Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
We are a bank holding company and are headquartered in Washington Township, New Jersey. Through the Bank, we provide personal and business financial services to individuals and small to mid-sized businesses primarily in New Jersey, Pennsylvania, and New York. The Bank has branches in Galloway Township, Northfield, Washington Township, and Collingswood, New Jersey and Philadelphia, Pennsylvania. The vast majority of our revenue and income is currently generated through the Bank.
We manage our Company for the long term. We are focused on the fundamentals of growing customers, loans, deposits and revenue and improving profitability, while investing for the future and managing risk, expenses and capital. We continue to invest in our products, markets and brand, and embrace our commitments to our customers, shareholders, employees and the communities where we do business. Our approach is concentrated on organically growing and deepening client relationships across our businesses that meet our risk/return measures.
We focus on small to mid - sized business and retail customers and offer a range of loan products, deposit services, and other financial products through our retail branches and other channels. The Company's results of operations are dependent primarily on its net interest income, which is the difference between the interest income earned on its interest earning-assets and the interest expense paid on its interest-bearing liabilities. In our operations, we have three major lines of lending: residential real estate mortgage, commercial real estate mortgage, and construction lending. Our interest income is primarily generated from our lending and investment activities. Our deposit products include checking, savings, money market accounts, and certificates of deposit. The majority of our deposit accounts are obtained through our retail banking business, which provides us with low cost funding to grow our lending efforts. The Company also generates income from loan and deposit fees and other non-interest related activities. The Company's non-interest expense primarily consists of employee compensation, administration, and other operating expenses.
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As of December 31, 2022, we had total assets of $1.98 billion, total liabilities of $1.72 billion, and total shareholders' equity of $266.0 million. Net income available to common shareholders for 2022 was $41.8 million. In 2022, net income available to common shareholders increased 2.6% over the previous year primarily due to higher net interest income, partially offset by an increase in the provision for loan losses and higher non-interest expense. At December 31, 2022, total assets decreased 7.1% and total equity increased 14.5%, compared to December 31, 2021. Our risk based tier 1 capital ratio remained strong during the year and was 19.3% at December 31, 2022. In addition, during 2022 we returned $7.9 million of capital to our common shareholders through common stock dividends.
Our business operations are subject to risks and uncertainties that could materially affect our operating results, including the continued adverse impact of the COVID-19 pandemic on the local and national economy and our business and results of operations. The extent of such impact will depend on future developments, which are highly uncertain. There continues to be various other risks and uncertainties that could impact the Company’s businesses and future results, such as changes to the U.S. economic condition, market interest rates, the Federal Reserve Board's monetary policy, other government policies, and actions of regulatory agencies.
Results of Operations
Net Income
We recorded net income available to common shareholders of $41.8 million or $3.51 per basic common share and $3.44 per diluted common share, for the year ended December 31, 2022, compared to $40.7 million, or $3.43 per basic common share and $3.36 per diluted common share, for the year ended December 31, 2021, an increase of $1.1 million or 2.6%.
Net Interest Income
Net interest income increased $4.2 million, or 6.1%, to $73.3 million for the year ended 2022 compared to $69.1 million for the year ended 2021. The increase in net interest income was primarily due to an increase in interest income of $5.4 million, partially offset by an increase in interest expense of $1.2 million. Interest income for 2022 increased to $87.5 million, an increase of $5.4 million, or 6.6%, from $82.1 million for 2021, primarily due to an increase in interest earned on average deposits held at the Federal Reserve Bank ("FRB") of $3.1 million and an increase in interest and fees on loans of $2.3 million due to higher average outstanding loan balances and higher interest rates. Interest expense increased to $14.2 million for 2022, from $13.0 million for 2021, an increase of $1.2 million, or 9.3%. The increase in interest expense was primarily due to an increase in market interest rates on our deposit accounts.
Comparative Average Balances, Yields and Rates
The following table presents the average daily balances of assets, liabilities and equity and the respective interest earned or paid on interest-earning assets and interest-bearing liabilities, as well as average annualized rates, for the years ended December 31, 2022 and 2021. Interest rate spread is the difference between the average yield earned on interest-earning assets and the average rate paid on interest-bearing liabilities. Net interest margin is net interest income divided by average earning assets. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances and have been reflected in the table as loans carrying a zero yield. The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.
