Old Second Bancorp Inc: Form 10-Q for the period ended Sep 30, 2023

Overview

The following discussion provides additional information regarding our operations for the three and nine months ended September 30, 2023, compared to the three and nine months ended September 30, 2022, and our financial condition at September 30, 2023, compared to December 31, 2022. This discussion should be read in conjunction with our consolidated financial statements as well as the financial and statistical data appearing elsewhere in this report and our Form 10-K for the year ended December 31, 2022. The results of operations for the three and nine months ended September 30, 2023, are not necessarily indicative of future results. Dollar amounts presented in the following tables are in thousands, except per share data, and September 30, 2023 and 2022 amounts are unaudited.

In this report, unless the context suggests otherwise, references to the “Company,” “we,” “us,” and “our” mean the combined business of Old Second Bancorp, Inc. and its subsidiary bank, Old Second National Bank (the “Bank”).

We have made, and will continue to make, various forward-looking statements with respect to financial and business matters. Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forward-looking statements. For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” on page 3 of this report.

Business Overview

The Company is a bank holding company headquartered in Aurora, Illinois. Through our wholly-owned subsidiary bank, Old Second National Bank, a national banking organization also headquartered in Aurora, Illinois, we offer a wide range of financial services through our 48 banking centers located in Cook, DeKalb, DuPage, Kane, Kendall, LaSalle and Will counties in Illinois. These banking centers offer access to a full range of traditional retail and commercial banking services including treasury management operations as well as fiduciary and wealth management services. We focus our business on establishing and maintaining relationships with our clients while maintaining a commitment to provide for the financial services needs of the communities in which we operate. We emphasize relationships with individual customers as well as small to medium-sized businesses throughout our market area. We also have extensive wealth management services, which includes a registered investment advisory platform in addition to trust administration and trust services related to personal and corporate trusts and employee benefit plan administration services.

Our results of operations depend generally on net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. Net interest income is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. In addition, we are subject to interest rate risk to the degree that our interest-earning assets mature or reprice at different times, or at different speeds, than our interest-bearing liabilities. Our results of operations are also affected by noninterest income, such as service charges, wealth management fees, loan fees, gains from the sale of newly originated loans, gains or losses on investments and certain other noninterest related items. Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, professional fees, data processing expenses and provision for credit losses.

We are significantly impacted by prevailing economic conditions, including federal monetary and fiscal policies, and federal regulations of financial institutions. Deposit balances are influenced by numerous factors such as competing investments, the level of income and the personal rate of savings within our market areas. Factors influencing lending activities include the demand for housing and the interest rate pricing competition from other lending institutions.

As of September 30, 2023, all of our capital ratios were in excess of all regulatory requirements. While we believe that we have sufficient capital to withstand an extended economic recession, our reported and regulatory capital ratios could be adversely impacted by credit losses.

Merger with West Suburban Bancorp, Inc.

On December 1, 2021, we completed our merger with West Suburban Bancorp, Inc. (“West Suburban”), the holding company for West Suburban Bank. Under the terms of the merger agreement, each share of West Suburban common stock was converted into 42.413 shares of our common stock and $271.15 in cash. Total cash and stock consideration paid was approximately $295.2 million. With the acquisition of West Suburban, we acquired 34 branches in DuPage, Kane, Kendall and Will counties in Illinois. The transaction is discussed in more detail in Note 2 to our Consolidated Financial Statements included in this report and in Note 2 of our Annual Report in Form 10-K.

Recent Banking Events

There were three significant bank failures in the first five months of 2023, primarily due to the failed banks’ lack of liquidity as depositors sought to withdraw their deposits. Due to rising interest rates, the failed banks were unable to sell investment securities held to meet liquidity needs without realizing substantial losses. As a result of the bank closures during 2023 and in an effort to strengthen public confidence in the banking system and protect depositors, regulators announced that any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law, which could increase the cost of our FDIC insurance assessment. Additionally, the Federal Reserve announced the creation of a new Bank Term Funding Program in an effort to minimize the need for banks to sell securities at a loss in times of stress. We have access but have not received or requested funds from this Program and, though we do have access to the Federal Reserve Discount Window, we have not accessed these funds and have an unused capacity of $18.7 million at September 30, 2023. The future impact of these failures on the economy, financial institutions and their depositors, as well as any governmental regulatory responses or actions resulting from the same, is difficult to predict at this time.

Financial Overview

Net income for the third quarter of 2023 was $24.3 million, or $0.54 per diluted share, compared to $19.5 million, or $0.43 per diluted share, for the third quarter of 2022. The increase was primarily due to growth in our loan portfolio and higher loan and security yields, partially offset by increased funding costs and increased other short-term borrowing, which resulted in growth in net interest income. Noninterest income decreased in the third quarter of 2023, compared to the like quarter of 2022, as a result of net losses on security sales and a reduction in mortgage banking revenues. An increase was also noted in noninterest expense for the current quarter, primarily due to higher salaries and employee benefits and $629,000 of liquidation and deconversion costs incurred in the third quarter of 2023 related to the 2022 sale of our Visa credit card portfolio. Also contributing to the increase in net income in the third quarter of 2023, compared to the third quarter of 2022, were acquisition costs, net of gains on branch sales, of $2.0 million incurred in the prior year like quarter, compared to no acquisition related costs or branch sales in the third quarter of 2023. Adjusted net income, a non-GAAP financial measure that excludes Visa portfolio and land trust portfolio gains on sale, Visa portfolio liquidation and deconversion costs, and any merger related costs, as applicable, was $24.8 million for the third quarter of 2023, compared to $25.6 million for the second quarter of 2023, and $19.6 million for the third quarter of 2022. Adjusted net income was $73.8 million for the nine months ended September 30, 2023, compared to $49.4 million for the nine months ended September 30, 2022. See the discussion entitled “Non-GAAP Financial Measures” on page 40, as well as the table below, which provides a reconciliation of this non-GAAP measure to the most comparable GAAP equivalents.

The following provides an overview of some of the factors impacting our financial performance for the three month period ended September 30, 2023, compared to the like period ended September 30, 2022:

