Cass Information Systems Inc: Form 10-Q for the period ended Sep 30, 2022

Overview

Cass provides payment and information processing services to large manufacturing, distribution and retail enterprises from its offices/locations in St. Louis, Missouri, Columbus, Ohio, Greenville, South Carolina, Wellington, Kansas, Jacksonville, Florida, Breda, Netherlands, Basingstoke, United Kingdom, and Singapore. The Company’s services include freight invoice rating, payment processing, auditing, and the generation of accounting and transportation information. Cass also processes and pays energy invoices, which include electricity and gas as well as waste and telecommunications expenses, and is a provider of telecom expense management solutions. Cass solutions include a B2B payment platform for clients that require an agile fintech partner. Additionally, the Company offers an on-line platform to provide generosity services for faith-based and non-profit organizations. The Company’s bank subsidiary, the “Bank,” supports the Company’s payment operations. The Bank also provides banking services to its target markets, which include privately-owned businesses and faith-based ministries in the St. Louis metropolitan area as well as other selected cities in the United States.

The specific payment and information processing services provided to each customer are developed individually to meet each customer’s requirements, which can vary greatly. In addition, the degree of automation such as electronic data interchange, imaging, work flow, and web-based solutions varies greatly among customers and industries. These factors combine so that pricing varies greatly among the customer base. In general, however, Cass is compensated for its processing services through service fees and investment of account balances generated during the payment process. The amount, type, and calculation of service fees vary greatly by service offering, but generally follow the volume of transactions processed. The Company also earns financial fees on a transaction level basis for invoice payment services when making customer payments. Financial fees include interchange revenue, foreign exchange fees and fees received through early payment of invoices. Fees are recognized at the point in time when the payment transactions are made, which is when the performance obligation is satisfied. Interest income from the balances generated during the payment processing cycle is affected by the amount of time Cass holds the funds prior to payment and the dollar volume processed. Both the number of transactions processed and the dollar volume processed are therefore key metrics followed by management. Other factors will also influence revenue and profitability, such as changes in the general level of interest rates, which have a significant effect on net interest income. The funds generated by these processing activities are invested in overnight investments, investment grade securities, advances to payees, and loans generated by the Bank. The Bank earns most of its revenue from net interest income, or the difference between the interest earned on its loans and investments and the interest paid on its deposits and other borrowings. The Bank also assesses fees on other services such as cash management services.

Industry-wide factors that impact the Company include the willingness of large corporations to outsource key business functions such as freight, energy, telecommunication and environmental payment and audit. The benefits that can be achieved by outsourcing transaction processing, and the management information generated by Cass’ systems can be influenced by factors such as the competitive pressures within industries to improve profitability, the general level of transportation costs, deregulation of energy costs, and consolidation of telecommunication providers. Economic factors that impact the Company include the general level of economic activity that can affect the volume and size of invoices processed, the ability to hire and retain qualified staff, and the growth and quality of the loan portfolio. The general level of interest rates also has a significant effect on the revenue of the Company. As discussed in greater detail in Item 7A, “Quantitative and Qualitative Disclosures about Market Risk” in the Company’s 2021 Annual Report on Form 10-K, a decline in the general level of interest rates can have a negative impact on net interest income and conversely, a rise in the general level of interest rates can have a positive impact on net interest income. The cost of fuel is another factor that has a significant impact on the transportation sector. As the price of fuel goes up or down, the Company’s earnings increase or decrease with the dollar amount of transportation invoices.

Currently, management views Cass’ major opportunity as the continued expansion of its payment and information processing service offerings and customer base. Management intends to accomplish this by maintaining the Company’s leadership position in applied technology, which when combined with the security and processing controls of the Bank, makes Cass unique in the industry.

Critical Accounting Policies

The Company has prepared the consolidated financial statements in this report in accordance with the Financial Accounting Standards Board Accounting Standards Codification. In preparing the consolidated financial statements, management makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. These estimates have been generally accurate in the past, have been consistent and have not required any material changes. There can be no assurances that actual results will not differ from those estimates. The accounting policy that requires significant management estimates and is deemed critical to the Company’s results of operations or financial position has been discussed with the Audit Committee of the Board of Directors and is described below.

