Atlantic Union Bankshares Corp: Form 10-Q for the period ended Sep 30, 2023

Management’s discussion and analysis is presented to aid the reader in understanding and evaluating the results of operations, financial condition, liquidity, and capital resources of the Company and its subsidiaries. This discussion and analysis should be read in conjunction with the Company’s consolidated financial statements, the notes to the financial statements, and the other financial data included in this report, as well as the Company’s 2022 Form 10-K, including under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section therein. Highlighted in the discussion are material changes from prior reporting periods and identifiable trends materially affecting the Company. Results of operations for the interim periods are not necessarily indicative of results that may be expected for the full year or for any other period. Amounts are rounded for presentation purposes; however, some of the percentages presented are computed based on unrounded amounts.

In management’s discussion and analysis, the Company provides certain financial information determined by methods other than in accordance with GAAP. These non-GAAP financial measures are a supplement to GAAP, which is used to prepare the Company’s financial statements, and should not be considered in isolation or as a substitute for comparable measures calculated in accordance with GAAP. In addition, the Company’s non-GAAP financial measures may not be comparable to non-GAAP financial measures of other companies. The Company uses the non-GAAP financial measures discussed herein in its analysis of the Company’s performance. The Company’s management believes that these non-GAAP financial measures provide additional understanding of ongoing operations, enhance comparability of results of operations with prior periods and show the effects of significant gains and charges in the periods presented without the impact of items or events that may obscure trends in the Company’s underlying performance. Non-GAAP financial measures may be identified with the symbol (+) and may be labeled as adjusted. Refer to the “Non-GAAP Financial Measures” section within this Item 2 for more information about these non-GAAP financial measures, including a reconciliation of these measures to the most directly comparable GAAP financial measures.

FORWARD-LOOKING STATEMENTS

Certain statements in this report may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that include, without limitation, statements regarding our expectations with regard to our business, financial and operating results, including our deposit base and funding and the impact of future economic conditions, anticipated changes in the interest rate environments and the related impacts on the Company’s net interest margin, changes in economic conditions, management’s belief regarding liquidity and capital resources, and the expected impact of our cost saving measures initiated in the second quarter of 2023, statements regarding the pending merger with American National, and statements that include other projections, predictions, expectations, or beliefs about future events or results or otherwise are not statements of historical fact. Such forward-looking statements are based on certain assumptions as of the time they are made, and are inherently subject to known and unknown risks, uncertainties, and other factors, some of which cannot be predicted or quantified, that may cause actual results, performance, or achievements to be materially different from those expressed or implied by such forward-looking statements. Forward-looking statements are often characterized by the use of qualified words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate,” “intend,” “will,” “may,” “view,” “opportunity,” “potential,” “continue,” “confidence,” or words of similar meaning or other statements concerning opinions or judgment of the Company and our management about future events. Although we believe that our expectations with respect to forward-looking statements are based upon reasonable assumptions within the bounds of our existing knowledge of our business and operations, there can be no assurance that actual future results, performance, or achievements of, or trends affecting, us will not differ materially from any projected future results, performance, achievements or trends expressed or implied by such forward-looking statements. Actual future results, performance, achievements or trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of or changes in:

• market interest rates and their related impacts on macroeconomic conditions, customer and client behavior, our funding costs and our loan and securities portfolios;
• inflation and its impacts on economic growth and customer and client behavior;
• adverse developments in the financial industry generally, such as bank failures, responsive measures to mitigate and manage such developments, related supervisory and regulatory actions and costs, and related impacts on customer and client behavior;
• the sufficiency of liquidity;
• general economic and financial market conditions, in the United States generally and particularly in the markets in which we operate and which our loans are concentrated, including the effects of declines in real estate values, an increase in unemployment levels and slowdowns in economic growth;
• the failure to close our previously announced merger with American National when expected or at all because required regulatory, American National shareholder or other approvals and other conditions to closing are not received or satisfied on a timely basis or at all, and the risk that any regulatory approvals may result in the imposition of conditions that could adversely affect the combined company or the expected benefits of the proposed merger;
• the occurrence of any event, change or other circumstances that could give rise to the right of one or both of the parties to terminate the merger agreement;
• any change in the purchase accounting assumptions used regarding the American National assets acquired and liabilities assumed to determine the fair value and credit marks, particularly in light of the current rising interest rate environment;
• the possibility that the anticipated benefits of the proposed merger, including anticipated cost savings and strategic gains, are not realized when expected or at all;
• the proposed merger being more expensive or taking longer to complete than anticipated, including as a result of unexpected factors or events;
• the diversion of management’s attention from ongoing business operations and opportunities do to the proposed merger;
• potential adverse reactions or changes to business or employee relationships, including those resulting from the announcement or completion of the proposed merger;
• the dilutive effect of shares of the Company’s common stock to be issued at the completion of the proposed merger;
• changes in the Company’s or American National’s share price before closing;
• monetary and fiscal policies of the U.S. government, including policies of the U.S. Department of the Treasury and the Federal Reserve;
• the quality or composition of our loan or investment portfolios and changes therein;
• demand for loan products and financial services in our market areas;
• our ability to manage our growth or implement our growth strategy;
• the effectiveness of expense reduction plans;
• the introduction of new lines of business or new products and services;
• our ability to recruit and retain key employees;
• real estate values in our lending area;
• changes in accounting principles, standards, rules, and interpretations, and the related impact on our financial statements;
• an insufficient ACL or volatility in the ACL resulting from the CECL methodology, either alone or as that may be affected by inflation, changing interest rates, or other factors;
• our liquidity and capital positions;
• concentrations of loans secured by real estate, particularly commercial real estate;
• the effectiveness of our credit processes and management of our credit risk;
• our ability to compete in the market for financial services and increased competition from fintech companies;
• technological risks and developments, and cyber threats, attacks, or events;
• operational, technological, cultural, regulatory, legal, credit, and other risks associated with the exploration, consummation and integration of potential future acquisitions, whether involving stock or cash considerations;
• the potential adverse effects of unusual and infrequently occurring events, such as weather-related disasters, terrorist acts, geopolitical conflicts or public health events, and of governmental and societal responses thereto; these potential adverse effects may include, without limitation, adverse effects on the ability of our borrowers to satisfy their obligations to us, on the value of collateral securing loans, on the demand for our loans or our other products and services, on supply chains and methods used to distribute products and services, on incidents of cyberattack and fraud, on our liquidity or capital positions, on risks posed by reliance on third-party service providers, on other aspects of our business operations and on financial markets and economic growth;
• the discontinuation of LIBOR and its impact on the financial markets, and our ability to manage operational, legal, and compliance risks related to the discontinuation of LIBOR and implementation of one or more alternate reference rates;
• performance by our counterparties or vendors;
• deposit flows;
• the availability of financing and the terms thereof;
• the level of prepayments on loans and mortgage-backed securities;
• legislative or regulatory changes and requirements;
• actual or potential claims, damages, and fines related to litigation or government actions, which may result in, among other things, additional costs, fines, penalties, restrictions on our business activities, reputational harm, or other adverse consequences;
• the effects of changes in federal, state or local tax laws and regulations;
• any event or development that would cause us to conclude that there was an impairment of any asset, including intangible assets, such as goodwill; and
• other factors, many of which are beyond our control.