• Net interest and dividend income was $63.0 million for the third quarter of 2023, compared to $55.6 million for the third quarter of 2022. Growth in interest and dividend income in the third quarter of 2023 was primarily due to loan growth and higher yields on loans, partially offset by higher funding and borrowing costs, as well as increased other short-term borrowings.
• We recorded a net provision for credit losses of $3.0 million in the third quarter of 2023, driven by a $3.0 million increase in the allowance for credit losses on loans based on increased historical loss rates, loan growth, our assessment of nonperforming loan metrics and trends, and estimated future credit losses, net of a reversal of $12,000 in our allowance for unfunded commitments based on an adjustment of historical benchmark assumptions, such as funding rates and the period used to forecast those rates, within the ACL calculation. We recorded a net provision for credit loss of $4.5 million in the third quarter of 2022.
• Noninterest income was $9.9 million for the third quarter of 2023, compared to $11.5 million for the third quarter of 2022. Contributing to the decrease were security losses of $924,000 due to strategic sales in the third quarter of 2023, compared to losses on the call of securities of $1,000 in the third quarter of 2022. Also contributing to the reduction in noninterest income was a $1.1 million decrease in other income, primarily due to the gain on sale of both our Visa credit card portfolio and the land trust portfolio in 2022. These decreases were partially offset by an increase of $195,000 in wealth management income and a $773,000 increase in the cash surrender value of BOLI.
• Noninterest expense was $37.4 million for the third quarter of 2023, compared to $36.0 million for the third quarter of 2022, an increase of $1.4 million, or 4.0%. Contributing to the increase in noninterest expense in the third quarter of 2023 was higher salaries and employee benefits, as well as $629,000 of net liquidation and deconversion costs from the 2022 sale of our Visa credit card portfolio. Partially offsetting the increase in noninterest expense was a reduction of occupancy, furniture and equipment and computer and data processing expenses, primarily from acquisition costs, net of gains on branch sales, incurred in the third quarter of 2022 stemming from our West Suburban acquisition in the fourth quarter of 2021.
• We had a provision for income tax expense of $8.1 million for the third quarter of 2023, compared to a provision for income tax expense of $7.1 million for the third quarter of 2022. The effective tax rate for these two periods was 25.1% and 26.5%, respectively.
• Our community-focused banking franchise experienced growth of $159.9 million in total loans in the first nine months of 2023, compared to the year ended December 31, 2022, and an increase of $160.2 million in total loans compared to the third quarter of 2022. We believe we are positioned for continued loan growth, though likely at a slower pace, as we continue to serve our customers’ needs in a competitive economic environment. We continue to seek to provide value to our customers and the communities in which we operate, by executing on growth opportunities in our local markets and developing new banking relationships, while seeking to ensure the safety and soundness of our Bank, our customers, and our employees.
• Nonaccrual loans increased $30.5 million as of September 30, 2023, compared to December 31, 2022, primarily due to a few larger credits that moved from substandard accrual to nonaccrual in the first nine months of 2023. There were additions of two office buildings and one health care facility credit as of March 31, 2023, and additions of one medical office development and one office building as of September 30, 2023. The additions are partially offset by three charge offs totaling $6.8 million, recorded in the third quarter of 2023. Nonperforming loans as a percent of total loans was 1.6% as of September 30, 2023, compared to 0.9% as of December 31, 2022, and 1.4% as of September 30, 2022. Classified assets increased to $153.7 million as of September 30, 2023, which is $43.2 million, or 39.1% more than December 31, 2022, and $38.4 million, or 33.3%, more than September 30, 2022.

Critical Accounting Estimates

Our consolidated financial statements are prepared based on the application of accounting policies in accordance with generally accepted accounting principles (“GAAP”) and follow general practices within the banking industry. These policies require the reliance on estimates and assumptions, which may prove inaccurate or are subject to variations. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements. Changes in underlying factors, assumptions, or estimates could have a material impact on our future financial condition and results of operations.

Of the significant accounting policies used in the preparation of our consolidated financial statements, we have identified certain items as critical accounting policies based on the associated estimates, assumptions, judgments and complexity. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Estimates” in our Annual Report on Form 10-K for the year ended December 31, 2022. There have been no material changes to our critical accounting policies or the estimates made pursuant to those policies during the most recent quarter from those disclosed in our 2022 Annual Report in Form 10-K.

Non-GAAP Financial Measures

This report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the presentation of net interest income and net interest margin on a tax equivalent (“TE”) basis, adjusted net income, adjusted basic and diluted earnings per share, our adjusted efficiency ratio, and our tangible common equity to tangible assets ratio. Management believes that the presentation of these non-GAAP financial measures (a) provides important supplemental information that contributes to a proper understanding of our operating performance, (b) enables a more complete understanding of factors and trends affecting our business, and (c) allows investors to evaluate our performance in a manner similar to management, the financial services industry, bank stock analysts, and bank regulators. Management uses non-GAAP measures as follows: in the preparation of our operating budgets, monthly financial performance reporting, and in our presentation of our performance to investors. However, we acknowledge that these non-GAAP financial measures have a number of limitations. Limitations associated with non-GAAP financial measures include the risk that persons might disagree as to the appropriateness of items comprising these measures and that different companies might calculate these measures differently. These measures should not be considered an alternative to our GAAP results. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measures is presented below or alongside the first instance where each non-GAAP financial measure is used.

Results of Operations

Overview

Three months ended September 30, 2023 and 2022

Our income before taxes was $32.5 million in the third quarter of 2023 compared to $26.6 million in the third quarter of 2022. This increase in pretax income was primarily due to a $7.5 million increase in net interest and dividend income, and a $1.5 million decrease in provision for credit losses. Income before taxes was negatively impacted by a $1.6 million decrease in noninterest income, primarily due to $924,000 of security losses and a $1.1 million decrease in other income in the third quarter of 2023, as well as a $1.4 million increase in noninterest expense. Our net income was $24.3 million, or $0.54 per diluted share, for the third quarter of 2023, compared to net income of $19.5 million, or $0.43 per diluted share, for the third quarter of 2022. The Bank remains well positioned to navigate uncertain macroeconomics; we have mitigated interest rate risk, controlled expenses in an inflationary environment, and actively managed daily liquidity. Furthermore, we continue to possess strong liquidity metrics and an outsized securities portfolio for funding needs.

Net interest and dividend income was $63.0 million in the third quarter of 2023, compared to $55.6 million in the third quarter of 2022. The $7.4 million increase was primarily driven by significant growth in our loan portfolio as well as the effect of higher market interest rates on our loan portfolios. Higher interest income was partially offset by an increase in interest expense in the third quarter of 2023, compared to the third quarter of 2022, primarily due to a rise in deposit interest rates, and an increase in other short-term borrowing expense due to additional FHLB advances. As of June 30, 2023, we redeemed the $45.0 million senior debt issuance that was due in 2026, which resulted in no senior debt interest expense recorded for the third quarter of 2023.

Nine months ended September 30, 2023 and 2022

Our income before taxes was $99.5 million for the nine months ended September 30, 2023 compared to $59.7 million for the nine months ended September 30, 2022. This increase in pretax income was primarily due to a $48.6 million increase in net interest and dividend income and a $3.3 million decrease in noninterest expenses. These changes were partially offset by a $3.5 million increase in provision for credit losses, and a $8.7 million decrease in noninterest income, mainly due to $4.1 million of security losses recorded in the first nine months of 2023 and a $4.5 million decrease in mortgage banking revenues. Our net income was $73.5 million, or $1.62 per diluted share, for the nine months ended September 30, 2023, compared to net income of $43.8 million, or $0.97 per diluted share, for the same period of 2022.

Net interest and dividend income was $190.7 million for the nine months ended September 30, 2023, compared to $142.1 million for the same period of 2022. The $48.6 million increase was primarily driven by significant growth in our loan portfolio as well as the effect of higher market interest rates on our loan and securities portfolios. Higher interest and dividend income was partially offset by an increase in interest expense in the first nine months of 2023, compared to the first nine months of 2022, primarily due to a rise in deposit interest rates, an increase in other short-term borrowing expense due to FHLB advances, and an increase in the rate paid on our senior notes. The senior notes redeemed on June 30, 2023 had an effective cost of 10.95% for the nine months ending September 30, 2023.

Net Interest Income

Net interest income, which is our primary source of earnings, is the difference between interest income earned on interest-earning assets, such as loans and investment securities, as well as accretion income on purchased loans, and interest incurred on interest-bearing liabilities, such as deposits and borrowings. Net interest income depends upon the relative mix of interest-earning assets and interest-bearing liabilities, the ratio of interest-earning assets to total assets and of interest-bearing liabilities to total funding sources, and movements in market interest rates. Our net interest income can be significantly influenced by a variety of factors, including overall loan demand, economic conditions, credit risk, the amount of nonearning assets including nonperforming loans and OREO, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities, early withdrawal of deposits, exercise of call options on borrowings or securities, a general rise or decline in interest rates, changes in the slope of the yield-curve, and balance sheet growth or contraction.

