Lakeland Financial Corp: Form 10-Q for the period ended Sep 30, 2023

OVERVIEW

Net income in the first nine months of 2023 was $64.1 million, which decreased $13.7 million, or 17.6%, from $77.8 million for the comparable period of 2022. Diluted income per common share was $2.49 in the first nine months of 2023, a decrease of 17.8% from $3.03 in the comparable period of 2022. The decrease in net income for 2023 was primarily due to an increase in noninterest expense of $18.5 million, or 22.3%, and an increase in provision for credit losses expense of $5.1 million. Offsetting these items was an increase to net interest income of $2.4 million, or 1.6%, and an increase to noninterest income of $1.3 million, or 4.2%. Pretax pre-provision earnings, a non-GAAP measure calculated by adding net interest income to noninterest income and subtracting noninterest expense, were $79.8 million in the first nine months of 2023, a decrease of $14.8 million, or 15.6%, compared to $94.6 million for the comparable period of 2022.

Annualized return on average total equity was 14.44% in the first nine months of 2023 versus 16.89% in the comparable period of 2022. Annualized return on average total assets was 1.33% in the first nine months of 2023 versus 1.61% for the comparable period of 2022. The Company's average equity to average assets ratio was 9.21% in the first nine months of 2023 versus 9.53% in the comparable period of 2022. Equity has been negatively impacted by unrealized losses from the available-for-sale investment securities portfolio, which are reported as a component of accumulated other comprehensive income (loss).

The Company's second quarter 2023 net income was negatively impacted by the recognition of a wire fraud loss of $13.6 million, net of tax, or $0.53 per diluted earnings per share. Core operational profitability, which is a non-GAAP financial measure that excludes the estimated effect of this one-time event, decreased by $1.5 million, or 1.9%, to $76.4 million for the first nine months of 2023 from $77.8 million for the comparable period of 2022.

Net income in the third quarter of 2023 was $25.3 million, down 11.5%, or $3.3 million, from $28.5 million for the comparable period of 2022. Diluted earnings per common share was $0.98 in the third quarter of 2023, down 11.7% from $1.11 in the comparable period of 2022. The decrease was driven primarily by a decrease in net interest income of $4.1 million, or 7.8%, and an increase in noninterest expense of $1.2 million, or 4.3%, and was partially offset by an increase in noninterest income of $671,000, or 6.6%. Pretax pre-provision earnings in the third quarter of 2023 were $30.1 million, a decrease of $4.6 million, or 13.3%, compared to $34.8 million for the comparable period of 2022.

Annualized return on average total equity was 16.91% in the third quarter of 2023 versus 19.39% in the comparable period of 2022. Annualized return on average total assets was 1.54% in the third quarter of 2023 versus 1.80% in the comparable period of 2022. The average equity to average assets ratio was 9.12% in the third quarter of 2023 versus 9.27% the comparable period of 2022.

The Company’s tangible common equity to tangible assets ratio, which is a non-GAAP financial measure, was 8.62% at September 30, 2023, compared to 8.20% at September 30, 2022 and 8.79% at December 31, 2022. Unrealized losses from available-for-sale investment securities were $266.4 million at September 30, 2023, compared to $256.1 million at September 30, 2022 and $215.3 million at December 31, 2022. When excluding the impact of accumulated other comprehensive income (loss) on tangible common equity and tangible assets, the Company's adjusted tangible common equity to adjusted tangible assets ratio, which is a non-GAAP financial measure, was 11.74% at September 30, 2023, compared to 11.32% at September 30, 2022 and 11.38% at December 31, 2022.

Total assets were $6.427 billion as of September 30, 2023 versus $6.432 billion as of December 31, 2022, a decrease of $5.5 million, or less than 1%. Total loans, net of the allowance for credit losses, and cash and cash equivalents increased $161.1 million, or 3.5%, and $16.0 million, or 12.3%, respectively, between December 31, 2022 and September 30, 2023. Offsetting these increases was a decrease in available-for-sale securities of $210.0 million, or 17.7%. Total deposits increased $196.5 million, or 3.6%, between December 31, 2022 and September 30, 2023. Deposits have shifted from noninterest bearing to interest bearing products as a result of the rising interest rate environment. Noninterest bearing deposits decreased $359.1 million, or 20.7%, and interest bearing deposits increased $555.6 million, or 14.9%. Total borrowings decreased $207.0 million, or 69.7%. Total equity decreased $11.7 million, or 2.1%, from $568.9 million at December 31, 2022 to $557.2 million at September 30, 2023. Retained earnings increased $28.8 million, or 4.5%, as a result of net income of $64.1 million, offset by dividends declared and paid of $35.3 million. Accumulated other comprehensive income (loss), decreased $39.2 million, or 20.7%, due primarily to a decline in the fair market values of available-for-sale investment securities during the nine months ended September 30, 2023.

CRITICAL ACCOUNTING POLICIES

The Company’s accounting policies are described in Note 1 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2022.

Certain of the Company’s accounting policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Some of the facts and circumstances which could affect these judgments include changes in interest rates, in the performance of the economy or in the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for credit losses. See “Note 4 – Allowance for Credit Losses and Credit Quality” for more information on this critical accounting policy.

RESULTS OF OPERATIONS

Overview

Selected income statement information for the three and nine months ended September 30, 2023 and 2022 is presented in the following table:

(dollars in thousands)

(1) Noninterest expense/net interest income plus noninterest income.

