First Interstate Bancsystem Inc: Form 10-Q for the period ended Sep 30, 2023

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

When we refer to “we,” “our,” “us,” “First Interstate,” or the “Company” in this report, we mean First Interstate BancSystem, Inc. and our consolidated subsidiaries, including our wholly-owned subsidiary, First Interstate Bank, unless the context indicates that we refer only to the parent company, First Interstate BancSystem, Inc. When we refer to the “Bank” or “FIB” in this report, we mean only First Interstate Bank.

The following discussion of our consolidated financial data reflects our historical results of operations and financial condition and should be read in conjunction with our financial statements and related notes thereto presented elsewhere in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2022, including the audited financial statements and related notes contained therein, as previously filed with the Securities and Exchange Commission, or SEC.

Cautionary Note Regarding Forward-Looking Statements and Factors that Could Affect Future Results

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Rule 175 promulgated thereunder, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, and Rule 3b-6 promulgated thereunder, that involve inherent risks and uncertainties. Any statements about our plans, objectives, expectations, strategies, beliefs, or future performance or events constitute forward-looking statements. Such statements are identified by words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trends,” “objectives,” “views,” “continues” or similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “may,” or similar expressions. Forward-looking statements involve known and unknown risks, uncertainties, assumptions, estimates and other important factors that could cause actual results to differ materially from any results, performance or events expressed or implied by such forward-looking statements. A detailed discussion of risks that may cause actual results to differ materially from current expectations in the forward-looking statements is included below in this report under the caption “Risk Factors” and in our Annual Report on Form 10-K for the year ended December 31, 2022, under the captions “Cautionary Note Regarding Forward-Looking Statements” and “Risk Factors”. These factors and the other risk factors described in our periodic and current reports filed with the SEC from time to time, however, are not necessarily all of the important factors that could cause our actual results, performance, or achievements to differ materially from those expressed in or implied by any of our forward-looking statements. Other unknown or unpredictable factors also could harm our results.

All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth above. Interested parties are urged to read in their entirety the referenced risk factors prior to making any investment decision with respect to the Company. Forward-looking statements speak only as of the date they are made and we do not undertake or assume any obligation to update publicly any of these statements to reflect actual results, new information or future events, changes in assumptions or changes in other factors affecting forward-looking statements, except to the extent required by applicable law. If we update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements.

Non-GAAP Financial Measures

In addition to financial measures presented in accordance with GAAP, this document contains GAAP financial measures and non-GAAP financial measures where management believes it to be helpful in understanding our results of operations or financial position. Where non-GAAP financial measures are used, the comparable GAAP financial measure, as well as the reconciliation to the comparable GAAP financial measure, can be found herein.

Fully-Taxable Equivalent Basis. Interest income, yields, and ratios on an FTE basis are considered non-GAAP financial measures. Management believes net interest income on an FTE basis provides an insightful picture of the interest margin for comparison purposes. The FTE basis also allows management to assess the comparability of revenue arising from both taxable and tax-exempt sources. The FTE basis assumes a federal statutory tax rate of 21 percent. We encourage readers to consider the Unaudited Consolidated Financial Statements and other financial information contained in this Form 10-Q in their entirety, and not to rely on any single financial measure.

Executive Overview

We are a financial and bank holding company focused on community banking. Since our incorporation in Montana in 1971, we have grown both organically and through strategic acquisitions. We operate 305 banking offices, including detached drive-up facilities, in communities across fourteen states—Arizona, Colorado, Idaho, Iowa, Kansas, Minnesota, Missouri, Montana, Nebraska, North Dakota, Oregon, South Dakota, Washington, and Wyoming. Through our bank subsidiary, First Interstate Bank, we deliver a comprehensive range of banking products and services—including online and mobile banking—to individuals, businesses, municipalities, and others throughout our market areas. We are proud to provide lending opportunities to clients that participate in a wide variety of industries, including:

Our principal business activity is lending to, accepting deposits from, and conducting financial transactions with and for individuals, businesses, municipalities, and other entities located in the communities we serve. We derive our income principally from interest charged on loans and, to a lesser extent, from interest and dividends earned on fixed income investments.

We also derive income from non-interest sources such as: (i) fees received in connection with various lending and deposit services; (ii) wealth management services, such as trust, employee benefit, investment, and insurance services; (iii) mortgage loan originations, sales, and servicing; (iv) merchant and electronic banking services; and (v) from time-to-time, gains on sales of assets and securities.

Our principal expenses include: (i) interest expense on deposit accounts and other borrowings; (ii) salaries and employee benefits; (iii) data processing and communication costs primarily associated with maintaining loan and deposit functions; (iv) furniture, equipment, and occupancy expenses for maintaining our facilities; (v) professional fees, including FDIC insurance assessments; (vi) income tax expense; (vii) provisions for credit losses; (viii) intangible amortization; and (ix) other real estate owned expenses. From time to time, we also incur acquisition costs related to our strategic acquisitions.

Recent Trends and Developments

Our community banking footprint spans across the Rocky Mountain and Pacific Northwest regions and has also expanded into the Midwest and Southwest regions, in large part due to our acquisition activity. As part of our normal course of business, we continue to evaluate bank acquisitions and other strategic opportunities on an on-going basis.

During the first half of 2023, the banking industry experienced significant volatility with multiple high-profile bank failures leading to broader industry concerns related to funding and liquidity. Despite these developments, the Company’s liquidity position and balance sheet remains strong and the capital ratios continue to exceed all regulatory well-capitalized requirements as of September 30, 2023. Our deposit base is diversified, including by depositor, which includes from individuals, businesses across multiple industries, municipalities, and other entities, as well as geographically, across the communities we serve. As of September 30, 2023, our FDIC insured deposits were 66.78% of total deposits, including accounts eligible for pass-through insurance. However, in light of these events, the Company took a number of pro-active actions which included outreach to clients and collateral optimization actions to maximize its availability to various liquidity sources.