Three months ended September 30, 2023 and 2022

The increased yield of 10 basis points on interest earning assets compared to the linked period was driven by higher yields on loan originations than those in the previous period as well as repricing within the existing variable rate portfolios for securities available-for-sale and loans. Changes in the market interest rate environment impact earning assets at varying intervals depending on the repricing timeline of loans, as well as the securities maturity, paydown and purchase activities.

The year over year increase of 136 basis points on interest earning assets was driven by significant increases to benchmark interest rates as well as strong loan growth throughout the period, specifically within the leases, commercial real estate and multifamily portfolios, as these loan segments generally produce the greatest yield. The increases in benchmark interest rates impacted yields on the securities portfolio through the inverse relationship between interest rates and market value coupled with maturities and strategic sales of lower yielding assets, as we work to increase the weighted average yield in the portfolio.

Average balances of interest-bearing deposit accounts have decreased steadily since the third quarter of 2022 through the third quarter of 2023, from $3.23 billion to $2.79 billion, with decreases reflected in all deposit categories excluding time deposits. We have continued to control the cost of funds over the periods reflected, with the rate of overall interest-bearing deposits increasing to 65 basis points for the quarter ended September 30, 2023, from 40 basis points for the quarter ended June 30, 2023, and from nine basis points for the quarter ended September 30, 2022. A 32 basis point increase in the cost of money market funds for the quarter ended September 30, 2023 compared to prior linked quarter, and a 91 basis point increase compared to the prior year like quarter were both due to select deposit account exception pricing, and drove a significant portion of the overall increase. Average rates paid on time deposits for the quarter ended September 30, 2023 increased by 63 basis points and 140 basis points in the quarter over linked quarter and year over year quarters, respectively, primarily due to CD rate specials we offered.

Borrowing costs decreased in the third quarter of 2023 compared to the second quarter of 2023, primarily due to the redemption of the senior notes as of June 30, 2023, partially offset by an increase in average short-term borrowings of $24.6 million stemming from increased average FHLB advances over the prior quarter. The increase of $421.7 million year over year of average FHLB advances was based on daily liquidity needs. Subordinated and junior subordinated debt interest expense were essentially flat over each of the periods presented. We redeemed all of the $45.0 million senior notes, net of deferred issuance costs, on June 30, 2023, resulting in senior notes having no balance or related interest expense in the third quarter of 2023. In February 2023, we paid off the remaining balance of $9.0 million on the original $20.0 million term note issued in 2020, resulting in notes payable and other borrowings having no balance after that time.

Our net interest margin (GAAP) increased three basis points to 4.64% for the third quarter of 2023 compared to 4.61% for the second quarter of 2023, and increased 71 basis points compared to 3.93% for the third quarter of 2022. Our net interest margin (TE) increased two basis points to 4.66% for the third quarter of 2023, compared to 4.64% for the second quarter of 2023, and increased 70 basis points compared to 3.96% for the third quarter of 2022. The increase in the current quarter, compared to the prior quarter, is primarily due to the growth in loan interest income due to the rising interest rate environment, and a decrease in borrowing interest expense due to the redemption of the senior notes in June 2023. The increase in the current quarter, compared to the prior year like quarter, is primarily due to an increase in market interest rates, and the related rate resets on loans and securities during the past year, as well as continuing loan growth relative to a more modest increase in costs of interest-bearing liabilities. See the discussion entitled “Non-GAAP Financial Measures” and the tables on page 45 that provide a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent.

Nine months ended September 30, 2023 and 2022

The year over year increase of 187 basis points on interest earning assets was driven by significant increases to benchmark interest rates as well as strong loan growth throughout the period, specifically within the leases, commercial real estate-investor, construction and multi-family portfolios. The increases in benchmark interest rates impacted yields on the securities portfolio through the inverse relationship between interest rates and market value coupled with maturities and strategic sales of lower yielding assets and timely purchase of higher yielding securities as we work to increase the weighted average yield in the portfolio. Average securities available-for-sale decreased $367.0 million for the nine months ended September 30, 2023, compared to the nine months ended September 30, 2022, due to paydowns, changes in market value, and strategic sales. Due to market interest rate increases year over year, securities available-for-sale interest income was $34.7 million for the nine months ended September 30, 2023, compared to $26.1 million for the like 2022 period, reflecting an increase in yield of 134 basis points. Average loans, including loans held for sale, increased $438.0 million in the nine months ended September 30, 2023, compared to the nine months ended September 30, 2022, primarily driven by the growth in leases, commercial real estate-investor, construction, and multi-family portfolios. Growth in the loan portfolio, as well as the rising interest rate environment, resulted in $181.5 million of loan interest income in the nine months ended September 30, 2023, compared to $121.3 million in the like 2022 period, reflecting an increase in yield of 152 basis points.

Average balances of interest-bearing deposit accounts have decreased steadily since September 30, 2022 through the nine months ended September 30, 2023, from $3.32 billion to $2.89 billion, with such decreases reflected in all categories. We have continued to control the cost of funds over the periods reflected, with the rate of overall interest-bearing deposits increasing by 35 basis points to 43 basis points from eight basis points as of September 30, 2022. A 61 basis point increase in the cost of money market funds as of September 30, 2023, compared to September 30, 2022, was due to select deposit account exception pricing and drove a significant portion of the overall increase. Interest expense paid on time deposits also contributed to the increased cost of deposits year over year, as the cost of average time deposits increased 89 basis points to 114 basis points for the nine months ended September 30, 2023, compared to 25 basis points for the nine months ended September 30, 2022, primarily due to CD rate specials we offered.

Borrowing costs increased in the nine months ended September 30, 2023 primarily due to the increase in short term borrowings from higher average FHLB advance growth of $342.5 million since the nine months ended September 30, 2022, based on daily liquidity needs. Subordinated and junior subordinated debt interest expense remained flat over the periods presented. Senior notes interest expense had the most significant interest expense increase, as this issuance referenced three-month LIBOR, and rising market interest rates resulted in a 557 basis point increase to 10.95%, from 5.38% for the nine months ended September 30, 2022. We redeemed these notes on June 30, 2023, which contributed to the significant basis point increase due to the $362,000 in deferred issuance costs that were recognized as interest expense due to the early redemption. In the first quarter of 2023, we paid off the remaining balance of $9.0 million on the original $20.0 million term note issued in 2020, recorded within notes payable and other borrowings.

Our net interest margin (GAAP) increased 135 basis points to 4.66% for the nine months ended September 30, 2023, compared to 3.31% for the nine months ended September 30, 2022. Our net interest margin (TE) increased 135 basis points to 4.68% for the nine months ended September 30, 2023, compared to 3.33% for the nine months ended September 30, 2022. The increase in the current period, compared to the prior year like period, is primarily due to an increase in market interest rates, and the related rate resets on loans and securities during the past year, as well as continuing loan growth relative to a more modest increase in the cost of interest-bearing liabilities.

We continue to observe competitive pressure to maintain reduced interest rates on loans retained at renewal. While our loan prices are targeted to achieve certain returns on equity, significant competition for commercial and industrial loans as well as commercial real estate loans has put pressure on loan yields, and our stringent underwriting standards limit our ability to make higher-yielding loans.