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For the Years Ended December 31,
2022 2021
Average
Balance Interest
Income/
Expense Yield/
Cost Average
Balance Interest
Income/
Expense Yield/
Cost
( Dollars in thousands)
Assets
Loans (1) (2)
$ 1,580,318 $ 82,900 5.25 % $ 1,513,959 $ 80,643 5.33 %
Investment securities 25,922 772 2.98 % 26,000 753 2.90 %
Deposits with banks 338,277 3,811 1.13 % 523,491 676 0.13 %
Total interest-earning assets 1,944,517 $ 87,483 4.50 % 2,063,450 $ 82,072 3.98 %
Non-interest earning assets 79,869 77,370
Allowance for loan losses (30,449) (30,019)
Total assets $ 1,993,937 $ 2,110,801
Liabilities and Equity
Interest bearing deposits
NOWs $ 92,535 $ 417 0.45 % $ 75,502 $ 323 0.43 %
Money markets 352,339 3,927 1.11 % 322,201 2,140 0.66 %
Savings 195,029 905 0.46 % 146,585 664 0.45 %
Time deposits 514,421 4,890 0.95 % 632,874 6,399 1.01 %
Brokered certificates of deposit 26,785 932 3.48 % 34,292 228 0.66 %
Total interest-bearing deposits 1,181,109 11,071 0.94 % 1,211,454 9,754 0.81 %
Borrowings 119,422 3,085 2.58 % 158,943 3,202 2.01 %
Total interest-bearing liabilities 1,300,531 $ 14,156 1.09 % 1,370,397 $ 12,956 0.95 %
Non-interest bearing deposits 428,549 506,645
Other liabilities 14,389 15,030
Total liabilities 1,743,469 1,892,072
Equity 250,468 218,729
Total liabilities and equity $ 1,993,937 $ 2,110,801
Net interest income $ 73,327 $ 69,116
Interest rate spread 3.41 % 3.03 %
Net interest margin 3.77 % 3.35 %
(1) Interest income includes $5.0 million and $7.5 million of net fee income for the years ended 2022 and 2021, respectively.
(2) Average balances are net of unearned income and include nonperforming loans.
Net interest income and the net interest margin in any one period can be significantly affected by a variety of factors including the mix and overall size of our earning assets portfolio and the cost of funding those assets. We expect net interest income and our net interest margin to fluctuate based on changes in interest rates and changes in the amount and composition of our interest-earning assets and interest-bearing liabilities.
Rate/Volume Analysis
For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume ( i.e. , changes in volume multiplied by the previous rate) and (ii) changes in rate ( i.e. , changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate.
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Years ended December 31,
2022 vs 2021
Variance due to change in
Average
Volume Average
Rate Net
Increase/
(Decrease)
( Dollars in thousands)
Interest Income:
Loans (net of deferred costs/fees) $ 3,535 $ (1,278) $ 2,257
Investment securities (2) 21 19
Deposits with banks (239) 3,374 3,135
Total interest income 3,294 2,117 5,411
Interest Expense:
Deposits (244) 1,561 1,317
Borrowed funds (796) 679 (117)
Total interest expense (1,040) 2,240 1,200
Net interest income $ 4,334 $ (123) $ 4,211
Provision for loan losses
Our provision for loan losses in each period is driven by net charge-offs and changes to the allowance for loan losses. We recorded a provision for loan losses of $1.8 million and $0.5 million in 2022 and 2021, respectively. The provision for loan losses as a percentage of interest income was 2.06% and 0.61% in 2022 and 2021, respectively.
Our provision for loan losses increased by $1.3 million in 2022 compared to 2021 primarily as a result of the growth of the loan portfolio. For more information about our provision and allowance for loan and lease losses and our loss experience, see “Risk Management and Asset Quality-Allowance for Loan and Lease Losses” and NOTE 4. Loans and Allowance for Loan and Lease Losses in the Notes to the Consolidated Financial Statements.
Non-interest Income
The table below displays the components of non-interest income for 2022 and 2021.