Beginning in the third quarter of 2022, the Bank began borrowing from the FHLB to fund loan growth and cushion the Bank further against the outflow of deposits. Although decreasing since December 31, 2022, total deposits increased over the three months ended September 30, 2023. As a result, and due to investment portfolio cash flows, during the three months ended September 30, 2023, FHLB advances were paid down, and other borrowed funds decreased $0.5 billion to $2.1 billion at September 30, 2023, from $2.6 billion at June 30, 2023 at an average rate of 5.56% and 5.31%, respectively.

As of October 26, 2023, the Bank had available borrowing capacity of $4.9 billion with the FHLB and $3.1 billion with the Federal Reserve Bank based on pledged investment securities and loan collateral.

U.S. inflation data hit a multi-decade high in June 2022, climbing to 9.1%, as reported by the Bureau of Labor Statistics, decreasing to 3.0% in June 2023, with a modest increase to 3.7% in September 2023. While our operating expenses are affected by general inflation, the asset and liability structure of the Company largely consists of monetary items. Monetary items, such as cash, investments, loans, deposits and other borrowings, are assets and liabilities which are or will be converted into a fixed number of dollars regardless of changes in prices. As a result, changes in interest rates have a more significant impact on a financial institution’s performance than does general inflation. However, inflation may have negative impacts on the Company’s clients and their customers, impacting their ability or willingness to repay loans or maintain deposits.

The Federal Reserve stated its current objective is to return the rate of inflation to 2% and it has been aggressively acting to achieve this goal. In response to sustained inflationary pressures, the Federal Reserve increased short-term interest rates 525 basis points between March 16, 2022 and July 26, 2023. Although the general inflationary pressures are easing, the Federal Reserve has continued to raise interest rates into the third quarter of 2023 and has reduced its ownership of agency mortgage-backed securities and U.S. Treasury securities. With the recent interest rate increases, the short end (up to two years) of the yield curve on U.S. Treasuries has increased, which has resulted in increased returns on our interest earning assets. The Company’s quarterly yield on interest earning assets increased to 4.63% as of September 30, 2023 from 4.52% as of June 30, 2023, and 3.99% as of September 30, 2022.

However, increases in short-term interest rates have also impacted the Company’s cost of funds, primarily as a result of the shift of non-interest-bearing deposits into higher-cost interest-bearing and time deposit balances and variable rate debt. The Company’s cost of funds increased to 1.59% during the three months ended September 30, 2023, from 1.43% during the three months ended June 30, 2023, and 0.28% during the three months ended September 30, 2022. Overall, the change in the mix and cost of funds has offset the changes in the mix and yield on earning assets, resulting in compression of the Company’s FTE net interest margin to 3.07% during the three months ended September 30, 2023, from 3.12% during the three months ended June 30, 2023, and 3.71% during the three months ended September 30, 2022.

Gross domestic product declined 2.6% during the first half of 2022, increased 5.3% in the second half of 2022, increased 4.3% in the first half of 2023, with the recent advance estimate released for the third quarter of 2023 suggesting growth at a seasonally- and inflation-adjusted rate of 4.9% for the quarter ending September 30, 2023. While gross domestic product has expanded at or above 2.0% since the second quarter of 2022, it is unclear whether the volatility of 2022 in the economic performance of the U.S. economy will re-emerge leading to an economic slowdown, downturn, or recession or whether its regular pattern of growth will continue. Any economic slowdown, downturn, or recession could impact the Company and one of its primary lending sources, by impacting the level of deposits held by our clients, whether through a higher volume of withdrawals or through a lower volume of deposits. The credit quality of the Company’s loans may also be impacted if clients must weather adverse economic conditions which could result in an increase in credit losses or other related expenses.

Primary Factors Used in Evaluating Our Business

As a banking institution, we manage and evaluate various aspects of both our financial condition and our results of operations. We monitor our financial condition and performance and evaluate the levels and trends of line items included in our consolidated balance sheets, consolidated statements of income, and comprehensive (loss) income. We also utilize various financial ratios that are commonly used in our industry. We analyze these ratios and financial trends against our own historical performance and the financial condition and performance of comparable banking institutions in our region and across the nation.

As discussed in our Annual Report on Form 10-K for the year ended December 31, 2022, our financial performance is impacted by a number of external factors outside our control, as well as our ability to execute on the key components of our strategy for continued success and future growth. See Part II – Other Information “Item 1A – Risk Factors” for an update of the risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2022.

Critical Accounting Estimates and Significant Accounting Policies

Our consolidated financial statements are prepared in accordance with generally accepted accounting principles (“GAAP”) in the United States and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. The most significant accounting policies we follow are summarized in Note 1 of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2022, as referenced in Note 1 to the unaudited financial statements in this quarterly report. There have been no material changes in our critical accounting estimates and policies described in our Annual Report on Form 10-K for the year ended December 31, 2022, during the quarterly period covered by this quarterly report, except for the transition to new CECL modeling tools during the second quarter of 2023 and the adoption of ASU 2022-02 on January 1, 2023. Refer to “Note – Basis of Presentation” in the accompanying “Notes to Unaudited Consolidated Financial Statements” for further discussion of the CECL model transition and “Note – Recent Authoritative Accounting Guidance” in the accompanying “Notes to Unaudited Consolidated Financial Statements” for further discussion of the adoption.

