PEOPLES BANCORP OF NORTH CAROLINA INC 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following is a discussion of the financial position and results of operations of the Company and should be read in conjunction with the information set forth under Item 1A Risk Factors in the Company’s Annual Report of Form 10-K and the Company’s Consolidated Financial Statements and Notes thereto on pages A-20 through A-62 of the Company’s 2023 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the 2024 Annual Meeting of Shareholders. Introduction Management’s discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of the Company. The Company is the parent company of the Bank and a registered bank holding company operating under the supervision of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell, Wake, Rowan and Forsyth counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”). Overview Our business consists principally of attracting deposits from the general public and investing these funds in commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of our interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, a positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses. Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve, inflation, interest rates, market and monetary fluctuations. Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered. Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers, and (2) small businesses and commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating the allowance for credit losses (“ACL”, “allowance for credit losses”, or “allowance”) and changes in these economic factors could result in increases or decreases to the provision for loan losses. Prior to the COVID-19 pandemic, economic conditions, while not as robust as the period from 2004 to 2007, had stabilized such that businesses in our market area were growing and investing again. The uncertainty expressed in the local, national and international markets through the primary economic indicators of activity were previously sufficiently stable to allow for reasonable economic growth in our markets. Subsequently, continuing supply-chain disruption and rising inflation has caused the Federal Reserve Federal Open Market Committee (“FOMC”) to increase the target federal funds rate 500 basis points since March 1, 2022 to a range of 5.25% to 5.50% at March 31, 2024. Although we are unable to control the external factors that influence our business, by maintaining high levels of balance sheet liquidity, managing our interest rate exposures and by actively monitoring asset quality, we seek to minimize the potentially adverse risks of unforeseen and unfavorable economic trends. Because the assets and liabilities of a bank are primarily monetary in nature (payable in fixed, determinable amounts), the performance of a bank is affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same. The effect of inflation on banks is normally not as significant as its influence on those businesses that have large investments in plants and inventories. During periods of high inflation there are normally corresponding increases in the money supply, and banks will normally experience above average growth in assets, loans, and deposits. Also, general increases in the price of goods and services can be expected to result in increased operating expenses. 29 Table of Contents Our business emphasis has been and continues to be to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We expect growth to be achieved in our local markets and through expansion opportunities in contiguous or nearby markets. While we would be willing to consider growth by acquisition in certain circumstances, we do not consider the acquisition of another company to be necessary for our continued ability to provide a reasonable return to our shareholders. We believe that we can be more effective in serving our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability and experience of our Bank officers and managers. Summary of Critical Accounting Policies The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance. The following is a summary of some of the more subjective and complex accounting policies of the Company. A more complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2023 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the 2024 Annual Meeting of Shareholders. There have been no significant changes to the application of significant accounting policies since December 31, 2023. Results of Operations Summary. Net earnings were $3.9 million or $0.74 per share and $0.72 per diluted share for the three months ended March 31, 2024, compared to $3.2 million or $0.58 per share and $0.56 per diluted share for the prior year period. The increase in first quarter 2024 net earnings is primarily the result of an increase in non-interest income and a decrease in the provision for credit losses, which were partially offset by a decrease in net interest income and an increase in non-interest expense, compared