2022 2021 $ Change % Change
( Dollars in thousands)
Service fees on deposit accounts $ 4,927 $ 5,662 $ (735) (13.0) %
Other Loan fees 1,379 1,346 33 2.5 %
Bank owned life insurance income 568 575 (7) (1.2) %
Gain on sale of SBA loans 98 214 (116) (54.2) %
Gain on sale and valuation adjustments of OREO 328 60 268 446.7 %
Other 1,082 942 140 14.9 %
Total non-interest income $ 8,382 $ 8,799 $ (417) (4.7) %
Non-interest income decreased by $0.4 million to $8.4 million in 2022 compared to 2021 primarily due to a decrease in fee income related to commercial deposit accounts, partially offset by an increase in the gain on sale of OREO.
The fee income for the year ended December 31, 2022 from the commercial deposit accounts of depositors who do business in the cannabis industry totaled $4.4 million and is included in service fees on deposit accounts in the accompanying consolidated statements of income. Such deposit fee income totaled $5.1 million during the year ended December 31, 2021. Please refer to Note 15. Commitments and Contingencies in the Notes to the Consolidated Financial Statements for our banking services to customers who do business in the cannabis industry.
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Non-Interest Expense
The following table displays the components of non-interest expense for 2022 and 2021.
2022 2021 $ Change % Change
( Dollars in thousands)
Compensation and benefits $ 10,835 $ 9,731 $ 1,104 11.3 %
Professional services 2,249 3,724 (1,475) (39.6) %
Occupancy and equipment 2,522 2,381 141 5.9 %
Data processing 1,293 1,306 (13) (1.0) %
FDIC insurance and other assessments 1,050 1,104 (54) (4.9) %
OREO expense 493 287 206 71.8 %
Other operating expense 5,391 3,970 1,421 35.8 %
Total non-interest expense $ 23,833 $ 22,503 $ 1,330 5.9 %
Non-interest expense increased $1.3 million to $23.8 million for 2022, from $22.5 million for 2021 primarily due to an increase in other operating expense of $1.4 million, an increase in compensation and benefits of $1.1 million, and an increase in OREO expense of $206 thousand, partially offset by a decrease in professional services expense of $1.5 million. The increase in other operating expense was primarily driven by a $793 thousand increase in Pennsylvania shares tax, a $172 thousand increase in director fees, and a $321 thousand increase in other loan expense. The increase in compensation and benefits was primarily due to a $425 thousand increase in salaries, and a $597 thousand increase in pension cost. The decrease in professional services expense was mainly due to the prior year remediation efforts related to our BSA Secrecy Act ("BSA") compliance.
Income Tax
Income tax expense increased $0.3 million to $14.3 million on income before taxes of $56.1 million for 2022, compared to income tax expense of $13.9 million on income before taxes of $54.9 million for 2021. The effective income tax rates for 2022 and 2021 were 25.4% and 25.4%, respectively.
Financial Condition
General
At December 31, 2022, the Company’s total assets were $1.98 billion, a decrease of $151.5 million or 7.1%, from December 31, 2021. The decrease in total assets was primarily attributable to a decrease in cash and cash equivalents, partially offset by an increase in loans. Cash and cash equivalents decreased $414.4 million, to $182.2 million at December 31, 2022, primarily due to a decrease in deposits, as well as in increase in loans receivable. Total loans outstanding increased $266.6 million at December 31, 2022, primarily due to an increase in residential 1 to 4 family loans of $165.1 million; commercial non-owner occupied loans of $72.3 million; and construction loans of $39.7 million; net of a decrease of $24.7 million in commercial and industrial loans. The decrease in the commercial and industrial loan portfolio is primarily due to the Paycheck Protection Program loans, which decreased $25.1 million to $2.8 million at December 31, 2022, from $27.8 million at December 31, 2021.
Total liabilities were $1.72 billion at December 31, 2022. This represented a $185.2 million, or 9.7%, decrease from $1.90 billion at December 31, 2021. The decrease in total liabilities was primarily due to a decrease in total deposits, partially offset by an increase in borrowings. Total deposits decreased $192.4 million, or 10.9%, to $1.6 billion at December 31, 2022, from $1.8 billion at December 31, 2021. Deposits from the cannabis industries decreased to $177.3 million at December 31, 2022, from $375.2 million at December 31, 2021. Total borrowings were $126.1 million at December 31, 2022, an increase of $5.2 million, compared to December 31, 2021, primarily due to an increase in FHLB advances of $5.0 million.
Total equity was $266.0 million and $232.4 million at December 31, 2022 and December 31, 2021, respectively, an increase of $33.7 million from December 31, 2021.