The preparation of financial statements in conformity with GAAP requires management to measure the Company’s financial position and operating results primarily in terms of historic dollars. Changes in the relative value of money due to inflation or recession are generally not considered. The primary effect of inflation on our operations is reflected in increased operating expenses. Management considers changes in interest rates to impact our financial condition and results of operations to a far greater degree than changes in prices due to inflation. We manage our interest rate risk in several ways. Refer to “Note – Derivatives and Hedging Activities” in the accompanying “Notes to Unaudited Consolidated Financial Statements” for further discussion on how we manage interest rate risk. There can be no assurance that we will not be materially adversely affected by future changes in interest rates, as interest rates are highly sensitive to many factors that are beyond our control.

Results of Operations

The following discussion and analysis is intended to provide detail about the results of our operations and financial condition.

Net income decreased $13.0 million to $72.7 million, or $0.70 per share, during the three months ended September 30, 2023, as compared to net income of $85.7 million, or $0.80 per share, for the same period in 2022. The decrease during the quarter ended September 30, 2023 compared to the same period in 2022 was primarily attributable to lower net interest income as a result of higher interest expense on deposits and other borrowed funds. Lower net interest income was partially offset by lower non-interest expenses and an increase in non-interest income related to the $24.2 million loss on investment securities during the 2022 period.

Net income increased $79.6 million to $196.0 million, or $1.89 per share during the nine months ended September 30, 2023, as compared to net income of $116.4 million, or $1.13 per share for the same period in 2022. The increase during the nine months ended September 30, 2023 was primarily attributable to an increase in net interest income after the reduction of provision for credit losses of $28.0 million, which was largely related to the non-PCD provision expense in 2022 associated with the GWB acquisition, and lower non-interest expenses of $99.9 million, related to the acquisition related expenses of $115.0 million in 2022. These impacts were partially offset by a decrease in non-interest income and an increase in income tax expense in 2023.

Net Interest Income

Our operating results depend primarily on our net interest income, which is the difference between the interest the Company earns on its interest-earning assets, such as loans and investment securities, and the expense the Company pays on interest-bearing liabilities, such as deposits and borrowings. Net interest income depends on both the volume of our interest-earning assets and interest-bearing liabilities and the interest rates the Company earns or pays on them.

Changes in interest rate spread, which is the difference between interest earned on assets and interest paid on liabilities, has the most significant impact on net interest income. Other factors like volume of loans, investment securities, and other interest-earning assets compared to the volume of interest-bearing deposits and indebtedness also cause changes in our net interest income between periods. Non-interest-bearing sources of funds, such as demand deposits and stockholders’ equity, help to support earning assets.

For the periods indicated, the following table presents condensed average balance sheet information, together with interest income and yields earned on average interest-earning assets and interest expense and rates paid on average interest-bearing liabilities.

(Dollars in millions)

Net interest income decreased $53.1 million during the three months ended September 30, 2023, as compared to the same period in 2022, primarily due to an increase in interest expense as a result of higher levels and costs of interest-bearing liabilities.

Net interest income included interest accretion related to the fair valuation of acquired loans of $5.2 million during the three months ended September 30, 2023, compared to interest accretion of $17.7 million during the three months ended September 30, 2022.

Our net FTE interest margin ratio, a non-GAAP financial measure, decreased 64 basis points for the three months ended September 30, 2023, as compared to the same period in 2022. Exclusive of the impact of interest accretion on acquired loans, the net FTE interest margin ratio, decreased 47 basis points to 3.00% during the three months ended September 30, 2023, as compared to 3.47% for the same period in 2022.

(Dollars in millions)

55

Net interest income decreased $13.2 million during the nine months ended September 30, 2023 as compared the same period in 2022, primarily due to a decrease in interest accretion related to the fair valuation of acquired loans and an increase in interest expense as a result of higher levels and costs of interest-bearing liabilities.

Net interest income included interest accretion related to the fair valuation of acquired loans of $15.0 million during the nine months ended September 30, 2023, compared to interest accretion of $42.0 million for the same period in 2022.

Our net FTE interest margin ratio, a non-GAAP measure, increased 9 basis points for the nine months ended September 30, 2023, as compared to the same period in 2022. Exclusive of the impact of interest accretion on acquired loans, the net FTE interest margin ratio, increased 5 basis points to 3.11% during the nine months ended September 30, 2023, as compared to 3.06% for the same period in 2022.

The table below sets forth a summary of the changes in interest income and interest expense resulting from estimated changes in average asset and liability balances (volume) and estimated changes in average interest rates (referred to as “rate”) for the three and the nine month periods ended September 30, 2023 and 2022. Changes which are not due solely to volume or rate have been allocated to these categories based on the respective percent changes in average volume and average rate as they compare to each other.

(Dollars in millions)

(1) Interest income and average rates for tax exempt loans and securities are presented on a FTE basis.

(Reduction of) provision for Credit Losses

The Company had a $0.1 million reduction of credit losses, which included a provision for credit losses of $3.2 million on loans held for investment, reduction of credit losses for unfunded commitments of $2.0 million, and a reduction of credit losses for investment securities of $1.3 million during the three months ended September 30, 2023, as compared to an $8.4 million provision for credit losses during same period in 2022. The provision incorporated the impact of net charge-offs of $1.1 million, or an annualized 0.02% of average loans outstanding, for the third quarter of 2023, compared to $12.0 million, or an annualized 0.27% of average loans outstanding during the same period in 2022. Net loan charge-offs in the third quarter of 2023 were composed of charge-offs of $6.2 million and recoveries of $5.1 million.

The provision during the nine months ended September 30, 2023 of $26.8 million included a provision for credit losses on loans held for investment of $25.3 million, provision for credit losses on unfunded commitments of $2.6 million, and a provision reduction of credit losses for investment securities of $1.1 million. This compares to a provision for credit losses of $68.0 million which included a provision for credit losses on loans held for investment of $60.2 million that included the CECL day-2 impact from the Great Western acquisition, provision for credit losses on unfunded commitments of $5.9 million, and a provision for credit losses on held-to-maturity investment securities of $1.9 million during the same period in 2022.