to the prior year period, as discussed below. The annualized return on average assets was 0.96% for the three months ended March 31, 2024, compared to 0.81% for the same period one year ago, and annualized return on average shareholders’ equity was 13.51% for the three months ended March 31, 2024, compared to 11.78% for the same period one year ago. Net Interest Income. Net interest income, the major component of the Company’s net income, is the amount by which interest and fees generated by interest-earning assets exceed the total cost of funds used to carry them. Net interest income is affected by changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as changes in the yields earned and rates paid. Net interest margin is calculated by dividing tax-equivalent net interest income by average interest-earning assets, and represents the Company’s net yield on its interest-earning assets. Net interest income was $13.3 million for the three months ended March 31, 2024, compared to $14.3 million for the three months ended March 31, 2023. The decrease in net interest income is due to a $4.0 million increase in interest expense, partially offset by a $3.0 million increase in interest income. Net interest income after the provision for credit losses was $13.2 million for the three months ended March 31, 2024, compared to $14.1 million for the three months ended March 31, 2023. The provision for credit losses for the three months ended March 31, 2024 was $91,000, compared to $224,000 for the three months ended March 31, 2023. The decrease in the provision for credit losses is primarily attributable to a reduction in reserves on unfunded loan commitments, which was partially offset by reserves on loans individually evaluated at March 31, 2024. Interest income was $19.8 million for the three months ended March 31, 2024, compared to $16.8 million for the three months ended March 31, 2023. The increase in interest income is due to a $2.3 million increase in interest income and fees on loans, a $524,000 increase in interest income on balances due from banks and a $230,000 increase in interest income on investment securities. The increase in interest income and fees on loans is primarily due to an increase in total loans and rate increases by the Federal Reserve from February 2023 through July 2023. The increase in interest income on balances due from banks is also due to an increase in balances outstanding and rate increases by the Federal Reserve. The increase in interest income on investment securities is primarily due to higher yields on securities purchased during the three months ended March 31, 2024. During the three months ended March 31, 2024, average loans were $1.09 billion, an increase of $55.5 million from average loans of $1.0 million for the three months ended March 31, 2023. During the three months ended March 31, 2024, average investment securities available for sale were $443.5 million, a decrease of $32.8 million from average investment securities available for sale of $476.3 million for the three months ended March 31, 2023. The average yield on loans for the three months ended March 31, 2024 and 2023 was 5.57% and 5.04%, respectively. The average yield on investment securities available for sale was 3.36% and 2.98% for the three months ended March 31, 2024 and 2023, respectively. The average yield on earning assets was 4.96% and 4.41% for the three months ended March 31, 2024 and 2023, respectively. 30 Table of Contents Interest expense was $6.5 million for the three months ended March 31, 2024, compared to $2.5 million for the three months ended March 31, 2023. The increase in interest expense is primarily due to an increase in time deposits and an increase in rates paid on interest-bearing liabilities. During the three months ended March 31, 2024, average interest-bearing non-maturity deposits were $648.3 million, a decrease of $126.8 million from average interest-bearing non-maturity deposits of $775.1 million for the three months ended March 31, 2023. During the three months ended March 31, 2024, average certificates of deposit were $352.2 million, an increase of $233.5 million from average certificates of deposit of $118.8 million for the three months ended March 31, 2023. The average rate paid on interest-bearing checking and savings accounts was 1.28% and 0.78% for the three months ended March 31, 2024 and 2023, respectively. The average rate paid on certificates of deposit was 4.20% for the three months ended March 31, 2024, compared to 1.76% for the same period one year ago. The average rate paid on interest-bearing liabilities was 2.40% for the three months ended March 31, 2024, compared to 1.05% for the same period one year ago. The following table sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the three months ended March 31, 2024 and 2023. