PROVIDENT FINANCIAL HOLDINGS INC 10-Q

ITEM 3 – Quantitative and Qualitative Disclosures about Market Risk. One of the Corporation’s principal financial objectives is to achieve long-term profitability while reducing its exposure to fluctuating interest rates. The Corporation has sought to reduce the exposure of its earnings to changes in interest rates by attempting to manage the repricing mismatch between interest-earning assets and interest-bearing liabilities. The principal element in achieving this objective is to increase the interest-rate sensitivity of the Corporation’s interest-earning assets by retaining for its portfolio new loan originations with interest rates subject to periodic adjustment to market conditions. In addition, the Corporation maintains an investment portfolio, which is largely in U.S. government agency MBS and U.S. government sponsored enterprise MBS with contractual maturities of up to 30 years that reprice frequently or have a relatively short average life. The Corporation relies on retail deposits as its primary source of funds while utilizing FHLB – San Francisco advances as a secondary source of funding. Management believes retail deposits, unlike brokered deposits, reduces the effects of interest rate fluctuations because they generally represent a more stable source of funds. As part of its interest rate risk management strategy, the Corporation promotes transaction accounts and time deposits with terms up to seven years. Through the use of an internal interest rate risk model, the Corporation is able to analyze its interest rate risk exposure by measuring the change in net portfolio value (“NPV”) over a variety of interest rate scenarios. NPV is defined as the net present value of expected future cash flows from assets, liabilities and off-balance sheet contracts. The calculation is intended to illustrate the change in NPV that would occur in the event of an immediate change in interest rates of -100, +100, +200 and +300 basis points (“bp”) with no effect given to steps that management might take to counter the effect of the interest rate movement. As of March 31, 2021, the targeted federal funds rate range was 0.00% to 0.25%, making an immediate change of -200 basis points or more improbable. The following table is derived from the internal interest rate risk model and represents the NPV based on the indicated changes in interest rates as of March 31, 2021 (dollars in thousands). Basis Points ("bp") Change in Rates Net Portfolio Value NPV Change (1) Portfolio Value of Assets NPV as Percentage of Portfolio Value Assets (2) Sensitivity Measure (3) +300 bp $ 253,402 $ 108,003 $ 1,319,005 19.21% +732 bp +200 bp $ 224,281 $ 78,882 $ 1,293,825 17.33% +544 bp +100 bp $ 189,911 $ 44,512 $ 1,263,500 15.03% +314 bp 0 bp $ 145,399 $ — $ 1,223,142 11.89% 0 bp -100 bp $ 130,035 $ (15,364 ) $ 1,206,653 10.78% -111 bp (1) Represents the increase (decrease) of the NPV at the indicated interest rate change in comparison to the NPV at March 31, 2021 (“base case”). (2) Derived from the NPV divided by the portfolio value of total assets. (3) Derived from the change in the NPV ratio from the base case amount assuming the indicated change in interest rates (expressed in basis points). The following table is derived from the internal interest rate risk model and represents the change in the NPV at a -100 basis point rate shock at March 31, 2021 and June 30, 2020. At March 31, 2021 At June 30, 2020 (-100 bp rate shock) (-100 bp rate shock) Pre-Shock NPV Ratio: NPV as a % of PV Assets 11.89% 11.93% Post-Shock NPV Ratio: NPV as a % of PV Assets 10.78% 10.57% Sensitivity Measure: Change in NPV Ratio -111 bp -136 bp 64 The pre-shock NPV ratio decreased four basis points to 11.89 percent at March 31, 2021 from 11.93 percent at June 30, 2020 while the post-shock NPV ratio increased 21 basis points to 10.78 percent at March 31, 2021 from 10.57 percent at June 30, 2020. The increase of the NPV ratios was primarily attributable to net income in the first nine months of fiscal 2021 and the changes in the composition of the balance sheet and interest rates, partly offset by a $5.0 million cash dividend distribution from the Bank to Provident Financial Holdings, Inc. in September 2020. As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing tables. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. Additionally, certain assets, such as ARM loans, have features that restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from time deposits could likely deviate significantly from those assumed when calculating the results described in the tables above. It is also possible that, as a result of an interest rate increase, the higher mortgage payments required from ARM borrowers could result in an increase in delinquencies and defaults. Accordingly, the data presented in the tables in this section should not be relied upon as indicative of actual results in the event of changes in interest rates. Furthermore, the NPV presented in the foregoing tables is not intended to present the fair market value of the Corporation, nor does it represent amounts that would be available for distribution to shareholders in the event of the liquidation of the Corporation. The Corporation measures and evaluates the potential effects of interest rate movements through an interest rate sensitivity "gap" analysis. Interest rate sensitivity reflects the potential effect on net interest income when there is movement in interest rates. For loans, securities and liabilities with contractual maturities, the table presents contractual repricing or scheduled maturity. For transaction accounts (checking, money market and savings deposits) that have no contractual maturity, the table presents estimated principal cash flows and, as applicable, the Corporation's historical experience, management's judgment and statistical analysis concerning their most likely withdrawal behaviors. 