For information regarding our non-performing loans, see “Financial Condition – Non-Performing Assets” included herein. For more information on our allowance for credit losses, see “Financial Condition – Allowance for Credit Losses” included herein.

Non-Interest Income

Non-interest income also contributes to our operating results with fee-based revenues such as payment services, mortgage banking and wealth management revenues, service charges on deposit accounts and other service charges, commissions and fees being our principal source of non-interest income. The following table presents the composition of our non-interest income as of the periods indicated:

(Dollars in millions)

Total non-interest income increased $19.1 million for the three months ended September 30, 2023, as compared to the same period in 2022 and decreased $19.1 million for the nine months ended September 30, 2023, as compared to the same period in 2022. Significant components of this fluctuation are discussed below.

Payment services revenues consist of interchange fees that merchants pay for processing electronic payment transactions and ATM service fees. Payment services revenues decreased $1.2 million during the three months ended September 30, 2023 and increased $3.3 million during the nine months ended September 30, 2023, as compared to the same periods in 2022. The increase during the nine months ended September 30, 2023 reflects higher credit and debit card volume in addition to an additional month of revenues related to the acquisition of GWB on February 1, 2022.

Mortgage banking revenues include gains on residential real estate loans sold, net mortgage servicing revenues and direct costs related to loans sold (including amortization, mortgage servicing rights impairment and recoveries and other expenses), and origination and processing fees on residential real estate loans held for sale. Mortgage banking revenues decreased $0.7 million during the three months ended September 30, 2023 compared to the same period in 2022. For the nine months ended September 30, 2023, mortgage banking revenues decreased $9.2 million compared to the same period in 2022. Included in the nine months ended September 30, 2022 was a $3.4 million recovery of mortgage servicing rights impairment. Excluding the 2022 impairment recovery, mortgage banking revenues decreased $5.8 million during the nine months ended September 30, 2023, compared to the nine months ended September 30, 2022. The decrease in mortgage banking revenues was driven by a decline in home loan production volume, largely as a result of higher interest rates during the nine months ended September 30, 2023, and tighter gain-on-sale spreads.

Service charges on deposit accounts are primarily driven by service fees and overdraft charges on deposit accounts. Service charges on deposit accounts increased $0.3 million during the three months ended September 30, 2023 compared to the same period in 2022. For the nine months ended September 30, 2023, service charges on deposit accounts decreased $2.7 million, as compared to the same period in 2022, primarily due to the company’s discontinuance of assessing non-sufficient fund fees and a reduction of overdraft fees on April 1, 2022 for the legacy footprint and as of May 23, 2022 for the acquired GWB footprint.

Other service charges, commissions, and fees primarily include fees earned on certain derivative interest rate contracts, insurance commissions, and safe deposit boxes. Other service charges, commissions, and fees decreased $2.5 million during the three months ended September 30, 2023 compared to the same period in 2022. For the nine months ended September 30, 2023, other service charges, commissions and fees decreased $5.6 million as compared to the same period in 2022. The decreases during the three and the nine months ended September 30, 2023 were primarily the result of decreased swap fee revenues earned on derivative interest rate swap contracts offered to clients.

Investment securities losses, net includes realized gains and losses associated with the sales of investment securities. Investment securities losses, net was zero during the three months ended September 30, 2023 compared to a net loss of $24.2 million in the same period in 2022. The 2022 period included the loss of $46.3 million incurred on the sale of $500 million in U.S. treasury notes previously swapped. The loss incurred on the sale was offset by the recognition of a deferred swap termination gain of $22.1 million. During the nine months ended September 30, 2023, investment securities losses, net increased $0.9 million as compared to the same period in 2022 due to the disposition of $853.0 million in carrying value of available-for-sale investment securities during the first quarter of 2023 compared to the aforementioned loss in 2022.

Other income primarily includes company-owned life insurance revenues, check printing income, agency stock dividends, and gains on sales of miscellaneous assets. Other income decreased $1.2 million during the three months ended September 30, 2023 compared to the same period in 2022, primarily due to a loss on the sale of loans held for sale during the three months ended September 30, 2023. Other income decreased $6.4 million during the nine months ended September 30, 2023, as compared to the same period in 2022, primarily due a decrease in the credit valuation discount on derivatives acquired in the GWB acquisition, gain on the disposition of the GWB acquired subordinated debt, and gains on the sale of premises and equipment during the nine months ended September 30, 2022 compared to an increase in life insurance proceeds offset by a loss on the sale of loans held for sale during the nine months ended September 30, 2023.

Non-Interest Expense

Non-interest expense decreased $12.1 million during the three months ended September 30, 2023 compared to the same period in 2022. The decrease was primarily the result of a decrease in incentive compensation accrued during the three months ended September 30, 2023 and a decrease in acquisition expenses related to the GWB acquisition incurred during the three months ended September 30, 2022.

Non-interest expense decreased $99.9 million during the nine months ended September 30, 2023 as compared to the same period in 2022. The decrease was the result of lower incentive compensation accruals and a decrease in acquisition expenses related to the GWB acquisition incurred during the nine months ended September 30, 2022, partially offset by increased expenses in 2023 as a result of three full quarters of combined operations, post-GWB acquisition. Expenses related to acquisitions include legal fees, consulting fees, investment banking fees, conversion and contract termination costs, and retention and severance compensation costs. Other significant components of non-interest expense are discussed below. For additional information regarding acquisitions, see “Note 2 – Acquisitions” in the accompanying “Notes to Unaudited Consolidated Financial Statements” included in this report.

The following table presents the composition of our non-interest expense as of the periods indicated:

(Dollars in millions)

The increases in employee benefits, outsourced technology services, and occupancy, net, during the nine-month period ended September 30, 2023, as compared to the same period in 2022, are primarily due to having a full first quarter 2023 of expenses from additional costs resulting from the GWB acquisition.

