WASHINGTON TRUST BANCORP INC 10-K

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following analysis is intended to provide the reader with a further understanding of the consolidated financial condition and results of operations of the Corporation for the periods shown. For a full understanding of this analysis, it should be read in conjunction with other sections of this Annual Report on Form 10-K, including Part I, “Item 1. Business”, Part II, “Item 6. Selected Financial Data” and Part II, “Item 8. Financial Statements and Supplementary Data.” Information pertaining to 2018 was included in the Corporation’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019, starting on page 35 under Part II, Item 7. “Management’s Discussion and Analysis of Results of Operations and Financial Condition,” which was filed with the SEC on February 25, 2020. Critical Accounting Policies and Estimates Accounting policies involving significant judgments, estimates and assumptions by management, which have, or could have, a material impact on the Corporation’s consolidated financial statements are considered critical accounting policies. As of December 31, 2020, management considers the following to be its critical accounting policies: the determination of the allowance for credit losses on loans, the valuation of goodwill and identifiable intangible assets, and accounting for defined benefit pension plans. As a result of the adoption of Accounting Standards Codification (“ASC”) 326 effective January 1, 2020, Washington Trust updated its critical accounting policy for the Allowance of Credit Losses on Loans. The updated policy is described in detail below. Allowance for Credit Losses on Loans The ACL on loans is management’s estimate of expected credit losses over the expected life of the loans at the reporting date. The ACL on loans is increased through a provision for credit losses recognized in the Consolidated Statements of Income and by recoveries of amounts previously charged-off. The ACL on loans is reduced by charge-offs on loans. Loan charge-offs are recognized when management believes the collectability of the principal balance outstanding is unlikely. Full or partial charge-offs on collateral dependent individually analyzed loans are generally recognized when the collateral is deemed to be insufficient to support the carrying value of the loan. The level of the ACL on loans is based on management’s ongoing review of all relevant information, from internal and external sources, relating to past events, current conditions and reasonable and supportable forecasts. Historical credit loss experience provides the basis for the calculation of loss given default and the estimation of expected credit losses. As discussed further below, adjustments to historical information are made for differences in specific risk characteristics, such as differences in underwriting standards, portfolio mix, delinquency level, or term, as well as for changes in environmental conditions, that may not be reflected in historical loss rates. Management employs a process and methodology to estimate the ACL on loans that evaluates both quantitative and qualitative factors. The methodology for evaluating quantitative factors consists of two basic components. The first component involves pooling loans into portfolio segments for loans that share similar risk characteristics. Pooled loan portfolio segments include commercial real estate (including commercial construction loans), commercial and industrial (including PPP loans), residential real estate (including homeowner construction), home equity and other consumer loans. The second component involves identifying individually analyzed loans that do not share similar risk characteristics with loans that are pooled into portfolio segments. Individually analyzed loans include nonaccrual commercial loans, reasonably expected TDRs and executed TDRs, as well as certain other loans based on the underlying risk characteristics and the discretion of management to individually analyze such loans. For loans that are individually analyzed, the ACL is measured using a discounted cash flow (“DCF”) method based upon the loan’s contractual effective interest rate, or at the loan’s observable market price, or, if the loan is collateral dependent, at the fair value of the collateral. Factors management considers when measuring the extent of expected credit loss include payment status, collateral value, borrower financial condition, guarantor support and the probability of collecting scheduled principal and interest payments when due. For collateral dependent loans for which repayment is to be provided substantially through the sale of the collateral, management adjusts the fair value for estimated costs to sell. For collateral dependent loans for which repayment is to be provided substantially through the operation of the -34- Management's Discussion and Analysis collateral, such as accruing TDRs, estimated costs to sell are not incorporated into the measurement. Management may also adjust appraised values to reflect estimated market value declines or apply other discounts to appraised values for unobservable factors resulting from its knowledge of circumstances associated with the collateral. For pooled loans, the Corporation utilizes a DCF methodology to estimate credit losses over the expected life of the loan. The life of the loan excludes expected extensions, renewals and modifications, unless 1) the extension or renewal options are included in the original or modified contract terms and not unconditionally cancellable by the Corporation, or 2) management reasonably expects at the reporting date that a TDR will be executed with an individual borrower. The methodology incorporates the probability of default and loss given default, which are identified by default triggers such as past due by 90 or more days, whether a charge-off has occurred, the loan has been placed on nonaccrual status, the loan has been modified in a TDR or the loan is risk-rated as special mention or classified. The probability of default for the life of the loan is determined by the use of an econometric factor. Management utilizes the national unemployment rate as an econometric factor with a one-year forecast period and one-year straight-line reversion period to the historical mean of its macroeconomic assumption in order to estimate the probability of default for each loan portfolio segment. Utilizing a third party regression model, the forecasted national unemployment rate is correlated with the probability of default for each loan portfolio segment. The DCF methodology combines the probability of default, the loss given default, maturity date and prepayment speeds to estimate a reserve for each loan. The sum of all the loan level reserves are aggregated for each portfolio segment and a loss rate factor is derived. Quantitative loss factors are also supplemented by certain qualitative risk factors reflecting management’s view of how losses may vary from those represented by quantitative loss rates. These qualitative risk factors include: 1) changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses; 2) changes in international, national, regional, and local economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments; 3) changes in the nature and volume of the portfolio and in the terms of loans; 4) changes in the experience, ability, and depth of lending management and other relevant staff; 5) changes in the volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified or rated loans; 6) changes in the quality of the institution’s credit review system; 7) changes in the value of underlying collateral for collateral dependent loans; 8) the existence and effect of any concentrations of credit, and changes in the level of such concentrations; and 9) the effect of other external factors such as legal and regulatory requirements on the level of estimated credit losses in the institution’s existing portfolio. Qualitative loss factors are applied to each portfolio segment with the amounts determined by historical loan charge-offs of a peer group of similar-sized regional banks. Because the methodology is based upon historical experience and trends, current economic data, reasonable and supportable forecasts, as well as management’s judgment, factors may arise that result in different estimations. While significant deterioration in the economic forecast due to the COVID-19 pandemic was estimated in the ACL on loans, continued uncertainty regarding the severity and duration of the pandemic and related economic effects will continue to affect the ACL. Deteriorating conditions or assumptions could lead to further increases in the ACL on loans. In addition, various regulatory agencies periodically review the ACL on loans. Such agencies may require additions to the allowance based on their judgments about information available to them at the time of their examination. The ACL on loans is an estimate, and ultimate losses may vary from management’s estimate. Valuation of Goodwill and Identifiable Intangible Assets Goodwill represents the excess of the purchase price over the net fair value of the acquired businesses. Goodwill is not amortized, but is tested for impairment at the reporting unit level, defined as the segment level, at least annually in the fourth quarter or more frequently whenever events or circumstances occur that indicate that it is more-likely-than-not that an impairment loss has occurred. In 2020, due to the changes in the macroeconomic environment resulting from the COVID-19 pandemic, management performed an interim impairment assessment on goodwill as of March 31, 2020 in addition to its annual assessment. In assessing impairment, the Corporation has the option to perform a qualitative analysis to determine whether the existence of events or circumstances leads to a determination that it is more-likely-than-not that the fair value of the reporting unit is less than its carrying amount. If, after assessing the totality of such events or circumstances, we -35- Management's Discussion and Analysis determine it is not more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, then we would not be required to perform an impairment test. The quantitative impairment analysis requires a comparison of each reporting unit’s fair value to its carrying value to identify potential impairment. Goodwill impairment exists when a reporting unit’s carrying value of goodwill exceeds its implied fair value. Significant judgment is applied when goodwill is assessed for impairment. This judgment includes, but may not be limited to, the selection of appropriate discount rates, the identification of relevant market comparables and the development of cash flow projections. The selection and weighting of the various fair value techniques may result in a higher or lower fair value. Judgment is applied in determining the weightings that are most representative of fair value. The annual and interim quantitative assessments of goodwill for the two reporting units (Commercial Banking and Wealth Management Services) were performed utilizing a DCF analysis (“income approach”) and estimates of selected market information (“market approach”). The income approach measures the fair value of an interest in a business by discounting expected future cash flows to present value. The market approach takes into consideration fair values of comparable companies operating in similar lines of business that are potentially subject to similar economic and environmental factors and could be considered reasonable investment alternatives. The results of the income approach and the market approach were weighted equally. The results of both the March 31, 2020 and December 31, 2020 quantitative impairment analyses indicated that the remaining fair value significantly exceeded the carrying value for both reporting units. Intangible assets identified in acquisitions consist of wealth management advisory contracts. The fair value of intangible assets was estimated using valuation techniques, based on a DCF analysis. The value attributed to other intangible assets was based on the time period over which they are expected to generate economic benefits. Intangible assets are amortized over their estimated lives using a method that approximates the amount of economic benefits that are realized by the Corporation. Intangible assets with definite lives are tested for impairment whenever events or circumstances occur that indicate that the carrying amount may not be recoverable. If applicable, the Corporation tests each of the intangibles by comparing the carrying value of the intangible asset to the sum of undiscounted cash flows expected to be generated by the asset. If the carrying amount of the asset exceeds its undiscounted cash flows, then an impairment loss would be recognized for the amount by which the carrying amount exceeds its fair value. Impairment would result in a write-down to the estimated fair value based on the anticipated discounted future cash flows. The remaining useful life of the intangible assets that are being amortized is also evaluated to determine whether events and circumstances warrant a revision to the remaining period of amortization. The Corporation makes certain estimates and assumptions that affect the determination of the expected future cash flows from the intangible assets. For intangible assets such as wealth management advisory contracts, these estimates and assumptions include account attrition, market appreciation for wealth management AUA and anticipated fee rates, estimated revenue growth, projected costs and other factors. Significant changes in these estimates and assumptions could cause a different valuation for these intangible assets. Changes in the original assumptions could change the amount of the intangible assets recognized and the resulting amortization. Subsequent changes in assumptions could result in recognition of impairment of these intangible assets. When there are events or circumstances that occur indicating that the carrying amount of the Corporation’s intangible assets may not be recoverable, the Corporation tests each of the intangibles by comparing the carrying value of the intangible asset to the sum of undiscounted cash flows expected to be generated by the asset. As of December 31, 2020, the carrying value of intangible assets was deemed to be recoverable. These assumptions used in the impairment tests of goodwill and intangible assets are susceptible to change based on changes in economic conditions and other factors. Any change in the estimates which the Corporation uses to determine the carrying value of the Corporation’s goodwill and identifiable intangible assets, or which otherwise adversely affects their value or estimated lives could adversely affect the Corporation’s results of operations. See Note 9 to the Consolidated Financial Statements for additional information. -36- Management's Discussion and Analysis Defined Benefit Pension Plans The determination of the defined benefit obligation and net periodic benefit cost related to our defined benefit pension plans requires estimates and assumptions such as discount rates, mortality, rates of return on plan assets and compensation increases. Management evaluates the assumptions annually and uses an actuarial firm to assist in making these estimates. Changes in assumptions due to market conditions, governing laws and regulations, or circumstances specific to the Corporation could result in material changes to defined benefit pension obligation and net periodic benefit cost. See Note 17 to the Consolidated Financial Statements for additional information. Overview The Corporation offers a comprehensive product line of banking and financial services to individuals and businesses, including commercial, residential and consumer lending, retail and commercial deposit products, and wealth management services through its offices in Rhode Island, eastern Massachusetts and Connecticut; its ATMs; telephone banking; mobile banking and its internet website (www.washtrust.com). Our largest source of operating income is net interest income, which is the difference between interest