the increase over the third quarter of 2022 was higher net gains on sale of loans.

Partially offsetting these three and nine month contributors to increased noninterest income was incremental net losses 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 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.

For the three months ended September 30, 2023, noninterest expense decreased $9.0 million, or 11.5%, compared to same period 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 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.

For the three and nine months ended September 30, 2023, income tax expense increased $1.7 million and decreased $2.4 million, respectively, compared to the same periods of 2022.

The increase compared to the third quarter of 2022 was primarily related to higher levels of pre-tax income in third quarter of 2023 while the decrease compared to the nine months ended September 30, 2022 is principally due to higher levels of expected tax credits in the prior year.

For the three and nine months ended September 30, 2023, net income decreased by $28.5 million and $122.5 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 from the second quarter of 2022 and the $28.4 million Payrailz gain from the third quarter of 2022, both included in equity method investment income.

Partially offsetting the decrease over the first nine months of 2022 was a $3.1 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

June 30, 2023 vs.

September 30, 2023 vs.

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.

Total assets at September 30, 2023 were $10.95 billion, an increase of $1.09 billion, or 11.1%, compared to total assets of $9.86 billion at December 31, 2022.

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

• 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.

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 combined with higher levels of loan sales in the first half of 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 $9.88 billion at June 30, 2023, an increase of $994.2 million, or 11.2%, from $8.88 billion at December 31, 2022.

• Cash and cash equivalents, comprised of cash and due from banks and federal funds sold, combined with investment securities available-for-sale was $1.63 billion at September 30, 2023, an increase of $203.3 million, or 14.2%, compared to $1.43 billion at December 31, 2022.

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

• Growth in total loans and leases held for investment of $858.5 million, or 11.7%, during the first nine months of 2023, from $7.34 billion at December 31, 2022, to $8.20 billion at September 30, 2023, resulting from strong origination activity during the first nine months of 2023 of $2.97 billion.

Total deposits were $10.00 billion at September 30, 2023, an increase of $1.12 billion, or 12.6%, 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.

At September 30, 2023, the Bank’s total uninsured deposits were approximately $1.48 billion, or 14.6%, of total deposits.

Borrowings decreased to $25.8 million at September 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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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.

As of September 30, 2023, the Company and the Bank each had total assets of $10.95 billion and $10.87 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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Deposit Insurance Assessments.

Also under the Dodd-Frank Act, the minimum ratio of net worth to insured deposits of the federal Deposit Insurance Fund administered by the FDIC was increased from 1.15 percent to 1.35 percent and the FDIC is required, in setting deposit insurance assessments, to offset the effect of the increase on institutions with assets of less than $10 billion, which results in institutions with assets greater than $10 billion paying higher assessments.

Also under the Dodd-Frank Act, the minimum ratio of net worth to insured deposits of the Deposit Insurance Fund administered by the FDIC was increased from 1.15 percent to 1.35 percent and the FDIC is required, in setting deposit insurance assessments, to offset the effect of the increase on institutions with assets of less than $10 billion, which results in institutions with assets greater than $10 billion paying higher assessments.

In addition, following the fourth consecutive quarter where the total assets of a bank exceeds $10 billion, as reported in its quarterly Call Report, the FDIC utilizes a different method for determining deposit insurance assessments.

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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 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.

Nonperforming assets, excluding loans measured at fair value, at September 30, 2023 were $105.8 million, which represented a $32.4 million, or 44.1%, increase from December 31, 2022.

These nonperforming assets at September 30, 2023 were comprised of $99.1 million in nonaccrual loans and leases and $6.7 million in foreclosed assets.

Of the $105.8 million of nonperforming assets, $69.0 million carried a government guarantee, leaving an unguaranteed exposure of $36.8 million in total nonperforming assets at September 30, 2023.

This represents an increase of $18.0 million, or 95.7%, 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.

June 30, 2023 (1)

September 30, 2023 (1)

December 31, 2022 (1)

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(1) Excludes loans measured at fair value.

June 30, 2023 (1)

September 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 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.

Total nonperforming assets, including loans measured at fair value, at September 30, 2023 were $154.0 million, which represented a $33.6 million, or 27.9%, increase from December 31, 2022.

These nonperforming assets at September 30, 2023 were comprised of $147.3 million in nonaccrual loans and leases and $6.7 million in foreclosed assets.

Of the $154.0 million of nonperforming assets, $108.8 million carried a government guarantee, leaving an unguaranteed exposure of $45.2 million in total nonperforming assets at September 30, 2023.

This represents an increase of $19.1 million, or 73.6%, 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 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.

As a percentage of the Bank’s total capital, nonperforming loans and leases, excluding loans measured at fair value, represented 11.0% at September 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 September 30, 2023 and December 31, 2022 were 3.7% and 2.3%, respectively.

As of September 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 $567.6 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 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.

At September 30, 2023 , the portion of criticized and classified loans and leases guaranteed by the SBA or USDA totaled $227.0 million and total portfolio unguaranteed exposure risk was $340.6 million, or 6.8% 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 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 September 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:

General Lending at 13.2%, Wine and Craft Beverage at 11.2%, Senior Housing at 11.4%, Sponsor Search Fund Lending at 10.5%, Sponsor Finance at 5.0%, Hotels at 4.5%, Venture Banking at 4.1%, A griculture at 3.9%, Healthcare at 3.9%, and Senior Care at 3.9%.