Please also refer to such other factors as discussed throughout Part I, Item 1A, “Risk Factors” and Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of the 2022 Form 10-K, Part II, Item 1A, “Risk Factors” in our Quarterly Reports on Form 10-Q for the quarters ended June 30, 2023 and March 31, 2023, and related disclosures in other filings, which have been filed with the SEC and are available on the SEC’s website at www.sec.gov (http://www.sec.gov). All risk factors and uncertainties described herein and therein should be considered in evaluating forward-looking statements, and all of the forward-looking statements made in this report are expressly qualified by the cautionary statements contained or referred to herein and therein. The actual results or developments anticipated may not be realized or, even if substantially realized, they may not have the expected consequences to or effects on the Company or our businesses or operations. Readers are cautioned not to rely too heavily on the forward-looking statements contained in this Quarterly Report, and undue reliance should not be placed on such forward-looking statements. Forward-looking statements speak only as of the date they are made. We do not intend or assume any obligation to update, revise or clarify any forward-looking statements that may be made from time to time by or on behalf of the Company, whether as a result of new information, future events or otherwise.

CRITICAL ACCOUNTING ESTIMATES

The Company’s consolidated financial statements are prepared based on the application of accounting and reporting policies in accordance with GAAP and conform to general practices within the banking industry. The Company’s financial position and results of operations are affected by management’s application of accounting policies, which require the use of estimates, assumptions, and judgments, which may prove inaccurate or are subject to variations. Changes in underlying factors, estimates, assumptions or judgements could result in material changes in the Company’s consolidated financial position and/or results of operations.

Certain accounting policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. The Company has identified the ALLL and fair value measurements as accounting policies that require the most difficult, subjective or complex judgments and, as such, could be most subject to revision as new or additional information becomes available or circumstances change. Therefore, the Company evaluates these accounting policies and related critical accounting estimates on an ongoing basis and updates them as needed. Management has discussed these accounting policies and critical accounting estimates summarized below with the Audit Committee of the Board of Directors.

Effective September 30, 2023, the Company implemented certain changes to its ALLL estimation methodology. These changes did not have a significant impact on the overall ALLL estimate. The ALLL represents the estimated balance that management considers adequate to absorb expected credit losses over the expected contractual life of the loan portfolio. The Company estimates the ALLL using a loan-level PD/LGD method for all loans.

Determining the appropriateness of the ALLL is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the then-existing loan portfolio, in light of the factors then prevailing, may result in significant changes in the ALLL in future periods. There are both internal factors (i.e., loan balances, credit quality, and the contractual lives of loans) and external factors (i.e., economic conditions such as trends in housing prices, interest rates GDP, inflation, and unemployment) that can impact the ALLL estimate.

The Company considers a number of external economic variables in developing the ALLL. Prior to September 30, 2023, the most significant of these external economic variables was the Virginia unemployment rate. The Company now considers various national economic variables in developing the ALLL, including the national unemployment rate, national gross domestic product, national CRE pricing index, national home price index, and national retail sales. The national unemployment rate is used in all models regardless of the loan portfolio type, and a second economic variable is used in each cohort model depending on the loan portfolio type. The ALLL quantitative estimate is sensitive to changes in the economic variable forecasts during the two-year reasonable and supportable period. In determining forecasted expected losses, the Company uses multiple Moody’s economic variable forecasts and applies probability weights to the related economic scenarios. Because current economic conditions and forecasts can change and future events are inherently difficult to predict, the anticipated amount of estimated credit losses on loans, and therefore the appropriateness of the ALLL, could change significantly. It is difficult to estimate how potential changes in any one economic factor or input might affect the overall ALLL because a wide variety of factors and inputs are considered in estimating the ALLL and changes in those factors and inputs may not occur at the same rate and may not be consistent across all loan types. Additionally, changes in factors and inputs may be directionally inconsistent, such that improvement in one factor may offset deterioration in others.

The Company reviews its ALLL estimation process regularly for appropriateness as the economic and internal environment are constantly changing. While the ALLL estimate represents management’s current estimate of expected credit losses, due to uncertainty surrounding internal and external factors, there is potential that the estimate may not be adequate over time to cover credit losses in the portfolio. While management uses available information to estimate expected losses on loans, future changes in the ALLL may be necessary based on changes in portfolio composition, portfolio credit quality, economic conditions and/or other factors.

The Company provides additional information on its critical accounting estimates in Note 1 “Summary of Significant Accounting Policies” in Part I, Item 1 of this Quarterly Report and under “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Estimates” in its 2022 Form 10-K. The Company’s significant accounting policies are discussed in detail in Note 1 “Summary of Significant Accounting Policies” in the “Notes to the Consolidated Financial Statements” contained in Item 8 "Financial Statements and Supplementary Data" of the Company’s 2022 Form 10-K.