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on total average interest-earning assets for the same periods. Yield information does not give effect to changes in fair value of available for sale investment securities that are reflected as a component of shareholders’ equity. Yields and interest income on tax-exempt investments for the three months ended March 31, 2024 and 2023 have been adjusted to a tax equivalent basis using an effective tax rate of 22.98% for securities that are both federal and state tax exempt and an effective tax rate of 20.48% for federal tax-exempt securities. Non-accrual loans and the interest income that was recorded on non-accrual loans, if any, are included in the yield calculations for loans in all periods reported. The Company believes the presentation of net interest income on a tax-equivalent basis provides comparability of net interest income from both taxable and tax-exempt sources and facilitates comparability within the industry. Although the Company believes these non-GAAP financial measures enhance investors’ understanding of its business and performance, these non-GAAP financial measures should not be considered an alternative to GAAP. The reconciliations of these non-GAAP financial measures to their most directly comparable GAAP financial measures are presented below. 31 Table of Contents Three months ended March 31, 2024 Three months ended March 31, 2023 (Dollars in thousands) Average Balance Interest Yield / Rate Average Balance Interest Yield / Rate Interest-earning assets: Loans receivable $ 1,092,658 $ 15,138 5.57 % $ 1,037,124 $ 12,883 5.04 % Investments - taxable 310,014 3,008 3.90 % 340,536 2,829 3.37 % Investments - nontaxable* 136,791 763 2.24 % 138,819 754 2.20 % Due from banks 66,518 907 5.48 % 32,453 383 4.79 % Total interest-earning assets 1,605,981 19,816 4.96 % 1,548,932 16,849 4.41 % Non-interest earning assets: Cash and due from banks 32,045 37,515 Allowance for credit losses (11,062 ) (10,443 ) Other assets 20,838 20,784 Total assets $ 1,647,802 $ 1,596,788 Interest-bearing liabilities: Interest-bearing demand, MMDA & savings deposits $ 648,306 $ 2,060 1.28 % $ 775,101 $ 1,488 0.78 % Time deposits 352,247 3,681 4.20 % 118,763 516 1.76 % Junior subordinated debentures 15,464 284 7.39 % 15,464 248 6.50 % Other 72,695 481 2.66 % 42,233 211 2.03 % Total interest-bearing liabilities 1,088,712 6,506 2.40 % 951,561 2,463 1.05 % Non-interest bearing liabilities and shareholders' equity: Demand deposits 427,752 523,544 Other liabilities 13,814 12,433 Shareholders' equity 117,524 109,250 Total liabilities and shareholders' equity $ 1,647,802 $ 1,596,788 Net interest spread $ 13,310 2.56 % $ 14,386 3.36 % Net yield on interest-earning assets 3.33 % 3.77 % Taxable equivalent adjustment Investment securities $ 6 $ 48 Net interest income $ 13,304 $ 14,338 *Includes U.S. Government agency securities that are non-taxable for state income tax purposes of $10.9 million in 2024 and $11.6 million in 2023. A tax rate of 2.50% was used to calculate the tax equivalent yield on these securities. Changes in interest income and interest expense can result from variances in both volume and rates. The following table describes the impact on the Company’s tax equivalent net interest income resulting from changes in average balances and average rates for the periods indicated. The changes in net interest income due to both volume and rate changes have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each. 32 Table of Contents Three months ended March 31, 2024 compared to three months ended March 31, 2023 Three months ended March 31, 2023 compared to three months ended March 31, 2022 (Dollars in thousands) Changes in average volume Changes in average rates Total Increase (Decrease) Changes in average volume Changes in average rates Total Increase (Decrease) Interest income: Loans: Net of unearned income $ 730 1,525 2,255 1,780 1,361 3,141 Investments - taxable (275 ) 454 179 307 1,517 1,824 Investments - nontaxable (11 ) 20 9 49 144 193 Due from banks 433 91 524 (1,389 ) 1,661 272 Total interest income 877 2,090 2,967 747 4,683 5,430 Interest expense: Interest-bearing demand, MMDA & savings deposits (323 ) 895 572 (29 ) 1,114 1,085 Time deposits 1,727 1,438 3,165 53 316 369 Junior subordinated debentures - 36 36 - 173 173 Other 177 93 270 11 162 173 Total interest expense 1,581 2,462 4,043 35 1,765 1,800 Net interest income $ (704 ) (372 ) (1,076 ) 712 2,918 3,630 Provision for Credit Losses. The provision for credit losses for the three months ended March 31, 2024 was $91,000, compared to $224,000 for the three months ended March 31, 2023. The decrease in the provision for credit losses is primarily attributable to a provision reduction of $337,000 for other construction loans and all land development and other land loans as a result of an overall decrease in funded loan balances and unfunded commitments in this category, a decrease in provision of $224,000 for loans secured by owner-occupied, nonfarm nonresidential properties as a result of a $200,000 recovery during the first quarter of 2024, partially offset by an increase in provision for individually evaluated loans of $321,000 for commercial and