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, 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.

Wine and Craft Beverage at 11.5%, General Lending at 10.3%, Senior Housing at 10.2%, Sponsor Search Fund Lending at 7.0%, 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 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 $142.9 million increase in potential problem and classified loans and leases in the first nine 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 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.

At September 30, 2023, the Company had a total of $37.1 million in loans modified in the first nine months of 2023 to borrowers experiencing financial difficulty, all of which remained current with $14.6 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 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 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.

At September 30, 2023 , and December 31, 2022 , Risk Grade 5 loans and leases, excluding lo ans measured at fair value, totaled $385.1 million and $286.5 million, respectively, for a nine month increase of $84.9 million.

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

Sponsor Search Fund Lending ($25.4 million or 30.0%), Sponsor Finance ($23.7 million or 23.9%), General Lending ($21.0 million or 24.7%), Venture Banking ($15.9 million or 18.7%), Asset-Based Lending ($13.7 million or 16.1%), Bioenergy ($13.4 million or 15.8%), Senior Housing ($9.0 million or 10.6%) and Wine and Craft Beverage ($7.0 million or 8.3%).

Partially offsetting the above increase were decreases in Risk Grade 5 loans principally concentrated in two verticals:

Broadband ($12.4 million or 14.5%) and Entertainment Centers ($9.0 million or 10.6%).

Of the above listed verticals, Asset-Based Lending, Sponsor Finance, Senior Housing and Venture Banking 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 September 30, 2023, approximately 95.4% 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 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.

At September 30, 2023, the Company had $10.5 million in unguaranteed loans on SBA payment assistance.

Allowance for Credit Losses on Loans and Leases

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.

The ACL of $96.6 million at December 31, 2022, increased by $24.7 million, or 25.6%, to $121.3 million at September 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 September 30, 2023, respectively.

The increase in the ACL during the first nine months of 2023 was primarily the result of loan growth, combined with specific reserve changes on individually evaluated loans and charge-off related impacts.

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

Actual past due held for investment loans and leases, inclusive of loans measured at fair value, have increased by $40.6 million since December 31, 2022.

Actual past due held for in vestment loans and leases, inclusive of loans measured at fair value, have increased by $46.7 million since December 31, 2022 .

Total loans and leases 90 or more days past due increased $45.2 million, or 80.0 %, compared to December 31, 2022 .

This increase was comprised of a $19.7 million increase in unguaranteed exposure combined with a $25.5 million increase in the guaranteed portion of past due loans 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.

At September 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 0.8% and 0.7%, respectively.

Total ungu aranteed loans and leases past due were comprised of $34.5 million carried at historical cost, an increase of $13.3 million, and $8.0 million measured at fair value, a decrease of $1.6 million, as of September 30, 2023 compared to December 31, 2022 .

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

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 believes the ACL of $121.3 million at September 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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and (d) availability under lines of credit.

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.

At September 30, 2023, the total amount of these four items was $4.34 billion, or 39.6% 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 customer deposits.

To date, an increasing retail deposit base and a stable amount of brokered deposits have been adequate to meet loan obligations, while maintaining the desired level of immediate liquidity.

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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 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.

At September 30, 2023, none of the investment securities portfolio was pledged to secure public deposits or pledged to retail repurchase agreements, leaving $1.10 billion available to pledge as collateral.

Contractual Obligations

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One of the primary objectives of asset/liability management is to maximize the net interest margin while minimizing the earnings risk associated with changes in interest rates.

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

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

One method used to manage interest rate sensitivity is to measure the repricing differences, or interest rate gaps, between interest-earning assets and interest-bearing liabilities, across various time periods.

As of September 30, 2023, the balance sheet’s total cumulative gap position was 4.7%, meaning that over the entire life of the Company's assets and liabilities, more assets will reprice than liabilities.

For further information, see Item 3.

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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 and non-parallel interest rate shocks applied to a dynamic balance sheet to measure interest rate risk.

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.

As of September 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.

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

Asset/liability sensitivity is primarily derived from the prime-based loans that adjust as the prime interest rate changes, rates on cash accounts that adjusts as the federal funds rate changes and the longer duration of indeterminate term deposits.

Asset/liability sensitivity is primarily derived from the prime-based loans that adjust as the prime interest rate changes, rates on cash accounts that adjust as the federal funds rate changes and the longer duration of indeterminate term deposits.

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

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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 June 30, 2023, and December 31, 2022, are presented in the table below.

Capital amounts and ratios as of September 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 - June 30, 2023

Consolidated - September 30, 2023

Common Equity Tier 1 (to Risk-Weighted Assets) $ 942,495 11.63 % $ 364,764 4.50 % N/A N/A

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Tier 1 Capital (to Average Assets) 942,495 8.56 440,488 4.00 N/A N/A

Bank - June 30, 2023

Bank - September 30, 2023

Common Equity Tier 1 (to Risk-Weighted Assets) $ 802,562 10.25 % $ 352,192 4.50 % $ 508,722 6.50 %

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Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-Q

Item 2. Management’s Discussion and Analysis