RECENT ACCOUNTING PRONOUNCEMENTS (ISSUED BUT NOT FULLY ADOPTED)

In March 2023, the FASB issued ASU No. 2023-02 Investments—Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Tax Credit Structures Using the Proportional Amortization Method. Prior to the issuance of ASU 2023-02, companies could only apply the proportional amortization method to low-income-housing tax credit structures. Topic 323 allows for the expansion of use of the proportional amortization method to all tax equity investments that meet certain conditions. Under the proportional amortization method, the initial cost of the investment is amortized in proportion to the income tax credits and other income tax benefits received and presents this net amount as a component of income tax expense (benefit). The amendments are effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted. The Company evaluated the impact of ASU No. 2023-02 and concluded that it will not have a significant impact on its consolidated financial statements.

ABOUT ATLANTIC UNION BANKSHARES CORPORATION

Headquartered in Richmond, Virginia, Atlantic Union Bankshares Corporation (NYSE: AUB) is the holding company for Atlantic Union Bank. Atlantic Union Bank has 109 branches and 123 ATMs located throughout Virginia and in portions of Maryland and North Carolina as of September 30, 2023. Certain non-bank financial services affiliates of Atlantic Union Bank include: Atlantic Union Equipment Finance, Inc., which provides equipment financing; Atlantic Union Financial Consultants, LLC, which provides brokerage services; and Union Insurance Group, LLC, which offers various lines of insurance products.

Shares of the Company’s common stock are traded on the New York Stock Exchange under the symbol "AUB". Additional information is available on the Company’s website at https://investors.atlanticunionbank.com. The information contained on the Company’s website is not a part of or incorporated into this Quarterly Report.

RESULTS OF OPERATIONS

INDUSTRY IMPACTS

In March and April of 2023, the banking industry experienced significant volatility due to three high-profile bank failures. These bank failures resulted in significant concerns within the banking industry related to liquidity, deposit outflows, and unrealized losses on investment securities. These concerns and volatility in the banking industry may persist if other industry participants experience similar high-profile financial challenges or if other banks are closed by federal or state banking regulators. These events in the banking industry have reinforced the importance of maintaining access to diverse sources of funding and the benefits of a robust and stable deposit base.

In light of the bank closures and uncertainty in the banking industry, a continued rising interest rate environment, and persistent concerns about recessionary conditions in the U.S. economy, the Company continues to actively monitor balance sheet trends, deposit flows, and liquidity needs to ensure that the Company and the Bank are able to meet the needs of the Bank’s customers and maintain financial flexibility. During the first nine months of 2023, the Company’s LHFI, net of deferred fees and costs, and total deposits increased from December 31, 2022 by $834.5 million and $854.8 million, respectively, and the Company’s short-term borrowings decreased by $688.9 million from December 31, 2022. As of September 30, 2023, the Company estimates that approximately 73.2% of the Company’s deposits were insured or collateralized, and that the Company maintained available liquidity sources to cover approximately 132% of uninsured and uncollateralized deposits. In addition, to further bolster the Company’s funding position, the Company augmented customer deposit growth by also increasing brokered deposits to $516.7 million at September 30, 2023.

Despite the negative developments within the broader banking industry during the first nine months of 2023, the Company’s and the Bank’s regulatory capital ratios continued to exceed the standards to be considered well-capitalized under regulatory requirements. See “Capital Resources” within this Item 2 for additional information about the Company’s regulatory capital.

The Company is continually monitoring the impact of other various global and national events on the Company’s results of operations and financial condition, including inflation and rising interest rates. Inflation has risen, although at a slower pace in the second half of 2023, as a result of growth in economic activity and demand for goods and services, as well as labor shortages and global supply chain issues. In an effort to combat inflation, the FOMC increased the Federal Funds target rates throughout 2022 and 2023 to its current range of 5.25% to 5.50%. The FOMC has noted that it will continue to assess additional information and its implications for monetary policy, and in determining future actions with respect to the target rates, the FOMC will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments. The FOMC also confirmed the continued reduction to the Federal Reserve’s holdings of U.S. Treasury securities and agency debt and agency MBS. These developments helped drive the meaningful increase in deposit costs and deposit competition that the Company continues to experience. The Company anticipates that the net impact of these factors will result in a continued contraction of its net interest margin. The timing and impact of inflation, market interest rates, and the competitive landscape of deposits on the Company's business and results of operations will depend on future developments, which are highly uncertain and difficult to predict. The Company will continue to deploy various asset liability management strategies to seek to manage the Company's risk related to interest rate fluctuations. Refer to “Liquidity” within this Item 2 for additional information about the Company’s liquidity and “Quantitative and Qualitative Disclosures about Market Risk” in Part II, Item 3 of this Quarterly Report for additional information about the Company’s interest rate sensitivity.

RECENT STRATEGIC ACTIONS

Merger with American National Bankshares Inc.

On July 24, 2023, the Company and American National entered into a merger agreement. Under the merger agreement, American National will merge with and into the Company, with the Company continuing as the surviving entity. Immediately following the merger, American National Bank and Trust Company will merge with and into the Bank, with the Bank continuing as the surviving bank. Subject to the terms and conditions of the merger agreement, at the effective time of the merger, each outstanding share of American National common stock will be converted into the right to receive 1.35 shares of the Company’s common stock. The merger agreement was unanimously approved by the boards of directors of the Company and American National, and is subject to customary closing conditions, including receipt of required regulatory approvals and American National shareholder approval. The proposed merger is expected to close in the first quarter of 2024.

During the third quarter of 2023, the Company incurred pre-tax merger costs of approximately $2.0 million related to the proposed merger with American National.

Cost Saving Initiatives

As previously disclosed, the Company initiated a series of strategic cost saving measures during the second quarter of 2023 that is expected to reduce our annual expense run rate by approximately $17 million. As a result of these measures, the Company incurred pre-tax expenses of $8.7 million in the third quarter of 2023 and $3.9 million in the second quarter of 2023, principally composed of severance charges related to headcount reductions, costs related to modifying certain third-party vendor contracts, and charges for exiting certain leases.