industrial loans and $94,000 for 1-4 family loans secured by first liens during the three months ended March 31, 2024. Non-Interest Income. Non-interest income was $6.0 million for the three months ended March 31, 2024, compared to $3.6 million for the three months ended March 31, 2023. The increase in non-interest income is primarily attributable to a $2.5 million net loss on the sales of securities during the three months ended March 31, 2023, and no comparable losses in the three months ended March 31, 2024. Non-Interest Expense. Non-interest expense was $14.5 million for the three months ended March 31, 2024, compared to $13.7 million for the three months ended March 31, 2023. The increase in non-interest expense is primarily attributable to a $480,000 increase in salaries and employee benefits expense primarily due to an increase in insurance expense and a $254,000 increase in appraisal management fee expense due to an increase in appraisal volume. Income Taxes. Income tax expense was $787,000 for the three months ended March 31, 2024, compared to $851,000 for the three months ended March 31, 2023. The effective tax rate was 16.62% for the three months ended March 31, 2024, compared to 21.15% for the three months ended March 31, 2023. The decrease in the effective tax rate is primarily due to a $322,000 interest receivable booked during the three months ended March 31, 2024 on a deposit for taxes paid prior to a recent settlement with the North Carolina Department of Revenue (“NCDOR”) to withdraw the disallowance of certain tax credits previously purchased by the Bank. Analysis of Financial Condition Investment Securities. Available for sale securities were $394.7 million as of March 31, 2024, compared to $391.9 million as of December 31, 2023. Average investment securities available for sale for the three months ended March 31, 2024 were $443.5 million, compared to $454.8 million for the year ended December 31, 2023. Loans. Total loans were $1.09 billion as of March 31, 2024, compared to $1.08 billion at December 31, 2023. Average loans represented 68% of average earning assets for the three months ended March 31, 2024 and the year ended December 31, 2023. The Bank had $1.3 million and $686,000 in mortgage loans held for sale as of March 31, 2024 and December 31, 2023, respectively. 33 Table of Contents Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market. Real estate mortgage loans include both commercial and residential mortgage loans. At March 31, 2024, the Bank had $116.6 million in residential mortgage loans, $107.8 million in home equity loans and $659.5 million in commercial mortgage loans, which include $510.2 million secured by commercial property and $149.3 million secured by residential property. At December 31, 2023, the Bank had $112.8 million in residential mortgage loans, $107.7 million in home equity loans and $639.9 million in commercial mortgage loans, which include $488.9 million secured by commercial property and $151.0 million secured by residential property. All residential mortgage loans are originated as fully amortizing loans, with no negative amortization Allowance for Credit Losses (ACL). The allowance for credit losses reflects management’s assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance that management believes will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. The allowance for credit losses on loans is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on the loans. Loans are charged off against the allowance when management believes the uncollectibility of a loan balance is confirmed. Expected recoveries do not exceed the aggregate of amounts previously charged-off and expected to be charged-off. Accrued interest receivable is excluded from the estimate of credit losses. The allowance for credit losses represents management’s estimate of lifetime credit losses inherent in loans as of March 31, 2024. The allowance for credit losses is estimated by management using relevant available information, from both internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts. The Company measures expected credit losses for loans on a pooled basis when similar risk characteristics exist. The Company calculates the allowance for credit losses using a Weighted Average Remaining Maturity (“WARM”) methodology. The ACL balance was $10.8 million at March 31, 2024 as compared to $11.0 million at December 31, 2023. The decrease is primarily composed of a $213,000 decrease in allowance for other construction loans all land development, and other land loans as a result of loan balance decreases in this category during the first quarter of 2024, a decrease of $57,000 in reserves in loans secured by owner-occupied, nonfarm nonresidential properties as a result of a $200,000 recovery during the first quarter of 2024, partially offset by an increase in reserves of $85,000 in loans secured by other nonfarm nonresidential properties caused by an increase in balances for loans in this category at March 31, 2024 as