(2) Non-GAAP financial measure. The Company believes that disclosing non-GAAP financial measures provides investors with information useful to understanding the Company’s financial performance. Additionally, these non-GAAP measures are used by management for planning and forecasting purposes, including measures based on “tangible common equity,” which is “total equity” excluding intangible assets, net of deferred tax, and “tangible assets,” which is “total assets” excluding intangible assets, net of deferred tax. The tangible capital ratio is calculated by excluding the balance of goodwill, net of deferred taxes. See reconciliation on the next page.

(3) Non-GAAP financial measure. Calculated by removing the fair market value adjustment impact of the investment securities portfolio from tangible equity and tangible assets. Management believes this is an important measure because it provides better comparability to prior periods. See reconciliation on the next page.

(4) Non-GAAP financial measure. Pretax pre-provision earnings is calculated by adding net interest income to noninterest income and subtracting noninterest expense. Management believes this is an important measure because it may enable investors to identify the trends in the Company's earnings exclusive of the effects of tax and provision expense, which may vary significantly from period to period. See reconciliation on the next page.

Reconciliations of non-GAAP measures are provided below (in thousands, except for per share data).

(dollars in thousands)

(1) Long-term, incentive-based compensation accruals were reduced as a result of the wire fraud loss.

Adjusted core noninterest expense, adjusted earnings before income taxes, core operational profitability, core operational diluted earnings per common share and adjusted core efficiency ratio are non‐GAAP financial measures calculated using GAAP amounts. These adjusted amounts are calculated by excluding the impact of the wire fraud loss and corresponding reduction to salaries and employee benefits for the nine month periods ended September 30, 2023 and 2022. There was no impact to the three month periods ended September 30, 2023 and 2022. Management considers these measures of financial performance to be meaningful to understanding the company’s core business performance for these periods.

Net Income

Net income was $64.1 million in the first nine months of 2023, which decreased $13.7 million, or 17.6%, from $77.8 million for the comparable period of 2022. The decrease in net income for the first nine months of 2023 was primarily due to an increase in noninterest expense of $18.5 million, or 22.3%, and an increase in the provision for credit losses of $5.1 million. Offsetting these items was an increase to net interest income of $2.4 million, or 1.6%, and an increase to noninterest income of $1.3 million, or 4.2%.

The Company's second quarter 2023 net income was negatively impacted by the recognition of a wire fraud loss of $13.6 million, net of tax, or $0.53 per diluted earnings per share. Core operational profitability, which is a non-GAAP financial measure that excludes the estimated effect of this one-time event, decreased by $1.5 million, or 1.9%, to $76.4 million for the first nine of 2023 from $77.8 million for the comparable period of 2022.

Net income in third quarter of 2023 was $25.3 million, down 11.5% from $28.5 million for the comparable period of 2022. Diluted earnings per common share was $0.98 in the third quarter of 2023, down 11.7% from $1.11 in the comparable period of 2022. The decrease was driven primarily by a decrease in net interest income of $4.1 million, or 7.8%, and an increase in noninterest expense of $1.2 million, or 4.3%, and was partially offset by an increase in noninterest income of $671,000, or 6.6%.

Net Interest Income

The following tables set forth consolidated information regarding average balances and rates:

(fully tax equivalent basis, dollars in thousands)

(1) Tax exempt income was converted to a fully taxable equivalent basis at a 21 percent tax rate. The tax equivalent rate for tax exempt loans and tax exempt securities acquired after January 1, 1983 included the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) adjustment applicable to nondeductible interest expenses. Taxable equivalent basis adjustments were $4.0 million and $4.1 million for the nine-month periods ended September 30, 2023 and September 30, 2022, respectively.

(2) Loan fees, which are immaterial in relation to total taxable loan interest income for the nine-months ended September 30, 2023 and 2022, are included as taxable loan interest income.

(3) Nonaccrual loans are included in the average balance of taxable loans.

(fully tax equivalent basis, dollars in thousands)

(1) Tax exempt income was converted to a fully taxable equivalent basis at a 21 percent tax rate. The tax equivalent rate for tax exempt loans and tax exempt securities acquired after January 1, 1983 included the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) adjustment applicable to nondeductible interest expenses. Taxable equivalent basis adjustments were $1.3 million and $1.5 million in the three-month periods ended September 30, 2023 and September 30, 2022, respectively.

(2) Loan fees, which are immaterial in relation to total taxable loan interest income for the three months ended September 30, 2023 and 2022, are included as taxable loan interest income.

(3) Nonaccrual loans are included in the average balance of taxable loans.

Net interest income, on a fully tax equivalent basis, increased $2.3 million, or 1.5%, to $152.4 million for the nine months ended September 30, 2023, compared to $150.2 million for the first nine months of 2022. Growth in average loans and an improvement in earning assets yields were the primary drivers behind the $88.0 million, or 52.3%, increase in tax equivalent interest income between the two periods. Offsetting these increases was a decrease in the average balance of investment securities. Interest expense, which mostly offset the positive impact of the increase to tax equivalent interest income, increased by $85.7 million, or 472.0%. and was driven by increased funding costs from increased average interest bearing liabilities and a decrease in average noninterest bearing liabilities.