Allowance for Credit Losses. The Company performs periodic and systematic detailed reviews of its loan portfolio to determine management’s estimate of the lifetime expected credit losses. Although these estimates are based on established methodologies for determining allowance requirements, actual results can differ significantly from estimated results. These policies affect both segments of the Company. The impact and associated risks related to these policies on the Company’s business operations are discussed in the “Provision and Allowance for Credit Losses and Allowance for Unfunded Commitments” section of this report.

Results of Operations

The following paragraphs more fully discuss the results of operations and changes in financial condition for the three-month period ended September 30, 2022 (“Third Quarter of 2022”) compared to the three-month period ended September 30, 2021 (“Third Quarter of 2021”) and the nine-month period ended September 30, 2022 (“Nine Months Ended 2022”) compared to the nine-month period ended September 30, 2021 (“Nine Months Ended 2021”).The following discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and related notes and with the statistical information and financial data appearing in this report, as well as in the Company’s 2021 Annual Report on Form 10-K. Results of operations for the Third Quarter of 2022 are not necessarily indicative of the results to be attained for any other period.

Net Income

The following table summarizes the Company’s operating results:

(In thousands except per share data)

Key profitability metrics were up during the three and nine months ended September 30, 2022 driven by significant revenue growth in financial fees and net interest income. Partially offsetting the revenue growth was an increase in operating expenses as more fully described below.

Fee Revenue and Other Income

The Company’s fee revenue is derived mainly from transportation and facility processing and financial fees. As the Company provides its processing and payment services, it is compensated by service fees which are typically calculated on a per-item basis and by the accounts and drafts payable balances generated in the payment process which can be used to generate interest income. In addition, the Company's fee revenue consists of financial fees which are generated through the payment process. Processing volumes, average payments in advance of funding, and fee revenue were as follows:

(In thousands)

1. Facility expense transaction volumes have been restated for the current and prior periods to reflect total invoices processed. In prior periods, billing account numbers were utilized for the telecom division as a proxy for transactions.

2. Includes energy, telecom and environmental.

Third Quarter of 2022 compared to Third Quarter of 2021:

Processing fee revenue increased $503,000, or 2.7%, primarily attributable to the increase in transportation and facility-related transaction volumes of 0.6% and 6.8%, respectively.

Financial fee revenue increased $2,628,000, or 30.5%, primarily attributable to the 21.1% and 30.1% increases in transportation and facility-related dollar volumes, respectively. The increase in dollar volumes contributed to a 29.8% increase in average payments in advance of funding, which is a significant driver of financial fee revenue. The significant increase in transportation invoice dollar volume was driven by inflationary pressures, supply chain disruptions and fuel surcharges, among other factors. Facility-related invoices increased 6.8%, while dollar volume increased 30.1%. The increase in facility-related dollar volume was largely due to an increase in energy prices.

Nine Months Ended September 30, 2022 compared to Nine Months Ended September 30, 2021:

Processing fee revenue increased $1,302,000, or 2.3%, primarily attributable to the increase in transportation and facility-related transaction volumes of 0.2% and 4.7%, respectively.

Financial fee revenue increased $9,284,000, or 40.2%, primarily attributable to the 28.2% and 26.8% increases in transportation and facility-related dollar volumes, respectively. The increase in dollar volumes contributed to a 44.2% increase in average payments in advance of funding.

Net Interest Income

Net interest income is the difference between interest earned on loans, investments, and other earning assets and interest expense on deposits and other interest-bearing liabilities. Net interest income is a significant source of the Company’s revenues. The following table summarizes the changes in tax-equivalent net interest income and related factors:

(In thousands)

*Presented on a tax-equivalent basis assuming a tax rate of 21% for both 2022 and 2021.