The following tables set forth certain information relating to our average consolidated balance sheets and reflect the yield on average earning assets and cost of average interest-bearing liabilities for the periods indicated. These yields reflect the related interest, on an annualized basis, divided by the average balance of assets or liabilities over the applicable period. Average balances are derived from daily balances. For purposes of discussion, net interest income and net interest income to total earning assets in the following tables have been adjusted to a non-GAAP TE basis using a marginal rate of 21% in 2023 and 2022 to compare returns more appropriately on tax-exempt loans and securities to other earning assets.

Analysis of Average Balances,

Tax Equivalent Income / Expense and Rates

(Dollars in thousands - unaudited)

​

1 Represents a non-GAAP financial measure. See the discussion entitled “Reconciliation of Tax-Equivalent Non-GAAP Financial Measures” below that provides a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent. Tax equivalent basis is calculated using a marginal tax rate of 21% in 2023 and 2022.

2 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 45, and includes loan fee expense of $780,000 for the third quarter of 2023, $242,000 for the second quarter of 2023, and $750,000 of loan fee income for the third quarter of 2022. Nonaccrual loans are included in the above-stated average balances.

Analysis of Average Balances,

Tax Equivalent Income / Expense and Rates

(Dollars in thousands - unaudited)

1 Represents a non-GAAP financial measure. See the discussion entitled “Reconciliation of Tax-Equivalent Non-GAAP Financial Measures” below that provides a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent. Tax equivalent basis is calculated using a marginal tax rate of 21% in 2023 and 2022.

2 Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, as discussed in the table on page 45, and includes fee expense of $1.8 million and $2.1 million for the nine months ended September 30, 2023 and 2022, respectively. Nonaccrual loans are included in the above-stated average balances.

Reconciliation of Tax-Equivalent Non-GAAP Financial Measures

Net interest and dividend income (TE) and net interest income (TE) to average interest earning assets are non-GAAP measures that have been adjusted on a TE basis using a marginal rate of 21% for 2023 and 2022 to compare returns more appropriately on tax-exempt loans and securities to other earning assets. The table below provides a reconciliation of each non-GAAP (TE) measure to the GAAP equivalent for the periods indicated:

Noninterest Income

Three months ended September 30, 2023 and 2022

The following table details the major components of noninterest income for the periods presented:

(Dollars in thousands)

N/M - Not meaningful

Noninterest income increased $1.7 million, or 20.1%, in the third quarter of 2023, compared to the second quarter of 2023, and decreased $1.6 million, or 14.1%, compared to the third quarter of 2022. The increase from the second quarter of 2023 was primarily driven by a $204,000 increase in residential mortgage banking revenue, a $623,000 decrease in securities losses, net, based on strategic sales, a $501,000 increase in the cash surrender value of BOLI, and a $251,000 increase in other income primarily due to contract incentives achieved on brokerage activities, as well as various recoveries on prior year sold mortgage claims.

The decrease in noninterest income of $1.6 million in the third quarter of 2023, compared to the third quarter of 2022, is primarily due to an increase in security losses, net, of $923,000 on strategic sales for the quarter ended September 30, 2023, a decrease of $267,000 on mortgage servicing rights mark to market gains, and a $1.1 million decrease in other income due to a $743,000 pretax gain on a Visa credit card portfolio sale and a $180,000 pretax gain on the sale of a land trust portfolio recorded in the third quarter of 2022. These decreases were partially offset by a $773,000 increase in the cash surrender value of BOLI due to market interest rate changes.

Nine months ended September 30, 2023 and 2022

(Dollars in thousands)

N/M - Not meaningful

Noninterest income decreased $8.7 million, or 25.5%, for the nine months ended September 30, 2023 compared to the nine months ended September 30, 2022. This decrease was primarily driven by a $4.5 million decline in mortgage banking revenue, comprised mostly of a $3.8 million decrease in MSRs mark to market gains and a $571,000 decrease in net gain on sales of mortgage loans. In addition, the current nine month period decreased due to a $4.1 million increase in net losses on the sale of securities for the year over year period. Partially offsetting these decreases was a $227,000 increase in service charges on deposits and a $1.2 million increase in the cash surrender value of BOLI.

Noninterest Expense

Three months ended September 30, 2023 and 2022

The following table details the major components of noninterest expense for the periods presented:

(Dollars in thousands)

1 The efficiency ratio shown in the table above is a GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits and OREO expenses, divided by the sum of net interest income and total noninterest income less net gains or losses on securities, and mark to market gains or losses on MSRs.

2 The adjusted efficiency ratio shown in the table above is a non-GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits, OREO expenses, and acquisition-related costs, net of gains on branch sales, Visa credit card portfolio liquidation and related deconversion costs, as well as any merger related costs, if applicable, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains or losses on securities, mark to market gains or losses on MSRs, gain on the sale of our Visa credit card and land trust portfolios, and includes a tax equivalent adjustment on the change in cash surrender value of BOLI. See the discussion entitled “Non-GAAP Financial Measures” above and the table on page 49 that provides a reconciliation of this non-GAAP financial measure to the most comparable GAAP equivalent.

Noninterest expense for the third quarter of 2023 increased $2.6 million, or 7.4%, compared to the second quarter of 2023, and increased $1.4 million, or 4.0%, compared to the third quarter of 2022. The increase in the third quarter of 2023 compared to the second quarter of 2023 was attributable to a $1.3 million increase in salaries and employee benefits, primarily due to an increase in salaries and the officer incentive accrual. Also contributing to the increase in the third quarter of 2023 was a $632,000 increase in computer and data processing costs as the second quarter reflects software contract incentives, and a $787,000 increase in other expenses primarily due to $629,000 of liquidation costs recorded from the September 2023 Visa credit card portfolio deconversion, which was sold in the third quarter of 2022 and we continued to service through the third quarter of 2023. Partially offsetting the increase in noninterest expense in the third quarter of 2023 was a $186,000 decrease in legal fees, as the second quarter of 2023 experienced higher legal costs due to senior debt redemption, the proxy filing, and benefit plan reviews.

The year over year increase in noninterest expense is primarily attributable to a $2.1 million increase in salaries and employee benefits, primarily due to an increase in salaries due to higher wage rates and an increase in full-time equivalent employees in the current year. Also contributing to the increase was a $765,000 growth in other expense, which was primarily due to $629,000 of liquidation and deconversion costs recorded on the Visa credit card portfolio liquidation in the third quarter of 2023. Partially offsetting the increase in noninterest expense in the third quarter of 2023, compared to the third quarter of 2022, was a $613,000 decrease in furniture and equipment expenses, a $621,000 decrease in computer and data processing expenses, and a $115,000 decrease in legal fees, all stemming from acquisition related costs that were recorded in the third quarter of 2022.

Nine months ended September 30, 2023 and 2022

(Dollars in thousands)

1 The efficiency ratio shown in the table above is a GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits and OREO expenses, divided by the sum of net interest income and total noninterest income less net gains or losses on securities, and mark to market gains or losses on MSRs.