earned on loans and securities and interest paid on deposits and borrowings. In addition, we generate noninterest income from a number of sources, including wealth management services, mortgage banking activities and deposit services. Our principal noninterest expenses include salaries and employee benefit costs, outsourced services provided by third party vendors, occupancy and facility-related costs and other administrative expenses. We continue to leverage our strong regional brand to build market share and remain steadfast in our commitment to provide superior service. In 2021, we plan to open a new full-service branch in East Greenwich, Rhode Island. The COVID-19 pandemic has caused an unprecedented disruption to the economy and the communities we serve. Washington Trust took action to support our customers experiencing financial difficulty due to the COVID-19 pandemic, including loan payment deferment modifications and participation in the SBA’s PPP. In addition, in the first quarter of 2020, we implemented our business continuity and pandemic plans, which included remote working arrangements for the majority of our workforce, closing our branches and offering drive-through banking or special banking services by appointment only, and promoting social distancing. In the third quarter of 2020, we briefly reopened our branch lobbies to customers while adhering to social distancing guidelines, before once again closing our branches and offering drive-through banking or special banking services by appointment only in the fourth quarter of 2020. Remote working arrangements continue for a significant portion of our workforce. Risk Management The Corporation has a comprehensive enterprise risk management (“ERM”) program through which the Corporation identifies, measures, monitors and controls current and emerging material risks. The Board of Directors is responsible for oversight of the ERM program. The ERM program enables the aggregation of risk across the Corporation and ensures the Corporation has the tools, programs and processes in place to support informed decision making, to anticipate risks before they materialize and to maintain the Corporation’s risk profile consistent with its risk strategy. The Board of Directors has approved an ERM Policy that addresses each category of risk. The risk categories include: credit risk, interest rate risk, liquidity risk, price and market risk, compliance risk, strategic and reputation risk, and operational risk. A description of each risk category is provided below. Credit risk represents the possibility that borrowers or other counterparties may not repay loans or other contractual obligations according to their terms due to changes in the financial capacity, ability and willingness of such borrowers or counterparties to meet their obligations. In some cases, the collateral securing the payment of the loans may be sufficient to assure repayment, but in other cases the Corporation may experience significant credit losses which could have an adverse effect on its operating results. The Corporation makes various assumptions and judgments about the collectability of its loan portfolio, including the creditworthiness of its borrowers and counterparties and the value of -37- Management's Discussion and Analysis the real estate and other assets serving as collateral for the repayment of loans. Credit risk also exists with respect to investment securities. For further discussion regarding the credit risk and the credit quality of the Corporation’s loan portfolio, see Notes 5 and 6 to the Consolidated Financial Statements. For further discussion regarding the Corporation’s securities portfolio, see Note 4 to the Consolidated Financial Statements. Interest rate risk is the risk of loss to future earnings due to changes in interest rates. It exists because the repricing frequency and magnitude of interest-earning assets and interest-bearing liabilities are not identical. Liquidity risk is the risk that the Corporation will not have the ability to generate adequate amounts of cash in the most economical way for it to meet its maturing liability obligations and customer loan demand. For detailed disclosure regarding liquidity management, asset/liability management and interest rate risk, see “Liquidity and Capital Resources” and “Asset/Liability Management and Interest Rate Risk” sections below. Price and market risk refers to the risk of loss arising from adverse changes in interest rates and other relevant market rates and prices, such as equity prices. Interest rate risk, discussed above, is the most significant market risk to which the Corporation is exposed. The Corporation is also exposed to financial market risk and housing market risk. Compliance risk represents the risk of regulatory sanctions or financial loss resulting from the failure to comply with laws, rules and regulations and standards of good banking practice. Activities which may expose the Corporation to compliance risk include, but are not limited to, those dealing with the prevention of money laundering, privacy and data protection, adherence to all applicable laws and regulations and employment and tax matters. Strategic and reputation risk represent the risk of loss due to impairment of reputation, failure to fully develop and execute business plans, and failure to assess existing and new opportunities and threats in business, markets and products. Operational risk is the risk of loss due to human behavior, inadequate or failed internal systems and controls, and external influences such as market conditions, fraudulent activities, natural disasters and security risks. ERM is an overarching program that includes all areas of the Corporation. A framework approach is utilized to assign responsibility and to ensure that the various business units and activities involved in the risk management life-cycle are effectively integrated. The Corporation has adopted the “three lines of defense” concept that is an industry best practice for ERM. Business units are the first line of defense in managing risk. They are responsible for identifying, measuring, monitoring, and controlling current and emerging risks. They must report on and escalate their concerns. Corporate functions such as Credit Risk Management, Financial Administration, Information Assurance and Compliance, comprise the second line of defense. They are responsible for policy setting and for reviewing and challenging the risk management activities of the business units. They collaborate closely with business units on planning and resource allocation with respect to risk management. Internal Audit is a third line of defense. They provide independent assurance to the Board of Directors of the effectiveness of the first and second lines in fulfilling their risk management responsibilities. For additional factors that could adversely impact Washington Trust’s future results of operations and financial condition, see the section labeled “Risk Factors” in Item 1A of this Annual Report on Form 10-K. -38- Management's Discussion and Analysis Results of Operations The following table presents a summarized consolidated statement of operations: (Dollars in thousands) Change Years Ended December 31, 2020 2019 $ % Net interest income $127,444 $133,414 ($5,970) (4 %) Noninterest income 99,442 67,080 32,362 48 Total revenues 226,886 200,494 26,392 13 Provision for loan losses 12,342 1,575 10,767 684 Noninterest expense 125,384 110,740 14,644 13 Income before income taxes 89,160 88,179 981 1 Income tax expense 19,331 19,061 270 1 Net income $69,829 $69,118 $711 1 % The following table presents a summary of performance metrics and ratios: Years Ended December 31, 2020 2019 Diluted earnings per common share $4.00 $3.96 Return on average assets (net income divided by average assets) 1.22 % 1.34 % Return on average equity (net income available for common shareholders divided by average equity) 13.51 % 14.34 % Net interest income as a percentage of total revenues 56 % 67 % Noninterest income as a percentage of total revenues 44 % 33 % Net income totaled $69.8 million in 2020, compared to $69.1 million in 2019. Net interest income in 2020 was negatively impacted by the decline in market interest rates, as interest-earning asset yields declined faster than the downward repricing of interest-bearing liabilities. However, the decline in market interest rates also spurred mortgage origination, refinancing and sales activity, resulting in strong mortgage banking results in 2020. Our 2020 results also reflected an increase in provision for credit losses due to the estimated impact of the COVID-19 pandemic under the CECL accounting methodology. Noninterest expenses increased in 2020, largely due to increases in salaries and employee benefits expense, which included volume-related increases in mortgage banking commissions expense. Average Balances/Net Interest Margin - Fully Taxable Equivalent (“FTE”) Basis The following table presents average balance and interest rate information. Tax-exempt income is converted to an FTE basis using the statutory federal income tax rate adjusted for applicable state income taxes net of the related federal tax benefit. Unrealized gains (losses) on available for sale securities and fair value adjustments on mortgage loans held for sale are excluded from the average balance and yield calculations. Nonaccrual loans, as well as interest recognized on these loans, are included in amounts presented for loans. -39- Management's Discussion and Analysis Years ended December 31, 2020 2019 (Dollars in thousands) Average Balance Interest Yield/ Rate Average Balance Interest Yield/ Rate Assets: Cash, federal funds sold and short-term investments $160,427 $459 0.29 % $85,447 $1,667 1.95 % Mortgage loans held for sale 54,237 1,762 3.25 30,928 1,237 4.00 Taxable debt securities 902,278 20,050 2.22 947,875 26,367 2.78 Nontaxable debt securities — — — 450 23 5.11 Total securities 902,278 20,050 2.22 948,325 26,390 2.78 FHLB stock 45,235 2,240 4.95 47,761 2,855 5.98 Commercial real estate 1,632,460 52,231 3.20 1,481,116 68,193 4.60 Commercial & industrial 767,176 27,410 3.57 596,451 28,545 4.79 Total commercial 2,399,636 79,641 3.32 2,077,567 96,738 4.66 Residential real estate 1,488,343 55,866 3.75 1,368,824 54,932 4.01 Home equity 277,296 10,032 3.62 286,767 14,011 4.89 Other 18,929 941 4.97 23,153 1,137 4.91 Total consumer 296,225 10,973 3.70 309,920 15,148 4.89 Total loans 4,184,204 146,480 3.50 3,756,311 166,818 4.44 Total interest-earning assets 5,346,381 170,991 3.20 4,868,772 198,967 4.09 Noninterest-earning assets 358,569 300,549 Total assets $5,704,950 $5,169,321 Liabilities and Shareholders’ Equity: Interest-bearing demand deposits $159,366 $806 0.51 % $144,836 $2,537 1.75 % NOW accounts 593,105 368 0.06 469,540 310 0.07 Money market accounts 839,915 5,402 0.64 693,921 7,713 1.11 Savings accounts 415,741 265 0.06 365,927 272 0.07 Time deposits (in-market) 742,236 13,138 1.77 794,124 16,056 2.02 Total interest-bearing in-market deposits 2,750,363 19,979 0.73 2,468,348 26,888 1.09 Wholesale brokered time deposits 501,306 5,833 1.16 461,862 10,213 2.21 Total interest-bearing deposits 3,251,669 25,812 0.79 2,930,210 37,101 1.27 FHLB advances 920,704 15,806 1.72 1,015,914 26,168 2.58 Junior subordinated debentures 22,681 641 2.83 22,681 980 4.32 PPPLF borrowings 66,492 233 0.35 — — — Total interest-bearing liabilities 4,261,546 42,492 1.00 3,968,805 64,249 1.62 Noninterest-bearing demand deposits 759,841 615,049 Other liabilities 167,861 104,463 Shareholders’ equity 515,702 481,004 Total liabilities and shareholders’ equity $5,704,950 $5,169,321 Net interest income (FTE) $128,499 $134,718 Interest rate spread 2.20 % 2.47 % Net interest margin 2.40 % 2.77 % -40- Management's Discussion and Analysis Interest income amounts presented in the preceding table include the following adjustments for taxable equivalency for the years indicated: (Dollars in thousands) Years ended December 31, 2020 2019 Commercial loans $1,055 $1,299 Nontaxable debt securities — 5 Total $1,055 $1,304 Net Interest Income Net interest income, the primary source of our operating income, totaled $127.4 million and $133.4 million, respectively, for 2020 and 2019. Net interest income is affected by the level of, and changes in, interest rates, and changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Prepayment penalty income associated with loan payoffs is included in net interest income. The following discussion presents net interest income on a FTE basis by adjusting income and yields on tax-exempt loans and securities to be comparable to taxable loans and securities. The analysis of net interest income, net interest margin and the yield on loans may be impacted by the periodic recognition of prepayment penalty fee income associated with loan payoffs. Prepayment penalty fee income associated with loans payoffs in both 2020 and 2019 was immaterial. The analysis of net interest income, net interest margin and the yield on loans is also impacted by changes in the level of net amortization of premiums and discounts on securities and loans, which is included in interest income. As market interest rates decline (as they did in the latter portion of 2019 and in 2020), loan prepayments and the receipt of payments on mortgage-backed securities generally increase. This results in accelerated levels of amortization reducing net interest income and may also result in the proceeds having to be reinvested at a lower rate than the loan or mortgage-backed security being prepaid. In addition, as PPP loans are forgiven by the SBA, unamortized net fee balances are accelerated and amortized into net interest income. Late in 2020, $18.0 million of PPP loans were forgiven by the SBA. As a result, the acceleration of net fee balances of $423 thousand was included in interest income and also reported in the net amount of amortization of premiums and discounts on securities and loans in the Consolidated Statements of Cash Flows. The total net amount of amortization of premiums and discounts on securities and loans in the Consolidated Statements of Cash Flows (a net reduction to net interest income) amounted to $5.7 million in 2020, up by $1.2 million from 2019. FTE net interest income in 2020 amounted to $128.5 million, down by $6.2 million, or 5%, from 2019. Growth in average interest-earning assets, net of increased average interest-bearing liability balances, contributed approximately $18.2 million of additional net interest income in 2019, however, this was offset by declines in asset yields out-pacing declines in funding costs, which reduced net interest income by $24.4 million. The net interest margin was 2.40% in 2020, down by 37 basis points from 2.77% in 2019. Compression in net interest margin resulted from the downward repricing of assets, which occurred at a faster pace than the downward repricing of liabilities. Total average securities for 2020 decreased by $46.0 million, or 5%, from the average balance for 2019, due to timing of reinvestment of security portfolio cash flows. The FTE rate of return on securities was 2.22% in 2020, down by 56 basis points from 2.78% in 2019, reflecting purchases of relatively lower yielding debt securities and lower market interest rates. Total average loan balances increased by $427.9 million, or 11%, from the average balance for 2019. This reflected growth in average commercial loan balances, which included the origination of PPP loans in 2020, as well as growth in average residential real estate loan balances, which included purchases of residential mortgage loans in the latter -41- Management's Discussion and Analysis portion of 2019 and first quarter of 2020. The yield on total loans in 2020 was 3.50%, down by 94 basis points from 4.44% in 2019. Yields on LIBOR-based and prime-based loans reflected lower market interest rates. The average balance of FHLB advances for 2020 decreased by $95.2 million, or 9%, compared to the average balance for 2019. The average rate paid on such advances in 2020 was 1.72%, down by 86 basis points from 2.58% in 2019, due to lower rates on short-term advances. Included in total average interest-bearing deposits were out-of-market brokered time