The following table presents certain key condensed balance sheet data as of December 31, 2022 and December 31, 2021:
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December 31,
2022 December 31,
2021 $ Change % Change
( Dollars in thousands)
Cash and cash equivalents $ 182,150 $ 596,553 $ (414,403) (69.5) %
Investment securities 18,744 23,269 (4,525) (19.4) %
Loans, net of unearned income 1,751,459 1,484,847 266,612 18.0 %
Allowance for loan losses (31,845) (29,845) (2,000) 6.7 %
Total assets 1,984,915 2,136,445 (151,530) (7.1) %
Total deposits 1,575,981 1,768,410 (192,429) (10.9) %
FHLBNY borrowings 83,150 78,150 5,000 6.4 %
Subordinated debt 42,921 42,732 189 0.4 %
Total liabilities 1,718,881 1,904,084 (185,203) (9.7) %
Total equity 266,034 232,361 33,673 14.5 %
Total liabilities and equity 1,984,915 2,136,445 (151,530) (7.1) %
Cash and cash equivalents
Cash and cash equivalents decreased $414.4 million to $182.2 million at December 31, 2022, from $596.6 million at December 31, 2021, a decrease of 69.5%. The decrease was primarily due to a decrease in deposits mainly attributed to a decrease in deposits from the cannabis businesses, as well as in increase in loans receivable. The decrease in cannabis deposits is primarily due to increased competition for such deposits from other banks. See “Deposits” below.
During 2022, an armored car company used by the Bank to transport and store cash for the Bank’s cannabis-related customers, informed the Company that some of the cash stored for the Bank is missing from its vault and is presumed to have been stolen. Based on preliminary estimates, the Company believes that the amount missing that is attributable to the Bank is approximately $9.5 million. The exact amount of the potential loss, if any, is unknown at this time. Please see Note 15 Commitments and Contingencies of the Notes to Consolidated Financial Statements.
Investment securities
Total investment securities decreased to $18.7 million at December 31, 2022, from $23.3 million at December 31, 2021, a decrease of $4.5 million or 19.4%. The decrease was primarily due to pay downs of $2.9 million and $1.0 million valuation decline.
Loans, net unearned income
Loans receivable increased to $1.75 billion at December 31, 2022, from $1.48 billion at December 31, 2021. The increase was primarily due to an increase in residential 1 - 4 family of $165.1 million; commercial non-owner occupied of $72.3 million; and construction loans of $39.7 million; partially offset by a decrease of $24.7 million in commercial and industrial loans.
Allowance for loan losses
Allowance for loan losses increased $2.0 million, to $31.8 million, or 6.70%, at December 31, 2022, from $29.8 million at December 31, 2021. The increase was primarily due to the provision of $1.8 million due to the increase in the loan portfolio.
Deposits
At December 31, 2022, the Bank’s total deposits decreased to $1.6 billion from $1.8 billion at December 31, 2021, a decrease of $192.4 million, or 10.9%. The decrease in deposits was primarily attributed to a decrease in non-interest bearing demand deposits of $201.3 million, and time deposits of $91.9 million, partially offset by an increase in brokered CD balances of $101.3 million. Deposits from the cannabis businesses decreased to $177.3 million at December 31, 2022, from $375.2 million at December 31, 2021, a decrease of $197.9 million. The decrease in such deposits is primarily attributable to increased competition from other banks, as more banks are soliciting deposits from these businesses and offering favorable terms and fees for such deposits. The Bank expects this trend to continue in the foreseeable future.
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Borrowings
At December 31, 2022, total borrowings increased $5.2 million to $126.1 million at December 31, 2022, from $120.9 million at December 31, 2021. The increase in borrowings was primarily due to an increase in FHLBNY advances of $5.0 million.
Equity
Total shareholders’ equity increased to $266.0 million at December 31, 2022, from $232.4 million at December 31, 2021, an increase of $33.7 million or 14.5%. The increase in total shareholders' equity was primarily due to the retention of earnings from the period, partially offset by the recognition of $8.1 million of cash dividends.
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Liquidity and Capital Resources
Liquidity is a measure of our ability to generate cash to support asset growth, meet deposit withdrawals, satisfy other contractual obligations, and otherwise operate on an ongoing basis. At December 31, 2022, our cash position was $182.2 million. We invest cash that is in excess of our immediate operating needs primarily in our interest-bearing account at the Federal Reserve.