compared to December 31, 2023. Additionally, the allowance for credit losses calculation includes subjective adjustments for qualitative risk factors that are likely to cause estimated credit losses to differ from historical experience. These qualitative adjustments may increase or reduce reserve levels and include adjustments for: local, state and national economic outlook; levels and trends of delinquencies; trends in volume, mix and size of loans; seasoning of the loan portfolio; experience of staff; concentrations of credit; and interest rate risk. The portion of the ACL balance attributable to qualitative factors was $5.2 million at March 31, 2024 and December 31, 2023. A decrease of $36,000 between these periods is mainly attributable to the decrease in reserves of $109,000 for other construction loans and all land development and other land loans as a result of decreases in loan balances for this category, partially offset by an increase in reserves of $84,000 for loans secured by other nonfarm nonresidential properties as a result of balance increases for this category. No changes to the risk status of any of the risk factors was made during the first quarter of 2024. Loans that do not share risk characteristics are evaluated on an individual basis. When management determines that foreclosure is probable and the borrower is experiencing financial difficulty, the expected credit losses are based on the fair value of collateral at the reporting date adjusted for selling costs as appropriate. Three loans, totaling $891,000, were individually evaluated as of March 31, 2024, and two loans totaling $432,000 were individually evaluated as of December 31, 2023. Reserves on individually evaluated loans were $424,000 and $432,000 at March 31, 2024 and December 31, 2023, respectively. Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit issued to meet customer financing needs. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for off-balance sheet loan commitments is represented by the contractual amount of those instruments. Such financial instruments are recorded when they are funded. The Company records an allowance for credit losses on off-balance sheet credit exposures, unless the commitments to extend credit are unconditionally cancelable. The allowance for credit losses on off-balance sheet credit exposures is estimated by loan segment at each balance sheet date under the current expected credit loss model using the same methodologies as portfolio loans, taking into consideration the likelihood that funding will occur as well as any third-party guarantees. The allowance for unfunded commitments is included in other liabilities on the Company’s consolidated balance sheets. 34 Table of Contents The allowance for credit losses on off-balance sheet credit exposures was $1.7 million and $1.8 million at March 31, 2024 and December 31, 2023, respectively. The decrease of $72,000 in the first quarter of 2024 was the result of a decrease in the allowance balance of $69,000 for other construction loans and all land development and other land loans. The overall balances in this category decreased in the first quarter of 2024. Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectability becomes doubtful. Upon loan origination, the Bank’s originating loan officer evaluates the quality of the loan and assigns one of eight risk grades. The loan officer monitors the loan’s performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by the Bank’s Credit Administration. Before making any changes in these risk grades, management considers assessments as determined by the third-party credit review firm (as described below), regulatory examiners and the Bank’s Credit Administration. Any issues regarding the risk assessments are addressed by the Bank’s senior credit administrators and factored into management’s decision to originate or renew the loan. The Bank Board reviews, on a monthly basis, an analysis of the Bank’s reserves relative to the range of reserves estimated by the Bank’s Credit Administration. As an additional measure, the Bank engages an independent third party to review the underwriting, documentation and risk grading analyses. This independent third party reviews and evaluates loan relationships greater than or equal to $1.5 million as well as a periodic sample of commercial relationships with exposures below $1.5 million, excluding loans in default, and loans in process of litigation or liquidation. The third party’s evaluation and report is shared with management and the board of directors of the Bank (the “Bank Board”). Management considers certain commercial loans with weak credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk. Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in estimating the allowance. The provision for credit losses charged or credited to earnings is based upon management’s judgment of the amount necessary to maintain the allowance at a level appropriate to absorb probable incurred losses in the loan portfolio at the balance sheet date. The amount each quarter is dependent upon many factors, including growth and changes in the composition of the loan portfolio, net charge-offs, delinquencies, management’s assessment of loan portfolio quality, the value of collateral, and other macro-economic factors and trends. The evaluation of these factors is performed quarterly by management through an analysis of the appropriateness of the allowance. Since the adoption of CECL on January 1, 2023, the allowance for credit losses represents management’s estimate of credit losses for the remaining estimated life of the Bank’s financial assets, including loan receivables and some off-balance sheet credit exposures. Estimating the amount of the allowance for credit losses requires significant judgment and the use of estimates related to historical experience, current conditions, reasonable and supportable forecasts, and the value of collateral on collateral-dependent loans. The loan portfolio also represents the largest asset type on our consolidated balance sheet. Credit losses are charged against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for credit losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors. There are many factors affecting the allowance for credit losses; some are quantitative while others require qualitative judgment. Although management believes its process for determining the allowance adequately considers all the potential factors that could potentially result in credit losses, the process includes subjective elements and is susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for credit losses could be required that could adversely affect our earnings or financial position in future periods. Various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance. Such agencies may require adjustments to the allowance based on their judgments of information available to them at the time of their examinations. Management believes it has established the allowance for credit losses pursuant to CECL, and has taken into account the views of its regulators and the current economic environment. Management considers the allowance adequate to cover the estimated losses inherent in the Bank’s loan portfolio as of the date of the financial statements. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions, thus adversely affecting the operating results of the Company. 35 Table of Contents Non-performing Assets. Non-performing assets were $4.0 million or 0.23% of total assets at March 31, 2024, compared to $3.9 million or 0.24% of total assets at December 31, 2023. Non-accrual loans were $4.0 million at March 31, 2024, compared to $3.8 million at December 31, 2023. As a percentage of total loans outstanding, non-accrual loans were 0.36% at March 31, 2024 and December 31, 2023. Non-accrual loans over $250,000 are individually evaluated for impairment. Non-performing assets include $3.4 million in commercial and residential mortgage loans and $553,000 in other loans at March 31, 2024, compared to $3.4 million in commercial and residential mortgage loans and $464,000 in other loans at December 31, 2023. The Bank had no loans 90 days past due and still accruing at March 31, 2024 and December 31, 2023. The Bank had no other real estate owned at March 31, 2024 and December 31, 2023. Deposits. Deposits were $1.45 billion as of March 31, 2024, compared to $1.39 billion as of December 31, 2023. Core deposits, a non-GAAP measure, which include noninterest-bearing demand deposits, NOW, MMDA, savings and non-brokered certificates of deposit of denominations of $250,000 or less, were $1.30 billion at March 31, 2024, compared to $1.24 billion at December 31, 2023. Management believes it is useful to calculate and present core deposits because of the positive impact this low cost funding source provides to the Bank’s overall cost of funds and profitability. Certificates of deposit in amounts of more than $250,000 totaled $148.8 million at March 31, 2024, compared to $148.9 million December 31, 2023. Estimated uninsured deposits totaled $390.2 million, or 26.86% of total deposits, at March 31, 2024, compared to $382.1 million, or 27.45% of total deposits, at December 31, 2023. Uninsured amounts are estimated based on the portion of account balances in excess of FDIC insurance limits. The Bank did not have any significant deposit concentrations at March 31, 2024. Borrowed Funds. There were no FHLB borrowings outstanding at March 31, 2024 and December 31, 2023. Securities sold under agreements to repurchase were $59.2 million at March 31, 2023, compared to $86.7 million at December 31, 2023. The decrease in securities sold under agreements to repurchase is primarily due to customers transferring funds from securities sold under agreements to repurchase to deposits via the IntraFi network’s Insured Cash Sweep (“ICS”) during the three months ended March 31, 2024 Junior Subordinated Debentures (related to Trust Preferred Securities). Junior subordinated debentures were $15.5 million at March 31, 2024 and December 31, 2023. Asset Liability and Interest Rate Risk Management. The objective of the Company’s Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities. This is done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income. The Company manages its exposure to fluctuations in interest rates through policies established by the Asset/Liability Committee (“ALCO”) of the Bank. The ALCO meets quarterly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company. ALCO seeks to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements. The ability to control these fluctuations has a direct impact on the profitability of the Company. Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities. The Company’s rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year. Rate sensitive assets therefore include both loans and available for sale securities. Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds. Average rate sensitive assets for the three months ended March 31, 2024 totaled $1.61 billion, exceeding average rate sensitive liabilities of $1.09 billion by $517.3 million. The Company has an overall interest rate risk management strategy that may incorporate the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. By using derivative instruments, the Company is exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative. The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company. The Company did not have any interest rate derivatives outstanding as of March 31, 2024. Included in the rate sensitive assets are $184.6 million in variable rate loans indexed to prime rate subject to immediate repricing upon changes by the FOMC. Certain variable rate loans are structured to establish floors on interest rates charged to protect against downward movements in the prime rate. At March 31, 2024, the Company had $118.7 million in loans with interest rate floors. No floors were in effect on loans with floors on interest rates charged at March 31, 2024. 36 Table of Contents Liquidity. The objectives of the Company’s liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements. Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities. In addition, the Company’s liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit. As of March 31, 2024, such unfunded commitments to extend credit were $370.5 million, while commitments in the form of standby letters of credit totaled $3.3 million. As of December 31, 2023, such unfunded commitments to extend credit were $367.5 million, while commitments in the form of standby letters of credit totaled $3.7 million. The Bank uses several sources to meet its liquidity requirements. The primary source is core deposits, which includes demand deposits, savings accounts and non-brokered certificates of deposit of denominations less than $250,000. The Bank considers these to be a stable portion of the Bank’s liability mix and the result of on-going consumer and commercial banking relationships. As of March 31, 2024, the Bank’s core deposits, a non-GAAP measure, totaled $1.30 billion, or 90% of total deposits. As of December 31, 2023, the Bank’s core deposits totaled $1.24 billion, or 89% of total deposits. The other sources of funding for the Bank are through large denomination certificates of deposit, including brokered deposits, federal funds purchased, securities under agreements to repurchase and FHLB borrowings. The Bank is also able to borrow from the Federal Reserve Bank (“FRB”) on a short-term basis. The Bank’s policies include the ability to access wholesale funding of up to 40% of total assets. The Bank’s wholesale funding includes FHLB borrowings, FRB borrowings, brokered deposits, internet certificates of deposit and certificates of deposit issued to the State of North Carolina. The Bank’s ratio of wholesale funding to total assets was 0.49% and 0.50% as of March 31, 2024 and December 31, 2023, respectively. The Bank has a line of credit with the FHLB equal to 20% of the Bank’s total assets. There were no FHLB borrowings outstanding at March 31, 2024 and December 31, 2023. At March 31, 2024, the carrying value of loans pledged as collateral to the FHLB totaled $217.4 million compared to $214.1 million at December 31, 2023. The remaining availability under the line of credit with the FHLB was $126.5 million at March 31, 2024 compared to $122.2 million at December 31, 2023. The Bank had no borrowings from the FRB at March 31, 2024 or December 31, 2023. FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB. At March 31, 2024, the carrying value of loans pledged as collateral to the FRB totaled $612.1 million compared to $611.2 million at December 31, 2023. Availability under the line of credit with the FRB was $477.0 million at March 31, 2024 compared to $445.1 million at December 31, 2023. The Bank also had the ability to borrow up to $110.5 million for the purchase of overnight federal funds from five correspondent financial institutions as of March 31, 2024. The liquidity ratio for the Bank, which is