deposits, which increased by $39.4 million, or 9%, from 2019. The average rate paid on wholesale brokered time deposits in 2020 was 1.16%, down by 105 basis points from 2.21% in 2019, reflecting lower market interest rates. Average in-market interest-bearing deposits, which excludes wholesale brokered time deposits, increased by $282.0 million, or 11%, from the average balance in 2019, largely due to growth in average lower-cost deposit categories, partially offset by maturities of higher-cost promotion time deposits. The average rate paid on in-market interest-bearing deposits in 2020 was 0.73%, down by 36 basis points from 1.09% in 2019, largely due to downward repricing of interest-bearing in-market deposits reflecting lower market interest rates. The average balance of noninterest-bearing demand deposits for 2020 increased by $144.8 million, or 24%, from the average balance for 2019. See additional disclosure under the caption “Sources of Funds.” -42- Management's Discussion and Analysis Volume/Rate Analysis - Interest Income and Expense (FTE Basis) The following table presents certain information on a FTE basis regarding changes in our interest income and interest expense for the period indicated. The net change attributable to both volume and rate has been allocated proportionately. (Dollars in thousands) Changes Due To Years Ended December 31, 2020 vs. 2019 Volume Rate Net Change Interest on interest-earning assets: Cash, federal funds sold and short-term investments $827 ($2,035) ($1,208) Mortgage loans held for sale 792 (267) 525 Taxable debt securities (1,218) (5,099) (6,317) Nontaxable debt securities (11) (12) (23) Total securities (1,229) (5,111) (6,340) FHLB stock (144) (471) (615) Commercial real estate 6,412 (22,374) (15,962) Commercial & industrial 7,100 (8,235) (1,135) Total commercial 13,512 (30,609) (17,097) Residential real estate 4,621 (3,687) 934 Home equity (449) (3,530) (3,979) Other (210) 14 (196) Total consumer (659) (3,516) (4,175) Total loans 17,474 (37,812) (20,338) Total interest income 17,720 (45,696) (27,976) Interest on interest-bearing liabilities: Interest-bearing demand deposits 231 (1,962) (1,731) NOW accounts 98 (40) 58 Money market accounts 1,398 (3,709) (2,311) Savings accounts 32 (39) (7) Time deposits (in-market) (1,008) (1,910) (2,918) Total interest-bearing in-market deposits 751 (7,660) (6,909) Wholesale brokered time deposits 810 (5,190) (4,380) Total interest-bearing deposits 1,561 (12,850) (11,289) FHLB advances (2,274) (8,088) (10,362) Junior subordinated debentures — (339) (339) PPPLF borrowings 233 — 233 Total interest expense (480) (21,277) (21,757) Net interest income (FTE) $18,200 ($24,419) ($6,219) Provision for Credit Losses Effective January 1, 2020, Washington Trust adopted ASC 326, often referred to as CECL, which requires the measurement of expected lifetime credit losses for financial assets measured at amortized cost, as well as unfunded commitments that are considered off-balance sheet credit exposures. CECL requires that the ACL be calculated based on current expected credit losses over the full remaining expected life of the financial assets and also consider expected future changes in macroeconomic conditions. See Note 2 to the Consolidated Financial Statements for additional disclosure on the impact of adopting ASC 326. Prior to January 1, 2020, the provision for loan losses was based on the incurred loss model. The incurred loss model was based on management’s periodic assessment of the adequacy of the ACL on loans which, in turn, was based on -43- Management's Discussion and Analysis such interrelated factors as the composition of the loan portfolio and its inherent risk characteristics; the levels of nonperforming loans, past due loans and net charge-offs, both current and historic; local economic and credit conditions; the direction of real estate values; and regulatory guidelines. The provision for loan losses was charged against earnings in order to maintain an allowance that reflected management’s best estimate of probable losses inherent in the loan portfolio at the balance sheet date. Provisions for credit losses charged to earnings in 2020 and 2019 amounted to $12.3 million and $1.6 million, respectively. In addition to the change in accounting methodology described above, the increase in the provision was attributable to expected losses related the COVID-19 pandemic and also reflected loan growth and changes in the underlying portfolio. Estimating an appropriate level of ACL in loans necessarily involves a high degree of judgment and continued uncertainty regarding the severity and duration of the pandemic and related economic effects will continue to affect the ACL. Net charge-offs totaled $1.1 million, or 0.03% of average loans, in 2020, compared to net charge-offs of $1.6 million, or 0.04% of average loans, in 2019. The ACL on loans was $44.1 million, or 1.05% of total loans, at December 31, 2020, compared to an allowance for loan losses of $27.0 million, or 0.69% of total loans, at December 31, 2019. See additional discussion under the caption “Asset Quality” for further information on the ACL on loans. Noninterest Income Noninterest income is an important source of revenue for Washington Trust. The principal categories of noninterest income are shown in the following table: (Dollars in thousands) Change Years Ended December 31, 2020 2019 $ % Noninterest income : Wealth management revenues $35,454 $36,848 ($1,394) (4 %) Mortgage banking revenues 47,377 14,795 32,582 220 Card interchange fees 4,287 4,214 73 2 Service charges on deposit accounts 2,742 3,684 (942) (26) Loan related derivative income 3,991 3,993 (2) — Income from bank-owned life insurance 2,491 2,354 137 6 Net realized losses on securities — (53) 53 100 Other income 3,100 1,245 1,855 149 Total noninterest income $99,442 $67,080 $32,362 48 % Noninterest Income Analysis Revenue from wealth management services represented 36% of total noninterest income in 2020, compared to 55% in 2019. A substantial portion of wealth management revenues is dependent on the value of wealth management AUA and is closely tied to the performance of the financial markets. This portion of wealth management revenues is referred to as “asset-based” and includes trust and investment management fees. Wealth management revenues also include “transaction-based” revenues, such as commissions and other service fees that are not primarily derived from the value of assets. -44- Management's Discussion and Analysis The categories of wealth management revenues are shown in the following table: (Dollars in thousands) Change Years Ended December 31, 2020 2019 $ % Wealth management revenues: Asset-based revenues $34,363 $35,806 ($1,443) (4 %) Transaction-based revenues 1,091 1,042 49 5 Total wealth management revenues $35,454 $36,848 ($1,394) (4 %) Wealth management revenues for 2020 decreased by $1.4 million, or 4%, from 2019, due to a decline in asset-based revenues. The decrease in asset-based revenues was directionally consistent with a decline in the average balance of AUA in 2020. The following table presents the changes in wealth management AUA: (Dollars in thousands) 2020 2019 Wealth management AUA: Balance at the beginning of period $6,235,801 $5,910,814 Net investment appreciation & income 774,265 1,119,826 Net client asset outflows (143,329) (836,722) Other (1) — 41,883 Balance at the end of period $6,866,737 $6,235,801 (1) Represents the classification of certain non-fee generating assets as AUA due to a reporting change in the fourth quarter of 2019. Wealth management AUA totaled $6.9 billion at December 31, 2020, up by $630.9 million, or 10%, from December 31, 2019, reflecting net investment appreciation partially offset by net client asset outflows in 2020. AUA and related asset-based revenues were adversely impacted by client outflows in the second half of 2019, which was largely associated with the departures of two senior counselors in June 2019. The average balance of AUA in 2020 decreased by 1% from the average balance in 2019. Mortgage banking revenues represented 48% of total noninterest income in 2020, compared to 22% for 2019. These revenues are dependent on mortgage origination volume and are sensitive to interest rates and the condition of housing markets. The composition of mortgage banking revenues and the volume of loans sold are shown in the following table: (Dollars in thousands) Change Years Ended December 31, 2020 2019 $ % Mortgage banking revenues: Realized gains on loan sales, net (1) $42,008 $13,978 $28,030 201 % Unrealized gains, net (2) 5,998 354 5,644 1,594 Loan servicing fee income, net (3) (629) 463 (1,092) (236) Total mortgage banking revenues $47,377 $14,795 $32,582 220 % Loans sold to the secondary market (4) $1,139,761 $591,172 $548,589 93 % (1) Includes gains on loan sales, commission income on loans originated for others, servicing right gains, and gains (losses) on forward loan commitments. (2) Represents fair value adjustments on mortgage loans held for sale and forward loan commitments. (3) Represents loan servicing fee income, net of servicing right amortization and valuation adjustments. (4) Includes brokered loans (loans originated for others). -45- Management's Discussion and Analysis Mortgage banking revenues in 2020 increased by $32.6 million, or 220%, from 2019, primarily due to an increase in net realized gains associated with mortgage banking activities. Net realized gains rose due to increases in both sales volume and sales yield on loans sold to the secondary market. Mortgage loans sold to the secondary market totaled $1.1 billion in 2020 compared to $591.2 million in 2019. As noted in the above table, mortgage banking revenues also include net unrealized gains and net loan servicing fee income. Net unrealized gains and losses correlate to changes in the mortgage pipeline and corresponding changes in the fair value of mortgage loan commitments. Net loan servicing fee income associated with loans sold with servicing retained, declined in 2020, largely due to increased amortization of servicing rights resulting from higher prepayment speeds on the serviced mortgage portfolio. Mortgage origination, refinancing and sales activity increased year-over-year in response to declines in market interest rates. Service charges on deposit accounts decreased by $942 thousand, or 26%, from 2019, primarily due to lower overdraft activity and related fee income. Other income increased by $1.9 million, or 149%, from 2019. Included in other income for 2020 was a gain of $1.4 million associated with the sale of our limited partnership interest in a low-income housing tax credit investment. Noninterest Expense The following table presents noninterest expense comparisons: (Dollars in thousands) Change Years Ended December 31, 2020 2019 $ % Noninterest expense: Salaries and employee benefits $82,899 $72,761 $10,138 14 % Outsourced services 11,894 10,598 1,296 12 Net occupancy 8,023 7,821 202 3 Equipment 3,831 4,081 (250) (6) Legal, audit and professional fees 3,747 2,535 1,212 48 FDIC deposit insurance costs 1,818 618 1,200 194 Advertising and promotion 1,469 1,534 (65) (4) Amortization of intangibles 914 943 (29) (3) Debt prepayment penalties 1,413 — 1,413 — Other 9,376 9,849 (473) (5) Total noninterest expense $125,384 $110,740 $14,644 13 % Noninterest Expense Analysis Salaries and employee benefits expense for 2020 increased by $10.1 million, or 14%, from 2019, largely reflecting volume-related increases in mortgage banking commissions expense, higher staffing levels, annual merit increases, and increases in performance-based compensation expense. These were partially offset by increases in deferred labor costs (a contra expense) associated with portfolio loan originations. Outsourced services expense for 2020 increased by $1.3 million, or 12%, from 2019, reflecting volume-related increases in third party processing costs and the expansion of services provided by third party vendors. Legal, audit and professional fees for 2020 increased by $1.2 million, or 48%, from 2019, reflecting increased costs associated with various legal and consulting matters. FDIC deposit insurance costs for 2020 increased by $1.2 million, or 194%, from 2019, due to $1.1 million of FDIC assessment credits that were recognized in 2019. Debt prepayment penalty expense totaled $1.4 million in 2020, resulting from paying off $13.6 million in higher-yielding FHLB advances. There were no such expenses incurred in 2019. -46- Management's Discussion and Analysis Income Taxes The following table presents the Corporation’s income tax expense and effective tax rate for the periods indicated: (Dollars in thousands) Years ended December 31, 2020 2019 Income tax expense $19,331 $19,061 Effective income tax rate 21.7 % 21.6 % The effective tax rates differed from the federal rate of 21%, primarily due to state income tax expense, offset by the benefits of tax-exempt income and income from bank-owned life insurance BOLI. The Corporation’s net deferred tax assets amounted to $12.2 million at December 31, 2020, compared to $8.3 million at December 31, 2019. The Corporation has determined that a valuation allowance is not required for any of the deferred tax assets since it is more-likely-than-not that these assets will be realized primarily through future reversals of existing taxable temporary differences or by offsetting projected future taxable income. Net deferred tax assets increased in 2020, largely reflecting an increase in the deferred tax asset associated with the ACL on loans. See Note 10 to the Consolidated Financial Statements for additional information regarding income taxes. Segment Reporting The Corporation manages its operations through two business segments, Commercial Banking and Wealth Management Services. Activity not related to the segments, including activity related to the investment securities portfolio, wholesale funding matters and administrative units are considered Corporate. The Corporate unit also includes income from BOLI and the residual impact of methodology allocations such as funds transfer pricing offsets. Methodologies used to allocate income and expenses to business lines are periodically reviewed and revised. See Note 19 to the Consolidated Financial Statements for additional disclosure related to business segments. Commercial Banking The following table presents a summarized statement of operations for the Commercial Banking business segment: (Dollars in thousands) Change Years Ended December 31, 2020 2019 $ % Net interest income $128,600 $112,414 $16,186 14 % Provision for loan losses 12,342 1,575 10,767 684 Net interest income after provision for credit losses 116,258 110,839 5,419 5 Noninterest income 61,463 27,857 33,606 121 Noninterest expense 79,669 69,147 10,522 15 Income before income taxes 98,052 69,549 28,503 41 Income tax expense 21,216 15,189 6,027 40 Net income $76,836 $54,360 $22,476 41 % Net interest income for the Commercial Banking segment increased by $16.2 million, or 14%, from 2019, reflecting growth in loans partially offset by lower yields on loans due to declines in market interest rates. Provisions for credit losses charged to earnings in 2020 and 2019 amounted to $12.3 million and $1.6 million, respectively. In addition to the change in accounting methodology described above under the caption “Provision for Credit Losses,” the increase reflected expected losses related the COVID-19 pandemic, as well as loan growth and changes in the underlying portfolio. -47- Management's Discussion and Analysis Noninterest income derived from the Commercial Banking segment increased by $33.6 million, or 121%, from 2019, largely reflecting higher mortgage banking revenues and a gain of $1.4 million associated with the 2020 sale of our limited partnership interest in a low-income housing tax credit investment.. See additional discussion under the caption “Noninterest Income” above. Commercial Banking noninterest expenses were up by $10.5 million, or 15%, from 2019, reflecting increases in salaries and employee benefits, FDIC deposit insurance costs, outsourced services and legal expenses. See additional discussion under the caption “Noninterest Expense” above. Wealth Management