Total average earning assets were $6.104 billion for the nine months ended September 30, 2023, a decrease of $75.2 million, or 1.2%, compared to $6.179 billion for the nine months ended September 30, 2022. A decrease to average investment securities of $262.3 million, or 17.8%, from $1.473 billion for the nine months ended September 30, 2022 to $1.211 billion for the nine months ended September 30, 2023, and a decrease to the Company's cash held in interest bearing deposits of $223.2 million, or 69.2%, from $322.4 million for the nine months ended September 30, 2022 to $99.2 million for the nine months ended September 30, 2023, drove the contraction in average earning assets between the two periods. Offsetting these decreases was an increase in average loans outstanding, which increased $410.1 million, or 9.4%, to $4.791 billion during the nine months ended September 30, 2023, compared to $4.381 billion during the same period of 2022. Total average interest bearing liabilities were $4.247 billion for the nine months ended September 30, 2023, an increase of $326.9 million, or 8.3%, from $3.920 billion for the nine months ended September 30, 2022. This increase was driven by increased interest bearing deposits of $151.2 million, or 3.9%, from $3.877 billion for the nine months ended September 30, 2022 to $4.028 billion for the nine months ended September 30, 2023, and an increase in total average borrowings of $175.7 million, or 409.9%, from $42.9 million for the nine months ended September 30, 2022 to $218.6 million for the nine month ended September 30, 2023. Noninterest bearing demand deposits decreased $359.6 million, or 19.2%, from $1.869 billion for the nine months ended September 30, 2022 to $1.509 billion for the nine months ended September 30, 2023.

The tax equivalent net interest margin was 3.33% for the nine months ended September 30, 2023, compared to 3.25% during the first nine months of 2022, representing an 8 basis point, or 2.5%, expansion between the two periods. The net interest margin expansion was driven by a 525 basis point increase to the target Federal Funds rate implemented by the Federal Reserve through a series of rate increases beginning in March of 2022, increasing the target Federal Funds Rate range from a zero-bound range of 0.00%-0.25% in March 2022 to a range of 5.25%-5.50% at September 30, 2023. The impact of the higher interest rate environment has increased earning asset yields by 197 basis points, or 54.1%, to 5.61% for the nine months ended September 30, 2023, up from 3.64% for the comparable period of 2022. The increase in earning asset yields was offset by an increase in the Company's funding costs, as depositors sought higher interest bearing deposit products and competition for deposits increased throughout the industry. Interest expense as a percentage of average earning assets increased to 2.28% for the nine months ended September 30, 2023, up from 0.39% for the comparable period of 2022, an increase of 189 basis points, or 484.6%. The Company anticipates the cost of funds may continue to rise throughout the remainder of 2023 as a result of increased market competition for deposits, shifts from noninterest bearing deposits into interest bearing deposits, and elevated wholesale funding costs.

Net interest income, on a fully tax equivalent basis, decreased by $4.2 million, or 7.8%, for the three months ended September 30, 2023 as compared to the three months ended September 30, 2022. Tax equivalent net interest income benefited from increased average loan balances and yields between the two periods. Offsetting this benefit were increased interest bearing liabilities and an increased funding costs.

Total average earning assets were $6.146 billion for the third quarter of 2023, an increase of $154.3 million, or 2.6%, compared to $5.992 billion for the third quarter of 2022. The increase in average earning assets was driven by an increase in average loans of $433.8 million, or 9.8%, from $4.416 billion for the third quarter of 2022 to $4.850 billion for the third quarter of 2023. Offsetting the increase in average loans was a decrease in average investment securities, which decreased $257.8 million, or 18.0%, from $1.429 billion for the third quarter of 2022 to $1.171 billion for the third quarter of 2023. Total average interest bearing liabilities were $4.382 billion for the third quarter of 2023, an increase of $560.7 million, or 14.7%, from $3.822 billion for the third quarter of 2022. This increase was driven by increased interest bearing deposits of $333.1 million, or 8.7%, from $3.822 billion for the third quarter of 2022 to $4.155 billion for the third quarter of 2023 and increased average borrowings of $227.6 million for the third quarter of 2023 compared to no average borrowings for the third quarter of 2022. Noninterest bearing demand deposits decreased $399.1 million, or 22.0%, from $1.817 billion for the third quarter of 2022 to $1.418 billion for the third quarter of 2023.

The tax equivalent net interest margin contracted by 36 basis points, or 10.1%, to 3.21% for the third quarter of 2023, compared to 3.57% for the third quarter of 2022. Earning asset yields expanded 157 basis points, or 37.0%, from 4.24% for the third quarter of 2022 to 5.81% for the third quarter of 2023. This increase was offset by an increase in the Company's funding costs as interest expense as a percentage of average earning assets increased 193 basis points, or 288.1%, from 0.67% for the third quarter of 2022 to 2.60% for the third quarter of 2023. Increases to the Company's earning asset yields and interest expense as a percentage of average earning assets between the two periods were driven by the Federal Reserve's action to increase the target Federal Funds rate to 5.50% from 0.25%. The target Federal Funds rate was increased 225 basis points between September 30, 2022 and September 30, 2023, increasing the target Federal Funds rate range from 3.00%-3.25% to 5.25%-5.50%. While the rate increases have positively affected the Company's yields on earning assets, the Company has experienced a corresponding increase to funding costs, as depositors sought higher interest bearing deposit products and competition for deposits increased throughout the industry. The Company anticipates the cost of funds may continue to rise throughout the remainder of 2023 as a result of increased market competition for deposits, shifts from noninterest bearing deposits into interest bearing deposits, and elevated wholesale funding costs.

