SB FINANCIAL GROUP, INC. 10-K

Item 7A. Quantitative and Qualitative Disclosures about Market Risk. Asset liability management involves developing, executing and monitoring strategies to maintain appropriate liquidity, maximize net interest income and minimize the impact that significant fluctuations in market interest rates would have on current and future earnings. The business of the Company and the composition of its balance sheet consist of investments in interest-earning assets (primarily loans, mortgage-backed securities, and securities available-for-sale) which are primarily funded by interest-bearing liabilities (deposits and borrowings). With the exception of specific loans which are originated and held for sale, all of the financial instruments of the Company are for other than trading purposes. All of the Company’s transactions are denominated in U.S. dollars with no specific foreign exchange exposure. In addition, the Company has limited exposure to commodity prices related to agricultural loans. The impact of changes in foreign exchange rates and commodity prices on interest rates are assumed to be insignificant. The Company’s financial instruments have varying levels of sensitivity to changes in market interest rates resulting in market risk. Interest rate risk is the Company’s primary market risk exposure; to a lesser extent, liquidity risk also impacts market risk exposure. Interest rate risk is the exposure of a banking institution’s financial condition to adverse movements in interest rates. Accepting this risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to the Company’s earnings and capital base. Accordingly, effective risk management that maintains interest rate risks at prudent levels is essential to the Company’s safety and soundness. Evaluating a financial institution’s exposure to changes in interest rates includes assessing both the adequacy of the management process used to control interest rate risk and the organization’s quantitative level of exposure. When assessing the interest rate risk management process, the Company seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain interest rate risks at prudent levels of consistency and continuity. Evaluating the quantitative level of interest rate risk exposure requires the Company to assess the existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity and asset quality (when appropriate). The FRB together with the OCC and the FDIC adopted a Joint Agency Policy Statement on interest rate risk effective June 26, 1996. The policy statement provides guidance to examiners and bankers on sound practices for managing interest rate risk, which will form the basis for ongoing evaluation of the adequacy of interest rate risk management at supervised institutions. The policy statement also outlines fundamental elements of sound management that have been identified in prior Federal Reserve guidance and discusses the importance of these elements in the context of managing interest rate risk. Specifically, the guidance emphasizes the need for active board of director and senior management oversight and a comprehensive risk management process that effectively identifies, measures and controls interest rate risk. Financial institutions derive their income primarily from the excess of interest collected over interest paid. The rates of interest an institution earns on its assets and owes on its liabilities generally are established contractually for a period of time. Since market interest rates change over time, an institution is exposed to lower profit margins (or losses) if it cannot adapt to interest rate changes. For example, assume that an institution’s assets carry intermediate or long-term fixed rates and that those assets are funded with short-term liabilities. If market interest rates rise by the time the short-term liabilities must be refinanced, the increase in the institution’s interest expense on its liabilities may not be sufficiently offset if assets continue to earn at the long-term fixed rates. Accordingly, an institution’s profits could decrease on existing assets because the institution will either have lower net interest income or possibly, net interest expense. Similar risks exist when assets are subject to contractual interest rate ceilings, or rate-sensitive assets are funded by longer-term, fixed-rate liabilities in a declining rate environment. There are several ways an institution can manage interest rate risk including: 1) matching repricing periods for new assets and liabilities, for example, by shortening or lengthening terms of new loans, investments, or liabilities; 2) selling existing assets or repaying certain liabilities; and 3) hedging existing assets, liabilities, or anticipated transactions. An institution might also invest in more complex financial instruments intended to hedge or otherwise change interest rate risk. Interest rate swaps, futures contracts, options on futures contracts, and other such derivative financial instruments can be used for this purpose. Because these instruments are sensitive to interest rate changes, they require management’s expertise to be effective. The Company has not purchased derivative financial instruments in the past, but during 2019 and 2018 the Company entered into interest rate swap agreements as an accommodation to certain loan customers (see Note 10 to the Consolidated Financial Statements). The Company may purchase such instruments in the future if market conditions are favorable. The following table details quantitative disclosures of market risk and provides information about the Company’s financial instruments used for purposes other than trading that are sensitive to changes in interest rates as of December 31, 2020. The table does not present when these items may actually reprice. For loans receivable, securities, and liabilities with contractual maturities, the table presents principal cash flows and related weighted-average interest rates by contractual maturities as well as the historical impact of interest rate fluctuations on the prepayment of loans and mortgage backed securities. For core deposits (demand deposits, interest-bearing checking, savings, and money market deposits) that have no contractual maturity, the table