Salaries and wages expense decreased $6.5 million during the three months ended September 30, 2023, as compared to the same period in 2022. Salaries and wages decreased $7.6 million during the nine months ended September 30, 2023 as compared to the same period in 2022. The decreases during the three and the nine months ended September 30, 2023 are the result of lower mortgage loan originator commissions and lower levels of incentive accruals during the 2023 periods as compared to 2022, partially offset by inflationary wage pressure and severance costs primarily related to permanent staffing reductions within the mortgage group during the second quarter of 2023.

FDIC insurance premiums increased $0.9 million during the three months ended September 30, 2023 compared to the same period in 2022 and increased $5.2 million during the nine months ended September 30, 2023, as compared to the same period in 2022, primarily attributable to the incremental two basis point assessment fee imposed by the FDIC which began in the first quarter of 2023. The Company is expecting additional FDIC expenses related to the Notice of Proposed Rulemaking by the FDIC in May 2023. To recover the cost associated with protecting uninsured depositors during the recent bank failures, the proposal would implement a 12.5 basis point annual special assessment on uninsured deposits reported in bank’s call reports as of December 31, 2022, excluding the first $5.0 billion of uninsured deposits. The FDIC is proposing to collect the special assessment for an estimated eight consecutive quarters beginning with the first quarter 2024. A final rule is not expected until later in 2023 after a public comment period and the FDIC's final deliberations have concluded. As proposed, the estimated impact of the special assessment is approximately $9.8 million, which is expected to be recognized upon the rule's final issuance. The ultimate impact and timing of recognition will depend on the final outcome of the ongoing FDIC deliberations.

Other expenses primarily include advertising and public relations costs; office supply, postage, freight, telephone, and travel expenses; donations expense; debit and credit card expenses; board of director fees; legal expenses; and other losses. Other expenses decreased $1.4 million during the three months ended September 30, 2023 compared to the same period in 2022, primarily due to an increase in credit card rewards. Other expenses increased $6.6 million during the nine months ended September 30, 2023, as compared to the same period in 2022, mainly attributable to swap servicing fees, sales and use taxes, credit and debit card processing, credit card rewards, and increases in fraud losses.

Income Tax Expense

Our effective tax rate was 23.2% for the three months ended September 30, 2023 compared to 20.7% for the three months ended September 30, 2022 and 23.4% for the nine months ended September 30, 2023 compared to 20.9% for the same period in 2022.

Financial Condition

Total Assets

Total assets decreased $1,747.0 million, or 5.4%, to $30,540.8 million as of September 30, 2023, from $32,287.8 million as of December 31, 2022, primarily due to a decrease in cash and cash equivalents and investment securities as a result of a decline in deposits and securities sold under repurchase agreements, partially offset by an increase in loans held for investment. Significant fluctuations in balance sheet accounts are discussed below. More information regarding the results as of December 31, 2022 can be found in our Annual Report on Form 10-K for the year ended December 31, 2022.

Investment Securities

We manage our investment portfolio primarily as a source of liquidity. In doing so, we seek to obtain the highest yield possible within our risk tolerance and liquidity guidelines, while satisfying the pledging requirements for deposits of state and political subdivisions and securities sold under repurchase agreements. Our portfolio principally comprises U.S. treasuries, U.S. government agency residential and commercial mortgage-backed securities and collateralized mortgage obligations, U.S. government agency, collateralized loan obligations, corporate securities, and tax-exempt securities. Federal funds sold and interest-bearing deposits in the Bank are additional investments that are classified as cash equivalents rather than as investment securities. Investment securities classified as available-for-sale are recorded at fair value, while investment securities classified as held-to-maturity are recorded at amortized cost. Unrealized gains or losses, net of the deferred tax effect, on available-for-sale securities are reported as increases or decreases in accumulated other comprehensive income or loss, a component of stockholders’ equity.

Investment securities decreased $1,510.7 million, or 14.5%, to $8,887.2 million, or 29.1% of total assets, as of September 30, 2023, from $10,397.9 million, or 32.2% of total assets, as of December 31, 2022. The decrease was the result of the disposition of $853.0 million of investment securities during the first quarter of 2023, normal amortization of the portfolio that was used to pay down short-term borrowings, and declines in fair market values during the period. There have been no new purchases during the nine months ended September 30, 2023.

As of September 30, 2023 and December 31, 2022, the estimated duration of our investment portfolio was 3.7 years.

As of September 30, 2023 and December 31, 2022, we had $8,317.5 million and $2,620.8 million, respectively, of investment securities that had been in a continuous loss position for more than twelve months. At September 30, 2023 and December 31, 2022, the Company had no allowance for credit losses on available-for-sale securities and an allowance for credit losses on held-to maturity securities classified as corporate and municipal securities of $0.8 million and $1.9 million, respectively.

Loans Held for Investment, Net of Deferred Fees and Costs

Loans held for investment, net of deferred fees and costs, increased $114.1 million as of September 30, 2023 as compared to December 31, 2022.

The following table presents the composition and comparison of loans held for investment for the periods indicated:

Non-Performing Assets

Non-performing assets include non-performing loans and OREO.

Non-Performing Loans. Non-performing loans include non-accrual loans and loans contractually past due 90 days or more and still accruing interest.

Non-accrual loans. We generally place loans on non-accrual status when they become 90 days past due unless they are well secured and in the process of collection. When a loan is placed on non-accrual status, any interest previously accrued but not collected is reversed from income. Non-accrual loans increased approximately $22.2 million, or 37.5%, to $81.4 million, as of September 30, 2023, from $59.2 million as of December 31, 2022, primarily due to construction and commercial real estate loans. As of September 30, 2023 there were approximately $37.4 million of non-accrual loans for which there was no related allowance for credit losses, as these loans had sufficient collateral securing the loan for repayment.