Services The following table presents a summarized statement of operations for the Wealth Management Services business segment: (Dollars in thousands) Change Years Ended December 31, 2020 2019 $ % Net interest expense ($141) ($438) $297 (68 %) Noninterest income 35,454 36,856 (1,402) (4) Noninterest expense 28,779 27,502 1,277 5 Income before income taxes 6,534 8,916 (2,382) (27) Income tax expense 1,746 2,308 (562) (24) Net income $4,788 $6,608 ($1,820) (28 %) Noninterest income for the Wealth Management Services segment decreased by $1.4 million, or 4%, compared to 2019, due to a decline in asset-based revenues. See further discussion of wealth management revenues under the caption “Noninterest Income” above. Noninterest expenses for the Wealth Management Services segment increased by $1.3 million, or 5%, compared to 2019, including increases in salaries and employee benefits, legal and outsourced services expenses. See additional discussion under the caption “Noninterest Expense” above. Corporate The following table presents a summarized statement of operations for the Corporate unit: (Dollars in thousands) Change Years Ended December 31, 2020 2019 $ % Net interest (expense) income ($1,015) $21,438 ($22,453) (105 %) Noninterest income 2,525 2,367 158 7 Noninterest expense 16,936 14,091 2,845 20 (Loss) income before income taxes (15,426) 9,714 (25,140) (259) Income tax (benefit) expense (3,631) 1,564 (5,195) (332) Net (loss) income ($11,795) $8,150 ($19,945) (245 %) Net interest income for the Corporate unit was down by $22.5 million, or 105%, compared to 2019. Lower interest income on securities, resulting from a decline in average balances of securities and lower yields on securities, was partially offset by lower wholesale funding costs. The decline in net interest income for the Corporate unit reflected unfavorable net funds transfer pricing allocations with the Commercial Banking segment as the downward repricing of assets occurred at a faster pace than the repricing of liabilities. Noninterest expense for the Corporate unit increased by $2.8 million, or 20%, from 2019. Included in noninterest expense in 2020 was debt prepayment penalty expense of $1.4 million. There was no such expense incurred in 2019. -48- Management's Discussion and Analysis Excluding the debt prepayment penalty expense, the remaining increase in noninterest expense from 2019 included increases in salaries and benefits, legal and other professional fees and outsourced services. See additional discussion under the caption “Noninterest Expense” above. Financial Condition Summary The following table presents selected financial condition data: (Dollars in thousands) Change December 31, 2020 2019 $ % Cash and due from banks $194,143 $132,193 $61,950 47 % Total securities 894,571 899,490 (4,919) (1) Total loans 4,195,990 3,892,999 302,991 8 Allowance for credit losses on loans 44,106 27,014 17,092 63 Total assets 5,713,169 5,292,659 420,510 8 Total deposits 4,378,353 3,498,882 879,471 25 FHLB advances 593,859 1,141,464 (547,605) (48) Total shareholders’ equity 534,195 503,492 30,703 6 Total assets amounted to $5.7 billion at December 31, 2020, up by $420.5 million, or 8%, from the end of 2019. This reflected growth in total loans and an increase in the balance of cash and due from banks. The cash and due from banks balance rose largely due to increased levels of cash collateral pledged to derivative counterparties. See Note 14 to the Consolidated Financial Statements for additional disclosure regarding derivative financial instruments. The ACL on loans increased by $17.1 million, or 63%, from the end of 2019. This largely reflected the adoption of the ASC 326 effective January 1, 2020 and the estimated impact of the COVID-19 pandemic. See additional disclosure in the Asset Quality section under the caption “Allowance for credit losses on loans.” Total deposits increased by $879.5 million, or 25%, reflecting increases in both in-market deposits and wholesale brokered time deposits. FHLB advances decreased by $547.6 million, or 48%, from December 31, 2019. Shareholders’ equity amounted to $534.2 million at December 31, 2020, up by $30.7 million, or 6%, from the balance at December 31, 2019. Securities I nvestment security activity is monitored by the Investment Committee, the members of which also sit on the Asset/Liability Committee (“ALCO”). Asset and liability management objectives are the primary influence on the Corporation’s investment activities. However, the Corporation also recognizes that there are certain specific risks inherent in investment activities. The securities portfolio is managed in accordance with regulatory guidelines and established internal corporate investment policies that provide limitations on specific risk factors such as market risk, credit risk and concentration, liquidity risk and operational risk to help monitor risks associated with investing in securities. Reports on the activities conducted by Investment Committee and the ALCO are presented to the Board of Directors on a regular basis. The Corporation’s securities portfolio is managed to generate interest income, to implement interest rate risk management strategies, and to provide a readily available source of liquidity for balance sheet management. Securities are designated as either available for sale, held to maturity or trading at the time of purchase. The Corporation does does not maintain a portfolio of trading securities. As of December 31, 2020 and December 31, 2019, the Corporation did not have securities designated as held to maturity. Securities available for sale may be sold in response to changes in market conditions, prepayment risk, rate fluctuations, liquidity, or capital requirements. Debt securities available for sale are reported at fair value, with any unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity, net of tax, until realized. -49- Management's Discussion and Analysis Determination of Fair Value The Corporation uses an independent pricing service to obtain quoted prices. The prices provided by the independent pricing service are generally based on observable market data in active markets. The determination of whether markets are active or inactive is based upon the level of trading activity for a particular security class. Management reviews the independent pricing service’s documentation to gain an understanding of the appropriateness of the pricing methodologies. Management also reviews the prices provided by the independent pricing service for reasonableness based upon current trading levels for similar securities. If the prices appear unusual, they are re-examined and the value is either confirmed or revised. In addition, management periodically performs independent price tests of securities to ensure proper valuation and to verify our understanding of how securities are priced. As of December 31, 2020 and 2019, management did not make any adjustments to the prices provided by the pricing service. Our fair value measurements generally utilize Level 2 inputs, representing quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, and model-derived valuations in which all significant input assumptions are observable in active markets. See Notes 4 and 15 to the Consolidated Financial Statements for additional information regarding the determination of fair value of investment securities. Securities Portfolio The carrying amounts of securities held are as follows: (Dollars in thousands) December 31, 2020 2019 2018 Amount % Amount % Amount % Available for Sale Debt Securities: Obligations of U.S. government-sponsored enterprises $131,669 15 % $157,648 18 % $242,683 26 % Mortgage-backed securities issued by U.S. government agencies and U.S. government-sponsored enterprises 740,305 83 719,080 80 660,793 72 Obligations of states and political subdivisions — — — — 937 — Individual name issuer trust preferred debt securities 12,669 1 12,579 1 11,772 1 Corporate bonds 9,928 1 10,183 1 11,625 1 Total available for sale debt securities $894,571 100 % $899,490 100 % $927,810 100 % (Dollars in thousands) December 31, 2020 2019 2018 Amount % Amount % Amount % Held to Maturity Debt Securities: Mortgage-backed securities issued by U.S. government agencies and U.S. government-sponsored enterprises $— — % $— — % $10,415 100 % Total held to maturity debt securities $— — % $— — % $10,415 100 % The securities portfolio stood at $894.6 million as of December 31, 2020, or 16% of total assets, compared to $899.5 million as of December 31, 2019, or 17% or total assets. The largest component of the securities portfolio is mortgage-backed securities, all of which are issued by U.S. government agencies or U.S. government-sponsored enterprises. As of December 31, 2020, the net unrealized gain position on available for sale debt securities amounted to $13.0 million, compared to $4.2 million as of December 31, 2019. These net positions included gross unrealized losses of $2.6 million and $4.9 million, respectively, of as December 31, 2020 and December 31, 2019. -50- Management's Discussion and Analysis See Note 4 to the Consolidated Financial Statements for additional information. The schedule of maturities of available for sale debt securities is presented below. Mortgage-backed securities are included based on weighted average maturities, adjusted for anticipated prepayments. All other debt securities are included based on contractual maturities. Actual maturities may differ from amounts presented because certain issuers have the right to call or prepay obligations with or without call or prepayment penalties. Yields on tax- exempt obligations are not computed on a tax equivalent basis. (Dollars in thousands) December 31, 2020 Within 1 Year 1-5 Years 5-10 Years After 10 Years Totals Available for Sale Debt Securities: Obligations of U.S. government-sponsored enterprises: Amortized cost $806 $41,896 $88,484 $— $131,186 Weighted average yield 2.15 % 2.58 % 1.30 % — % 1.72 % Mortgage-backed securities issued by U.S. government agencies and U.S. government-sponsored enterprises: Amortized cost 128,165 308,963 172,044 116,718 725,890 Weighted average yield 2.49 2.34 2.13 1.71 2.22 Individual name issuer trust preferred debt securities: Amortized cost — — 13,341 — 13,341 Weighted average yield — — 0.82 — 0.82 Corporate bonds: Amortized cost — — 3,279 7,874 11,153 Weighted average yield — — 0.84 1.34 1.19 Total available for sale debt securities: Amortized cost $128,971 $350,859 $277,148 $124,592 $881,570 Weighted average yield 2.49 % 2.37 % 1.79 % 1.69 % 2.11 % Fair value $131,519 $357,148 $279,859 $126,045 $894,571 Federal Home Loan Bank Stock The Bank is a member of the FHLB, which is a cooperative that provides services to its member banking institutions. The primary reason for the Bank’s membership is to gain access to a reliable source of wholesale funding in order to manage interest rate risk. The purchase of FHLB stock is a requirement for a member to gain access to funding. The Bank purchases FHLB stock in proportion to the volume of funding received and views the purchases as a necessary long-term investment for the purposes of balance sheet liquidity and not for investment return. The Bank’s investment in FHLB stock totaled $30.3 million at December 31, 2020, compared to $50.9 million at December 31, 2019. No market exists for shares of FHLB stock and therefore, it is carried at cost. FHLB stock may be redeemed at par value five years following termination of FHLB membership, subject to limitations which may be imposed by the FHLB or its regulator, the Federal Housing Finance Board, to maintain capital adequacy of the FHLB. While the Bank currently has no intentions to terminate its FHLB membership, the ability to redeem its investment in FHLB stock would be subject to the conditions imposed by the FHLB. Management monitors the investment to determine if impairment exists. Based on the capital adequacy and the liquidity position of the FHLB, management believes there is no impairment related to the carrying amount of its FHLB stock as of December 31, 2020. Loans Total loans amounted to $4.2 billion at December 31, 2020, up by $303.0 million, or 8%, from the end of 2019, largely due to originations of PPP loans within the commercial and industrial portfolio. -51- Management's Discussion and Analysis The following table sets forth the composition of the Corporation’s loan portfolio for each of the past five years: (Dollars in thousands) December 31, 2020 2019 2018 2017 2016 Amount % Amount % Amount % Amount % Amount % Commercial: Commercial real estate (1) $1,633,024 39 % $1,547,572 40 % $1,392,408 38 % $1,210,495 36 % $1,195,557 37 % Commercial & industrial (2) 817,408 19 585,289 15 620,704 17 612,334 18 576,109 18 Total commercial 2,450,432 58 2,132,861 55 2,013,112 55 1,822,829 54 1,771,666 55 Residential real estate: Residential real estate (3) 1,467,312 35 1,449,090 37 1,360,387 37 1,227,248 36 1,122,748 35 Consumer: Home equity 259,185 6 290,874 7 280,626 8 292,467 9 301,472 9 Other (4) 19,061 1 20,174 1 26,235 — 31,527 1 38,485 1 Total consumer 278,246 7 311,048 8 306,861 8 323,994 10 339,957 10 Total loans $4,195,990 100 % $3,892,999 100 % $3,680,360 100 % $3,374,071 100 % $3,234,371 100 % (1) CRE consists of commercial mortgages primarily secured by income-producing property, as well as construction and development loans. Construction and development loans are made to businesses for land development or the on-site construction of industrial, commercial, or residential buildings. (2) C&I consists of loans to businesses and individuals, a portion of which are fully or partially collateralized by real estate. C&I also includes PPP loans. (3) Residential real estate consists of mortgage and homeowner construction loans secured by one- to four-family residential properties. (4) Other consists of loans to individuals secured by general aviation aircraft and other personal installment loans. An analysis of the maturity and interest rate sensitivity of the Corporation’s loan portfolio as of December 31, 2020 follows: (Dollars in thousands) Commercial Consumer CRE (1) C&I Total Commercial Residential Real Estate (2) Home Equity Other Total Consumer Total Amounts due in: One year or less $240,570 $119,416 $359,986 $39,111 $3,429 $2,589 $6,018 $405,115 After one year to five years 773,807 456,192 1,229,999 170,929 11,879 9,596 21,475 1,422,403 After five years 618,647 241,800 860,447 1,257,272 243,877 6,876 250,753 2,368,472 Total $1,633,024 $817,408 $2,450,432 $1,467,312 $259,185 $19,061 $278,246 $4,195,990 Interest rate terms on amounts due after one year: Predetermined rates $136,034 $372,118 $508,152 $379,803 $26,234 $14,709 $40,943 $928,898 Variable or adjustable rates 1,256,420 325,874 1,582,294 1,048,398 229,522 1,763 231,285 2,861,977 (1) Includes construction and development loans that will convert to repayment terms following the construction period and will be reclassified to either the commercial real estate or commercial & industrial category. (2) Includes homeowner construction loans. Maturities of homeowner construction loans are included based on their contractual conventional mortgage repayment terms following the completion of construction. Generally, the actual maturity of loans is substantially shorter than their contractual maturity due to prepayments and, in the case of loans secured by real estate, due to payoff of loans upon the sale of the property by the borrower. The average life of loans secured by real estate tends to increase when market loan rates are higher than rates on existing portfolio loans and, conversely, tends to decrease when rates on existing portfolio loans are higher than market loan rates. Under the latter scenario, the average yield on portfolio loans tends to decrease as higher yielding loans are repaid or refinanced at lower rates. Due to the fact that the Bank may, consistent with industry practice, renew a significant portion of commercial loans at or immediately prior to their maturity by renewing the loans on substantially similar or revised terms, the principal repayments actually received by the Bank are anticipated to be significantly less than the amounts contractually due in any particular period. In other