Provision for Credit Losses

The Company recorded provision for credit losses expense of $5.6 million for the nine months ended September 30, 2023, compared to provision expense of $417,000 during the comparable period of 2022, an increase of $5.1 million, or 1,230.9%. The increase in provision during the nine months ended September 30, 2023, compared to the comparable period in 2022, was primarily attributable to loan growth and increased qualitative risk factors for current market conditions impacting certain segments of the loan portfolio. Net charge-offs were $6.1 million during the nine month period ended September 30, 2023, compared to net charge-offs of $951,000 during the comparable period of 2022, an increase of $5.1 million, or 536.3%. The increase in charge-offs during the nine months ended September 30, 2023, compared to the comparable period in 2022 was the result of a charge-off of $5.5 million attributable to a single commercial borrower during the first quarter of 2023.

The Company recorded provision expense of $400,000 during the third quarter of 2023, compared to no provision expense recorded during the third quarter of 2022. Provision expense during the quarter was primarily driven by growth in the loan portfolio. Net charge-offs were $353,000 during the third quarter of 2023, compared to $284,000 during the third quarter of 2022.

Additional factors considered by management included key loan quality metrics, including reserve coverage of nonperforming loans and economic conditions in the Company’s markets, and changes in the facts and circumstances of watch list credits, which includes the security position of the borrower. Management’s overall view on current credit quality was also a factor in the determination of the provision for credit losses. The Company’s management continues to monitor the adequacy of the provision based on loan levels, asset quality, economic conditions and other factors that may influence the assessment of the collectability of loans.

Noninterest Income

Noninterest income categories for the nine month and three month period ended September 30, 2023 and 2022 are shown in the following tables:

(dollars in thousands)

42

(dollars in thousands)

Noninterest income increased by $1.3 million, or 4.2%, to $32.7 million for the nine months ended September 30, 2023, compared to $31.3 million for the prior year nine-month period. The increase was driven by increases to bank owned life insurance income of $2.6 million, other income of $348,000, or 22.3%, interest rate swap fee income of $302,000, or 61.4%, and wealth advisory fees of $219,000, or 3.3%. These increases were offset by decreases to mortgage banking income of $955,000, or 123.9%, service charges on deposit accounts of $590,000, or 6.8%, loan and service fees of $349,000, or 3.8%, and investment brokerage fees of $341,000, or 19.9%.

The company’s noninterest income increased $671,000, or 6.6%, to $10.8 million for the third quarter of 2023, compared to $10.2 million for the third quarter of 2022. The increase in noninterest income was primarily driven by an increase in bank owned life insurance income of $955,000, an increase in wealth advisory fees of $239,000, or 11.6%, and an increase in other income of $175,000, or 41.4%. Bank owned life insurance income benefited from improved market performance of the company's variable life insurance policies which track to the overall performance of the equity markets, and from the purchase of general life insurance policies during the fourth quarter of 2022. The increase in wealth advisory fees was driven by an increase in trust assets which benefited from new customer inflows. The increase to other income was driven by increased limited partnership income and higher dividend from the company's FHLB stock holding. Offsetting these increases to noninterest income was a decrease to service charges on deposit accounts of of $255,000, or 8.5%, primarily the result of increased earning credit rating for commercial depositors related to commercial treasury management fees and other changes to the deposit fee schedule for retail accounts, a decrease to investment brokerage fees of $243,000, or 37.3%, due to fluctuations in fee generating sales volume and mix, and a decrease to loan and service fees of $113,000, or 3.7%, due to a decline in fee-based volume.

Noninterest Expense

Noninterest expense categories for the nine month and three month period ended September 30, 2023 and 2022 are shown in the following tables:

(dollars in thousands)

(dollars in thousands)

Noninterest expense increased by $18.5 million, or 22.3%, for the nine months ended September 30, 2023, from $82.8 million to $101.3 million. The increase to noninterest expense during the year was driven by an $18.1 million wire fraud loss recorded as a component of noninterest expense during the second quarter of 2023. Other drivers contributing to the increase in noninterest expense include an increase to professional fees of $1.8 million, or 38.8%, an increase to FDIC insurance and other regulatory fees of $953,000, or 62.9%, and an increase to data processing fees and supplies of $795,000, or 8.4%. Adjusted core noninterest expense, which excludes the estimated impact of the wire fraud loss, increased by $2.3 million, or 2.8%, from $82.8 million for the nine months ended September 30, 2022, to $85.1 million for the nine months ended September 30, 2023.

Noninterest expense increased $1.2 million, or 4.3%, to $29.1 million for the third quarter of 2023, compared to $27.9 million during the third quarter of 2022. The increase in noninterest expense during the quarter was attributable to an increase in salaries and employee benefits of $1.3 million, or 9.1%, an increase in professional fees of $560,000, or 36.0%, and an increase in FDIC insurance and other regulatory fees of $413,000, or 90.2%. Salaries and employee benefits increased due to increases in salaries and employee insurance expense and an increase in deferred compensation expense which is tied to the market performance of the company's variable bank owned life insurance policies. Professional fees increased as a result of increased interest charges associated with the bank's cash swap collateral positions and increased legal expense related to the wire fraud loss and ongoing matters. The increase to FDIC insurance and other regulatory fees was caused by a blanket increase to the assessment rate used by the FDIC to calculate insurance premiums. Offsetting these increases was a decrease to other expense of $1.1 million, or 29.9%, driven by a decrease in accruals pertaining to ongoing legal matters.