presents principal cash flows and applicable related weighted-average interest rates based upon the Company’s historical experience, management’s judgment and statistical analysis, as applicable, concerning their most likely withdrawal behaviors. The current historical interest rates for core deposits have been assumed to apply for future periods in this table as the actual interest rates that will need to be paid to maintain these deposits are not currently known. Weighted-average variable rates are based upon contractual rates existing at the reporting date. 45 Principal/Notional Amount Maturing or Assumed to be Withdrawn in: ($ in thousands) 2021 2022 2023 2024 2025 Thereafter Total Rate sensitive assets Variable rate loans $ 77,748 $ 27,786 $ 14,253 $ 11,861 $ 13,649 $ 74,207 $ 219,504 Average interest rate 3.91 % 3.61 % 3.50 % 3.12 % 3.10 % 2.71 % 3.35 % Adjustable rate loans 29,892 27,155 25,048 24,771 23,568 220,525 350,959 Average interest rate 4.41 % 4.42 % 4.27 % 4.20 % 4.17 % 4.07 % 4.15 % Fixed rate loans 49,655 76,172 32,715 16,641 15,855 111,222 302,260 Average interest rate 3.51 % 2.25 % 4.57 % 4.44 % 4.13 % 3.89 % 3.53 % Total loans 157,295 131,113 72,016 53,273 53,072 405,954 872,723 Average interest rate 3.88 % 2.99 % 4.25 % 4.03 % 3.88 % 3.77 % 3.73 % Fixed rate investment securities 32,367 13,758 8,658 8,318 6,540 83,065 152,706 Average interest rate 1.17 % 1.60 % 1.81 % 2.09 % 2.07 % 1.91 % 1.73 % Variable rate investment securities 96 96 101 105 84 1,522 2,004 Average interest rate 2.74 % 2.75 % 2.74 % 2.73 % 2.61 % 3.34 % 3.19 % Fed funds sold & other - - - - - - - Average interest rate 0.00 % 0.00 % 0.00 % 0.00 % 0.00 % 0.00 % 0.00 % Total rate sensitive assets $ 189,758 $ 144,967 $ 80,775 $ 61,696 $ 59,696 $ 490,541 $ 1,027,433 Average interest rate 3.41 % 2.85 % 3.99 % 3.77 % 3.68 % 3.45 % 3.44 % Rate sensitive liabilities Demand - noninterest bearing $ 35,520 $ 30,506 $ 26,201 $ 22,501 $ 19,327 $ 117,594 $ 251,649 Demand - interest-bearing 21,032 18,529 16,326 14,383 12,673 93,842 176,785 Average interest rate 0.04 % 0.04 % 0.04 % 0.04 % 0.04 % 0.04 % 0.04 % Money market accounts 27,097 23,702 20,731 18,131 15,859 110,644 216,164 Average interest rate 0.29 % 0.29 % 0.29 % 0.29 % 0.29 % 0.29 % 0.29 % Savings 75,796 12,833 11,168 9,722 8,461 56,884 174,864 Average interest rate 0.13 % 0.13 % 0.13 % 0.13 % 0.13 % 0.13 % 0.13 % Certificates of deposit 156,843 47,367 18,253 4,328 2,482 276 229,549 Average interest rate 1.51 % 1.57 % 1.65 % 1.09 % 0.62 % 0.99 % 1.51 % Fixed rate FHLB advances 2,500 3,000 2,500 - - - 8,000 Average interest rate 2.77 % 2.88 % 2.93 % 0.00 % 0.00 % 0.00 % 2.86 % Variable rate FHLB advances - - - - - - - Average interest rate 0.00 % 0.00 % 0.00 % 0.00 % 0.00 % 0.00 % 0.00 % Fixed rate notes payable - - - - - - - Average interest rate 0.00 % 0.00 % 0.00 % 0.00 % 0.00 % 0.00 % 0.00 % Variable rate notes payable - - - - - 10,310 10,310 Average interest rate 0.00 % 0.00 % 0.00 % 0.00 % 0.00 % 2.02 % 2.02 % Fed funds purchased, repos & other 20,189 - - - - - 20,189 Average interest rate 0.20 % 0.00 % 0.00 % 0.00 % 0.00 % 0.00 % 0.20 % Total rate sensitive liabilities $ 338,977 $ 135,937 $ 95,179 $ 69,065 $ 58,802 $ 389,550 $ 1,087,510 Average interest rate 0.78 % 0.68 % 0.48 % 0.17 % 0.13 % 0.17 % 0.45 % Comparison of 2020 to 2019 First Years ($ in thousands) Year 2 - 5 Thereafter Total Total rate sensitive assets: December 31, 2020 $ 189,758 $ 347,134 $ 490,541 $ 1,027,433 December 31, 2019 164,736 300,359 466,010 931,105 Increase (decrease) $ 25,022 $ 46,775 $ 24,531 $ 96,328 Total rate sensitive liabilities: December 31, 2020 $ 338,977 $ 358,983 $ 389,550 $ 1,087,510 December 31, 2019 286,957 310,950 281,567 879,474 Increase (decrease) $ 52,020 $ 48,033 $ 107,983 $ 208,036 46 The above table reflects expected maturities, not expected repricing. The contractual maturities adjusted for anticipated prepayments and anticipated renewals at current interest rates, as shown in the preceding table, are only part of the Company’s interest rate risk profile. Other important factors include the ratio of rate-sensitive assets to rate-sensitive liabilities (which takes into consideration loan repricing frequency but not when deposits may be repriced) and the general level and direction of market interest rates. For core deposits, the repricing frequency is assumed to be longer than when such deposits actually reprice. For some rate-sensitive liabilities, their repricing frequency is the same as their contractual maturity. For variable-rate loans receivable, repricing frequency can be daily or monthly. For adjustable-rate loans receivable, repricing can be as frequent as annually for loans whose contractual maturities range from one to thirty years. The Company manages its interest rate risk by the employment of strategies to assure that desired levels of both interest-earning assets and interest-bearing liabilities mature or reprice with similar time frames. Such strategies include: 1) loans receivable which are renewed (and repriced) annually, 2) variable rate loans, 3) certificates of deposit with terms from one month to six years, 4) securities available-for-sale which mature at various times primarily from one through ten years, 5) federal funds borrowings with terms of one day to 90 days, and 6) FHLB borrowings with terms of one day to ten years. The majority of assets and liabilities of the Company are monetary in nature, and therefore the Company differs greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an important impact on the growth of total assets in the banking industry and the resulting need to increase equity capital at higher than normal rates in order to maintain an appropriate equity to assets ratio. Inflation significantly affects noninterest expense, which tends to rise during periods of general inflation. Management believes the most significant impact on financial results is the Company’s ability to react to changes in interest rates. Management seeks to maintain an essentially balanced position between interest sensitive assets and liabilities and actively manages loan, security, and liability maturities in order to protect against the effects of wide interest rate fluctuations on net income and shareholders’ equity.