Our primary source of funding has been deposits. Funds from other operations, financing arrangements, investment securities available-for-sale also provide significant sources of funding. The Company seeks to rely primarily on core deposits from customers to provide stable and cost-effective sources of funding to support loan growth. We focus on customer service which we believe has resulted in a history of customer loyalty. Stability, low cost and customer loyalty comprise key characteristics of core deposits.
We also use brokered deposits as a funding source, which is more volatile than core deposits. The Bank also joined the IntraFi network to secure an additional alternative funding source. IntraFi provides the Bank an additional source of external funds through their weekly CDARS® settlement process. The rates are comparable to brokered deposits and can be obtained within a shorter period time than brokered deposits. While deposit accounts comprise the vast majority of our funding needs, we maintain secured borrowing lines with the FHLBNY. At December 31, 2022, the Company had a $693.7 million line of credit from the FHLBNY, of which $83.2 million was outstanding, $50.0 million was a letter of credit to secure public deposits, and $560.5 million was unused.
Our investment portfolio primarily consists of mortgage-backed available for sale securities issued by US government agency and government sponsored entities. These available for sale securities are readily marketable and are available to meet our additional liquidity needs. At December 31, 2022, the Company's investment securities portfolio classified as available for sale was $9.4 million.
We had unused loan commitments of $159.0 million at December 31, 2022. Our loan commitments are normally originated with the full amount of collateral. Such commitments have historically been drawn at only a fraction of the total commitment. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The funding requirements for such commitments occur on a measured basis over time and would be funded by normal deposit growth.
Capital Adequacy
Consistent with the goal to operate a sound and profitable financial organization, the Company and Bank actively seeks to maintain their status as well-capitalized in accordance with regulatory standards. As of December 31, 2022, the Company and the Bank exceeded all applicable regulatory capital requirements. See Note 13 to our Consolidated Financial Statements for more information about the Company's and the Bank's regulatory capital compliance.
Interest Rate Sensitivity
Interest rate sensitivity is an important factor in the management of the composition and maturity configurations of earning assets and funding sources. The primary objective of asset/liability management is to ensure the steady growth of our primary earnings component, net interest income. Net interest income can fluctuate with significant interest rate movements. To lessen the impact of interest rate movements, management endeavors to structure the balance sheet so that repricing opportunities exist for both assets and liabilities in roughly equivalent amounts at approximately the same time intervals. Imbalances in these repricing opportunities at any point in time constitute interest rate sensitivity.
The measurement of our interest rate sensitivity, or "gap," is one of the principal techniques used in asset/liability management. Interest sensitive gap is the dollar difference between assets and liabilities that are subject to interest-rate pricing within a given time period, including both floating rate or adjustable rate instruments and instruments that are approaching maturity.
Our management and the Board of Directors oversee the asset/liability management function through the asset/liability committee of the Board that meets periodically to monitor and manage the balance sheet, control interest rate exposure, and evaluate our pricing strategies. The asset mix of the balance sheet is continually evaluated in terms of several variables: yield, credit quality, appropriate funding sources and liquidity. Management of the liability mix of the balance sheet focuses on expanding the various funding sources.
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In theory, interest rate risk can be diminished by maintaining a nominal level of interest rate sensitivity. In practice, this is made difficult by a number of factors, including cyclical variation in loan demand, different impacts on interest-sensitive assets and liabilities when interest rates change, and the availability of funding sources. Accordingly, we undertake to manage the interest-rate sensitivity gap by adjusting the maturity of and establishing rates on the earning asset portfolio and certain interest-bearing liabilities commensurate with management's expectations relative to market interest rates. Management generally attempts to maintain a balance between rate-sensitive assets and liabilities as the exposure period is lengthened to minimize our overall interest rate risk.
The interest rate sensitivity position as of December 31, 2022 is presented in the following table. Assets and liabilities are scheduled based on maturity or re-pricing data except for mortgage loans and mortgage-backed securities, which are based on prevailing prepayment assumptions and expected maturities and deposits which are based on recent retention experience of core deposits. The difference between rate-sensitive assets and rate-sensitive liabilities, or the interest rate sensitivity gap, is shown at the bottom of the table.