Sale-Leaseback Transaction

On September 20, 2023, the Bank executed a sale-leaseback transaction and sold 27 properties, which consisted of 25 branches and a drive thru and parking lot, each adjacent to a sold branch, to a single purchaser for an aggregate purchase price of $45.8 million. Concurrently, the Bank entered into absolute net lease agreements with the purchaser under which the Bank will lease each of the properties for an initial term of 17 years with specified renewal options. The sale-leaseback transaction resulted in a pre-tax gain of approximately $27.7 million during the third quarter of 2023, after transaction-related expenses. Refer to Note 5 “Leases” within Part I, Item 1 “Financial Statements” of this Quarterly Report for additional information.

AFS Securities Sales

Concurrent with the sale-leaseback transaction, also on September 20, 2023, the Company restructured a portion of its investment portfolio by selling low yielding AFS securities with a book value of $228.3 million, resulting in a pre-tax net loss of $27.7 million. The net proceeds from the securities sale transaction were reinvested into higher yielding AFS securities at the end of the third quarter of 2023.

During the first quarter of 2023, the Company executed a balance sheet repositioning strategy and sold AFS securities with a total book value of $505.7 million at a pre-tax loss of $13.4 million and used the net proceeds to reduce existing high costing FHLB borrowings. The deleverage strategy provided the Company with improved liquidity, enhanced tangible common equity, and additional run rate earnings.

SUMMARY OF FINANCIAL RESULTS

Third Quarter Net Income & Performance Metrics

• Net income available to common shareholders was $51.1 million and basic and diluted EPS was $0.68 for the third quarter of 2023, compared to $55.1 million and $0.74 for the third quarter of 2022.
• Adjusted operating earnings available to common shareholders(+), which excludes (net of taxes) expenses incurred associated with our strategic cost saving initiatives principally composed of severance charges related to headcount reductions, costs related to modifying certain third-party vendor contracts, and charges for exiting certain leases ($6.9 million in 2023), merger-related costs associated with the American National merger ($2.0 million in 2023), losses on the sale of securities ($21.8 million in 2023), and the gain related to the sale-leaseback transaction ($21.9 million in 2023), was $59.8 million and adjusted diluted operating EPS (+) was $0.80 for the quarter ended September 30, 2023, compared to adjusted operating earnings available to common shareholders(+) of $55.1 million and diluted adjusted operating EPS(+) of $0.74 for the third quarter of 2022.

Nine Month Net Income & Performance Metrics

• Net income available to common shareholders was $136.0 million and basic and diluted EPS was $1.81 for the first nine months of 2023, compared to $155.1 million and $2.07 for the first nine months of 2022.
• Adjusted operating earnings available to common shareholders(+), which excludes (net of taxes) expenses incurred associated with our strategic cost saving initiatives ($10.0 million in 2023), merger-related costs associated with the American National merger ($2.0 million in 2023), the legal reserve associated with an ongoing regulatory matter as previously disclosed ($4.0 million in 2023), strategic branch closing and facility consolidation costs ($4.4 million in 2022), losses on the sale of securities ($32.4 million in 2023 and $2,000 in 2022), the gain related to the sale-leaseback transaction ($21.9 million in 2023), and the gain on sale of DHFB ($8.0 million in 2022), was $162.4 million and adjusted diluted operating EPS (+) was $2.17 for the nine months ended September 30, 2023, compared to adjusted operating earnings available to common shareholders(+) of $151.5 million and diluted adjusted operating EPS(+) of $2.02 for the first nine months of 2022.

Balance Sheet

• Total assets were $20.7 billion at September 30, 2023, an increase of $275.1 million or approximately 1.8% (annualized) from December 31, 2022. Total assets increased during the first nine months of 2023 primarily due to a $834.5 million increase in LHFI, net of deferred fees and costs, driven primarily by increases in the commercial and industrial, commercial real estate non-owner occupied, and multifamily real estate portfolios, partially offset by a $676.8 million decrease in the investment securities portfolio, primarily due to the sales of AFS securities executed during the period, as well as a decline in the market value of the AFS securities portfolio, due to the impact of market interest rate fluctuations.
• Total LHFI, net of deferred fees and costs, were $15.3 billion at September 30, 2023, an increase of $834.5 million or 7.7% (annualized) from December 31, 2022.
• Total investments were $3.0 billion at September 30, 2023, a decrease of $676.8 million from December 31, 2022. AFS securities totaled $2.1 billion at September 30, 2023, compared to $2.7 billion at December 31, 2022. At September 30, 2023, total net unrealized losses on the AFS securities portfolio were $523.1 million, an increase of $60.6 million from $462.5 million at December 31, 2022. HTM securities are carried at cost and totaled $843.3 million at September 30, 2023, compared to $847.7 million at December 31, 2022 and had net unrealized losses of $81.2 million at September 30, 2023, an increase of $35.4 million from $45.8 million at December 31, 2022, due primarily to changes in interest rates and market conditions during the first nine months of 2023.
• At September 30, 2023, total deposits were $16.8 billion, an increase of $854.8 million or approximately 7.2% (annualized) from December 31, 2022, due to a $1.6 billion increase in interest-bearing deposits, which included approximately $516.7 million in brokered deposits, partially offset by a $738.3 million decrease in demand deposits, as customers continued to move funds from lower to higher yielding deposit products.

Net Interest Income

Net interest income, which represents the principal source of revenue for the Company, is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of average earning assets. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income, the net interest margin, and net income.

The following tables show interest income on earning assets and related average yields, as well as interest expense on interest-bearing liabilities and related average rates paid for the periods indicated:

(Dollars in thousands)

For the third quarter of 2023, net interest income was $151.9 million, an increase of $1.2 million from the third quarter of 2022. For the third quarter of 2023, net interest income (FTE)(+) was $155.7 million, an increase of $1.1 million from the third quarter of 2022. In the third quarter of 2023, net interest margin decreased 7 bps to 3.27% from 3.34% in the third quarter of 2022, and net interest margin (FTE)(+) decreased 8 bps to 3.35% in the third quarter of 2023 from 3.43% for the same period of 2022. The decreases in net interest margin and net interest margin (FTE)(+) were primarily driven by an increase in interest expense primarily due to higher deposit costs resulting from increases in market interest rates and changes in the deposit mix, as depositors migrated to higher cost interest bearing deposit accounts during the third quarter of 2023, as well as higher borrowing costs due to increased short-term borrowings and funding costs associated with increased market interest rates. These increases in interest expense were partially offset by higher loan yields due to increased short-term interest rates impacting variable rate loans, as well as net loan growth.