65 The following table represents the interest rate gap analysis of the Corporation's assets and liabilities as of March 31, 2021: Term to Contractual Repricing, Estimated Repricing, or Contractual Maturity (1) As of March 31, 2021 (Dollars In Thousands) 12 months or less Greater than 1 year to 3 years Greater than 3 years to 5 years Greater than 5 years or non-sensitive Total Repricing Assets: Cash and cash equivalents $ 66,225 $ — $ — $ 5,404 $ 71,629 Investment securities 17,508 — — 225,774 243,282 Loans held for investment 282,286 219,998 217,844 120,146 840,274 FHLB - San Francisco stock 7,970 — — — 7,970 Other assets 3,060 — — 23,081 26,141 Total assets 377,049 219,998 217,844 374,405 1,189,296 Repricing Liabilities and Equity: Checking deposits - non-interest bearing — — — 124,043 124,043 Checking deposits - interest bearing 48,106 96,211 96,211 80,176 320,704 Savings deposits 60,535 121,069 121,069 — 302,673 Money market deposits 19,973 19,972 — — 39,945 Time deposits 80,262 49,849 15,699 581 146,391 Borrowings 31,000 60,000 20,000 — 111,000 Other liabilities 241 — — 18,549 18,790 Stockholders' equity — — — 125,750 125,750 Total liabilities and stockholders' equity 240,117 347,101 252,979 349,099 1,189,296 Repricing gap positive (negative) $ 136,932 $ (127,103 ) $ (35,135 ) $ 25,306 $ — Cumulative repricing gap: Dollar amount $ 136,932 $ 9,829 $ (25,306 ) $ — $ — Percent of total assets 12 % 1 % (2) % — % — % (1) Cash and cash equivalents are presented as estimated repricing; investment securities and loans held for investment are presented as contractual maturities or contractual repricing (without consideration for prepayments); FHLB - San Francisco stock is presented as contractual repricing; transaction accounts (checking, savings and money market deposits) are presented as estimated repricing; while time deposits (without consideration for early withdrawals) and borrowings are presented as contractual maturities. The static gap analysis shows a positive position in the "cumulative repricing gap - dollar amount" category, indicating more assets are sensitive to repricing than liabilities. Management views non-interest bearing checking deposits to be the least sensitive to changes in market interest rates and these accounts are therefore characterized as long-term funding. Interest-bearing checking deposits are considered more sensitive, followed by increased sensitivity for savings and money market deposits. For the purpose of calculating gap, a portion of these interest-bearing deposit balances are assumed to be subject to estimated repricing as follows: interest-bearing checking deposits at 15% per year, savings deposits at 20% per year and money market deposits at 50% in the first and second years. 66 The gap results presented above could vary substantially if different assumptions are used or if actual experience differs from the assumptions used in the preparation of the gap analysis. Furthermore, the gap analysis provides a static view of interest rate risk exposure at a specific point in time without taking into account redirection of cash flows activity and deposit fluctuations. The extent to which the net interest margin will be impacted by changes in prevailing interest rates will depend on a number of factors, including how quickly interest-earning assets and interest-bearing liabilities react to interest rate changes. It is not uncommon for rates on certain assets or liabilities to lag behind changes in the market rates of interest. Additionally, prepayments of loans and early withdrawals of certificates of deposit could cause interest sensitivities to vary. As a result, the relationship between interest-earning assets and interest-bearing liabilities, as shown in the previous table, is only a general indicator of interest rate sensitivity and the effect of changing rates of interest on net interest income is likely to be different from that predicted solely on the basis of the interest rate sensitivity analysis set forth in the previous table. The Corporation also models the sensitivity of net interest income for the 12-month period subsequent to any given month-end assuming a dynamic balance sheet accounting for, among other items: • The Corporation’s current balance sheet and repricing characteristics; • Forecast balance sheet growth consistent with the business plan; • Current interest rates and yield curves and management estimates of projected interest rates; • Embedded options, interest rate floors, periodic caps and lifetime caps; • Repricing characteristics for market rate sensitive instruments; • Loan, investment, deposit and borrowing cash flows; • Loan prepayment estimates for each type of loan; and • Immediate, permanent and parallel movements in interest rates of plus 300, 200 and 100 and minus 100 basis points. The following table describes the results of the analysis at March 31, 2021 and June 30, 2020. At March 31, 2021 At June 30, 2020 Basis Point (bp) Change in Rates Change in Net Interest Income Basis Point (bp) Change in Rates Change in Net Interest Income +300 bp 8.04% +300 bp 15.11% +200 bp 5.15% +200 bp 9.95% +100 bp 2.94% +100 bp 5.25% -100 bp (0.33)% -100 bp (0.05)% At March 31, 2021 and June 30, 2020, the Corporation was asset sensitive as its interest-earning assets at those dates are expected to reprice more quickly than its interest-bearing liabilities during the subsequent 12-month period. Therefore, in a rising interest rate environment, the model projects an increase in net interest income over the subsequent 12-month period. In a falling interest rate environment, the results project a slight decrease in net interest income over the subsequent 12-month period at March 31, 2021 and June 30, 2020. Management believes that the assumptions used to complete the analysis described in the table above are reasonable. However, past experience has shown that immediate, permanent and parallel movements in interest rates will not necessarily occur. Additionally, while the analysis provides a tool to evaluate the projected net interest income to changes in interest rates, actual results may be substantially different if actual experience differs from the assumptions used to complete the analysis, particularly with respect to the 12-month business plan when asset growth is forecast. Therefore, the model results that the Corporation discloses should be thought of as a risk management tool to compare the trends of the Corporation’s current disclosure to previous disclosures, over time, within the context of the actual performance of the treasury yield curve. 67