As of December 31, 2022
3 Months
or Less Over 3
Months
Through 12
Months Over 1 Year Through
3 Years Over 3 Years Through
5 Years Over 5 Years Total
(Dollars in thousands)
Interest-earning assets:
Loans (1)
$ 320,454 $ 314,500 $ 704,350 $ 238,135 $ 155,871 $ 1,733,310
Investment securities 6,019 1,791 4,769 4,960 1,205 18,744
Cash and cash equivalents 154,985 — — — — 154,985
Total interest-earning assets $ 481,458 $ 316,291 $ 709,119 $ 243,095 $ 157,076 $ 1,907,039
Interest-bearing liabilities:
NOW, Saving and Money market deposits $ 32,216 $ 96,649 $ 257,730 $ 212,712 $ 20,993 $ 620,300
Retail time deposits 87,377 168,588 218,085 18,648 — 492,698
Brokered time deposits 11,667 97,537 1,233 — — 110,437
Borrowed funds 23,403 73,150 — — 30,000 126,553
Total interest-bearing liabilities $ 154,663 $ 435,924 $ 477,048 $ 231,360 $ 50,993 $ 1,349,988
Interest rate sensitive gap $ 326,795 $ (119,633) $ 232,071 $ 11,735 $ 106,083 $ 557,051
Cumulative interest rate gap $ 326,795 $ 207,162 $ 439,233 $ 450,968 $ 557,051 $ —
Ratio of rate-sensitive assets to rate-sensitive liabilities 311.3 % 72.6 % 148.6 % 105.1 % 308.0 % 141.3 %
Cumulative interest sensitivity gap to total assets 16.5 % 10.4 % 22.1 % 22.7 % 28.1 % —
(1) Loan balances exclude nonaccruing loans, deferred fees and costs, and loan discounts.
Off-Balance Sheet Arrangements and Contractual Obligations
In the ordinary course of business, we engage in financial transactions that are not recorded on the balance sheet, or may be recorded on the balance sheet in amounts that are different from the full contract or notional amount of the transaction. Our off-balance sheet arrangements include commitments to extend credit, standby letters of credit and other commitments. These transactions are primarily designed to meet the financial needs of our customers.
We enter into commitments to lend funds to customers, which are usually at a stated interest rate, if funded, and for specific purposes and time periods. When we make commitments, we are exposed to credit risk. However, the maximum credit risk for these commitments will generally be lower than the contractual amount because a significant portion of these commitments is expected to expire without being used by the customer. In addition, we manage the potential risk in commitments to lend by limiting the total amount of commitments, by monitoring maturity structure of these commitments and by applying the same credit standards for these commitments as for all of our credit activities.
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For commitments to lend, we generally require collateral or a guarantee. We may require various types of collateral, including accounts receivable, inventory, property, plant and equipment and income-producing commercial properties. Collateral requirements for each loan or commitment may vary based on the commitment type and our assessment of a customer’s credit risk according to the specific credit underwriting, including credit terms and structure.
Commitments to extend credit, or net unfunded loan commitments, represent arrangements to lend funds or provide liquidity subject to specified contractual conditions. These commitments generally have fixed expiration dates, may require payment of a fee, and contain termination clauses in the event the customer’s credit quality deteriorates. At December 31, 2022 and December 31, 2021, unused commitments to extend credit amounted to approximately $159.0 million and $117.7 million, respectively. Commitments to fund fixed-rate loans were immaterial at December 31, 2022. Variable-rate commitments are generally issued for less than one year and carry market rates of interest. Such instruments are not likely to be affected by annual rate caps triggered by rising interest rates. Management believes that off-balance sheet risk is not material to the results of operations or financial condition of the Company.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. At December 31, 2022 and December 31, 2021, standby letters of credit with customers were $1.5 million and $1.5 million, respectively.
At December 31, 2022, we had contractual obligations primarily relating to commitments to extent credits, deposits, secured and unsecured borrowings, and operating leases. We have adequate resources to fund all unfunded commitments to the extent required and meet all contractual obligations as they come due. Please refer to Notes 6, 7, 9, and 15 of the Notes to the Consolidated Financial Statements for detailed information regarding our contractual obligations.
Impact of Inflation and Changing Prices
The financial statements included in this document have been prepared in accordance with accounting principles generally accepted in the United States of America. These principles require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation.