(Dollars in thousands)

For the first nine months of 2023, net interest income was $457.5 million, an increase of $37.1 million from the same period of 2022. For the first nine months of 2023, net interest income (FTE)(+) was $468.7 million, an increase of $37.5 million from the same period of 2022. In the first nine months of 2023, net interest margin increased 19 bps to 3.35% from 3.16% in the first nine months of 2022, and net interest margin (FTE)(+) increased 19 bps to 3.43% in the first nine months of 2023 from 3.24% in the first nine months of 2022. The increases in net interest margin and net interest margin (FTE)(+) were primarily driven by higher loan yields due to increased short-term interest rates impacting variable rate loans, as well as net loan growth. These increases were partially offset by an increase in interest expense primarily due to higher deposit costs resulting from increases in market interest rates and changes in the deposit mix as depositors migrated to higher cost interest bearing deposit accounts during the nine months ended September 30, 2023, as well as higher borrowing costs due to increased short-term borrowings and funding costs associated with increased market interest rates.

The following tables show interest income on earning assets and related average yields as well as interest expense on interest-bearing liabilities and related average rates paid for the periods indicated (dollars in thousands):

AVERAGE BALANCES, INCOME AND EXPENSES, YIELDS AND RATES (TAXABLE EQUIVALENT BASIS)

(Dollars in thousands)

(1) Income and yields are reported on a taxable equivalent basis using the statutory federal corporate tax rate of 21%.

(2) Rates and yields are annualized and calculated from actual, not rounded amounts in thousands, which appear above.

(3) Nonaccrual loans are included in average loans outstanding.

(Dollars in thousands)

(1) Income and yields are reported on a taxable equivalent basis using the statutory federal corporate tax rate of 21%.

(2) Rates and yields are annualized and calculated from actual, not rounded amounts in thousands, which appear above.

(3) Nonaccrual loans are included in average loans outstanding.

The Volume Rate Analysis table below presents changes in net interest income (FTE)(+) and interest expense and distinguishes between the changes related to increases or decreases in average outstanding balances of interest-earning assets and interest-bearing liabilities (volume), and the changes related to increases or decreases in average interest rates on such assets and liabilities (rate). Changes attributable to both volume and rate have been allocated proportionally. Results, on a taxable equivalent basis, are as follows for the three and nine months ended September 30, 2023 and 2022 (dollars in thousands):

(1) The rate-related changes in interest income on loans, deposits, and other borrowings include the impact of lower accretion of the acquisition-related fair market value adjustments, which are detailed below.

The impact of net accretion related to acquisition accounting fair value adjustments for the first, second, and third quarters of 2022 and 2023 are reflected in the following table (dollars in thousands):

Noninterest Income

(Dollars in thousands)

Noninterest income increased $1.5 million or 5.9% to $27.1 million for the quarter ended September 30, 2023, compared to $25.6 million for the quarter ended September 30, 2022, primarily driven by a $27.7 million gain related to the sale-leaseback transaction, included within other operating income, and a $1.8 million increase in service charges on deposit accounts, partially offset by a $27.6 million loss on the sale of AFS securities in the third quarter of 2023.

Adjusted operating noninterest income,(+) which excludes losses on sale of securities ($27.6 million in 2023) and the gain related to the sale-leaseback transaction ($27.7 million in 2023), increased $1.4 million or 5.5% to $27.0 million for the quarter ended September 30, 2023, compared to $25.6 million for the quarter ended September 30, 2022. The increase in adjusted operating noninterest income(+) was primarily driven by a $1.8 million increase in service charges on deposit accounts, a $862,000 increase in other service charges, commissions, and fees due primarily to a merchant services vendor contract signing bonus, and a $645,000 increase in loan-related interest rate swap fees due to several new swap transactions. These increases in adjusted operating noninterest income(+) were partially offset by a $948,000 decrease in other operating income primarily due to a decline in equity method investment income, and a $724,000 decrease in mortgage banking income due to a decline in mortgage loan origination volumes and a decrease in gain on sale margins due to increases in market interest rates.

(Dollars in thousands)

Noninterest income decreased $33.1 million or 35.2% to $60.9 million for the nine months ended September 30, 2023, compared to $94.0 million for the nine months ended September 30, 2022, primarily driven by $41.0 million of losses incurred on the sale of AFS securities executed in the first and third quarters of 2023, partially offset by a $16.4 million increase in other operating income, which included a $27.7 million gain related to the sale-leaseback transaction during the third quarter of 2023, partially offset by a $9.1 million gain on sale of DHFB in the second quarter of 2022.

Adjusted operating noninterest income,(+) which excludes losses on sale of securities ($41.0 million in 2023 and $2,000 in 2022), the gain on sale of DHFB ($9.1 million in 2022), and the gain related to the sale-leaseback transaction ($27.7 million in 2023), decreased $10.7 million or 12.6% for the nine months ended September 30, 2023, compared to the nine months ended September 30, 2022. The decrease in adjusted operating noninterest income(+) was primarily driven by a $5.2 million decrease in fiduciary and asset management fees due to a decrease in assets under management mainly driven by the DHFB sale executed in the second quarter of 2022, a $4.7 million decrease in mortgage banking income due to a decline in mortgage loan origination volumes and decrease in gain on sale margins due to increases in market interest rates, a $2.2 million decrease in other operating income primarily due to a decline in equity method investment income, and a $2.1 million decrease in loan-related interest rate swap fees primarily due to lower transaction volumes. These decreases in adjusted operating noninterest income(+) were partially offset by a $2.2 million increase in service charges on deposit accounts, a $937,000 increase in other service charges, commissions, and fees due primarily to a merchant services vendor contract signing bonus, and a $559,000 increase in interchange fees.