The Company's income tax expense decreased $6.2 million, or 38.1%, to $10.1 million in the nine months ended September 30, 2023, compared to $16.4 million for the same period in 2022. The effective tax rate was 13.6% in the nine months ended September 30, 2023, compared to 17.4% for the comparable period of 2022. The year-to-date effective tax rate is reduced by the wire fraud loss, income from tax-advantaged sources such as federally tax exempt municipal bond interest income as well as a tax benefit from stock-based compensation vesting of shares for plan participants.

FINANCIAL CONDITION

Overview

Total assets were $6.427 billion as of September 30, 2023 versus $6.432 billion as of December 31, 2022, a decrease of $5.5 million, or less than 1%. Total loans, net of the allowance for credit losses, and cash and cash equivalents increased $161.1 million, or 3.5%, and $16.0 million, or 12.3%, respectively, between December 31, 2022 and September 30, 2023. Offsetting these increases was a decrease in available-for-sale securities of $210.0 million, or 17.7%. Total deposits increased $196.5 million, or 3.6%, between December 31, 2022 and September 30, 2023. Noninterest bearing deposits decreased $359.1 million, or 20.7%, and interest bearing deposits increased $555.6 million, or 14.9%. Total borrowings decreased $207.0 million, or 69.7%. Total equity decreased $11.7 million, or 2.1%, from $568.9 million at December 31, 2022 to $557.2 million at September 30, 2023. Retained earnings increased $28.8 million, or 4.5%, as a result of net income of $64.1 million, offset by dividends declared and paid of $35.3 million. Accumulated other comprehensive income (loss), decreased $39.2 million, or 20.7%, due primarily to a decline in available-for-sale securities fair market values during the nine months ended September 30, 2023.

Uses of Funds

Total Cash and Cash Equivalents

Total cash and cash equivalents increased by $16.0 million, or 12.3%, to $146.3 million at September 30, 2023, from $130.3 million at December 31, 2022. Cash and cash equivalents include short-term investments. The increase in cash and cash equivalents at September 30, 2023 was driven by an increase in interest bearing short-term investment accounts of $29.5 million, or 59.8%, offset by a decrease in cash and due from banks of $13.5 million, or 16.6%.

Investment Portfolio

The amortized cost and the fair value of securities as of September 30, 2023 and December 31, 2022 were as follows:

(dollars in thousands)

At September 30, 2023 and December 31, 2022, there were no holdings of securities of any one issuer, other than the U.S. government agencies and government sponsored entities, in an amount greater than 10% of stockholders’ equity. Management is aware that, as interest rates rise, any unrealized loss in the available-for-sale investment securities portfolio will increase, and as interest rates fall the unrealized gain in the investment portfolio will rise. Since the majority of the bonds in the investment portfolio are fixed-rate, with only a few adjustable-rate bonds, we would expect our investment portfolio to follow this market value pattern. This is taken into consideration when evaluating the gain or loss of investment securities in the portfolio and the potential for an allowance for credit losses.

Purchases of securities available-for-sale totaled $4.3 million in the first nine months of 2023. The purchases consisted of U.S. Treasury securities and mortgage-backed securities issued by government sponsored entities for CRA purposes. Investment securities represented 17.2% of total assets on September 30, 2023, compared to 20.4% of total assets on December 31, 2022. Effective duration for the investment portfolio was 6.7 years at September 30, 2023, compared to 4.0 years at December 31, 2019, before the pandemic, and 6.5 years at December 31, 2022. Duration of the portfolio extended following the deployment of excess liquidity to the portfolio and the dramatic rise in interest rates during 2022 and into 2023. The ratio of investment securities as a percentage of total assets remains elevated over historical levels of approximately 12-14% during 2014 to 2020. The Company expects the investment securities portfolio as a percentage of assets to decrease over time as the proceeds from pay downs, sales and maturities of these investment securities are used to fund loan portfolio growth and for other general liquidity purposes. Paydowns from prepayments and scheduled payments of $44.5 million were received in the first nine months of 2023, and the amortization of premiums, net of the accretion of discounts, was $3.7 million. Maturities and calls of securities totaled $12.1 million in the first nine months of 2023. Sales of available-for-sale investment securities totaled $102.8 million in the first nine months of 2023 and resulted in net losses of $16,000. No allowance for credit losses was recognized for available-for-sale or held-to-maturity securities as of September 30, 2023 and December 31, 2022.

The fair value of the available-for-sale investment securities portfolio as of September 30, 2023 included net unrealized losses of $266.4 million, compared to net unrealized losses of $215.3 million as of December 31, 2022. Unrealized losses in the available-for-sale investment securities portfolio resulted from the declines in market values of the investment securities. These declines were driven by the rising interest rate environment as a result of the Federal Reserve's monetary tightening policy to combat elevated levels of inflation affecting the U.S. economy.

The investment portfolio is managed by a third-party firm to provide for an appropriate balance between liquidity, credit risk, interest rate risk management and investment return and to limit the Company’s exposure to credit risk in the investment securities portfolio. The Company does not trade or invest in or sponsor certain unregistered investment companies defined as hedge funds and private equity funds under what is commonly referred to as the “Volcker Rule” of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Real Estate Mortgage Loans Held-for-Sale

Real estate mortgage loans held-for-sale increased by $215,000, or 60.2%, to $572,000 at September 30, 2023, from $357,000 at December 31, 2022. The balance of this asset category is subject to a high degree of variability depending on, among other factors, recent mortgage loan rates and the timing of loan sales into the secondary market. The Company generally sells conforming qualifying mortgage loans it originates on the secondary market. Proceeds from sales of residential mortgages totaled $6.1 million in the first nine months of 2023, compared to $34.3 million in the first nine months of 2022. Management expects the volume of loans originated for sale in the secondary market to remain at reduced levels due to elevated mortgage rates, limited inventory, and existing homeowners being locked in at historically low rates. Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of loans serviced for others were $340.1 million and $364.3 million, as of September 30, 2023 and December 31, 2022, respectively.