Our primary assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Interest rates, however, do not necessarily move in the same direction or with the same magnitude as the price of goods and services, since such prices are affected by inflation. In a period of rapidly rising interest rates, the liquidity and maturities of our assets and liabilities are critical to the maintenance of acceptable performance levels.
The principal effect of inflation on earnings, as distinct from levels of interest rates, is in the area of non-interest expense. Expense items such as employee compensation, employee benefits and occupancy and equipment costs may be subject to increases as a result of inflation. An additional effect of inflation is the possible increase in the dollar value of the collateral securing loans that we have made. We are unable to determine the extent, if any, to which properties securing our loans have appreciated in dollar value due to inflation.
Critical Accounting Policies
The Company’s accounting policies are more fully described in Note 1 - Description of Business and Summary of Significant Accounting Policies in the Consolidated Financial Statements. As disclosed in Note 1, the preparation of financial statements in conformity with generally accepted accounting principles in the United States ("GAAP") requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. The Company believes that the following discussion addresses the Company’s most critical accounting policies, which are those that are most important to the portrayal of the Company’s financial condition and results of operations and require management’s most difficult, subjective and complex judgments.
Allowance for Loan and Lease Losses : Our allowances for loan and lease losses represents management's best estimate of probable losses inherent in our loan portfolio excluding those loans accounted for under fair value. Our process for determining the allowance for loan and lease losses is discussed in Note 1 to the Consolidated Financial Statements.
We maintain the ALLL at levels that we believe to be appropriate to absorb estimated probable credit losses incurred in the loan and lease portfolios as of the balance sheet date. Our determination of the allowances is based on periodic evaluations of the
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loan and lease portfolios and other relevant factors. These critical estimates include significant use of our own historical data and other qualitative, quantitative data. These evaluations are inherently subjective, as they require material estimates and may be susceptible to significant change. Our allowance for loan and lease losses is comprised of two components. The specific allowance covers impaired loans and is calculated on an individual loan basis. The general based component covers loans and leases on which there are incurred losses that are not yet individually identifiable. The allowance calculation and determination process is dependent on the use of key assumptions. Key reserve assumptions and estimation processes react to and are influenced by observed changes in loan portfolio performance experience, the financial strength of the borrower, projected industry outlook, and economic conditions.
The process of determining the level of the allowance for loan and lease losses requires a high degree of judgment. To the extent actual outcomes differ from our estimates, additional provision for loan and lease losses may be required that would reduce future earnings.
Fair Value Estimates: ASC 820 - Fair Value Measurements defines fair value as a market-based measurement and is the price that would be received to sell a financial asset or paid to transfer a financial liability in an orderly transaction between market participants at the measurement date. The Company uses valuation techniques that are consistent with the market approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement costs). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability and are developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability and developed based on the best information available in the circumstances. In that regard, a fair value hierarchy has been established for valuation inputs that gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:
Level 1 Inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.
Level 2 Inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (for example, interest rates, volatilities, prepayment speeds, loss severities, credit risks and default rates) or inputs that are derived principally from or corroborated by observable market data by correlations or other means.
Level 3 Inputs - Significant unobservable inputs that reflect an entity's own assumptions that market participants would use in pricing the assets or liabilities.
The majority of our assets recorded at fair value are our investment securities available for sale. The fair value of our available for sale securities are provided by independent third-party valuation services. We also may have a small balance of SBA loans recorded at fair value, which represents the face value of the guaranteed portion of the SBA loans pending settlement. Other real estate owned (OREO) is recorded at fair value on a non-recurring basis and is based on the values of independent third-party full appraisals, less costs to sell (a range of 5% to 10%). Appraisals are updated every 12 months or sooner if we have identified possible further deterioration in value. Refer to Note 16 - Fair Value in the Notes to the Consolidated Financial Statements for further information.
Income Taxes: In the normal course of business, we and our subsidiaries enter into transactions for which the tax treatment is unclear or subject to varying interpretations. We evaluate and assess the relative risks and merits of the tax treatment of transactions, filing positions, filing methods and taxable income calculations after considering statutes, regulations, and other information, and maintain tax accruals consistent with our evaluation of these relative risks and merits. The result of our evaluation and assessment is by its nature an estimate.
When tax returns are filed, it is highly likely that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that ultimately would be sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination. The evaluation of a tax position taken is considered by itself and not offset or aggregated with other positions. Tax
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positions that meet the more likely than not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
Not applicable