Noninterest Expense

(Dollars in thousands)

Noninterest expense increased $8.6 million or 8.6% to $108.5 million for the quarter ended September 30, 2023, compared to $99.9 million for the quarter ended September 30, 2022, primarily driven by a $8.3 million increase in other expenses due primarily to expenses associated with strategic cost saving initiatives and merger-related costs.

Adjusted operating noninterest expense,(+) which excludes amortization of intangible assets ($2.2 million in 2023 and $2.5 million in 2022), expenses associated with strategic cost saving initiatives ($8.7 million in 2023), and merger-related costs associated with the American National merger ($2.0 million in 2023), decreased $1.8 million or 1.8% to $95.7 million for the quarter ended September 30, 2023, compared to $97.4 million for the quarter ended September 30, 2022. The decrease in adjusted operating non-interest expense(+) was primarily driven by a $2.4 million decrease in other expenses reflecting a decline in non-credit related losses on customer transactions, a $355,000 decrease in occupancy expenses reflecting the impacts of strategic actions, and a $350,000 decrease in technology and data processing expense. These decreases in adjusted operating non-interest expense(+) were partially offset by a $1.2 million increase in FDIC assessment premiums and other insurance reflecting an increase in the FDIC assessment rates, effective January 1, 2023, and a $916,000 increase in salaries and benefits expense.

(Dollars in thousands)

Noninterest expense increased $18.4 million or 6.1% to $322.4 million for the nine months ended September 30, 2023, compared to $304.0 million for the nine months ended September 30, 2022, primarily driven by a $9.8 million increase in salaries and benefits expense, which includes $2.8 million in expenses associated with strategic cost saving initiatives, and an $8.5 million increase in other expenses in 2023, due primarily to expenses related to strategic cost saving initiatives, merger-related costs, and the legal reserve associated with an ongoing regulatory matter previously disclosed, partially offset by strategic branch closing and facility consolidation costs in 2022.

Adjusted operating noninterest expense,(+) which excludes amortization of intangible assets ($6.7 million in 2023 and $8.4 million in 2022), expenses associated with strategic cost saving initiatives ($12.6 million in 2023), merger-related costs associated with the American National merger ($2.0 million in 2023), the legal reserve associated with an ongoing regulatory matter previously disclosed ($5.0 million in 2023), and strategic branch closing and facility consolidation costs ($5.5 million in 2022), increased $6.1 million or 2.1% to $296.2 million for the nine months ended September 30, 2023, compared to $290.1 million for the nine months ended September 30, 2022. The increase in adjusted operating non-interest expense(+) was primarily driven by a $7.0 million increase in salaries and benefits expense, outside of severance charges related to headcount reductions from our cost saving initiatives in the second quarter of 2023, a $3.9 million increase in FDIC assessment premiums and other insurance primarily due to the increase in the FDIC assessment rates, effective January 1, 2023, and a $701,000 increase in technology and data processing expense. These increases in adjusted operating non-interest expense(+) were partially offset by a $2.8 million decrease in other expenses primarily due to a decrease of non-credit related losses on customer transactions, a $1.2 million decrease in occupancy expenses, and a $1.1 million decrease in professional services related to strategic projects that occurred in the prior year.

Segment Results

Effective January 1, 2023, the Company made an organizational change to move certain lines of business in the wealth management division that primarily serve Wholesale Banking customers from the Consumer Banking segment to the Wholesale Banking segment. As a result, the Company re-allocated $9.6 million of goodwill from the Consumer Banking segment to the Wholesale Banking segment and restated its prior segment information for the year ended December 31, 2022, based on this organizational change. In addition, the Company restated its prior segment operating results for the three and nine months ended September 30, 2022, resulting in a reallocation of noninterest income ($3.0 million and $9.5 million, respectively) and noninterest expense ($4.0 million and $12.1 million, respectively) from the Consumer Banking segment to the Wholesale Banking segment. Refer to Note 4 “Goodwill and Intangible Assets” and Note 12 “Segment Reporting and Revenue” within Part I, Item 1 “Financial Statements” of this Quarterly Report for additional information.

Wholesale Banking

The Wholesale Banking segment provides loan and deposit services, as well as treasury management, and capital market services to wholesale customers primarily throughout Virginia, Maryland, North Carolina, and South Carolina. These customers include commercial real estate and commercial and industrial customers. This segment also includes the Company’s the equipment finance subsidiary, which has nationwide exposure. The private banking and trust businesses also reside in the Wholesale Banking segment.

The following table presents operating results for the three and nine months ended September 30, 2023 and 2022 for the Wholesale Banking segment (dollars in thousands):

(1) Operating results include a reallocation from the Consumer Banking segment, due to the January 1, 2023 organizational change discussed in Note 12, “Segment Reporting and Revenue,” in Part I, Item 1 of this Quarterly Report.

Wholesale Banking income before income taxes decreased for the three and nine months ended September 30, 2023 as compared to the three and nine months ended September 30, 2022, by $9.3 million and $38.5 million, respectively. The decreases were primarily due to a decrease in net interest income driven by spread compression on the deposit portfolio as a result of the rapid rise in interest rates, and an increase in the provision for credit losses due to increased uncertainty in the economic outlook and loan growth during 2023. In addition, noninterest expense increased for the first nine months of 2023 compared to the same period in 2022, primarily due to an increase in salaries and benefits expense. For the three months ended September 30, 2023 compared to the same period in 2022, the decrease in net interest income and the increase in the provision for credit losses were partially offset by an increase in noninterest income driven by an increase in loan-related interest rate swap fees due to several new swap transactions.

The following table presents the key balance sheet metrics as of September 30, 2023 and December 31, 2022 for the Wholesale Banking segment (dollars in thousands):

(1) Includes a reallocation of LHFI, net of deferred fees and costs, and total deposits from the Consumer Banking segment of $136.6 million and $258.7 million, respectively, due to the January 1, 2023 organizational change discussed in Note 12, “Segment Reporting and Revenue,” in Part I, Item 1 of this Quarterly Report.