circumstances, a loan, or a portion of a loan, may not be repaid due to the borrower’s inability to satisfy the contractual terms of the loan. -52- Management's Discussion and Analysis Washington Trust continues to work with and support our customers experiencing financial difficulty due to the COVID-19 pandemic. In 2020, we executed loan payment deferral modifications on 636 loans totaling $717.4 million. The majority of these modifications qualified as eligible loan modifications under Section 4013 of the CARES Act, as amended, and therefore, were not required to be classified as TDRs and were not reported as past due. As of December 31, 2020, we have active loan payment deferment modifications, or “deferments”, on 136 loans totaling $244.7 million, or 6% of total loans excluding PPP loans. As of February 19, 2021, we have active deferments on 92 loans totaling $185.9 million, or 5% of the balance of total loans excluding PPP loans at December 31, 2020. Management continues to actively monitor the deferments and loan portfolios in certain industry segments that it considers “at risk” of significant impact. Deferment extensions are prudently underwritten and have resulted in loan risk rating downgrades when warranted. Management considers deferments when estimating the ACL. Loss exposure within these industries is mitigated by a number of factors such as collateral values, LTV ratios, and other key indicators, however, some degree of credit loss is expected and has been incorporated into the allowance for credit loss recognition under the CECL accounting methodology. Commercial Loans The commercial loan portfolio represented 58% of total loans at December 31, 2020. In making commercial loans, we may occasionally solicit the participation of other banks. The Bank also participates in commercial loans originated by other banks. In such cases, these loans are individually underwritten by us using standards similar to those employed for our self-originated loans. Our participation in commercial loans originated by other banks amounted to $408.8 million and $399.7 million, respectively, at December 31, 2020 and December 31, 2019. Our participation in commercial loans originated by other banks also includes shared national credits, which are defined as participation in loans or loan commitments of at least $100 million that are shared by three or more banks. Commercial loans fall into two major categories, commercial real estate and commercial and industrial loans. Commercial real estate loans consist of commercial mortgages secured by real property where the primary source of repayment is derived from rental income associated with the property or the proceeds of the sale, refinancing or permanent financing of the property. Commercial real estate loans also include construction loans made to businesses for land development or the on-site construction of industrial, commercial, or residential buildings. Commercial and industrial loans primarily provide working capital, equipment financing and financing for other business-related purposes. Commercial and industrial loans are frequently collateralized by equipment, inventory, accounts receivable, and/or general business assets. A portion of the Bank’s commercial and industrial loans is also collateralized by real estate. Commercial and industrial loans also include PPP loans that are fully guaranteed by the U.S. government, tax-exempt loans made to states and political subdivisions, as well as industrial development or revenue bonds issued through quasi-public corporations for the benefit of a private or non-profit entity where that entity rather than the governmental entity is obligated to pay the debt service. Commercial Real Estate Loans CRE loans totaled $1.6 billion at December 31, 2020, up by $85.5 million, or 6%, from the balance at December 31, 2019. Included in CRE loans were construction and development loans of $111.2 million and $211.5 million, respectively, as of December 31, 2020 and December 31, 2019. In 2020, CRE loan originations and advances totaled approximately $270 million, which were partially offset by payoffs and pay-downs. -53- Management's Discussion and Analysis The following table presents a geographic summary of CRE loans by property location: (Dollars in thousands) December 31, 2020 December 31, 2019 Outstanding Balance % of Total Outstanding Balance % of Total Connecticut $649,919 40 % $616,484 40 % Massachusetts 468,947 29 458,029 30 Rhode Island 431,133 26 394,929 25 Subtotal 1,549,999 95 1,469,442 95 All other states 83,025 5 78,130 5 Total $1,633,024 100 % $1,547,572 100 % The following table presents a summary of CRE loans by property type segmentation: (Dollars in thousands) December 31, 2020 December 31, 2019 Count Outstanding Balance % of Total Count Outstanding Balance % of Total CRE Portfolio Segmentation: Multi-family dwelling 137 $524,874 32 % 123 $430,502 28 % Retail 136 339,569 21 110 314,661 20 Office 73 290,756 18 78 294,910 19 Hospitality 40 157,720 10 32 128,867 8 Healthcare 15 109,321 7 16 110,409 7 Industrial and warehouse 28 97,055 6 25 82,432 5 Commercial mixed use 22 42,405 2 48 73,895 5 Other 38 71,324 4 70 111,896 8 Total CRE loans 489 $1,633,024 100 % 502 $1,547,572 100 % Average CRE loan size $3,340 $3,083 Largest individual CRE loan outstanding $32,200 $25,962 The following table presents a summary of CRE loan deferments by industry segmentation: (Dollars in thousands) February 19, 2021 December 31, 2020 Count Balance % of Outstanding Balance (1) Count Balance % of Outstanding Balance (1) CRE Deferments by Segment: Hospitality 14 $61,054 39 % 20 $83,073 53 % Retail 3 20,600 6 5 39,781 12 Healthcare 1 18,307 17 2 22,305 20 Office 1 1,833 1 2 2,457 1 Commercial mixed use — — — 1 637 2 Multi-family dwelling — — — 1 364 — Other 7 27,786 39 7 27,785 39 Total CRE deferments 26 $129,580 8 % 38 $176,402 11 % (1) Percent of respective outstanding portfolio segment balance as of December 31, 2020. -54- Management's Discussion and Analysis As of February 19, 2021, we have active deferments on 26 CRE loans totaling $129.6 million, which represented 8% of the total CRE portfolio at December 31, 2020. While various industries have and will continue to experience adverse effects as a result of the COVID-19 pandemic, management currently considers the following CRE industry segments to be “at-risk” of significant impact: • The retail segment consisted of 136 loans with balances totaling $339.6 million at December 31, 2020, representing 21% of the total CRE portfolio. Our retail properties generally have single tenant drugstores or strong anchor tenants, often national grocery store chains. At February 19, 2021, we have active deferments on 3 retail loans totaling $20.6 million, which represented 6% of this segment’s balance at December 31, 2020. • The hospitality segment consisted of 40 loans with balances totaling $157.7 million at December 31, 2020, representing 10% of the total CRE portfolio. We generally underwrite this segment at an LTV of 65% or less. Our hospitality properties are largely limited service properties with no restaurants and limited meeting space. This segment also includes leisure travel properties that are located on the New England coastline. At February 19, 2021, we have active deferments on 14 hospitality loans totaling $61.1 million, which represented 39% of this segment’s balance at December 31, 2020. • The healthcare segment consisted of 15 loans with balances totaling $109.3 million at December 31, 2020, representing 7% of the total CRE portfolio. This segment is composed of assisted living, nursing homes and continuing care retirement communities. At February 19, 2021, we have an active deferment on 1 healthcare loan of $18.3 million, which represented 17% of this segment’s balance at December 31, 2020. Commercial and Industrial Loans C&I loans amounted to $817.4 million at December 31, 2020, up by $232.1 million, or 40%, from the balance at December 31, 2019. In 2020, C&I loan originations amounted to $302 million and were concentrated in PPP loans. Originations were partially offset by payoffs and pay-downs, including $18 million of PPP loans that were forgiven by the SBA. As of December 31, 2020, there were 1,706 PPP loans with a carrying value of $199.8 million included in the C&I portfolio. The average PPP loan size was $117 thousand. Net unamortized loan origination fees on PPP loans amounted to $3.9 million at December 31, 2020. Shared national credit balances outstanding included in the C&I loan portfolio totaled $43.8 million at December 31, 2020. All of these loans were included in the pass-rated category of commercial loan credit quality and were current with respect to contractual payment terms at December 31, 2020. -55- Management's Discussion and Analysis The following table presents a summary of C&I loan by industry segmentation: (Dollars in thousands) December 31, 2020 December 31, 2019 Count Outstanding Balance % of Total Count Outstanding Balance % of Total C&I Portfolio Segmentation: Healthcare and social assistance 253 $200,217 24 % 86 $138,857 24 % Manufacturing 146 88,802 11 65 53,561 9 Owner occupied and other real estate 268 74,309 9 157 46,033 8 Educational services 53 64,969 8 22 56,556 10 Retail 192 63,895 8 75 43,386 7 Accommodation and food services 271 47,020 6 64 16,562 3 Professional, scientific and technical 265 39,295 5 66 37,599 6 Entertainment and recreation 91 29,415 4 35 30,807 5 Information 32 28,394 3 11 22,162 4 Finance and insurance 106 26,244 3 57 28,501 5 Transportation and warehousing 42 24,061 3 23 20,960 4 Public administration 26 23,319 3 23 25,107 4 Other 772 107,468 13 225 65,198 11 Total C&I loans 2,517 $817,408 100 % 909 $585,289 100 % Average C&I loan size $325 $644 Largest individual C&I loan outstanding $19,500 $19,001 The C&I portfolio as of December 31, 2020 included PPP loans. The following table presents a summary of PPP loans by industry segmentation: (Dollars in thousands) December 31, 2020 Count Outstanding Balance % of Total PPP Loans by Segment: Healthcare and social assistance 173 $47,354 24 % Accommodation and food services 209 23,678 12 Manufacturing 89 23,321 12 Professional, scientific and technical 220 20,031 10 Retail 134 12,107 6 Educational services 32 9,681 5 Owner occupied and other real estate 115 9,241 5 Entertainment and recreation 61 3,386 2 Information 20 2,478 1 Finance and insurance 55 2,000 1 Transportation and warehousing 21 2,059 1 Public administration 4 483 — Other 573 43,961 21 Total PPP loans (included in the C&I loan portfolio) 1,706 $199,780 100 % As PPP loans are forgiven by the SBA, unamortized net fee balances are accelerated and amortized into net interest income. In 2020, $18.0 million of PPP loans were forgiven by the SBA and as a result, acceleration of net fee -56- Management's Discussion and Analysis balances of $423 thousand was included in interest income in 2020. From January 1, 2021 through February 19, 2021, additional PPP loans with principal balances totaling $26.7 million were forgiven by the SBA and as a result, acceleration of net fee balances of $521 thousand was included in interest income in 2021. Also in January 2021, Washington Trust began participating in PPP-2. As of February 19, 2021, we have originated 706 PPP-2 loans with principal balances totaling $67.8 million. The following table presents a summary of C&I loan deferments by industry segmentation: (Dollars in thousands) February 19, 2021 December 31, 2020 Count Balance % of Outstanding Balance, excl PPP loans (1) Count Balance % of Outstanding Balance, excl PPP loans (1) C&I Deferments by Segment: Healthcare and social assistance 5 $19,774 13 % 5 $19,620 13 % Accommodation and food services 1 2,836 12 2 2,889 12 Transportation and warehousing 4 1,120 5 4 1,120 5 Manufacturing 2 947 1 2 947 1 Entertainment and recreation 3 554 2 3 560 2 Owner occupied and other real estate 1 326 1 1 326 1 Other 4 7,623 12 4 7,673 12 Total C&I deferments 20 $33,180 5 % 21 $33,135 5 % (1) Percent of respective outstanding portfolio segment balance, excluding PPP loans, as of December 31, 2020. As of February 19, 2021, we have active deferments on 20 C&I loans totaling $33.2 million, which represented 5% of the total C&I portfolio (excluding PPP loans) at December 31, 2020. Healthcare and social assistance totaled $200.2 million as of December 31, 2020 and is our largest single C&I industry segment, representing 24% of the total C&I portfolio. This segment includes specialty medical practices, elder services and community and mental health centers. At February 19, 2021, we have active deferments on 5 healthcare and social assistance loans of $19.8 million, which represented 13% of this industry segment’s balances (excluding PPP loans) as of December 31, 2020. It is possible that there will be further disruption in this industry segment. While various industries have and will continue to experience adverse effects as a result of the COVID-19 pandemic, management currently considers the following C&I industry segments to be “at-risk” of significant impact: • The accommodation and food services industry segment consisted of 271 loans with balances totaling $47.0 million as of December 31, 2020, representing 6% of the total C&I portfolio. At February 19, 2021, we have an active deferment on 1 accommodation and food services loan of $2.8 million, which represented 12% of this industry segment’s balance (excluding PPP loans) at December 31, 2020. The deferment was executed for a restaurant. • The entertainment and recreation industry segment consisted of 91 loans with balances totaling $29.4 million as of December 31, 2020, representing 4% of the total C&I portfolio. This industry segment consists largely of golf courses and marinas. At February 19, 2021, we have active deferments on 3 entertainment and recreation industry loans totaling $554 thousand, which represented 2% of this industry segment’s balance (excluding PPP loans) at December 31, 2020. The deferments were executed for a gym and a recreational facility. Residential Real Estate Loans The residential real estate loan portfolio represented 35% of total loans at December 31, 2020. -57- Management's Discussion and Analysis Residential real estate loans are originated both for sale to the secondary market as well as for retention in the Bank’s loan portfolio. We also originate residential real estate loans for various investors in a broker capacity, including conventional mortgages and reverse mortgages. The table below presents residential real estate loan origination activity: (Dollars in thousands) Years ended December 31, 2020 2019 Amount % of Total Amount % of Total Originations for retention in portfolio (1) $502,120 30 % $347,390 37 % Originations for sale to the secondary market (2) 1,171,906 70 598,103 63 Total $1,674,026 100 % $945,493 100 % (1) Includes the full commitment amount of homeowner construction loans. (2) Includes brokered loans (loans originated for others). The table below presents residential real estate loan sales activity: (Dollars in thousands) Years ended December 31, 2020 2019 Amount % of Total Amount % of Total Loans sold with servicing rights retained $849,467 75 % $96,160 16 % Loans sold with servicing rights released (1) 290,294 25 495,012 84 Total $1,139,761 100 % $591,172 100 % (1) Includes brokered loans (loans originated for others). Residential real estate loan origination, refinancing and sales activity increased year-over-year in response to declines in market interest rates. Loans are sold with servicing retained or released. Loans sold with servicing rights retained result in the capitalization of servicing rights. Loan servicing rights are included in other assets and are subsequently amortized as an offset to mortgage banking revenues over the estimated period of servicing. The net balance of capitalized servicing rights amounted to $7.4 million and $3.5 million, respectively, as of December 31, 2020 and 2019. The balance of residential mortgage loans serviced for others, which are not included in the Consolidated Balance Sheets, amounted to $1.2 billion and $587.0 million, respectively, as of December 31, 2020 and 2019. Residential real estate loans held in portfolio