2 The adjusted efficiency ratio shown in the table above is a non-GAAP financial measure calculated as noninterest expense, excluding amortization of core deposits, OREO expenses, and acquisition-related costs, net of gains on branch sales, Visa credit card portfolio liquidation and related deconversion costs, as well as any merger related costs, if applicable, divided by the sum of net interest income on a fully tax equivalent basis, total noninterest income less net gains or losses on securities, mark to market gains or losses on MSRs, gain on the sale of our Visa credit card and land trust portfolios, and includes a tax equivalent adjustment on the change in cash surrender value of BOLI. See the discussion entitled “Non-GAAP Financial Measures” above and the table on page 49 that provides a reconciliation of this non-GAAP financial measure to the most comparable GAAP equivalent.

Noninterest expense for the nine months ended September 30, 2023, decreased $3.3 million, or 3.0%, compared to the nine months ended September 30, 2022, primarily due to a $7.8 million decrease in computer and data processing due to acquisition related costs incurred during the nine months ended September 30, 2022 as the result of our acquisition of West Suburban in December 2021. Salaries and employee benefits increased $4.9 million largely from incentives and merit increases effective during the nine months ended September 30, 2023. Net teller & bill paying decreased $1.7 million largely due to acquisition related costs that were incurred during the nine months ended September 30, 2022. In addition, FDIC insurance increased $351,000 due to growth in our asset size, a scheduled increase in rates used by the FDIC for assessments, as well as the absence of assessment credits fully utilized in the nine months ended September 30, 2022. Finally, card related expense increased $741,000 due to the growth in customer transactions and related volume changes.

Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures

N/A - not applicable

(Dollars in thousands)

50

N/A - not applicable

Income Taxes

We recorded income tax expense of $8.1 million for the third quarter of 2023 on $32.5 million of pretax income, compared to income tax expense of $9.4 million on $35.0 million of pretax income in the second quarter of 2023, and income tax expense of $7.1 million on $26.6 million of pretax income in the third quarter of 2022. Our effective tax rate was 25.1% in the third quarter of 2023, 26.9% for the second quarter of 2023, and 26.6% for the third quarter of 2022. The slight reduction in the effective tax rate for the third quarter of 2023 reflects the finalization of the 2022 income tax return, and related adjustments due to state apportionment factor changes and deferred tax allocations within the current period.

We recorded income tax expense of $26.0 million on $99.5 million of pretax income for the nine months ended September 30, 2023, compared to income tax expense of $15.9 million on $59.7 million of pretax income in the like 2022 period. The effective tax rate was 26.1% and 26.7% for the nine months ended September 30, 2023 and 2022, respectively.

Income tax expense reflected all relevant statutory tax rates and GAAP accounting. There were no significant changes in our ability to utilize our deferred tax assets during the quarter ended September 30, 2023. We had no valuation reserve on the deferred tax assets as of September 30, 2023.

Financial Condition

Total assets decreased $130.2 million to $5.76 billion at September 30, 2023, from $5.89 billion at December 31, 2022, due primarily to the decrease of $309.7 million in securities available-for-sale. The decrease in securities available-for-sale was primarily due to strategic sales. These decreases were partially offset by increases in net loans of $157.7 million, FHLB and FRB stock held of $15.3 million, and other assets of $8.7 million. We continue to actively assess potential investment opportunities to utilize our excess liquidity. Total deposits were $4.61 billion at September 30, 2023, a decrease of $496.4 million from December 31, 2022, through a combination of seasonal activity as well as leakage from excess savings stemming from COVID-related government payments and opportunities for alternative investments.

(Dollars in thousands)

Securities available-for-sale decreased $309.7 million as of September 30, 2023 compared to December 31, 2022, and decreased $380.1 million compared to September 30, 2022. The decrease in the portfolio during the third quarter of 2023 was driven by securities sales totaling $65.6 million and paydowns totaling $29.6 million, in addition to growth in unrealized losses of $8.1 million. We continue to seek to position the portfolio in higher credit quality, shorter duration securities with an appropriate mix of fixed- and floating-rate exposures.

(Dollars in thousands)

1 The “Other” segment includes consumer loans and overdrafts.

Total loans were $4.03 billion as of September 30, 2023, an increase of $159.9 million from December 31, 2022. The increase in total loans in the first nine months of 2023, compared to December 31, 2022, was due primarily to growth in loan originations, net of paydowns, within leases of $77.4 million, commercial real estate – investor of $59.5 million and multifamily of $48.3 million offset by net reductions in commercial real estate – owner occupied of $45.8 million from December 31, 2022. Total loans increased $160.2 million from September 30, 2022 to September 30, 2023, primarily due to growth in loan originations, net of paydowns, within commercial real estate – investor of $105.2 million, leases of $103.2 million and multifamily of $49.2 million, offset by net reductions in commercial real estate – owner occupied of $67.9 million and commercial of $53.2 million. As required by CECL, the balance (or amortized cost basis) of purchased credit deteriorated loans, or PCD loans (discussed below) is carried on a gross basis (rather than net of the associated credit loss estimate), and the expected credit losses for PCD loans are estimated and separately recognized as part of the allowance for credit losses, or ACL.

The quality of our loan portfolio is impacted not only by our credit decisions but also by the economic health of the communities in which we operate. Since we are located in a corridor with significant open space and undeveloped real estate, real estate lending (including commercial real estate, construction, residential, multifamily, and HELOCs) has been and continues to be a sizeable portion of our portfolio. These categories comprised 69.8% of the portfolio as of September 30, 2023, compared to 70.6% of the portfolio as of December 31, 2022. At September 30, 2023, our outstanding commercial real estate loans and undrawn commercial real estate commitments, excluding owner occupied real estate were equal to 288.9% of our Tier 1 capital plus allowance for credit losses, an increase from 304.2% at December 31, 2022. We continue to oversee and seek to manage our loan portfolio in accordance with interagency guidance on risk management.

Asset Quality

Nonperforming loans consist of nonaccrual loans and loans 90 days or greater past due. Prior to January 1, 2023, nonperforming loans also included performing troubled debt restructured loans accruing interest. Nonperforming loans increased by $30.4 million to $63.3 million at September 30, 2023 from $32.9 million at December 31, 2022 and increased $10.4 million from $52.9 million at September 30, 2022. Purchased credit deteriorated loans, or PCD loans, are purchased loans that, as of the date of acquisition, we determined had experienced a more-than-insignificant deterioration in credit quality since origination. PCD loans and their related deferred loan costs are included in our nonperforming loan disclosures, if such loans otherwise meet the definition of a nonperforming loan. Management continues to carefully monitor loans considered to be in a classified status. Nonperforming loans as a percent of total loans were 1.6% as of September 30, 2023, 0.9% as of December 31, 2022, and 1.4% as of September 30, 2022. The distribution of our nonperforming loans is shown in the following table.

(Dollars in thousands)

1 The “Other” segment includes consumer loans and overdrafts.

N/M – Not meaningful.

The components of our nonperforming assets are shown in the following table.

(Dollars in thousands)

N/A – Not applicable

1 As of January 1, 2023, the Company prospectively adopted ASU 2022-02 Topic 326 “Troubled Debt Restructurings (“TDRs”) and Vintage Disclosures”, which eliminated the need for recognition, measurement and disclosure of TDRs going forward. See Note 1 for further details of ASU 2022-02 adoption.

Loan charge-offs, net of recoveries, for the third quarter of 2023, prior linked quarter and year over year quarter are shown in the following table.