Loan Portfolio

The loan portfolio by portfolio segment as of September 30, 2023 and December 31, 2022 is summarized as follows:

(dollars in thousands)

46

Total loans, excluding real estate mortgage loans held-for-sale and deferred fees, increased by $161.1 million, or 3.5%, to $4.874 billion at September 30, 2023 from $4.713 billion at December 31, 2022. The increase was primarily driven by originations of loans concentrated in the commercial real estate and multi-famly residential, other commercial, and consumer 1-4 family mortgage loans categories and was offset by paydowns in commercial and industrial loans and the agri-business and agricultural loans segments, the latter of which traditionally experiences seasonal fluctuations in activity.

The following table summarizes the Company’s non-performing assets as of September 30, 2023 and December 31, 2022:

(dollars in thousands)

Total nonperforming assets decreased by $486,000, or 2.8%, to $16.7 million during the nine month period ended September 30, 2023. The ratio of nonperforming assets to total assets decreased 1 basis point from 0.27% at December 31, 2022 to 0.26% at September 30, 2023.

A loan is individually analyzed when full payment under the original loan terms is not expected. The analysis for smaller loans that are similar in nature and which are not in nonaccrual or modified status, such as residential mortgage, consumer, and credit card loans, is determined based on the class of loans. If a loan is individually analyzed, a portion of the allowance may be allocated so that the loan is reported, net, at the present value of estimated future cash flows or at the fair value of collateral if repayment is expected solely from the collateral. Total individually analyzed loans decreased by $14.6 million, or 46.6%, to $16.7 million at September 30, 2023 from $31.3 million at December 31, 2022, due primarily to a charge off of a single commercial credit during the first quarter of 2023 and nonaccrual loan paydowns.

Loans are charged against the allowance for credit losses when management believes that the principal is uncollectible. Subsequent recoveries, if any, are credited to the allowance. The allowance is an amount that management believes will be adequate to absorb current expected credit losses relating to specifically identified loans based on an evaluation of the loans by management, as well as other current expected losses in the loan portfolio. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans and current economic conditions that may affect the borrower’s ability to repay. Management also considers trends in adversely classified loans based upon a monthly review of those credits. General allowance is determined after considering the following factors: application of loss percentages using a probability of default/loss given default approach subject to a floor, emerging market risk, commercial loan focus and large credit concentrations, new industry lending activity and current economic conditions. Federal regulations require insured institutions to classify their own assets on a regular basis. The regulations provide for three categories of classified loans: Substandard, Doubtful and Loss. The regulations also contain a Special Mention category. Special Mention applies to loans that do not currently expose an insured institution to a sufficient degree of risk to warrant classification as Substandard, Doubtful or Loss but do possess credit deficiencies or potential weaknesses deserving management’s close attention. The Company’s policy is to establish a specific allowance for credit losses for any assets where management has identified conditions or circumstances that indicate an asset is nonperforming. If an asset or portion, thereof is classified as a loss, the Company’s policy is to either establish specified allowances for credit losses in the amount of 100% of the portion of the asset classified loss or charge-off such amount.

At September 30, 2023, the allowance for credit losses was 1.48% of total loans outstanding, versus 1.54% of total loans outstanding at December 31, 2022. At September 30, 2023, management believed the allowance for credit losses was at a level commensurate with the overall risk exposure of the loan portfolio. However, if economic conditions deteriorate, certain borrowers may experience difficulty and the level of nonperforming loans, charge-offs and delinquencies could rise and require increases in the allowance for credit losses. The process of identifying credit losses is a subjective process.

The Company has a relatively high percentage of commercial and commercial real estate loans, which are extended to businesses with a broad range of revenue and within a wide variety of industries. Traditionally, this type of lending may have more credit risk than other types of lending because of the size and diversity of the credits. The Company manages this risk by utilizing relatively conservative credit structures, by adjusting its pricing to the perceived risk of each individual credit and by diversifying the portfolio by customer, product, industry and market area. The Company has limited exposure to commercial office space borrowers, all of which are located in the Bank's Indiana markets. Loans totaling $71.9 million for this sector represented only 1.5% of total loans at September 30, 2023.

As of September 30, 2023, based on management’s review of the loan portfolio, the Company had 66 credit relationships totaling $186.4 million on the classified loan list versus 58 credit relationships totaling $161.0 million as of December 31, 2022. The increase in classified loans for the first nine months of 2023 resulted primarily from borrower risk rating downgrades of pass rated loans to the non-individually analyzed portion of the watch list. As of September 30, 2023, the Company had $166.1 million of assets classified as Special Mention, $20.2 million classified as Substandard, $0 classified as Doubtful and $0 classified as Loss as compared to $115.7 million, $45.3 million, $0 and $0, respectively, at December 31, 2022. Watch list loans as a percentage of total loans increased to 3.83% as of September 30, 2023, up from a historical low at 3.42% as of December 31, 2022.