defined as net cash, interest-bearing deposits, federal funds sold and certain investment securities, as a percentage of net deposits and short-term liabilities was 27.33% at March 31, 2024 and 25.39% at December 31, 2023. The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy was 10% at March 31, 2024 and December 31, 2023. Contractual Obligations and Off-Balance Sheet Arrangements. The Company’s contractual obligations include junior subordinated debentures, as well as certain payments under current lease agreements. Other commitments include commitments to extend credit. Capital Resources. Shareholders’ equity was $121.1 million, or 7.25% of total assets, at March 31, 2024, compared to $121.0 million, or 7.40% of total assets, at December 31, 2023. Annualized return on average equity for the three months ended March 31, 2024 was 13.51%, compared to 11.78% for the three months ended March 31, 2023. Total cash dividends paid on common stock were $1.9 million for the three months ended March 31, 2024 and 2023. In the first quarter of 2023, the Board of Directors authorized a stock repurchase program, whereby up to $2.0 million was allocated to repurchase the Company’s common stock. In the fourth quarter of 2023, the Board of Directors authorized an additional $2.0 million to be allocated to repurchase the Company’s common stock, which increased the total amount authorized in 2023 to $4.0 million. The Company repurchased approximately $4.0 million, or 181,022 shares of its common stock, under this stock repurchase program through March 31, 2024, when the program expired. 37 Table of Contents In 2013, the FRB approved its final rule on the Basel III capital standards, which implement changes to the regulatory capital framework for banking organizations. The Basel III capital standards, which became effective January 1, 2015, include new risk-based capital and leverage ratios, which were phased in from 2015 to 2019. The new minimum capital level requirements applicable to the Company and the Bank under the final rules are as follows: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total risk based capital ratio of 8% (unchanged from previous rules); and (iv) a Tier 1 leverage ratio of 4% (unchanged from previous rules). An additional capital conservation buffer was added to the minimum requirements for capital adequacy purposes beginning on January 1, 2016 and was phased in through 2019 (increasing by 0.625% on January 1, 2016 and each subsequent January 1, until it reached 2.5% on January 1, 2019). This resulted in the following minimum ratios beginning in 2019: (i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. Under the final rules, institutions would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained earnings that could be utilized for such actions. Under the regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 6.0% or greater and a common equity Tier 1 capital ratio of 4.5% or greater, as required by the Basel III capital standards referenced above. Tier 1 capital is generally defined as shareholders’ equity and trust preferred securities less all intangible assets and goodwill. Tier 1 capital includes $15.0 million in trust preferred securities at March 31, 2024 and December 31, 2023. The Company’s Tier 1 capital ratio was 13.84% and 13.94% at March 31, 2024 and December 31, 2023, respectively. Total risk-based capital is defined as Tier 1 capital plus supplementary capital. Supplementary capital, or Tier 2 capital, consists of the Company’s allowance for credit losses, not exceeding 1.25% of the Company’s risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets. The Company’s total risk-based capital ratio was 14.83% and 14.96% at March 31, 2024 and December 31, 2023, respectively. The Company’s common equity Tier 1 capital consists of common stock and retained earnings. The Company’s common equity Tier 1 capital ratio was 12.66% and 12.75% at March 31, 2024 and December 31, 2023, respectively. Financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater. The Company’s Tier 1 leverage capital ratio was 10.39% and 10.51% at March 31, 2024 and December 31, 2023, respectively. The Bank’s Tier 1 risk-based capital ratio was 13.73% and 13.83% at March 31, 2024 and December 31, 2023, respectively. The total risk-based capital ratio for the Bank was 14.72% and 14.85% at March 31, 2024 and December 31, 2023, respectively. The Bank’s common equity Tier 1 capital ratio was 13.73% and 13.83% at March 31, 2024 and December 31, 2023, respectively. The Bank’s Tier 1 leverage capital ratio was 10.23% and 10.35% at March 31, 2024 and December 31, 2023, respectively. A bank is considered to be “well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, a common equity Tier 1 capital ratio of 6.5% or greater and a leverage ratio of 5.0% or greater. Based upon these guidelines, the Bank was considered to be “well capitalized” at March 31, 2024. 38 Table of Contents Item 3. Quantitative and Qualitative Disclosures About Market Risk Not applicable