amounted to $1.5 billion at December 31, 2020, up by $18.2 million, or 1%, from the balance at December 31, 2019. In 2020, Washington Trust purchased $51.1 million of residential real estate mortgage loans with a weighted average yield of 3.38% from another financial institution. These loans were individually evaluated to Washington Trust’s underwriting standards and predominantly secured by properties in Massachusetts. -58- Management's Discussion and Analysis The following is a geographic summary of residential real estate loans by property location: (Dollars in thousands) December 31, 2020 December 31, 2019 Amount % of Total Amount % of Total Massachusetts $994,800 68 % $932,726 64 % Rhode Island 331,713 23 356,392 25 Connecticut 122,102 8 140,574 10 Subtotal 1,448,615 99 1,429,692 99 All other states 18,697 1 19,398 1 Total (1) $1,467,312 100 % $1,449,090 100 % (1) Includes residential mortgage loans purchased from and serviced by other financial institutions totaling $131.8 million and $151.8 million, respectively, as of December 31, 2020 and 2019. As of February 19, 2021, we have active deferments on 39 residential real estate loans totaling $22.4 million, which represented 2% of the total residential real estate portfolio balance as of December 31, 2020. The average size of residential real estate loans with active deferments as of February 19, 2021 was approximately $574 thousand and these loans have an estimated LTV ratio of 54%. Consumer Loans Consumer loans include home equity loans and lines of credit and personal installment loans. The consumer loan portfolio totaled $278.2 million at December 31, 2020, down by $32.8 million, or 11%, from December 31, 2019. Home equity lines of credit and home equity loans represented 93% of the total consumer portfolio at December 31, 2020. The Bank estimates that approximately 60% of the combined home equity lines of credit and home equity loan balances are first lien positions or subordinate to other Washington Trust mortgages. Purchased consumer loans, consisting of loans to individuals secured by general aviation aircraft, amounted to $10.0 million and $12.8 million, respectively, at December 31, 2020 and December 31, 2019. As of February 19, 2021, we have active deferments on 7 consumer loans totaling $738 thousand, which represented 0.3% of the total consumer portfolio balance as of December 31, 2020. Investment in Bank-Owned Life Insurance BOLI amounted to $84.2 million and $82.5 million, respectively, at December 31, 2020 and 2019. BOLI provides a means to mitigate increasing employee benefit costs. The Corporation expects to benefit from the BOLI contracts as a result of the tax-free growth in cash surrender value and death benefits that are expected to be generated over time. The purchase of the life insurance policy results in an income-earning asset on the Consolidated Balance Sheet that provides monthly tax-free income to the Corporation. The largest risk to the BOLI program is credit risk of the insurance carriers. To mitigate this risk, annual financial condition reviews are completed on all carriers. BOLI is invested in the “general account” of quality insurance companies. All such general account carriers were rated “A” or better by A.M. Best and “A2” or better by Moody’s at December 31, 2020. BOLI is included in the Consolidated Balance Sheet at its cash surrender value. Increases in BOLI’s cash surrender value are reported as a component of noninterest income in the Consolidated Statements of Income. Asset Quality Management continually monitors the asset quality of the loan portfolio using all available information. The Board of Directors of the Bank monitors credit risk management through two committees, the Finance Committee and the Audit Committee. The Finance Committee has primary oversight responsibility for the credit granting function, including approval authority for credit granting policies, review of management’s credit granting activities and approval of large exposure credit requests. The Audit Committee oversees various systems and procedures performed by management for monitoring the credit quality of the loan portfolio, conducting a credit review program, maintaining the integrity of the loan rating system and determining the adequacy of the ACL. The Audit Committee also approves the policy and methodology for establishing the ACL. These committees report the results of their respective oversight functions to -59- Management's Discussion and Analysis the Board of Directors. In addition, the Board of Directors receives information concerning asset quality measurements and trends on a regular basis. Nonperforming Assets Nonperforming assets include nonaccrual loans and property acquired through foreclosure or repossession (“OREO”). The following table presents nonperforming assets and additional asset quality data: (Dollars in thousands) December 31, 2020 2019 2018 2017 2016 Commercial: Commercial real estate $— $603 $925 $4,954 $7,811 Commercial & industrial — 657 — 283 1,337 Total commercial — 1,260 925 5,237 9,148 Residential Real Estate: Residential real estate 11,981 14,297 9,346 9,414 11,736 Consumer: Home equity 1,128 1,763 1,436 544 1,058 Other 88 88 — 16 116 Total consumer 1,216 1,851 1,436 560 1,174 Total nonaccrual loans 13,197 17,408 11,707 15,211 22,058 Property acquired through foreclosure or repossession, net — 1,109 2,142 131 1,075 Total nonperforming assets $13,197 $18,517 $13,849 $15,342 $23,133 Nonperforming assets to total assets 0.23% 0.35% 0.28% 0.34% 0.53% Nonperforming loans to total loans 0.31% 0.45% 0.32% 0.45% 0.68% Total past due loans to total loans 0.30% 0.40% 0.37% 0.59% 0.76% Accruing loans 90 days or more past due $— $— $— $— $— Total nonperforming assets decreased by $5.3 million from December 31, 2019. This included a $4.2 million decrease in nonaccrual loans and a $1.1 million decrease in OREO. The decrease in OREO reflected sales of three properties essentially at their carrying value during 2020. At December 31, 2020, there were no properties held in OREO. Nonaccrual Loans Loans, with the exception of certain well-secured loans that are in the process of collection, are placed on nonaccrual status and interest recognition is suspended when such loans are 90 days or more overdue with respect to principal and/or interest, or sooner if considered appropriate by management. Loans are removed from nonaccrual status when they have been current as to principal and interest for a period of time, the borrower has demonstrated an ability to comply with repayment terms, and when, in management’s opinion, the loans are considered to be fully collectible. During 2020, the Corporation made no changes in its practices or policies concerning the placement of loans into nonaccrual status. Interest income that would have been recognized if loans on nonaccrual status had been current in accordance with their original terms was approximately $844 thousand in 2020, compared to $1.2 million in 2019. Interest income attributable to these loans included in the Consolidated Statements of Income amounted to approximately $416 thousand and $516 thousand, respectively, in 2020 and 2019. -60- Management's Discussion and Analysis The following table presents the activity in nonaccrual loans: (Dollars in thousands) Years ended December 31, 2020 2019 Balance at beginning of period $17,408 $11,707 Additions to nonaccrual status 3,644 11,982 Loans returned to accruing status (3,282) (1,570) Loans charged-off (1,317) (2,020) Loans transferred to other real estate owned (313) (2,000) Payments, payoffs and other changes (2,943) (691) Balance at end of period $13,197 $17,408 The following table presents additional detail on nonaccrual loans: (Dollars in thousands) December 31, 2020 December 31, 2019 Days Past Due Days Past Due Over 90 Under 90 Total % (1) Over 90 Under 90 Total % (1) Commercial: Commercial real estate $— $— $— — % $603 $— $603 0.04 % Commercial & industrial — — — — — 657 657 0.11 Total commercial — — — — 603 657 1,260 0.06 Residential Real Estate: Residential real estate 5,172 6,809 11,981 0.82 4,700 9,597 14,297 0.99 Consumer: Home equity 644 484 1,128 0.44 996 767 1,763 0.61 Other 88 — 88 0.46 88 — 88 0.44 Total consumer 732 484 1,216 0.44 1,084 767 1,851 0.60 Total nonaccrual loans $5,904 $7,293 $13,197 0.31 % $6,387 $11,021 $17,408 0.45 % (1) Percentage of nonaccrual loans to the total loans outstanding within the respective category. There were no significant commitments to lend additional funds to borrowers whose loans were on nonaccrual status at December 31, 2020. As of December 31, 2020, the composition of nonaccrual loans was 100% residential and consumer and 0% commercial, compared to 93% and 7%, respectively, as of December 31, 2019. Nonaccrual residential real estate mortgage loans amounted to $12.0 million at December 31, 2020, down by $2.3 million from the end of 2019. As of December 31, 2020, the balance of nonaccrual residential mortgage loans was predominately secured by properties in Massachusetts, Rhode Island and Connecticut. Included in total nonaccrual residential real estate loans at December 31, 2020 were four loans purchased for portfolio and serviced by others amounting to $1.3 million. Management monitors the collection efforts of its third party servicers as part of its assessment of the collectability of nonperforming loans. Troubled Debt Restructurings In the course of resolving problem loans, the Corporation may choose to restructure the contractual terms of certain loans. A loan that has been modified or renewed is considered to be a TDR when two conditions are met: 1) the borrower is experiencing financial difficulty and 2) concessions are made for the borrower’s benefit that would not otherwise be considered for a borrower or a transaction with similar credit risk characteristics. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit the Corporation by increasing the ultimate probability of collection. -61- Management's Discussion and Analysis TDRs are classified as accruing or non-accruing based on management’s assessment of the collectability of the loan. Loans that are already on nonaccrual status at the time of the restructuring generally remain on nonaccrual status for approximately six months before management considers such loans for return to accruing status. Accruing restructured loans are placed into nonaccrual status if and when the borrower fails to comply with the restructured terms and management deems it unlikely that the borrower will return to a status of compliance in the near term and full collection of principal and interest is in doubt. TDRs are reported as such for at least one year from the date of the restructuring. In years after the restructuring, TDRs are removed from this classification if the restructuring did not involve a below-market rate concession and the loan is performing in accordance with their modified contractual terms for a reasonable period of time. As of December 31, 2020, there were no significant commitments to lend additional funds to borrowers whose loans had been restructured. See Note 5 to the Consolidated Financial Statements for disclosure regarding the Corporation’s election to account for eligible loan modifications under Section 4013 of the CARES Act, as amended. Loan modifications that did not qualify for the TDR accounting relief provided under the CARES Act were classified as TDRs. The following table sets forth information on TDRs as of the dates indicated. The amounts below consist of unpaid principal balance, net of charge-offs and unamortized deferred loan origination fees and costs. Accrued interest is not included in the carrying amounts set forth below. (Dollars in thousands) December 31, 2020 December 31, 2019 Count Amount Count Amount Accruing TDRs Commercial: Commercial real estate 3 $1,792 — $— Commercial & industrial 5 6,814 — — Total commercial 8 8,606 — — Residential Real Estate: Residential real estate 8 3,932 1 358 Consumer: Home equity 3 788 — — Other 1 14 1 18 Total consumer 4 802 1 18 Accruing TDRs 20 13,340 2 376 Nonaccrual TDRs Residential Real Estate: Residential real estate 5 2,273 3 492 Consumer: Home equity 1 72 — — Other — — — — Total consumer 1 72 — — Nonaccrual TDRs 6 2,345 3 492 Total TDRs 26 $15,685 5 $868 TDRs amounted to $15.7 million, up by $14.8 million from the end of 2019. As of December 31, 2020, the composition of TDRs was 55% commercial and 45% residential and consumer, compared to 0% and 100%, respectively, as of December 31, 2019. -62- Management's Discussion and Analysis The ACL included specific reserves for TDRs of $159 thousand and $97 thousand, respectively, at December 31, 2020 and 2019. Past Due Loans The following table presents past due loans by category: (Dollars in thousands) December 31, 2020 2019 Amount % (1) Amount % (1) Commercial: Commercial real estate $265 0.02 % $1,433 0.09 % Commercial & industrial 3 — 1 — Total commercial 268 0.01 1,434 0.07 Residential Real Estate: Residential real estate 10,339 0.70 11,429 0.79 Consumer: Home equity 1,667 0.64 2,696 0.93 Other 118 0.62 130 0.64 Total consumer 1,785 0.64 2,826 0.91 Total past due loans $12,392 0.30 % $15,689 0.40 % (1) Percentage of past due loans to the total loans outstanding within the respective category. As of December 31, 2020, the composition of past due loans (loans past due 30 days or more) was 98% residential and consumer and 2% commercial, compared to 91% and 9%, respectively, at December 31, 2019. Total past due loans decreased by $3.3 million from the end of 2019. Total past due loans included $8.5 million of nonaccrual loans as of December 31, 2020, compared to $11.5 million of as of December 31, 2019. All loans 90 days or more past due at December 31, 2020 and 2019 were classified as nonaccrual. Potential Problem Loans The Corporation classifies certain loans as “substandard,” “doubtful,” or “loss” based on criteria consistent with guidelines provided by banking regulators. Potential problem loans include classified accruing commercial loans that were less than 90 days past due at December 31, 2020 and other loans for which known information about possible credit problems of the related borrowers causes management to have doubts as to the ability of such borrowers to comply with the present loan repayment terms and which may result in disclosure of such loans as nonperforming at some time in the future. Potential problem loans are not included in the amounts of nonaccrual or TDRs presented above. They are assessed for loss exposure using the methods described in Note 5 to the Consolidated Financial Statements under the caption “Credit Quality Indicators.” Management cannot predict the extent to which economic conditions or other factors may impact borrowers and the potential problem loans. Accordingly, there can be no assurance that other loans will not become 90 days or more past due, be placed on nonaccrual, become restructured, or require increased allowance coverage and provision for loan losses. There were no potential problem loans at December 31, 2020, compared to $6.4 million in potential problem loans at September 30, 2020. The balance of potential problem loans at September 30, 2020 consisted of two commercial and industrial loan relationships. In the fourth quarter of 2020, the loans were restructured and classified as TDRs. -63- Management's Discussion and Analysis In addition and as a result of the COVID-19 pandemic, management has also enhanced monitoring of loan portfolios in certain industry segments that have been or could be potentially be “at-risk” of significant impact. See additional disclosure under the caption “ Commercial Loans” within the Financial Condition section. Allowance for Credit Losses on Loans The ACL on loans is management’s estimated valuation allowance at each reporting date in accordance with GAAP. The ACL on loans is increased through a provision for credit losses recognized in the Consolidated Statements of Income and by recoveries of amounts previously charged-off. The ACL on loans is reduced by charge-offs on loans. The Corporation’s general practice is to identify problem credits early and recognize full or partial charge-offs as promptly as practicable when it is