Allowance estimates are developed by management after taking into account actual loss experience adjusted for current economic conditions and a reasonably supportable forecast period. The Company has annual discussions regarding this methodology with regulatory authorities. Allowance estimates are considered a prudent measurement of the risk in the Company’s loan portfolio based upon loan segment. In accordance with applicable accounting guidance, the allowance is based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amounts. For a more thorough discussion of the allowance for credit losses methodology see the ("Critical Accounting Policies") section of this Item 2.

The allowance for credit losses decreased $501,000, or less than 1%, from $72.6 million at December 31, 2022 to $72.1 million at September 30, 2023. The decrease was a result of net charge-offs recorded during the period of $6.1 million, offset by provision expense of $5.6 million. Of the $6.1 million in net charge-offs, $5.5 million was attributable to a single deteriorated commercial relationship. The increased provision expense recorded during the nine months ended September 30, 2023 was primarily attributable to loan growth. As the bulk of the Company’s lending activity is concentrated in the commercial loan portfolio, which can result in overall asset quality being influenced by a small number of credits, management has historically considered growth and portfolio composition when determining credit loss allocations.

Sources of Funds

The Company's sources of funds include a diversified deposit base gathered throughout the Company's footprint and includes a stable mix of commercial, retail and public funds deposit accounts. While the traditional base of core deposits represents the primary source of funding for the Company, the Company has access to a robust array of other liquidity sources, including secured borrowings available from the Federal Home Loan Bank, the Federal Reserve Bank Discount Window and the Federal Reserve Bank Term Funding Program. In addition, the Company has access to unsecured borrowing capacity through long established relationships within the brokered deposit markets, Federal Funds lines from correspondent bank partners and Insured Cash Sweep (ICS) one-way buy funds available from the Intrafi network. As of September 30, 2023, the Company had access to $3.27 billion in unused liquidity available from these aggregate sources, up from $2.99 billion at December 31, 2022.

The average daily deposits and borrowings together with average rates paid on those deposits and borrowings for the nine months ended September 30, 2023 and 2022 are summarized in the following table:

(dollars in thousands)

Average total deposits were $5.537 billion for the nine months ended September 30, 2023, a decrease of $208.4 million, or 3.6%, from the comparable period in 2022. Average total borrowings were $218.6 million for the nine months ended September 30, 2023, an increase of $175.7 million, or 409.9%, from the comparable period in 2022. Total average deposit costs increased 189 basis points from 0.42% for the nine months ended September 30, 2022, compared to 2.31% for the nine months ended September 30, 2023. Total average borrowing costs increased 465 basis points from 0.40% for the nine months ended September 30, 2022 to 5.05% for the nine months ended September 30, 2023. As a result, total funding costs increased by 199 basis points from 0.42% for the nine months ended September 30, 2022, to 2.41% for the nine months ended September 30, 2023.

Deposits and Borrowings

As of September 30, 2023, total deposits increased by $196.5 million, or 3.6%, from December 31, 2022. Core deposits, which excludes brokered deposits, increased by $29.1 million, or less than 1%, to $5.480 billion as of September 30, 2023 from $5.451 billion as of December 31, 2022. Total brokered deposits were $177.4 million at September 30, 2023, compared to $10.0 million at December 31, 2022, an increase of $167.4 million.

The following table summarizes deposit composition at September 30, 2023 and December 31, 2022:

(dollars in thousands)

Core deposits have been stable during 2023. Utilization of brokered deposits as a wholesale funding alternative has returned to pre-pandemic levels. On September 30, 2023 commercial deposits represented 38.1% of total deposits versus 38.2% at December 31, 2022. Retail deposits represented 31.1% at September 30, 2023 versus 35.4% at December 31, 2022. Public Funds deposits represented 27.7% at September 30, 2023 versus 26.2% at December 31, 2022. Brokered deposits represented 3.1% of total deposits at September 30, 2023 versus less than 1% at December 31, 2022. Commercial deposits expanded $68.9 million, or 3.3%, from $2.09 billion at December 31, 2022 to $2.15 billion at September 30, 2023; retail deposits contracted $173.6 million, or 9.0%, from $1.93 billion at December 31, 2022 to $1.76 billion at September 30, 2023; and public funds deposits expanded $133.7 million, or 9.3%, from $1.43 billion at December 31, 2022 to $1.56 billion at September 30, 2023.

Uninsured deposits not covered by FDIC deposit insurance were 54% as of September 30, 2023, versus 56% at December 31, 2022. Uninsured deposits not covered by FDIC deposit insurance or the Indiana Public Deposit Insurance Fund (which insures public fund deposits in Indiana), were 28% of total deposits as of September 30, 2023, versus 30% as of December 31, 2022. As of September 30, 2023 and December 31, 2022, 98% of deposit accounts had deposit balances less than $250,000.

Capital

As of September 30, 2023, total stockholders’ equity was $557.2 million, a decrease of $11.7 million, or 2.1%, from $568.9 million at December 31, 2022. Net income of $64.1 million was offset by a decrease of $39.2 million in accumulated other comprehensive income (loss) and dividends declared and paid of $35.3 million.

The impact on equity for other comprehensive income (loss) is not included in regulatory capital. The banking regulators have established guidelines for leverage capital requirements, expressed in terms of Tier 1, or core capital, as a percentage of average assets, to measure the soundness of a financial institution. In addition, banking regulators have established risk-based capital guidelines for U.S. banking organizations. As of September 30, 2023, the Company's capital levels remained characterized as “well-capitalized”.