Loans contractually past due 90 days or more and still accruing interest. Loans past due 90 days or more accruing interest were $3.2 million as of September 30, 2023, a decrease of $3.2 million, or 50.0%, from $6.4 million as of December 31, 2022.

Other Real Estate Owned (OREO). OREO consists of real property acquired through foreclosure on the collateral underlying defaulted loans. We initially record OREO at fair value less estimated selling costs. Any excess of loan carrying value over the fair value of the real estate acquired is recorded as a charge against the allowance for credit losses. Estimated losses that result from the ongoing periodic valuation of these properties are charged to earnings in the period in which they are identified. OREO decreased $1.1 million, or 8.7%, to $11.6 million as of September 30, 2023, from $12.7 million as of December 31, 2022 as a result of valuation adjustments to OREO properties.

The following table sets forth information regarding non-performing assets as of the dates indicated:

(Dollars in millions)

The following table sets forth the allocation of our non-performing loans among our various loan categories as of the dates indicated.

(Dollars in millions)

Allowance for Credit Losses

The Company performs a quarterly assessment of the appropriateness of its allowance for credit losses in accordance with GAAP. The allowance for credit losses is established through a provision for credit losses based on our evaluation of quantitative and qualitative risk factors in our loan portfolio at each balance sheet date. In determining the allowance for credit losses, we estimate losses on specific loans, or groups of loans, where the expected loss can be identified and reasonably determined over the life of the loans. The balance of the allowance for credit losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature or tenure of the loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current environmental and economic factors, and the estimated impact of forecasted economic conditions on historical loan loss rates.

The allowance for credit losses is increased by provisions charged against earnings and net recoveries of charged-off loans and is reduced by negative provisions credited to earnings and net loan charge-offs. The allowance for credit losses consists of three elements:

(1) Specific valuation allowances associated with collateral-dependent and other individually evaluated loans. Specific valuation allowances are determined based on assessment of the fair value of the collateral underlying the loans as determined through independent appraisals, the present value of future cash flows, observable market prices, and any relevant qualitative or environmental factors impacting loans.

(2) Collective valuation allowances based on loan loss experience and future expectations for similar loans with similar characteristics and trends. The Company applies open pool methodologies for all portfolio segments. The open pool methodology averages quarterly loss rates by modeling segment, calculated as quarter-to-date net charge off balance divided by the end of period balance. Loss rates are recalculated quarterly with recoveries captured in the quarter a loan was charged off, are averaged across a look back period from 2009 to the current period, and are annualized. Macroeconomic-conditioned historical loss rates are applied to loan-level cash flows. Expected future principal and interest cash flows are calculated using contractual repayment terms and prepayment, utilization, interest rate, and probability of default assumptions. Macroeconomic sensitivity models calculate segment-specific multipliers using third party forecast data. The multipliers condition the annual loss rates over the 2-year forecast period, followed by a 1-year straight-line reversion to the unadjusted historical average loss rates. The unadjusted loss rates then apply for the remaining life of the loan. Estimated losses are totaled and aggregated to the segment level.

(3) General valuation allowances determined based on asset quality trends, industry concentrations, environmental risks, changes in portfolio composition, and other qualitative risk factors, both internal and external to the Company. Other qualitative factors, including changes in loan and lending policies, collateral quality, underwriting standards and personnel, credit review quality, and model imprecision, are also considered.

Based on the assessment of the appropriateness of the allowance for credit losses, the Company records provisions for credit losses to maintain the allowance for credit losses at appropriate levels.

Loans acquired in business combinations are initially recorded at fair value as adjusted for credit risk and an allowance for credit losses at the date of acquisition. For loans with no significant evidence of credit deterioration since origination, the difference between the fair value and the unpaid principal balance of the loan at the acquisition date is amortized into interest income using the effective interest method over the remaining period to contractual maturity. An allowance for credit loss is recorded for the expected credit losses over the life of the loan. Subsequent changes to the allowance for credit losses are recorded through provision expense using the same methodology as other loans held for investment.

For loans acquired in business combinations with evidence of deterioration in credit quality since origination, the Company determines the fair value of the loans by estimating the amount and timing of principal and interest cash flows initially expected to be collected on the loans and discounting those cash flows at an appropriate market rate of interest. An allowance for credit losses is recognized by estimating the expected credit losses of the purchased asset and recording an adjustment to the acquisition date fair value to establish the initial amortized cost basis of the asset. Differences between the established amortized cost basis, and the unpaid principal balance of the asset, is considered to be a non-credit discount/premium and is accreted/amortized into interest income using the level yield interest method. Subsequent changes to the allowance for credit losses are recorded through provision expense using the same methodology as other loans held for investment.

Loans, or portions thereof, are charged-off against the allowance for credit losses when management believes the collectability of the principal is unlikely, or, with respect to consumer installment loans, according to an established delinquency schedule. Generally, loans are charged-off when (1) there has been no material principal reduction within the previous 90 days and there is no pending sale of collateral or other assets, (2) there is no significant or pending event which will result in principal reduction within the upcoming 90 days, (3) it is clear that we will not be able to collect all or a portion of the loan, (4) payments on the loan are sporadic, will result in an excessive amortization, or are not consistent with the collateral held, or (5) foreclosure or repossession actions are pending. Loan charge-offs do not directly correspond with the receipt of independent appraisals or the use of observable market data if the collateral value is determined to be sufficient to repay the principal balance of the loan.