(Dollars in thousands)

1 Represents the percentage of net charge-offs attributable to each category of loans.

2 The “Other” segment includes consumer and overdrafts.

Net charge-offs of $6.6 million were recorded for the third quarter of 2023, compared to net charge-offs of $505,000 for the second quarter of 2023, and net charge-offs of $68,000 for the third quarter of 2022, reflecting continuing management attention to credit quality and remediation efforts. The net charge-offs for the third quarter of 2023 were primarily due to charge offs of three commercial real estate-investor loans of $6.8 million in aggregate. These three commercial real estate-investor credits had a reported reserve allocation of $4.7 million prior to the third quarter of 2023 charge-offs. We have continued our conservative loan valuations and aggressive recovery efforts on prior charge-offs.

Classified loans include nonaccrual loans and all other loans considered substandard. Classified assets include both classified loans and OREO. Loans classified as substandard are inadequately protected by either the current net worth and ability to meet payment obligations of the obligor, or by the collateral pledged to secure the loan, if any. These loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and carry the distinct possibility that we will sustain some loss if deficiencies remain uncorrected.

The following table shows classified assets by segment for the following periods.

(Dollars in thousands)

1 The “Other” segment includes consumer loans and overdrafts.

N/M - Not meaningful

Total classified loans increased $44.3 million and classified assets increased $43.2 million as of September 30, 2023 from December 31, 2022. The increase since December 31, 2022 is due to the addition of $26.7 million of classified loans in commercial real estate – investor, primarily due to four large credits, two of which are office buildings, one is an assisted living facility during the first six months of 2023, and one office building in the third quarter of 2023. The increase is also due to the growth in construction, primarily due to two large credits. The increase from September 30, 2022 is primarily due to the same loan additions to commercial real estate – investor and construction. Management monitors a ratio of classified assets to the sum of Bank Tier 1 capital and the ACL on loans as another measure of overall change in loan related asset quality, which is referred to as the “classified assets ratio.” The classified assets ratio was 23.51% for the period ended September 30, 2023, compared to 18.36% as of December 31, 2022, and 19.23% as of September 30, 2022.

Allowance for Credit Losses on Loans

The provision for credit losses, which includes a provision for losses on unfunded commitments, is a charge to earnings to maintain the allowance for credit losses (“ACL”) at a level consistent with management’s assessment of expected losses in the loan portfolio at the balance sheet date.

At September 30, 2023, our ACL on loans totaled $51.7 million, and our ACL on unfunded commitments, included in other liabilities, totaled $2.9 million. In the third quarter of 2023, we recorded provision expense on loans of $3.0 million, based on our assessment of nonperforming loan metrics and trends and estimated future credit losses, and a $12,000 reversal of provision on unfunded commitments, primarily due to an adjustment of historical benchmark assumptions, such as funding rates and the period used to forecast those rates, within the ACL calculation. These adjustments resulted in a $3.0 million net impact to the provision for credit losses for the third quarter of 2023.

Management estimates the amount of provision required on a quarterly basis and records the appropriate provision expense, or release of expense, to maintain an adequate reserve for all potential and estimated credit losses on loans, leases and unfunded commitments. The ACL on loans totaled $51.7 million as of September 30, 2023, $49.5 million as of December 31, 2022, and $48.8 million as of September 30, 2022. Our ACL on loans to total loans was 1.3% as of September 30, 2023, compared to 1.3% as of December 31, 2022 and September 30, 2022. See Item 7 – Critical Accounting Estimates in the Management Discussion and Analysis in our 2022 Annual Report in Form 10-K for discussion of our ACL methodology on loans. Allocations of the ACL may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off.

Below is a reconciliation of the activity in the allowance for credit losses on loans for the periods indicated (dollars in thousands):

1 The “Other” segment includes consumer loans and overdrafts.

The coverage ratio of the ACL on loans to nonperforming loans was 81.3% as of September 30, 2023, which was a decrease from the coverage ratio of 90.3% as of June 30, 2023 and a decrease from 92.3% as of September 30, 2023. When measured as a percentage of average loans, our total ACL on loans was 1.29% at September 30, 2023, 1.37% at June 30, 2023, and 1.30% at September 30, 2022.

In management’s judgment, an adequate ACL has been established to encompass the current lifetime expected credit losses at September 30, 2023, and general changes in lending policy, procedures and staffing, as well as other external factors. However, there can be no assurance that actual losses will not exceed the estimated amounts in the future, based on unforeseen economic events, changes in business climates and the condition of collateral at the time of default and repossession. Continued volatility in the economic environment stemming from the impacts of and response to inflation, potential recession, and the war in Ukraine and the conflict in the Middle East, and the associated effects on our customers, or other factors, such as changes in business climates and the condition of collateral at the time of default or repossession, may revise our current expectations of future credit losses in future reporting periods.

Deposits and Borrowings

(Dollars in thousands)

Total deposits were $4.61 billion at September 30, 2023, which reflects a $496.4 million decrease from total deposits of $5.11 billion at December 31, 2022, and a decrease of $667.0 million from total deposits of $5.28 billion at September 30, 2022. The decrease in deposits at September 30, 2023, compared to December 31, 2022, was primarily due to decreases in noninterest-bearing deposits of $189.0 million, money market accounts of $160.0 million and savings accounts of $142.1 million. The decrease in deposits at September 30, 2023, compared to September 30, 2022, was primarily due to decreases in noninterest-bearing deposits of $235.5 million, money market accounts of $229.6 million, and savings accounts of $160.5 million. Total quarterly average deposits decreased $659.4 million, or 12.4%, in the year over year period, driven by declines in our average demand deposits of $225.1 million, and savings, NOW and money markets combined of $440.7 million. In general, the bulk of the decline in deposits year over year can be characterized as rate sensitive with significant flows and transfers into investing activities, materially offsetting the significant expansion in those same accounts in the immediate aftermath of the pandemic.

The following table presents estimated insured and uninsured deposits at September 30, 2023 and December 31, 2022 by deposit type, as well as the weighted average rates for each year to date ending period.

(Dollars in thousands)

Deposits declined 9.7% for the nine months ended September 30, 2023 due to retail and commercial run off. Total deposit run off year to date has been very granular, and not necessarily attributable to large deposit accounts. Our deposit retention efforts for commercial clients were more effective due to high touch relationships where we had a larger share of wallet. The largest reduction in total deposits was from retail customers due to personal and real estate tax payments, real estate transactions, investments, and consumer spending. In terms of product mix, we observed some migration into time deposits, drawn by CD rate specials. Overall, our deposit level remains stable and we continue to monitor customer relationships and liquidity levels daily.

In addition to deposits, we used other liquidity sources for our funding needs in all periods presented, such as repurchase agreements and other short-term borrowings with the FHLBC. Securities sold under repurchase agreements totaled $25.9 million at September 30, 2023, a $6.3 million, or 19.5%, decrease from $32.2 million at December 31, 2022. Our excess liquidity on hand during much of 2022 allowed us to fund our short-term liquidity needs with cash on hand. During the third quarter of 2022, we began re-utilizing short-term borrowings from the FHLBC. The outstanding balance of our short-term FHLBC borrowings was $435.0 million as of September 30, 2023, $90.0 million as of December 31, 2022, and $25.0 million as of September 30, 2022.

We are also indebted on $25.8 million, net of deferred issuance costs, of junior subordinated debentures, which are related to the trust preferred securities issued by its statutory trust subsidiary, Old Second Capital Trust II (“Trust II”) as of September 30, 2023. The Trust II issuance converted from fixed to floating rate at three month LIBOR, which is now three month Term SOFR, plus 150 basis points on June 15, 2017. Upon conversion to a floating rate, we initiated a cash flow hedge which resulted in the total interest rate paid on this debt of 4.18% as of September 30, 2023, as compared to 6.77%, which was the rate paid during the period prior to the June 15, 2017 rate reset.