Third Quarter of 2022 compared to Third Quarter of 2021:

Average earning assets increased $206,923,000, or 10.2%. The overall increase in average interest-earning asset balances was primarily due to increases in average investments and loans, partially offset by a decrease in average short-term investments.

Average investment securities increased $309,866,000, or 59.9%, as cash provided by increases in funding sources was utilized to purchase investment securities. The average yield on taxable investment securities increased 73 basis points to 2.11% as a result of the increase in short and long-term interest rates. The average yield on tax-exempt investment securities declined two basis points to 2.85%. These securities are longer term fixed rate and do not reprice as quickly in a rising interest rate environment. The Company has not purchased tax-exempt investment securities during the first nine months of 2022.

Average loans increased $111,034,000 as organic growth in franchise, faith-based and other commercial and industrial loans more than offset a $36,254,000 reduction in average PPP loans. The average yield on loans declined 5 basis points to 4.03% primarily due to a $812,000 decrease in PPP loan fees, partially offset by the increase in short-term interest rates that began in March 2022 and continued through September 2022. Excluding the impact of the PPP loan fees, the average yield on loans increased 32 basis points.

The average balance of short-term investments decreased $213,977,000, or 33.1%, as available funds were deployed into investment securities and loans. The average yield on short-term investments increased 192 basis points to 2.07% primarily due to the increase in short-term interest rates that began in March 2022.

The average balance of interest-bearing deposits decreased $2,795,000, or 0.5% due to a decrease in average time deposits. The average rate paid on interest-bearing deposits increased 33 basis points to 0.52% due to the increase in short-term interest rates.

Average demand deposits increased $133,756,000, or 29.5%. The increase was driven by significant liquidity in the economy resulting in higher deposit balances.

Average accounts and drafts payable increased $171,732,000, or 17.0%. The increase in average accounts and drafts payable was primarily driven by inflationary pressures, fuel surcharges, and increased energy prices, which continue to drive prices higher.

Tax-equivalent net interest income increased $4,483,000, or 37.7%, compared to the same period in the prior year driven by the 10.2% increase in average interest-earning assets and 58 basis point increase in the net interest margin from 2.32% to 2.90%. The increase in the net interest margin was driven by the increase in short-term interest rates which positively impacts the Company's net interest margin over time as average interest-earning assets of $2,243,219,000 greatly exceed average interest-bearing liabilities of $597,469,000.

Nine Months Ended September 30, 2022 compared to Nine Months Ended September 30, 2021:

Average earning assets increased $230,728,000, or 11.7%. The overall increase in average interest-earning asset balances was primarily due to increases in average investments and loans, partially offset by a decrease in average short-term investments.

Average investment securities increased $318,143,000, or 70.0%. The average yield on taxable investment securities increased 59 basis points to 1.83% as a result of the increase in short and long-term interest rates. The average yield on tax-exempt investment securities declined six basis points to 2.90%.

Average loans increased $87,424,000, or 9.9%. The average yield on loans declined 14 basis points to 3.83% primarily due to a $2,155,000 decrease in PPP loan fees, partially offset by the increase in short-term interest rates that began in March 2022. Excluding the impact of the PPP loan fees, the average yield on loans increased 19 basis points.

Average short-term investments decreased $174,839,000, or 27.9%, as available funds were deployed into investment securities and loans. The average yield on short-term investments increased 90 basis points to 1.01% primarily due to the increase in short-term interest rates that began in March 2022.

The average balance of interest-bearing deposits increased $15,334,000, or 2.6% due to an increase in interest-bearing demand deposits. The average rate paid on interest-bearing deposits increased 9 basis points to 0.30% due to the increase in short-term interest rates.

Average demand deposits increased $164,488,000, or 38.2%. The increase was driven by significant liquidity in the economy resulting in higher deposit balances.

Average accounts and drafts payable increased $182,926,000, or 19.2%. The increase in average accounts and drafts payable was primarily driven by inflationary pressures, fuel surcharges, and increased energy prices, which continue to drive prices higher.