determined that the collection of loan principal is unlikely. Full or partial charge-offs on collateral dependent individually analyzed loans are recognized when the collateral is deemed to be insufficient to support the carrying value of the loan. The Corporation does not recognize a recovery when an updated appraisal indicates a subsequent increase in value. Appraisals are generally obtained with values determined on an “as is” basis from independent appraisal firms for real estate collateral dependent commercial loans in the process of collection or when warranted by other deterioration in the borrower’s credit status. Updates to appraisals are generally obtained for TDRs or nonaccrual loans or when management believes it is warranted. The Corporation has continued to maintain appropriate professional standards regarding the professional qualifications of appraisers and has an internal review process to monitor the quality of appraisals. For residential real estate loans and real estate collateral dependent consumer loans that are in the process of collection, valuations are obtained from independent appraisal firms with values determined on an “as is” basis. Effective January 1, 2020, the ACL on loans is management’s estimate of expected credit losses over the expected life of the loans at the reporting date. Prior to January 1, 2020, the ACL was management’s estimate of the risk of loss inherent in the loan portfolio as of the reporting date. See additional discussion regarding the ACL on loans under the caption “Critical Accounting Policies and Estimates” and the adoption of ASC 326 in Note 2 to the Consolidated Financial Statements. The following table presents additional detail on the Corporation’s loan portfolio and associated allowance: (Dollars in thousands) December 31, 2020 December 31, 2019 Loans Related Allowance Allowance / Loans Loans Related Allowance Allowance / Loans Individually analyzed loans $18,252 $379 2.08 % $17,783 $968 5.44 % Pooled (collectively evaluated) loans 4,177,738 43,727 1.05 3,875,216 26,046 0.67 Total $4,195,990 $44,106 1.05 % $3,892,999 $27,014 0.69 % Management employs a process and methodology to estimate the ACL on loans that evaluates both quantitative and qualitative factors. The methodology for evaluating quantitative factors consists of two basic components. The first component involves pooling loans into portfolio segments for loans that share similar risk characteristics. The second component involves individually analyzed loans that do not share similar risk characteristics with loans that are pooled into portfolio segments. In 2020, the ACL for individually analyzed loans was measured using a DCF method based upon the loan’s contractual effective interest rate, or at the loan’s observable market price, or, if the loan was collateral dependent, at the fair value of the collateral. In 2020, the ACL for pooled loans was measured utilizing a DCF methodology to estimate credit losses for each pooled portfolio segment. The methodology incorporates the probability of default and loss given default. Management utilizes the national unemployment rate as an econometric factor with a one-year forecast period and -64- Management's Discussion and Analysis one-year straight-line reversion period to its historical mean in order to estimate the probability of default for each loan portfolio segment. Utilizing a third party regression model, the forecasted national unemployment rate is correlated with the probability of default for each loan portfolio segment. The DCF methodology combines the probability of default, the loss given default, maturity date and prepayment speeds to estimate a reserve for each loan. The sum of all the loan level reserves are aggregated for each portfolio segment and a loss rate factor is derived. Quantitative loss factors for pooled loans are also supplemented by certain qualitative risk factors reflecting management’s view of how losses may vary from those represented by quantitative loss rates. The ACL on loans amounted to $44.1 million at December 31, 2020, up by $17.1 million, or 63%, from the balance at December 31, 2019. Upon adoption of ASC 326 on January 1, 2020, Washington Trust's ACL on loans increased by $6.5 million, or 24%. Provisions for credit losses charged to earnings in 2020 and 2019 amounted to $12.3 million and $1.6 million, respectively. In addition to the change in accounting methodology described above, the increase in the provision was attributable to anticipated losses related the COVID-19 pandemic and also reflected loan growth and changes in the underlying portfolio. Net charge-offs totaled $1.1 million, or 0.03% of average loans, in 2020, compared to net charge-offs of $1.6 million, or 0.04% of average loans, in 2019. The ACL on loans was 1.05% of total loans, at December 31, 2020, compared to 0.69% of total loans, at December 31, 2019. Estimating an appropriate level of ACL in loans necessarily involves a high degree of judgment. Continued uncertainty regarding the severity and duration of the COVID-19 pandemic and related economic effects will continue to affect the accounting for credit losses. It also is possible that asset quality could worsen, expenses associated with collection efforts could increase and loan charge-offs could increase. The following table presents the ACL on loans by portfolio segment. (Dollars in thousands) December 31, 2020 December 31, 2019 Allocated ACL ACL to Loans Allocated ACL ACL to Loans Commercial: Commercial real estate $22,065 1.35 % $14,741 0.95 % Commercial & industrial 12,228 1.50 3,921 0.67 Total commercial 34,293 1.40 18,662 0.87 Residential Real Estate: Residential real estate 8,042 0.55 6,615 0.46 Consumer: Home equity 1,300 0.50 1,390 0.48 Other 471 2.47 347 1.72 Total consumer 1,771 0.64 1,737 0.56 Total allowance for credit losses on loans at end of period $44,106 1.05 % $27,014 0.69 % -65- Management's Discussion and Analysis The following table presents the allocation of the ACL on loans. The allocation below is neither indicative of the specific amounts or the loan categories in which future charge-offs may occur, nor is it an indicator of any future loss trends. The total ACL on loans is available to absorb losses from any segment of the loan portfolio. (Dollars in thousands) December 31, 2020 2019 2018 2017 2016 Amount % (1) Amount % (1) Amount % (1) Amount % (1) Amount % (1) Commercial: Commercial real estate $22,065 39 % $14,741 40 % $15,381 38 % $12,729 36 % $11,166 37 % Commercial & industrial 12,228 19 3,921 15 5,847 17 5,580 18 6,992 18 Total commercial 34,293 58 18,662 55 21,228 55 18,309 54 18,158 55 Residential Real Estate: Residential real estate 8,042 35 6,615 37 3,987 37 5,427 36 5,252 35 Consumer: Home Equity 1,300 6 1,390 7 1,603 8 2,412 9 1,889 9 Other 471 1 347 1 254 — 340 1 705 1 Total Consumer 1,771 7 1,737 8 1,857 8 2,752 10 2,594 10 Balance at end of period $44,106 100 % $27,014 100 % $27,072 100 % $26,488 100 % $26,004 100 % (1) Percentage of loans outstanding in respective category to the total loans outstanding. -66- Management's Discussion and Analysis The following table reflects the activity in the ACL on loans during the years presented: (Dollars in thousands) December 31, 2020 2019 2018 2017 2016 Balance at beginning of period $27,014 $27,072 $26,488 $26,004 $27,069 Adoption of ASC 326 6,501 — — — — Charge-offs: Commercial: Commercial real estate 356 1,028 627 1,867 5,816 Commercial & industrial 586 21 10 336 759 Total commercial 942 1,049 637 2,203 6,575 Residential real estate: Residential real estate 99 486 250 74 200 Consumer: Home equity 224 390 193 79 147 Other 52 95 107 106 90 Total consumer 276 485 300 185 237 Total charge-offs 1,317 2,020 1,187 2,462 7,012 Recoveries: Commercial: Commercial real estate 51 125 25 82 56 Commercial & industrial 24 168 119 169 156 Total commercial 75 293 144 251 212 Residential real estate: Residential real estate 20 — 21 39 11 Consumer: Home equity 52 72 29 33 37 Other 25 22 27 23 37 Total consumer 77 94 56 56 74 Total recoveries 172 387 221 346 297 Net charge-offs 1,145 1,633 966 2,116 6,715 Provision charged to earnings 11,736 1,575 1,550 2,600 5,650 Balance at end of period $44,106 $27,014 $27,072 $26,488 $26,004 Net charge-offs to average loans 0.03 % 0.04 % 0.03 % 0.06 % 0.21 % Sources of Funds Our sources of funds include deposits, brokered time deposits, FHLB advances, other borrowings and proceeds from the sales, maturities and payments of loans and investment securities. The Corporation uses funds to originate and purchase loans, purchase investment securities, conduct operations, expand the branch network and pay dividends to shareholders. Deposits The Corporation offers a wide variety of deposit products to consumer and business customers. Deposits provide an important source of funding for the Bank as well as an ongoing stream of fee revenue. The Bank is a participant in the Demand Deposit Marketplace program, Insured Cash Sweep program and the Certificate of Deposit Account Registry Service program. The Bank uses these deposit sweep services to place -67- Management's Discussion and Analysis customer and client funds into interest-bearing demand accounts, money market accounts, and/or time deposits issued by other participating banks. Customer and client funds are placed at one or more participating banks to ensure that each deposit customer is eligible for the full amount of FDIC insurance. As a program participant, we receive reciprocal amounts of deposits from other participating banks. We consider these reciprocal deposit balances to be in-market deposits as distinguished from traditional out-of-market wholesale brokered deposits. The following table presents a summary of deposits: (Dollars in thousands) Change December 31, 2020 2019 $ % Noninterest-bearing demand deposits $832,287 $609,924 $222,363 36 % Interest-bearing demand deposits 174,290 159,938 14,352 9 NOW accounts 698,706 520,295 178,411 34 Money market accounts 910,167 765,899 144,268 19 Savings accounts 466,507 373,503 93,004 25 Time deposits (in-market) 704,855 784,481 (79,626) (10) Total in-market deposits 3,786,812 3,214,040 572,772 18 Wholesale brokered time deposits 591,541 284,842 306,699 108 Total deposits $4,378,353 $3,498,882 $879,471 25 % Total deposits amounted to $4.4 billion at December 31, 2020, up by $879.5 million, or 25%, in 2020. This included an increase of $306.7 million in out-of-market brokered time deposits. Excluding out-of-market brokered time deposits, in-market deposits were up by $572.8 million, or 18%, from the balance at December 31, 2019. Growth in in-market deposits included increases across all deposit categories, except in-market time deposits. In-market time deposits decreased in 2020, reflecting maturities of higher yielding promotional time certificates of deposit. The continued economic uncertainty resulting from the COVID-19 pandemic has caused a shift in consumer habits to save in liquid deposit accounts. Borrowings Borrowings primarily consist of FHLB advances, which are used as a source of funding for liquidity and interest rate risk management purposes. FHLB advances totaled $593.9 million at December 31, 2020, down by $547.6 million from the balance at the end of 2019. In 2020, Washington Trust began participating in the FRB’s PPPLF. PPPLF extends credit to depository institutions at a fixed interest rate of 0.35%. Only PPP loans can be pledged as collateral to access the facility. The maturity date of the PPPLF borrowings matches the maturity date of the pledged PPP loans. There were no PPPLF borrowings outstanding at December 31, 2020. Liquidity and Capital Resources Liquidity Management Liquidity is the ability of a financial institution to meet maturing liability obligations and customer loan demand. The Corporation’s primary source of liquidity is in-market deposits, which funded approximately 62% of total average assets in 2020. While the generally preferred funding strategy is to attract and retain low-cost deposits, the ability to do so is affected by competitive interest rates and terms in the marketplace. Other sources of funding include discretionary use of purchased liabilities (e.g., FHLB term advances and brokered time deposits), cash flows from the Corporation’s securities portfolios and loan repayments. Securities designated as available for sale may also be sold in response to short-term or long-term liquidity needs, although management has no intention to do so at this time. The Corporation has a detailed liquidity funding policy and a contingency funding plan that provide for the prompt and comprehensive response to unexpected demands for liquidity. Management employs stress testing methodology to estimate needs for contingent funding that could result from unexpected outflows of funds in excess of “business as -68- Management's Discussion and Analysis usual” cash flows. In management’s estimation, risks are concentrated in two major categories: (1) runoff of in-market deposit balances; and (2) unexpected drawdown of loan commitments. Of the two categories, potential runoff of deposit balances would have the most significant impact on contingent liquidity. Our stress test scenarios, therefore, emphasize attempts to quantify deposits at risk over selected time horizons. In addition to these unexpected outflow risks, several other “business as usual” factors enter into the calculation of the adequacy of contingent liquidity including: (1) payment proceeds from loans and investment securities; (2) maturing debt obligations; and (3) maturing time deposits. The Corporation has established collateralized borrowing capacity with the FRB and also maintains additional collateralized borrowing capacity with the FHLB in excess of levels used in the ordinary course of business. Borrowing capacity is impacted by the amount and type of assets available to be pledged. The table below presents unused funding capacity by source as of the dates indicated: (Dollars in thousands) December 31, 2020 2019 Additional Funding Capacity: Federal Home Loan Bank of Boston (1) $969,735 $534,990 Federal Reserve Bank of Boston (2) 20,678 24,686 Unencumbered investment securities 594,998 461,850 Total $1,585,411 $1,021,526 (1) As of December 31, 2020 and 2019, loans with a carrying value of $2.1 billion and $2.1 billion, respectively, and securities available for sale with a carrying value of $128.6 million and $271.4 million, respectively, were pledged to the FHLB resulting in this additional borrowing capacity. (2) As of December 31, 2020 and 2019, loans with a carrying value of $12.6 million and $16.6 million, respectively. and securities available for sale with a carrying value of $14.9 million and $17.0 million, respectively, were pledged to the FRB resulting in this additional unused borrowing capacity. In addition to the amounts presented above, the Bank also had access to a $40.0 million unused line of credit with the FHLB. The ALCO establishes and monitors internal liquidity measures to manage liquidity exposure. Liquidity remained within target ranges established by the ALCO during 2020. Based on its assessment of the liquidity considerations described above, management believes the Corporation’s sources of funding meet anticipated funding needs. Net cash provided by operating activities amounted to $36.5 million in 2020. Net income of $69.8 million was offset by mortgage banking related adjustments to reconcile net income to net cash used in operating activities. Net cash used in investing activities totaled $264.2 million in 2020, reflecting outflows to fund the increase in and purchases of loans, as well as purchases of debt securities. These outflows were partially offset by net inflows from maturities, calls and principal payments of securities. In 2020, net cash provided by financing activities amounted to $291.6 million, with net increases in deposits, partially offset by a net decrease in FHLB advances, the payment of dividends to shareholders and treasury stock purchases. See the Corporation’s Consolidated Statements of Cash Flows for further information about sources and uses of cash. Capital Resources Total shareholders’ equity amounted to $534.2 million at December 31, 2020, up by $30.7 