The actual capital amounts and ratios of the Company and the Bank as of September 30, 2023 and December 31, 2022, are presented in the table below. Capital ratios for September 30, 2023 are preliminary until the Call Report and FR Y-9C are filed.

(dollars in thousands)

50

FORWARD-LOOKING STATEMENTS

This document (including information incorporated by reference) contains, and future oral and written statements of the Company and its management may contain, forward-looking statements, within the meaning of such term in the federal securities law. Forward-looking statements are not historical facts and are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “project,” “possible,” “continue,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events.

The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain and, accordingly, the reader is cautioned not to place undue reliance on any forward-looking statement made by the Company. Actual results could differ materially from those addressed in the forward-looking statements as a result of numerous factors, including, without limitation:

• the effects of future economic, business and market conditions and changes, particularly in our Indiana market area, including prevailing interest rates and the rate of inflation;
• governmental monetary and fiscal policies and the impact the current economic environment will have on these;
• the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities and other interest sensitive assets and liabilities;
• changes in borrowers’ credit risks and payment behaviors;
• the failure of assumptions and estimates used in our reviews of our loan portfolio, underlying the establishment of reserves for possible credit losses, our analysis of our capital position and other estimates;
• the effects of disruption and volatility in capital markets on the value of our investment portfolio;
• risk of cyber-security attacks that could result in damage to the Company's or third-party service providers' networks or data of the Company;
• the effects of competition from a wide variety of local, regional, national and other providers of financial, investment and insurance services;
• the risks related to the recent failures of First Republic Bank, Silicon Valley Bank and Signature Bank, including the effects already recognized and increased deposit volatility;
• the timing and scope of any legislative and regulatory changes, including changes in banking, securities and tax laws and regulations and their application by our regulators;
• changes in the scope and cost of FDIC insurance, the state of Indiana’s Public Deposit Insurance Fund and other coverages;
• changes in the prices, values and sales volumes of residential and commercial real estate;
• the risk of labor availability, trade policy and tariffs, as well as supply chain constraints could impact loan demand from the manufacturing sector;
• the outcome of pending litigation and other claims we may be subject to from time to time;
• the effects of fraud by or affecting employees, customers or third parties;
• the effects of war or other conflicts, acts of terrorism or other catastrophic events, including storms, droughts, tornados and flooding, that may affect general economic conditions, including agricultural production and demand and prices for agricultural goods and land used for agricultural purposes, generally and in our markets;
• changes in the availability and cost of credit and capital in the financial markets;
• changes in technology or products that may be more difficult or costly, or less effective than anticipated;
• the risks related to mergers, acquisitions and divestitures, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and possible failures to achieve expected gains, revenue growth and/or expense savings from such transactions;
• changes in accounting policies, rules and practices; and
• the risks noted in the Risk Factors discussed under Item 1A of Part 1 of our Annual Report on Form 10-K for the year ended December 31, 2022, as well as other risks and uncertainties set forth from time to time in the Company’s other filings with the SEC.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.

Interest rate risk represents the Company’s primary market risk exposure. The Company does not have a material exposure to foreign currency exchange risk, does not have any material amount of derivative financial instruments and does not maintain a trading portfolio. The Corporate Risk Committee of the Board of Directors annually reviews and approves the policy used to manage interest rate risk. The policy was last reviewed and approved in July 2023. The policy sets guidelines for balance sheet structure, which are designed to protect the Company from the impact that interest rate changes could have on net income but do not necessarily indicate the effect on future net interest income. The Company, through the Bank's Asset and Liability Committee, manages interest rate risk by monitoring the computer simulated earnings impact of various rate scenarios and general market conditions. The Company then modifies its long-term risk parameters by attempting to generate the types of loans, investments, and deposits that currently fit the Company’s needs, as determined by the Asset and Liability Committee. This computer simulation analysis measures the net interest income impact of various interest rate scenario changes during the next twelve months. The Company continually evaluates the assumptions used in the model. The current balance sheet structure is considered to be within acceptable risk levels.

Interest rate scenarios for the base, falling 300 basis points, falling 200 basis points, falling 100 basis points, falling 50 basis points, falling 25 basis points, rising 25 basis points, rising 50 basis points, rising 100 basis points, rising 200 basis points and rising 300 basis points are listed below based upon the Company’s rate sensitive assets and liabilities at September 30, 2023. The net interest income shown represents cumulative net interest income over a twelve-month time horizon. Balance sheet assumptions used for the base scenario are the same for the rising and falling simulations.

The base scenario is an annual calculation that is highly dependent on numerous assumptions embedded in the model. While the base sensitivity analysis incorporates management’s best estimate of interest rate and balance sheet dynamics under various market rate movements, the actual behavior and resulting earnings impact will likely differ from that projected. For certain assets, the base simulation model captures the expected prepayment behavior under changing interest rate environments. Assumptions and methodologies regarding the interest rate or balance behavior of indeterminate maturity core deposit products, such as savings, money market, NOW and demand deposits reflect management’s best estimate of expected future behavior.

(dollars in thousands)

52

As required by Rules 13a-15(b) and 15d-15(b) under the Securities Exchange Act of 1934, management has evaluated, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e)) were effective as of September 30, 2023. Disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. These disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act is accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure.

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

There have been no material changes to the risk factors disclosed in Item 1A. of Part I of the Company’s Form 10-K for the year ended December 31, 2022. Please refer to that section of the Company’s Form 10-K for disclosures regarding the risks and uncertainties related to the Company’s business.