Tax-equivalent net interest income increased $8,804,000, or 25.9%, compared to the same period in the prior year driven by the 11.7% increase in average interest-earning assets and 30 basis point increase in the net interest margin from 2.31% to 2.61%. The increase in the net interest margin was driven by the increase in short-term interest rates which positively impacts the Company's net interest margin over time as average interest-earning assets of $2,196,704,000 greatly exceed average interest-bearing liabilities of $598,812,000.

For more information on the changes in net interest income, please refer to the tables that follow.

Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rate and Interest Differential

The following tables show the condensed average balance sheets for each of the periods reported, the tax-equivalent interest income and expense for each category of interest-earning assets and interest-bearing liabilities, and the average yield on such categories of interest-earning assets and the average rates paid on such categories of interest-bearing liabilities for each of the periods reported.

(In thousands)

1. Balances shown are daily averages.

2. Interest income on loans includes net loan fees of $99,000 and $969,000 for the third quarter of 2022 and 2021, respectively. The decrease in net loan fees is due to higher PPP fees in 2021.

3. For purposes of these computations, yields on investment securities are computed as interest income divided by the average amortized cost of the investments.

4. Interest income is presented on a tax-equivalent basis assuming a tax rate of 21% for both 2022 and 2021. The tax-equivalent adjustment was approximately $412,000 and $468,000 for the third quarter of 2022 and 2021, respectively.

(In thousands)

1. Balances shown are daily averages.

2. Interest income on loans includes net loan fees of $500,000 and $2,738,000 for the nine months ended September 30, 2022 and 2021, respectively. The decrease in net loan fees is due to higher PPP fees in 2021.

3. For purposes of these computations, yields on investment securities are computed as interest income divided by the average amortized cost of the investments.

4. Interest income is presented on a tax-equivalent basis assuming a tax rate of 21% for both the nine months ended September 30, 2022 and 2021. The tax-equivalent adjustment was approximately $1,294,000 and $1,417,000 for the nine months ended September 30, 2022 and 2021, respectively.

Analysis of Net Interest Income Changes

The following tables present the changes in interest income and expense between periods due to changes in volume and interest rates. That portion of the change in interest attributable to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of the change in each.

(In thousands)

1. Interest income includes net loan fees.

2. Interest income is presented on a tax-equivalent basis assuming a tax rate of 21% for the three months ended September 30, 2022 and 2021.

(In thousands)

1. Interest income includes net loan fees.

2. Interest income is presented on a tax-equivalent basis assuming a tax rate of 21% for the three months ended September 30, 2022 and 2021.

Provision and Allowance for Credit Losses and Allowance for Unfunded Commitments

The Company recorded a provision for credit losses and off-balance sheet credit exposures of $550,000, and $340,000 in the Third Quarter of 2022 and 2021, respectively. The Company recorded a provision for credit losses and off-balance sheet credit exposures of $850,000, and release of credit losses of $870,000 in the Nine Months Ended 2022 and 2021, respectively. The amount of the provision for (release of) credit losses is derived from the Company’s quarterly Current Expected Credit Loss (“CECL”) model. The amount of the provision for (release of) credit losses will fluctuate as determined by these quarterly analyses. The provision for credit losses in the Third Quarter of 2022 and the Nine Months Ended 2022 was driven by loan growth and external economic factors, including the reduction in the forecast of Gross Domestic Product.

The Company experienced no net loan recoveries in the Third Quarter of 2022 and $11,000 in the Third Quarter of 2021. There were $12,000 net loan recoveries in the Nine Months Ended 2022 and $28,000 in the Nine Months Ended 2021. The ACL was $13,049,000 at September 30, 2022 compared to $12,041,000 at December 31, 2021. The ACL represented 1.26% of outstanding loans at September 30, 2022 and 1.25% of outstanding loans at December 31, 2021. The allowance for unfunded commitments was $222,000 at September 30, 2022 and $367,000 at December 31, 2021. There were no nonperforming loans outstanding at September 30, 2022 or December 31, 2021.