million from December 31, 2019. This increase included net income of $69.8 million, partially offset by $35.8 million in dividend declarations. The Corporation declared dividends of $2.05 per share in 2020, representing an increase of 5 cents per share, or 3%, over last year. Changes in shareholders’ equity also included a net increase of $3.8 million in the AOCI component of shareholders’ equity. The net increase in AOCI reflected an increase in the fair value of available for sale debt securities, partially offset by a $3.9 million charge to AOCI associated with the annual remeasurement of pension plan liabilities. This charge was largely due to a decline in the discount rate used to measure the present value of pension plan liabilities as a result of a reduction in market interest rates in 2020. -69- Management's Discussion and Analysis Reductions to retained earnings of $6.1 million due to the adoption of ASC 326, as well as a net increase in treasury stock of $3.4 million were also included in changes in shareholders’ equity. The ratio of total equity to total assets amounted to 9.35% at December 31, 2020, compared to a ratio of 9.51% at December 31, 2019. Book value per share was $30.94 at December 31, 2020, compared to $29.00 at December 31, 2019. The Bancorp and the Bank are subject to various regulatory capital requirements and are considered “well capitalized,” with a total risk-based capital ratio of 13.51% at December 31, 2020, compared to 12.94% at December 31, 2019. See Note 13 to the Consolidated Financial Statements for additional discussion of regulatory capital requirements and the Corporation’s election of the option provided by regulatory guidance to delay the estimated impact of ASC 326 on regulatory capital. Contractual Obligations and Commitments The Corporation has entered into numerous contractual obligations and commitments. The following tables summarize our contractual cash obligations and other commitments at December 31, 2020: (Dollars in thousands) Payments Due by Period Total Less Than 1 Year (1) 1-3 Years 3-5 Years After 5 Years Contractual Obligations: FHLB advances (2) $593,859 $517,222 $1,669 $38,651 $36,317 Junior subordinated debentures 22,681 — — — 22,681 Operating leases 40,185 3,922 7,720 6,497 22,046 Third party application processing 24,277 6,183 10,828 7,162 104 Total contractual obligations $681,002 $527,327 $20,217 $52,310 $81,148 (1) Maturities or contractual obligations are considered by management in the administration of liquidity and are routinely refinanced in the ordinary course of business. (2) All FHLB advances are shown in the period corresponding to their scheduled maturity. See Note 12 to the Consolidated Financial Statements for additional information. (Dollars in thousands) Amount of Commitment Expiration – Per Period Total Less Than 1 Year 1-3 Years 3-5 Years After 5 Years Other Commitments: Commitments to extend credit $862,315 $297,403 $32,364 $103,085 $429,463 Standby letters of credit 11,709 11,317 392 — — Mortgage loan commitments (1) : Interest rate lock commitments 167,671 167,671 — — — Forward sale commitments 279,653 279,653 — — — Loan related derivative contracts (1) : Interest rate swaps with customers 991,002 10,583 194,283 220,199 565,937 Mirror swaps with counterparties 991,002 10,583 194,283 220,199 565,937 Risk participation-in agreements 92,717 — 9,370 20,130 63,217 Interest rate risk management contracts (1) : Interest rate swaps 60,000 40,000 20,000 — — Total commitments $3,456,069 $817,210 $450,692 $563,613 $1,624,554 (1) Amounts presented represent notional amounts. -70- Management's Discussion and Analysis Off-Balance Sheet Arrangements In the normal course of business, the Corporation engages in a variety of financial transactions that, in accordance with GAAP, are not recorded in the financial statements, or are recorded in amounts that differ from the notional amounts. Such transactions are used to meet the financing needs of its customers and to manage the exposure to fluctuations in interest rates. These financial transactions include commitments to extend credit, standby letters of credit, forward loan commitments, loan related derivative contracts and interest rate risk management contracts. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. The Corporation’s credit policies with respect to interest rate swap agreements with commercial borrowers, commitments to extend credit, and standby letters of credit are similar to those used for loans. Interest rate risk management contracts with other counterparties are generally subject to bilateral collateralization terms. For additional information on derivative financial instruments and financial instruments with off-balance sheet risk see Notes 14 and 22 to the Consolidated Financial Statements. Recently Issued Accounting Pronouncements See Note 2 to the Consolidated Financial Statements for details of recently issued accounting pronouncements and their expected impact on the Corporation’s financial statements. Asset/Liability Management and Interest Rate Risk Interest rate risk is the risk of loss to future earnings due to changes in interest rates. The ALCO is responsible for establishing policy guidelines on liquidity and acceptable exposure to interest rate risk. Periodically, the ALCO reports on the status of liquidity and interest rate risk matters to the Bank’s Board of Directors. The objective of the ALCO is to manage assets and funding sources to produce results that are consistent with the Corporation’s liquidity, capital adequacy, growth, risk and profitability goals. The Corporation utilizes the size and duration of the investment securities portfolio, the size and duration of the wholesale funding portfolio, off-balance sheet interest rate contracts and the pricing and structure of loans and deposits, to manage interest rate risk. The off-balance sheet interest rate contracts may include interest rate swaps, caps and floors. These interest rate contracts involve, to varying degrees, credit risk and interest rate risk. Credit risk is the possibility that a loss may occur if a counterparty to a transaction fails to perform according to terms of the contract. The notional amount of the interest rate contracts is the amount upon which interest and other payments are based. The notional amount is not exchanged, and therefore, should not be taken as a measure of credit risk. See Notes 14 and 22 to the Consolidated Financial Statements for additional information. The ALCO uses income simulation to measure interest rate risk inherent in the Corporation’s on-balance sheet and off-balance sheet financial instruments at a given point in time by showing the effect of interest rate shifts on net interest income over a 12-month horizon, a 13- to 24-month horizon and a 60-month horizon. The simulations assume that the size and general composition of the Corporation’s balance sheet remain static over the simulation horizons, with the exception of certain deposit mix shifts from low-cost core savings to higher-cost time deposits in selected interest rate scenarios. Additionally, the simulations take into account the specific repricing, maturity, call options, and prepayment characteristics of differing financial instruments that may vary under different interest rate scenarios. The characteristics of financial instrument classes are reviewed periodically by the ALCO to ensure their accuracy and consistency. The ALCO reviews simulation results to determine whether the Corporation’s exposure to a decline in net interest income remains within established tolerance levels over the simulation horizons and to develop appropriate strategies to manage this exposure. As of December 31, 2020 and 2019, net interest income simulations indicated that exposure to changing interest rates over the simulation horizons remained within tolerance levels established by the Corporation. All changes are measured in comparison to the projected net interest income that would result from an “unchanged” rate scenario where both interest rates and the composition of the Corporation’s balance sheet remain stable for a 60-month period. In addition to measuring the change in net interest income as compared to an unchanged rate scenario, the ALCO also measures the trend of both net interest income and net interest margin over a 60-month horizon to ensure the stability and adequacy of this source of earnings in different interest rate scenarios. -71- Management's Discussion and Analysis The ALCO regularly reviews a wide variety of interest rate shift scenario results to evaluate interest rate risk exposure, including scenarios showing the effect of steepening or flattening changes in the yield curve of up to 500 basis points, as well as parallel changes in interest rates of up to 400 basis points. Because income simulations assume that the Corporation’s balance sheet will remain static over the simulation horizon, the results do not reflect adjustments in strategy that the ALCO could implement in response to rate shifts. The following table sets forth the estimated change in net interest income from an unchanged rate scenario over the periods indicated for parallel changes in market interest rates using the Corporation’s on- and off-balance sheet financial instruments as of December 31, 2020 and 2019. Interest rates are assumed to shift by a parallel 100, 200 or 300 basis points upward or 100 basis points downward over a 12-month period, except for core savings deposits, which are assumed to shift by lesser amounts due to their relative historical insensitivity to market interest rate movements. Further, deposits are assumed to have certain minimum rate levels below which they will not fall. It should be noted that the rate scenarios shown do not necessarily reflect the ALCO’s view of the “most likely” change in interest rates over the periods indicated. December 31, 2020 December 31, 2019 Months 1 - 12 Months 13 - 24 Months 1 - 12 Months 13 - 24 100 basis point rate decrease (2.05%) (4.73%) (3.71%) (5.57%) 100 basis point rate increase 5.56 7.89 2.88 1.02 200 basis point rate increase 11.00 15.05 6.60 3.37 300 basis point rate increase 16.47 21.15 10.35 5.53 The ALCO estimates that the negative exposure of net interest income to falling rates as compared to an unchanged rate scenario results from a more rapid decline in earning asset yields compared to rates paid on deposits. If market interest rates were to fall and remain lower for a sustained period, certain core savings and time deposit rates could decline more slowly and by a lesser amount than other market interest rates. Asset yields would likely decline more rapidly than deposit costs as current asset holdings mature or reprice, since cash flow from mortgage-related prepayments and redemption of callable securities would increase as market interest rates fall. The overall positive exposure of net interest income to rising rates as compared to an unchanged rate scenario results from a more rapid projected relative rate of increase in asset yields than funding costs over the near term. For simulation purposes, deposit rate changes are anticipated to lag behind other market interest rates in both timing and magnitude. The ALCO’s estimate of interest rate risk exposure to rising rate environments, including those involving changes to the shape of the yield curve, incorporates certain assumptions regarding the shift in deposit balances from low-cost core savings categories to higher-cost deposit categories, which has characterized a shift in funding mix during the past rising interest rate cycles. The relative change in interest rate sensitivity for declining rates from December 31, 2019 as shown in the above table was attributable to a lower absolute level of market interest rates with certain rates and yields reaching floors or zero in declining rate scenarios. The relative increase in interest rate sensitivity for rising rates from December 31, 2019 was attributable to a relative increase in the proportion of low-cost core deposits to total sources of funds. Interest rate risk modeling assumes that core deposits reprice more slowly and by a lesser amount than the repricing of wholesale funding in response to changes in market interest rates. While the ALCO reviews and updates simulation assumptions and also periodically back-tests the simulation results to ensure that the assumptions are reasonable and current, income simulation may not always prove to be an accurate indicator of interest rate risk or future net interest margin. Over time, the repricing, maturity and prepayment characteristics of financial instruments and the composition of the Corporation’s balance sheet may change to a different degree than estimated. Simulation modeling assumes a static balance sheet, with the exception of certain modeled deposit mix shifts from low-cost core savings deposits to higher-cost time deposits in rising rate scenarios as noted above. As market interest rates have declined, the banking industry has attracted low-cost core savings deposits. The ALCO recognizes that a portion of these increased levels of low-cost balances could shift into higher yielding alternatives in -72- Management's Discussion and Analysis the future, particularly if interest rates rise and as confidence in financial markets strengthens, and has modeled deposit shifts out of these low-cost categories into higher-cost alternatives in the rising rate simulation scenarios presented above. Deposit balances may also be subject to possible outflow to non-bank alternatives in a rising rate environment, which may cause interest rate sensitivity to differ from the results as presented. Another significant simulation assumption is the sensitivity of core savings deposits to fluctuations in interest rates. Income simulation results assume that changes in both core savings deposit rates and balances are related to changes in short-term interest rates. The relationship between short-term interest rate changes and core deposit rate and balance changes may differ from the ALCO’s estimates used in income simulation. It should also be noted that the static balance sheet assumption does not necessarily reflect the Corporation’s expectation for future balance sheet growth, which is a function of the business environment and customer behavior. Mortgage-backed securities and residential real estate loans involve a level of risk that unforeseen changes in prepayment speeds may cause related cash flows to vary significantly in differing rate environments. Such changes could affect the level of reinvestment risk associated with cash flow from these instruments, as well as their market value. Changes in prepayment speeds could also increase or decrease the amortization of premium or accretion of discounts related to such instruments, thereby affecting interest income. The Corporation also monitors the potential change in market value of its available for sale debt securities in changing interest rate environments. The purpose is to determine market value exposure that may not be captured by income simulation, but which might result in changes to the Corporation’s capital position. Results are calculated using industry-standard analytical techniques and securities data. The following table summarizes the potential change in market value of the Corporation’s available for sale debt securities of December 31, 2020 and 2019 resulting from immediate parallel rate shifts: (Dollars in thousands) Security Type Down 100 Basis Points Up 200 Basis Points Obligations of U.S. government-sponsored enterprise securities (callable) $1,090 ($10,497) Mortgage-backed securities issued by U.S. government agencies and U.S. government-sponsored enterprises 12,490 (59,220) Trust preferred debt and other corporate debt securities (99) 179 Total change in market value as of December 31, 2020 $13,481 ($69,538) Total change in market value as of December 31, 2019 $17,741 ($81,705) ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk. Information regarding quantitative and qualitative disclosures about market risk appears under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” under the caption “Asset/Liability Management and Interest Rate Risk.” -73-