If a collateral-dependent loan is adequately collateralized, a specific valuation allowance for credit losses is not recorded. As such, significant changes in collateral-dependent and non-performing loans do not necessarily correspond proportionally with changes in the specific valuation component of the allowance for credit losses. Additionally, the Company expects the timing of charge-offs will vary between quarters and will not necessarily correspond proportionally to changes in the allowance for credit losses or changes in non-performing or collateral-dependent loans due to timing differences among the initial identification of a collateral-dependent loan, recording of a specific valuation allowance for collateral-dependent loans, and any resulting charge-off of uncollectible principal.

Our allowance for credit losses was $226.7 million, or 1.24% of loans held for investment as of September 30, 2023 compared to $220.1 million, or 1.22% of loans held for investment, as of December 31, 2022. The increase in the percentage from December 31, 2022 is primarily a result of loan growth and credit migration. The Company’s allowance for off-balance sheet credit losses was $18.8 million as of September 30, 2023, compared to $16.2 million as of December 31, 2022.

Although we have established our allowance for credit losses in accordance with GAAP in the United States and we believe that the allowance for credit losses is appropriate to provide for known and expected losses in the portfolio at all times, future provisions will be subject to on-going evaluations of the risks in the loan portfolio. If the economy declines or asset quality deteriorates, material additional provisions could be required.

The following table sets forth information regarding our allowance for credit losses as of and for the periods indicated:

(Dollars in millions)

Total Liabilities

Total liabilities decreased $1,758.7 million, or 6.0%, to $27,455.3 million as of September 30, 2023, from $29,214.0 million as of December 31, 2022, primarily due to decreases in deposits, securities sold under repurchase agreements, and other borrowed funds, partially offset by an increase in accrued interest payable. Significant fluctuations in liability accounts are discussed below.

Deposits

Our deposits consist of non-interest-bearing and interest-bearing demand, savings, individual retirement, and time deposit accounts. Total deposits decreased $1,394.1 million, or 5.6%, to $23,679.5 million as of September 30, 2023, from $25,073.6 million as of December 31, 2022, primarily due to a decrease in business-related non-interest-bearing balances and interest-bearing demand and savings deposits, partially offset by increases in time deposits.

The following table summarizes our deposits as of the dates indicated:

(Dollars in millions)

(1) Included in “Time, other” are Certificate of Deposit Account Registry Service, or CDARS, deposits of $50.9 million and $36.6 million as of September 30, 2023 and December 31, 2022, respectively.

Deposit Insurance

The deposits of the Bank are insured up to the applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC, generally up to $250,000 per insured depositor. The Bank pays deposit insurance premiums based on assessment rates established by the FDIC. The estimated amount of deposits in excess of the FDIC insurance limit at September 30, 2023 was $7.9 billion, or 33.2% of total deposits. Estimates of uninsured deposits are based on the methodologies and assumptions used in the Bank’s call reports and do not necessarily reflect an evaluation of all scenarios that potentially would determine the availability of deposit insurance to customer accounts based on FDIC regulations.

Securities Sold Under Repurchase Agreements

In addition to deposits, repurchase agreements with commercial depositors, which include municipalities, provide an additional source of funds. Under repurchase agreements, deposit balances are invested in short-term U.S. government agency securities overnight and are then repurchased the following day. All outstanding repurchase agreements are due in one day and balances fluctuate in the normal course of our client’s business. Securities sold under repurchase agreement balances decreased $163.4 million, or 15.5%, to $889.5 million as of September 30, 2023, from $1,052.9 million as of December 31, 2022.

Other Borrowed Funds

Other borrowed funds decreased $260.0 million as of September 30, 2023 compared to December 31, 2022, primarily due to the repayment of advances by the Company resulting in the Company’s lower outstanding borrowings with the FHLB during 2023.

Capital Resources and Liquidity Management

Capital Resources. Stockholders’ equity is influenced primarily by earnings, dividends, sales and redemptions of common stock, and changes in the unrealized holding gains or losses, net of taxes, on available-for-sale investment securities. Stockholders’ equity increased $11.7 million, or 0.4%, to $3,085.5 million as of September 30, 2023, from $3,073.8 million as of December 31, 2022, due to the retention of earnings, which was partially offset by a modest increase to the unrealized losses on available-for-sale securities through other comprehensive income, by stock repurchases of vested restricted shares tendered in lieu of cash for payment of income tax withholding amounts by participants, and by cash dividends paid.

On October 24, 2023, the Company’s board of directors declared a dividend of $0.47 per common share, payable on November 16, 2023, to common stockholders of record as of November 6, 2023. The dividend equates to a 7.2% annual yield based on the $26.10 average closing pricing of the Company’s common stock during the third quarter of 2023.

As a bank holding company, the Company must comply with the capital requirements established by the Federal Reserve, and our subsidiary Bank must comply with the capital requirements established by the FDIC. The current risk-based guidelines applicable to us and our Bank are based on the Basel III framework, as implemented by the federal bank regulators. As of September 30, 2023 and December 31, 2022, the Company had capital levels that, in all cases, exceeded the guidelines to be deemed “well-capitalized.” For additional information regarding our capital levels, see “Note – Regulatory Capital” in the accompanying “Notes to Unaudited Consolidated Financial Statements” included in this report.