The ACL has been established and is maintained to estimate the lifetime expected credit losses in the loan portfolio. An ongoing assessment is performed to determine if the balance is adequate. Charges or credits are made to expense based on changes in the economic forecast, qualitative risk factors, loan volume, and individual loans. For loans that are individually evaluated, the Company uses two impairment measurement methods: 1) the present value of expected future cash flows and 2) collateral value.

The Company also utilizes ratio analyses to evaluate the overall reasonableness of the ACL compared to its peers and required levels of regulatory capital. Federal and state regulatory agencies review the Company’s methodology for maintaining the ACL. These agencies may require the Company to adjust the ACL based on their judgments and interpretations about information available to them at the time of their examinations.

Summary of Credit Loss Experience

The following table presents information on the Company's provision for (release of) credit losses and analysis of the ACL:

(In thousands)

-31-

Operating Expenses

Total operating expenses for the Third Quarter of 2022 increased $5,631,000, or 18.3%, compared to the Third Quarter of 2021. Total operating expenses for the Nine Months Ended 2022 increased $12,770,000, or 14.3%, compared to the Nine Months Ended 2021. The following table details the components of operating expenses:

(In thousands)

Third Quarter of 2022 compared to Third Quarter of 2021:

Personnel costs increased $3,716,000, or 16.0%. Base salaries increased as a result of merit increases, wage pressures, an increase in average full-time equivalent employees of 7.5% due to the Touchpoint acquisition and strategic investments in various technology initiatives, including improved rating engine capabilities and investment in optical character recognition, artificial intelligence, machine learning and other processes to read images and produce data. Also driving the increase in personnel expense were increases in stock compensation and profit sharing of $241,000 and $448,000, respectively, due to improved Company earnings.

Other operating expenses increased $1,985,000, or 43.7%. These expenses increased due to higher levels of travel, employee procurement, data processing and other professional fees. Partially causing the increase in data processing and other professional fees is investments in technology initiatives, resulting in elevated expense levels as multiple technology platforms are being maintained prior to switching over to what the Company believes will be more efficient technology platforms for facility and freight data entry processing by the end of 2023.

Nine Months Ended September 30, 2022 compared to Nine Months Ended September 30, 2021:

Personnel costs increased $9,061,000, or 13.2%. Base salaries increased as a result of merit increases, wage pressures, an increase in average full-time equivalent employees of 3.8% due to the Touchpoint acquisition and strategic investments in various technology initiatives as described above. Also driving the increase in personnel expense were increases in stock compensation and profit sharing of $1,894,000 and $1,061,000, respectively, due to improved Company earnings.

Other operating expenses increased $3,950,000, or 33.5%. These expenses increased due to higher levels of travel, employee procurement, data processing and other professional fees as described above.

Financial Condition

Total assets at September 30, 2022 were $2,610,815,000, an increase of $55,914,000, or 2.2%, from December 31, 2021.

The Company experienced a decrease in cash and cash equivalents of $167,934,000, or 32.6%. The change in cash and cash equivalents reflects the Company’s daily liquidity position and is primarily affected by changes in funding sources, mainly accounts and drafts payable and deposits, cash flows in and out of loans, investments securities and payments in advance of funding. The decrease in cash and cash equivalents was primarily due to growth in loans and investment securities, which utilized cash to fund such growth.

The investment securities portfolio increased $90,336,000, or 13.4%, during the first nine months of 2022. Cash and cash equivalents were utilized to purchase U.S. treasury bonds, which increased from $0 at December 31, 2021 to $155,119,000 at September 30, 2022. The Company purchased U.S. treasury bonds with maturities between one and two years.

Loans increased $76,534,000, or 8.0%. The Company experienced $88,936,000 of growth in commercial and industrial loans due to growth in restaurant franchise loans and investment grade leases.

Payments in advance of funding decreased $22,206,000, or 7.6%. The decrease in the balance is primarily due to timing as average balances are higher for the three and nine months ended September 30, 2022 as compared to the same periods in 2021.

Other assets increased $69,588,000 due to an increase in the deferred tax asset of $20,747,000 as a result of unrealized losses on investment securities and an increase in accounts receivable from customers of $45,699,000.