In the second quarter of 2021, we entered into Subordinated Note Purchase Agreements with certain qualified institutional buyers pursuant to which we issued $60.0 million in aggregate principal amount of our 3.50% Fixed-to-Floating Rate Subordinated Notes due April 15, 2031 (the “Notes”). We sold the Notes to eligible purchasers in a private offering, and the proceeds of this issuance were used for general corporate purposes. The Notes bear interest at a fixed annual rate of 3.50% through April 14, 2026, payable semi-annually in arrears. As of April 15, 2026 forward, the interest rate on the Notes will generally reset quarterly to a rate equal to three-month Term SOFR (as defined by the Note) plus 273 basis points, payable quarterly in arrears. The Notes have a stated maturity of April 15, 2031, and are redeemable, in whole are in part, on April 15, 2026, or any interest payment date thereafter, and at any time upon the occurrence of certain events. As of September 30, 2023, we had $59.4 million of subordinated debentures outstanding, net of deferred issuance costs.

In December 2016, we completed a $45.0 million senior note issuance. The notes had a ten-year term, and included interest payable semiannually at 5.75% for five years. Beginning December 31, 2021, the interest became payable quarterly at three month LIBOR plus 385 basis points. On June 30, 2023, the senior notes were redeemed in full. The remaining balance of deferred debt issuance costs of $362,000 related to these senior notes was recognized as interest expense as of June 30, 2023.

On February 24, 2023, we paid off the remaining $9.0 million balance in notes payable and other borrowings, resulting in no balance in this line item as of September 30, 2023, compared to $9.0 million as of December 31, 2022, and $10.0 million as of September 30, 2022. The balance in notes payable was related to a $20.0 million dollar term note originated with a correspondent bank in the first quarter of 2020, to facilitate the redemption of our Old Second Capital Trust I trust preferred securities and related junior subordinated debentures, completed on March 2, 2020.

Capital

As of September 30, 2023, total stockholders’ equity was $532.6 million, which was an increase of $71.5 million from $461.1 million as of December 31, 2022. This increase is primarily attributable to an increase in retained earnings of $66.8 million due to net income of $73.5 million in the first nine months of 2023, partially offset by $6.7 million of dividends paid to our common stockholders. In addition, total stockholders’ equity as of September 30, 2023 increased over December 31, 2022, due to a reduction in unrealized net losses on available-for-sale securities, which decreased accumulated other comprehensive loss by $2.5 million in the first nine months of 2023, due to changes in market interest rates. Total stockholders’ equity as of September 30, 2023 increased $98.8 million compared to September 30, 2022 due to net income year over year and the increase in accumulated other comprehensive loss of $7.8 million year over year.

The following table shows the regulatory capital ratios and the current well capitalized regulatory requirements for the Company and the Bank as of the dates indicated:

1 Amounts are shown inclusive of a capital conservation buffer of 2.50%.

2 The prompt corrective action provisions are only applicable at the Bank level.

As part of its response to the impact of the COVID-19 pandemic, in the first quarter of 2020, U.S. federal regulatory authorities issued an interim final rule that provided banking organizations that adopted CECL during the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital relative to regulatory capital determined under the prior incurred loss methodology, followed by a three-year transition period to phase out the aggregate amount of the capital benefit provided during the initial two-year delay (i.e., a five-year transition in total). In connection with our adoption of CECL on January 1, 2020, we elected to utilize the five-year CECL transition. As of September 30, 2023, our capital measures exclude $1.9 million, which is the modified CECL transition adjustment.

As of September 30, 2023, the Company, on a consolidated basis, exceeded the minimum capital ratios to be deemed “well capitalized” and met the capital conservation buffer requirements. In addition to the above regulatory ratios, our GAAP common equity to total assets ratio, which is used as a performance measurement for capital analysis and peer comparisons, increased from 7.83% at December 31, 2022, to 9.25% at September 30, 2023. Our GAAP tangible common equity to tangible assets ratio was 7.67% at September 30, 2023, compared to 6.24% as of December 31, 2022. Our non-GAAP tangible common equity to tangible assets ratio, which management also considers a valuable performance measurement for capital analysis, increased from 6.28% at December 31, 2022, to 7.71% at September 30, 2023, primarily due to an increase in tangible common equity in the third quarter of 2023. The increase in tangible common equity was due to an increase in retained earnings of $66.8 million and an increase in accumulated other comprehensive loss of $2.5 million primarily related to improved unrealized losses on available-for-sale securities stemming from the changes in market interest rates.

Reconciliation of Tangible Common Equity to Tangible Assets Ratio Non-GAAP Measure

(Dollars in thousands)

The non-GAAP intangible asset exclusion reflects the 80% core deposit limitation per Basel III guidelines within risk based capital calculations, and is useful for us when reviewing risk based capital ratios and equity performance metrics.

Liquidity

Liquidity is our ability to fund operations, to meet depositor withdrawals, to provide for customers’ credit needs, and to meet maturing obligations and existing commitments. Our liquidity principally depends on our cash flows from operating activities, investment in and maturity of assets, changes in balances of deposits and borrowings, and our ability to borrow funds. In the third quarter of 2023, we continued to experience moderate loan growth, while deposits have trended down as clients moved balances to pursue higher yields as well as due to seasonal declines. We managed the change in our funding through borrowing from the Federal Home Loan Bank of Chicago (“FHLBC”) and sales of securities, which resulted in minimal losses and mitigated our interest rate risk profile. The bank failures in the first five months of 2023 exemplify the potentially serious results of the unexpected inability of insured depository institutions to obtain needed liquidity to satisfy deposit withdrawal requests, including how quickly such requests can accelerate once uninsured depositors lose confidence in an institution’s ability to satisfy its obligations to depositors. We seek to ensure our funding needs are met by maintaining a level of liquidity through asset and liability management. We monitor our borrowing capacity at the FHLBC as part of our liquidity management process as supervised by our Asset and Liability Committee (“ALCO”) and reviewed by our Board of Directors. In addition, our senior management team monitors cash balances daily to ensure we have adequate liquidity to meet our operational and financing needs. As of September 30, 2023, our cash on hand liquidity totaled $109.0 million, a decrease of $6.1 million over cash balances held as of December 31, 2022.

Net cash inflows from operating activities were $87.3 million during the first nine months of 2023, compared with net cash inflows of $60.1 million in the same period of 2022. Proceeds from sales of loans held-for-sale, net of funds used to originate loans held-for-sale, were a source of outflows for the first nine months of 2023 compared to a source of inflows for the like period of 2022. Interest paid, net of interest received, combined with changes in other assets and liabilities were a source of outflows for the nine months ended September 30, 2023 and source of inflows for the like period of 2022. The management of investing and financing activities, as well as market conditions, determines the level and the stability of net interest cash flows. Management’s policy is to mitigate the impact of changes in market interest rates to the extent possible, as part of the balance sheet management process.

Net cash inflows from investing activities were $124.5 million in the nine months ended September 30, 2023, compared to net cash outflows of $506.4 million in the same period in 2022. In the first nine months of 2023, securities transactions accounted for net inflows of $306.0 million, and the principal change on loans accounted for net outflows of $164.3 million. In the first nine months of 2022, securities transactions accounted for net outflows of $66.9 million, and principal on loans funded, net of paydowns, accounted for net outflows of $443.6 million.