Liquidity. Liquidity measures our ability to meet current and future cash flow needs on a timely basis and at a reasonable cost. We manage our liquidity position to meet the daily cash flow needs of clients, while maintaining an appropriate balance between assets and liabilities to meet the return-on-investment objectives of our shareholders. Our liquidity position is supported by management of liquid assets and liabilities and access to alternative sources of funds. Liquid assets include cash, interest-bearing deposits in banks, federal funds sold, available-for-sale investment securities, and maturing or prepaying balances in our held-to-maturity investment and loan portfolios. Liquid liabilities include core deposits, federal funds purchased, securities sold under repurchase agreements, and borrowings. Other sources of liquidity include the sale of loans, the ability to acquire additional national market funds through non-core deposits, the issuance of additional collateralized borrowings such as FHLB advances, the issuance of debt securities, additional borrowings through the Federal Reserve’s discount window, Federal Reserve’s Bank Term Funding Program (“BTFP”), and the issuance of preferred or common securities. Our short-term and long-term liquidity requirements are primarily to fund on-going operations, including payment of interest on deposits and debt, extensions of credit to borrowers, capital expenditures, and shareholder dividends. These liquidity requirements are met primarily through cash flow from operations, redeployment of prepaying and maturing balances in our loan and investment portfolios, the issuance of securities, borrowings and other debt financing, and increases in client deposits.

For the nine months ended September 30, 2023, net cash provided by operating activities was $358.7 million, net cash provided by investing activities was $1,329.7 million and net cash used in financing activities was $1,965.8 million. Major uses of cash were $1,394.1 million in outflows of deposits, $260.0 million in repayment of other borrowed funds, and the extension of credit to clients of $128.7 million. A major source of cash included $1,276.3 million in repayment of loans at maturity, exercise of call options, principal pay downs, and sales of available-for-sale securities. Total cash and cash equivalents were $593.1 million as of September 30, 2023, compared to $870.5 million as of December 31, 2022 and $591.9 million as of September 30, 2022. For additional information regarding our operating, investing, and financing cash flows, see the unaudited “Consolidated Statements of Cash Flows,” included in Part I, Item 1. For additional information regarding our deposits, see “Financial Condition – Deposits,” include in Part I, Item 2.

As a holding company, we are a corporation separate and apart from our subsidiary Bank and, therefore, we provide for our own liquidity. Our primary sources of funding include management fees and dividends declared and paid by the Bank and access to capital markets. There are statutory, regulatory, and debt covenant limitations that affect the ability of our Bank to pay dividends to us. Management believes that such limitations will not impact our ability to meet our ongoing short-term cash obligations.

The Company continuously monitors our liquidity position and adjustments are made to the balance between sources and uses of funds as deemed appropriate. We are not aware of any events that are reasonably likely to have a material adverse effect on our liquidity, capital resources, or operations. In addition, we are not aware of any regulatory recommendations regarding liquidity, which if implemented, would have a material adverse effect on us. The Bank satisfies incremental liquidity needs with either liquid assets or external funding sources. Available liquidity includes cash, FHLB advances and Federal Reserve Bank (FRB) borrowings, through either the discount window or the newly established BTFP. The Bank has pledged its investment securities portfolio to access wholesale funding as needed and does not intend to sell or restructure securities at this time.

Through the Bank’s relationship with the FHLB, the Bank owns $93.3 million of FHLB stock and has access to additional liquidity and funding sources through FHLB advances. The Bank’s borrowing capacity is dependent upon the amount of collateral the Bank places at the FHLB. As of September 30, 2023, the Bank had no short-term advances outstanding at FHLB and $2,067.0 million in outstanding FHLB borrowings consisting of fixed rate borrowings with tenors of up to five months. The Bank’s remaining borrowing capacity with the FHLB was $4,764.4 million as of September 30, 2023.

The Bank had no short-term borrowings outstanding with the Federal Reserve Bank's BTFP as of September 30, 2023. As of September 30, 2023, the Bank’s remaining borrowing capacity with the BTFP was $2.5 billion and its remaining borrowing capacity at the Federal Reserve Discount Window was $0.7 billion.

In addition to borrowing capacity with the FHLB and at the Federal Reserve Discount Window as described above, the Bank had additional liquidity of $2.5 billion available via cash, unpledged bond collateral, and the federal funds market as of September 30, 2023.

Recent Accounting Pronouncements

See “Note – Recent Authoritative Accounting Guidance” in the accompanying “Notes to Unaudited Consolidated Financial Statements” included in this report for details of recently issued accounting pronouncements and their expected impact on our financial statements.

Non-GAAP Reconciliation

(Dollars in millions)

66

QUANTITATIVE AND QUALITATIVE DISCLOSURES

ABOUT MARKET RISK

Based on the changes in interest rates and the composition of the Company’s balance sheet subsequent to December 31, 2022, the following update of the Company’s assessment of market risk as of September 30, 2023 is being provided. These updates and changes should be read in conjunction with the additional quantitative and qualitative disclosures in our Annual Report on Form 10-K for the year ended December 31, 2022.

As of September 30, 2023, our income simulation model predicted net interest income would decrease by 3.28% on an immediate upward 100 basis point parallel shock over the following twelve months, assuming a static balance sheet, which was lower than the previous increase of 0.17% as of December 31, 2022, and increase 5.22% on an immediate downward 100 basis point parallel shock. Assuming a 2.0% gradual reduction in interest rates during each of the next four consecutive quarters, net interest income would increase 5.81%.

CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Our management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Exchange Act. As of September 30, 2023, an evaluation was performed, under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of September 30, 2023 were effective in ensuring that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported within the time periods required by the SEC’s rules and forms, and is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting for the quarter ended September 30, 2023 that have materially affected, or are reasonably likely to materially affect, such control.

Limitations on Controls and Procedures

The effectiveness of our disclosure controls and procedures and our internal control over financial reporting is subject to various inherent limitations, including cost limitations, judgments used in decision making, assumptions about the likelihood of future events, the soundness of our systems, the possibility of human error, and the risk of fraud. Moreover, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions and the risk that the degree of compliance with policies or procedures may deteriorate over time. Because of these limitations, any system of disclosure controls and procedures or internal control over financial reporting may not be successful in preventing all errors or fraud or in making all material information known in a timely manner to the appropriate levels of management.

PART II.

OTHER INFORMATION

There have been no material changes in risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2022 during the period covered by this quarterly report.