Total liabilities at September 30, 2022 were $2,419,080,000, an increase of $109,977,000, or 4.8%, from December 31, 2021.

Total deposits at September 30, 2022 were $1,229,721,000, an increase of $8,218,000, or 0.7%, from December 31, 2021. Increases in demand deposits have offset declines in time deposits.

Accounts and drafts payable at September 30, 2022 were $1,146,334,000, an increase of $95,938,000, or 9.1%, from December 31, 2021. Accounts and drafts payable will fluctuate from period-end to period-end due to the payment processing cycle, which results in lower balances on days when payments clear and higher balances on days when payments are issued. For this reason, average balances are a more meaningful measure of accounts and drafts payable (for average balances refer to the tables under the “Distribution of Assets, Liabilities and Shareholders’ Equity; Interest Rate and Interest Differential” section of this report).

Total shareholders’ equity at September 30, 2022 was $191,735,000, a $54,063,000, or 22.0%, decrease from December 31, 2021. Total shareholders’ equity decreased due to a change in accumulated other comprehensive loss of $66,832,000 as a result of interest rates continuing to rise and the negative impact on the fair value of existing investment securities, share repurchases of $5,299,000, and dividends paid of $11,478,000. These decreases were partially offset by net income of $25,619,000 and stock-based compensation expense of $4,479,000.

Liquidity and Capital Resources

The discipline of liquidity management as practiced by the Company seeks to ensure that funds are available to fulfill all payment obligations relating to invoices processed as they become due and meet depositor withdrawal requests and borrower credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in supply of funds. Primary liquidity to meet demand is provided by short-term liquid assets that can be converted to cash, maturing securities and the ability to obtain funds from external sources.

The balance of liquid assets consists of cash and cash equivalents, which include cash and due from banks, interest-bearing deposits in other financial institutions, federal funds sold and money market funds. Cash and cash equivalents totaled $346,994,000 at September 30, 2022, a decrease of $167,934,000, or 32.6%, from December 31, 2021. At September 30, 2022, these assets represented 13.3% of total assets. These funds are the Company’s and its subsidiaries’ primary source of liquidity to meet future expected and unexpected loan demand, depositor withdrawals or reductions in accounts and drafts payable.

Secondary sources of liquidity include the investment portfolio and borrowing lines. Total investment securities were $763,789,000 at September 30, 2022, an increase of $90,336,000 from December 31, 2021. These assets represented 29.3% of total assets at September 30, 2022. Of the total portfolio, 8.5% mature in one year, 34.1% mature in one to five years, and 57.4% mature in five or more years.

The Bank has unsecured lines of credit at six correspondent banks to purchase federal funds up to a maximum of $83,000,000 in aggregate. As of September 30, 2022, the Bank also has secured lines of credit with the Federal Home Loan Bank of $228,858,000 collateralized by mortgage loans. The Company also has secured lines of credit from two banks up to a maximum of $150,000,000 collateralized by state and political subdivision securities. There were no amounts outstanding under any line of credit as of September 30, 2022 or December 31, 2021.

The deposits of the Company's banking subsidiary have historically been stable, consisting of a sizable volume of core deposits related to customers that utilize other commercial products of the Bank. The accounts and drafts payable generated by the Company has also historically been a stable source of funds. The Company is part of the Certificate of Deposit Account Registry Service (“CDARS”) and Insured Cash Sweep (“ICS”) deposit placement programs. Time deposits include $18,220,000 of CDARS deposits and interest-bearing demand deposits include $117,993,000 of ICS deposits. These programs offer the Bank’s customers the ability to maximize Federal Deposit Insurance Corporation (“FDIC”) insurance coverage. The Company uses these programs to retain or attract deposits from existing customers.