Net cash outflows from financing activities in the nine months ended September 30, 2023, were $218.0 million, compared with net cash outflows of $189.7 million in the nine months ended September 30, 2022. Net deposit outflows in the first nine months of 2023 were $495.4 million compared to net deposit outflows of $183.7 million in the first nine months of 2022. Other short-term borrowings had $345.0 million of net cash inflows in the first nine months of 2023, compared to net cash inflows of $25.0 million for other short-term borrowings in the first nine months of 2022. Changes in securities sold under repurchase agreements accounted for outflows of $6.3 million and outflows of $14.8 million for the nine months ended September 30, 2023 and 2022, respectively. Dividends paid on our common stock totaled $6.7 million for both the nine months ended September 30, 2023 and 2022. The purchase of treasury stock in the first nine months of 2023 due to shares acquired with equity award vestings resulted in outflows of $605,000, compared to cash outflows of $447,000 in the first nine months of 2022.

Cash and cash equivalents for the nine months ended September 30, 2023, totaled $109.0 million, as compared to $115.2 million as of December 31, 2022 and $116.2 million as of September 30, 2022. The decrease in cash and cash equivalents for the nine months ended September 30, 2023 was mainly attributable to loan growth and the payoffs of the remaining balance of the term note and senior notes, as well as deposit outflows, partially offset by security sales and FHLB advances during the first nine months of 2023. The year over year decrease is again driven by loan growth, as well as increased customer use of deposits. In addition to cash and cash equivalents on hand or held as deposits with other financial institutions, we rely on funding sources from customer deposits, cash flows from securities available-for-sale and loans, and a line of credit with the FHLBC to meet potential liquidity needs. These sources of liquidity are immediately available to satisfy any funding requirements due to depositor or borrower demands through the ordinary course of our business. Additional sources of funding include a $30.0 million undrawn line of credit held by the Company with a third party financial institution, as well as unpledged securities available-for-sale.

Interest Rate Risk

As part of our normal operations, we are subject to interest-rate risk on the assets we invest in (primarily loans and securities) and the liabilities we fund (primarily customer deposits and borrowed funds). Fluctuations in interest rates may result in changes in the fair market values of our financial instruments, cash flows, and net interest income. Like most financial institutions, we have an exposure to changes in both short-term and long-term interest rates. A financial institution’s ability to be relatively unaffected by changes in interest rates is a good indicator of its capability to perform in a volatile rate environment. We mitigate the impact of interest rate volatility to the Bank by managing our rate sensitivity under various scenarios.

During the third quarter of 2023, the Federal Reserve increased rates by 0.25% in July and held rates unchanged at the September FOMC meeting. The current market expectation is for rates to be unchanged for the remainder of 2023. The projected level of rate cuts in 2024 have been reduced and moved to later in the year, framing a “higher rates for a longer period” outcome. The Federal Reserve managed to shrink its balance sheet to $8.0 trillion by September 2023, down from its peak of $8.7 trillion in March 2023.

We manage interest rate risk within guidelines established by policy which are intended to limit the amount of rate exposure. In practice, we seek to manage our interest rate risk exposure within our guidelines so that such exposure does not pose a material risk to our future earnings. We manage various market risks in the normal course of our operations, including credit, liquidity risk, and interest-rate risk. Other types of market risk, such as foreign currency exchange risk and commodity price risk, do not arise in the normal course of our business activities and operations. In addition, since we do not hold a trading portfolio, we are not exposed to significant market risk from trading activities. Our interest rate risk exposures at September 30, 2023 and December 31, 2022 are outlined in the table below.

Our net income can be significantly influenced by a variety of external factors, including: overall economic conditions, policies and actions of regulatory authorities, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities other than those that are assumed, early withdrawal of deposits, exercise of call options on borrowings or securities, competition, a general rise or decline in interest rates, changes in the slope of the yield-curve, changes in historical relationships between indices (such as SOFR and Prime), and balance sheet growth or contraction. Our asset-liability committee seeks to manage interest rate risk under a variety of rate environments by structuring our on-balance sheet and off-balance sheet positions, which includes interest rate swap derivatives as discussed in Note 19 of our consolidated financial statements found in in our Annual Report on Form 10-K for the year ended December 31, 2022. We seek to monitor and manage interest rate risk within approved policy guidelines and limits. Asset and liability modeling and tracking is performed and presented to the Asset-Liability committee and the Board of Directors no less than quarterly. The presentations discuss our current and historical interest rate risk posture, shifts in the balance sheet composition, and the impact of interest rate movements on earnings and equity. Our current balance sheet is a moderately asset sensitive profile, as our variable rate assets reprice faster than our longer duration, low beta deposit base. Recent market events of failed liquidity management at other banks have been reviewed by the Asset-Liability committee. The committee concluded that we possess a strong liquidity profile and no new liquidity risks were identified. Prudently, we added new measures to assess liquidity risk and enhanced our reports to segment deposits by insured, uninsured, collateralized deposits; and monitor the bank’s funding sources and uses on a regular basis.

We also have a Risk Committee, chaired by our Chief Risk Officer, which reports no less than quarterly to senior management as well as our Board of Directors regarding compliance with risk tolerance limits, key risk factor changes, both internally and externally, due to portfolio changes as well as market conditions. Our enterprise risk management framework is governed by this committee, with input being provided by line of business managers, senior management and the Board.

We use simulation analysis to quantify the impact of various rate scenarios on our net interest income. Specific cash flows, repricing characteristics, and embedded options of the assets and liabilities held by us are incorporated into the simulation model. Earnings at risk are calculated by comparing the net interest income of a stable interest rate environment to the net interest income of a different interest rate environment in order to determine the percentage change. As of September 30, 2023, our net interest income profile remained sensitive to earnings gains (in both dollars and percentage) should interest rates rise. However, we have moved to a less sensitive profile compared to December 31, 2022, due to the impact of interest rate swaps and sales of variable rate securities.

The following table summarizes the effect on annual income before income taxes based upon an immediate increase or decrease in interest rates of 0.5%, 1.0%, and 2.0%, with no change in the slope of the yield curve.

The amounts and assumptions used in the simulation model should not be viewed as indicative of expected actual results. Actual results will differ from simulated results due to timing, magnitude, balance sheet composition and frequency of interest rate changes as well as changes in market conditions and management strategies. The above results do not take into account any management action to mitigate potential risk.

Effects of Inflation

In management’s opinion, although changes in interest rates affect our financial condition to a far greater degree than changes in the inflation rate, we monitor both. The annual US inflation rate for September 2023 was 3.7%, a moderate increase quarter-over-quarter, while Core CPI eased to 4.1%. Management believes the inflation rate will continue to come down, albeit at a much slower rate than experienced year-to-date as of September 2023. The downside risks of high inflation put upwards pressure to our expenses, which could impact our profits. Furthermore, higher costs of living weaken the financial condition of our borrowers which could affect our credit profile. Overall, we expect the risk of high inflation has been contained with minimal impact to our results.

Evaluation of Disclosure Controls and Procedures

The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended, as of September 30, 2023. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2023, the Company’s internal controls were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified.

There were no changes in the Company’s internal controls over financial reporting during the quarter ended September 30, 2023, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.