LHFI, net of deferred fees and costs, for the Wholesale Banking segment increased $867.5 million or 10.1% (annualized) to $12.3 billion at September 30, 2023 compared to December 31, 2022, with growth across the commercial and industrial, commercial real estate non-owner occupied, and multifamily real estate loan portfolios.

Wholesale banking deposits increased $408.7 million or 8.9% (annualized) to $6.5 billion at September 30, 2023 compared to December 31, 2022. This increase was primarily driven by an increase in interest checking accounts, partially offset by a decrease in demand deposits and money market balances.

Consumer Banking

The Consumer Banking segment provides loan and deposit services to consumers and small businesses throughout Virginia, Maryland, and North Carolina. Consumer Banking includes the home loan division and investment management and advisory services businesses.

The following table presents operating results for the three and nine months ended September 30, 2023 and 2022 for the Consumer Banking segment (dollars in thousands):

(1) Operating results include a reallocation to the Wholesale Banking segment, due to the January 1, 2023 organizational change discussed in Note 12, “Segment Reporting and Revenue,” in Part I, Item 1 of this Quarterly Report.

Consumer Banking income before income taxes increased for the three and nine months ended September 30, 2023, compared to the three and nine months ended September 30, 2022 by $9.0 million and $25.3 million, respectively. The increases were primarily driven by an increase in net interest income due to favorable funding credit on deposits and increased interest income attributable to the higher interest rate environment and higher average loan balances, partially offset by spread compression on the loan portfolio and a decrease in the provision for credit losses primarily driven by runoff in the third-party lending and auto portfolios. In addition, for the three months ended September 30, 2023 compared to the same period in 2022, noninterest income increased primarily due to an increase in service charges on deposit accounts and an increase in other service charges, commissions, and fees primarily due to a merchant services vendor contract signing bonus.

For the nine months ended 2023 compared to the same period in 2022, the increase in net interest income and the decrease in the provision for credit losses were partially offset by a decrease in noninterest income, primarily due to a decline in fiduciary and asset management fees driven by a decrease in assets under management primarily due to the sale of DHFB in the second quarter of 2022, and a decrease in mortgage banking income due to a decline in mortgage loan origination volumes driven by the rapid increase in market interest rates and a decline in gain on sale margins due to increases in market interest rates. In addition, noninterest expense increased driven by an increase in salaries and benefits expense, as well as an increase in FDIC assessment premiums and other insurance due to the increase in the FDIC assessment rates, effective January 1, 2023.

The following table presents the key balance sheet metrics as of September 30, 2023 and December 31, 2022 for the Consumer Banking segment (dollars in thousands):

(1) Includes a reallocation of LHFI, net of deferred fees and costs, and total deposits to the Wholesale Banking segment of $136.6 million and $258.7 million, respectively, due to the January 1, 2023 organizational change discussed in Note 12, “Segment Reporting and Revenue,” in Part I, Item 1 of this Quarterly Report.

LHFI, net of deferred fees and costs, for the Consumer Banking segment decreased $36.7 million or 1.6% (annualized) to $3.0 billion at September 30, 2023 compared to December 31, 2022. The decrease primarily occurred across the auto loan portfolio due to the exit from our indirect automobile financing business during the second quarter of 2023, as part of the strategic cost saving initiatives.

Consumer Banking deposits totaled $9.7 billion at both September 30, 2023 and December 31, 2022. The increase in time deposits, was almost wholly offset by a decrease in demand deposits, interest checking accounts, savings accounts, and money market balances, as customers moved funds from lower to higher yielding deposit products.

Income Taxes

The Company’s effective tax rate for the three months ended September 30, 2023 and 2022 was 17.6% and 17.0%, respectively. The effective tax rate for the nine months ended September 30, 2023 and 2022 was 16.3% and 17.0%, respectively. The changes for the three months and nine months periods in 2023, compared to the same periods in 2022, is a result of the proportionality of tax-exempt income as compared to pre-tax income in the periods.

DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

Overview

Assets

At September 30, 2023, total assets were $20.7 billion, an increase of $275.1 million or approximately 1.8% (annualized) from December 31, 2022. The increase in total assets was primarily due to an increase in LHFI, net of deferred fees and costs, of $834.5 million driven primarily by increases in the commercial and industrial, commercial real estate non-owner occupied and multifamily real estate portfolios, partially offset by a decline in the investment securities portfolio of $676.8 million, primarily due to the AFS securities sales during the first and third quarters of 2023 and the decline in market value of the AFS securities portfolio due to the impact of market interest rate fluctuations.

LHFI, net of deferred fees and costs, were $15.3 billion at September 30, 2023, an increase of $834.5 million or 7.7% (annualized) from December 31, 2022. At September 30, 2023, quarterly average LHFI, net of deferred fees and costs, increased $1.4 billion or 10.2% from the same period in the prior year. Refer to "Loan Portfolio" within this Item 2 and Note 3 "Loans and Allowance for Loan and Lease Losses" in Part I, Item 1 of this Quarterly Report for additional information on our loan activity.

At September 30, 2023, total investments were $3.0 billion, a decrease of $676.8 million from December 31, 2022. AFS securities totaled $2.1 billion at September 30, 2023, a $656.9 million decrease from December 31, 2022. At September 30, 2023, total net unrealized losses on the AFS securities portfolio were $523.1 million, compared to $462.5 million at December 31, 2022. HTM securities totaled $843.3 million at September 30, 2023, a $4.5 million decrease from December 31, 2022, with net unrealized losses of $81.2 million at September 30, 2023, compared to $45.8 million at December 31, 2022.

Liabilities and Stockholders’ Equity

At September 30, 2023, total liabilities were $18.3 billion, an increase of $259.0 million or approximately 1.9% (annualized) from $18.1 billion at December 31, 2022, which was primarily driven by an increase in deposits of $854.8 million, partially offset by a decrease in borrowings of $688.0 million.

Total deposits at September 30, 2023 were $16.8 billion, an increase of $854.8 million or approximately 7.2% (annualized) from December 31, 2022. For the quarter ended September 30, 2023, quarterly average deposits increased $307.4 million or 1.9% from the same period in the prior year. Total deposits at September 30, 2023 increased from December 31, 2022 due to a $1.6 billion increase in interest-bearing deposits, which includes $1.1 billion of interest-bearing customer deposits and $509.3 million in brokered deposits, partially offset by a $738.3 million decrease in demand deposits, as customers continued to move funds from lower to higher yielding products. Refer to “Deposits” within this Item 2 for additional information on this topic.