Net cash flows provided by operating activities were $40,799,000 for the nine months ended September 30, 2022, compared to $30,680,000 for the nine months ended September 30, 2021, an increase of $10,119,000. Net cash flows from investing and financing activities fluctuate greatly as the Company actively manages its investment and loan portfolios and customer activity influences changes in deposit and accounts and drafts payable balances. Other causes for the changes in these account balances are discussed earlier in this report. Due to the daily fluctuations in these account balances, the analysis of changes in average balances, also discussed earlier in this report, can be more indicative of underlying activity than the period-end balances used in the statements of cash flows. Management anticipates that cash and cash equivalents, maturing investments and cash from operations will continue to be sufficient to fund the Company’s operations and capital expenditures in 2022, which are estimated to range from $4 million to $6 million.

The Company faces market risk to the extent that its net interest income and fair market value of equity are affected by changes in market interest rates. For information regarding the market risk of the Company’s financial instruments, see Item 3, “Quantitative and Qualitative Disclosures about Market Risk.”

There are several trends and uncertainties that may impact the Company’s ability to generate revenues and income at the levels that it has in the past. In addition, these trends and uncertainties may impact available liquidity. Those that could significantly impact the Company include the general levels of interest rates, business activity, and energy costs as well as new business opportunities available to the Company.

As a financial institution, a significant source of the Company’s earnings is generated from net interest income. Therefore, the prevailing interest rate environment is important to the Company’s performance. A major portion of the Company’s funding sources are the non-interest bearing accounts and drafts payable generated from its payment and information processing services. Accordingly, higher levels of interest rates will generally allow the Company to earn more net interest income. Conversely, a lower interest rate environment will generally tend to depress net interest income. The Company actively manages its balance sheet in an effort to maximize net interest income as the interest rate environment changes. This balance sheet management impacts the mix of earning assets maintained by the Company at any point in time. For example, in a low interest rate environment, short-term relatively lower rate liquid investments may be reduced in favor of longer term relatively higher yielding investments and loans. If the primary source of liquidity is reduced in a low interest rate environment, a greater reliance would be placed on secondary sources of liquidity including borrowing lines, the ability of the Bank to generate deposits, and the investment portfolio to ensure overall liquidity remains at acceptable levels.

The overall level of economic activity can have a significant impact on the Company’s ability to generate revenues and income, as the volume and size of customer invoices processed may increase or decrease. Higher levels of economic activity increase both fee income (as more invoices are processed) and balances of accounts and drafts payable. Lower levels of economic activity, such as those previously experienced by the Company as a result of COVID-19 and governmental actions related thereto, decrease both fee income and balances of accounts and drafts payable.

The relative level of energy costs can impact the Company’s earnings and available liquidity. Lower levels of energy costs will tend to decrease transportation and energy invoice amounts resulting in a corresponding decrease in accounts and drafts payable. Decreases in accounts and drafts payable generate lower interest income.

New business opportunities are an important component of the Company’s strategy to grow earnings and improve performance. Generating new customers allows the Company to leverage existing systems and facilities and grow revenues faster than expenses.

As a bank holding company, the Company and the Bank are subject to capital requirements pursuant to the FRB’s capital guidelines which include (i) risk-based capital guidelines, which are designed to make capital requirements more sensitive to various risk profiles and account for off-balance sheet exposure; (ii) guidelines that consider market risk, which is the risk of loss due to change in value of assets and liabilities due to changes in interest rates; and (iii) guidelines that use a leverage ratio which places a constraint on the maximum degree of risk to which a financial holding company may leverage its equity capital base.

The Basel III Capital Rules require banking organizations, like Cass, to maintain:

• a minimum ratio of common equity Tier 1 capital to risk-weighted assets of at least 4.5%, plus a 2.5% capital conservation buffer;
• a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus a 2.5% capital conservation buffer;
• a minimum ratio of total capital (that is, Tier 1 plus Tier 2 capital) to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer; and
• a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to adjusted average consolidated assets.

The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of common equity Tier 1 capital to risk-weighted assets above the minimum but below the conservation buffer will face limitations on the payment of dividends, common stock repurchases and discretionary cash payments to executive officers based on the amount of the shortfall.

Common equity Tier 1 capital is generally defined as common stockholders’ equity and retained earnings. Tier 1 capital is generally defined as common equity Tier 1 and Additional Tier 1 capital. Additional Tier 1 capital generally includes certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries. Total capital includes Tier 1 capital (common equity Tier 1 capital plus Additional Tier 1 capital) and Tier 2 capital. Tier 2 capital is comprised of capital instruments and related surplus meeting specified requirements. Also included in Tier 2 capital is the allowance for credit losses limited to a maximum of 1.25% of risk-weighted assets and, for non-advanced approaches institutions like Cass that have exercised a one-time opt-out election regarding the treatment of Accumulated Other Comprehensive Income (“AOCI”), up to 45% of net unrealized gains on available-for-sale equity securities with readily determinable fair market values. The calculation of all types of regulatory capital is subject to deductions and adjustments specified in applicable regulations.

The calculation of all types of regulatory capital is subject to deductions and adjustments specified in the regulations. For instance, the Basel III Capital Rules and the Capital Simplification Rules provide for a number of deductions from and adjustments to common equity Tier 1 capital. These include, for example, the requirement that certain deferred tax assets and significant investments in non-consolidated financial entities be deducted from Tier 1 capital to the extent that any one such category exceeds 25% of common equity Tier 1 capital.

In determining the amount of risk-weighted assets for purposes of calculating risk-based capital ratios, all assets, including certain off-balance sheet assets, are multiplied by a risk weight factor assigned by the regulations based on the risks believed inherent in the type of asset. Higher levels of capital are required for asset categories believed to present greater risk. For example, a risk weight of 0% is assigned to cash and U.S. government securities, a risk weight of 50% is generally assigned to prudently underwritten first lien one to four-family residential mortgages, a risk weight of 100% is assigned to commercial and consumer loans, a risk weight of 150% is assigned to certain past due loans, and a risk weight of between 0% to 600% is assigned to permissible equity interests, depending on certain specified factors.

The Company and the Bank continue to exceed all regulatory capital requirements, as evidenced by the following capital amounts and ratios:

(Dollars in thousands)

Inflation

The Company’s assets and liabilities are primarily monetary, consisting of cash, cash equivalents, securities, loans, payables and deposits. Monetary assets and liabilities are those that can be converted into a fixed number of dollars. The Company's consolidated balance sheet reflects a net positive monetary position (monetary assets exceed monetary liabilities). During periods of inflation, the holding of a net positive monetary position will result in an overall decline in the purchasing power of a company. Management believes that replacement costs of equipment, furniture, and leasehold improvements will not materially affect operations. The rate of inflation does affect certain expenses, such as those for employee compensation, which may not be readily recoverable in the price of the Company’s services.

Impact of New and Not Yet Adopted Accounting Pronouncements

There are no new accounting pronouncements that are applicable to the company and/or materially impact the Company.

As described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021, the Company manages its interest rate risk through measurement techniques that include gap analysis and a simulation model. As part of the risk management process, asset/liability management policies are established and monitored by management.

The following table summarizes simulated changes in net interest income versus unchanged rates over the next 12 months as of September 30, 2022 and December 31, 2021.

The decrease in projected net interest income in a rising interest rate environment from December 31, 2021 to September 30, 2022 is primarily due to the purchase of $155,119,000 in U.S. treasury bonds throughout the first nine months of 2022. These bonds mature over a one to two year period and were purchased utilizing available liquid cash and cash equivalents.

The Company’s management, under the supervision and with the participation of the principal executive officer and the principal financial officer, evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report and concluded that, as of such date, these controls and procedures were effective.

There were no changes in the Third Quarter of 2022 in the Company's internal control over financial reporting identified by the Company’s principal executive officer and principal financial officer in connection with their evaluation that materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended).

The Company has included in Part I, Item 1A of its Annual Report on Form 10-K for the year ended December 31, 2021, a description of certain risks and uncertainties that could affect the Company’s business, future performance or financial condition (the “Risk Factors”). There are no material changes to the Risk Factors as disclosed in the Company’s 2021 Annual Report on Form 10-K.