Total short-term and long-term borrowings at September 30, 2023 were $1.0 billion, compared to $1.7 billion at December 31, 2022, a decrease of $688.0 million or 40.3% due to paydowns of short-term borrowings. Refer to Note 6 “Borrowings” in Part I, Item 1, and “Executive Overview” within this Item 2 of this Quarterly Report for additional information on our borrowing activity.

At September 30, 2023, stockholders’ equity was $2.4 billion, an increase of $16.1 million from December 31, 2022. The Company’s consolidated regulatory capital ratios continue to exceed the minimum capital requirements and are considered “well-capitalized” for regulatory purposes. Refer to “Capital Resources” within this Item 2, as well as Note 9 "Stockholders’ Equity" in Part I, Item 1 of this Quarterly Report for additional information on our capital resources.

During the third quarter of 2023, the Company declared and paid a quarterly dividend on the outstanding shares of Series A Preferred Stock of $171.88 per share (equivalent to $0.43 per outstanding depositary share), consistent with the fourth quarter of 2022 and the third quarter of 2022. During the third quarter of 2023, the Company also declared and paid cash dividends of $0.30 per common share, consistent with the fourth quarter of 2022 and the third quarter of 2022.

At September 30, 2023, the Company had no active share repurchase programs, as the most recent share repurchase program expired on December 9, 2022. Under that repurchase program, the Company repurchased an aggregate of approximately 1.3 million shares (or approximately $48.2 million) in 2022.

Securities

At September 30, 2023, the Company had total investments of $3.0 billion, or 14.6% of total assets, as compared to $3.7 billion, or 18.1% of total assets, at December 31, 2022. This decrease was primarily due to the sales of AFS securities executed during the period and the decline in market value of the AFS securities portfolio due to the impact of market interest rate fluctuations, which was partially offset by growth in the Company’s HTM portfolio. The Company seeks to diversify its portfolio to minimize risk and focuses on purchasing MBS for cash flow and reinvestment opportunities and securities issued by states and political subdivisions due to the tax benefits and the higher yield offered from these securities. The majority of the Company’s MBS are agency-backed securities, which have a government guarantee. For information regarding the hedge transaction related to AFS securities, see Note 8 "Derivatives" in Part I, Item 1 of this Quarterly Report.

The table below sets forth a summary of the AFS securities, HTM securities, and restricted stock as of the dates indicated (dollars in thousands):

The following table summarizes the weighted average yields(1) for AFS securities by contractual maturity date of the underlying securities as of September 30, 2023:

(1) Yields on tax-exempt securities have been computed on a tax-equivalent basis.

The following table summarizes the weighted average yields(1) for HTM securities by contractual maturity date of the underlying securities as of September 30, 2023:

(1) Yields on tax-exempt securities have been computed on a tax-equivalent basis.

Weighted average yield is calculated as the tax-equivalent yield on a pro rata basis for each security based on its relative amortized cost.

As of September 30, 2023, the Company maintained a diversified municipal bond portfolio with approximately 67% of its holdings in general obligation issues and the majority of the remainder primarily backed by revenue bonds. Issuances within the State of Texas represented 19% of the total municipal portfolio; no other state had a concentration above 10%. Substantially all municipal holdings are considered investment grade. When purchasing municipal securities, the Company focuses on strong underlying ratings for general obligation issuers or bonds backed by essential service revenues.

Liquidity

Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. The Company’s largest source of liquidity on a consolidated basis is the customer deposit base generated by our wholesale and consumer businesses. These deposits provide relatively stable and low-cost funding. Total deposits at September 30, 2023 were $16.8 billion, an increase of $854.8 million or approximately 7.2% (annualized) from December 31, 2022. For the quarter ended September 30, 2023, quarterly average deposits increased $307.4 million or 1.9% (annualized) compared to the prior quarter. Total deposits at September 30, 2023 increased from December 31, 2022 due to a $1.6 billion increase of interest-bearing deposits, which includes $509.3 million in brokered deposits, partially offset by a $738.3 million decrease in demand deposits, as customers continued to move funds from lower to higher costing products. Refer to “Deposits” within this Item 2 for additional information on this topic.

Liquid assets include cash, interest-bearing deposits with banks, money market investments, federal funds sold, LHFS, and securities and loans maturing or re-pricing within one year. Additional sources of liquidity available to the Company include its capacity to borrow additional funds when necessary through federal funds lines with several correspondent banks, a line of credit with the FHLB, the Federal Reserve Discount Window, the purchase of brokered certificates of deposit, corporate line of credit with a large correspondent bank, and debt and capital issuance. Management believes the Company’s overall liquidity to be sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs.

Starting in the first quarter of 2023, the Company is eligible to borrow from the Federal Reserve's BTFP, which provides additional contingent liquidity through the pledging of certain qualifying securities. The BTFP is a one-year program ending March 11, 2024, and the Company can borrow any time during the term and can repay the obligation at any time without penalty. As of September 30, 2023, liquidity of $531.0 million was available based on the par-value of qualifying securities from BTFP. The Company did not utilize the BTFP facility as of September 30, 2023.

The Company closely monitors changes in the industry and market conditions that may impact the Company’s liquidity and will use other borrowing means or other liquidity and funding strategies sources to fund its liquidity needs as needed. The Company is also closely tracking the potential impacts on the Company’s liquidity of declines in the fair value of the Company’s securities portfolio due to rising market interest rates and developments in the banking industry that may change the availability of traditional sources of liquidity or market expectations with respect to available sources and amounts of additional liquidity.

As of September 30, 2023, liquid assets totaled $5.6 billion or 27.2% of total assets, and liquid earning assets totaled $5.4 billion or 29.2% of total earning assets. Asset liquidity is also provided by managing loan and securities maturities and cash flows. As of September 30, 2023, loan payments of approximately $4.9 billion or 32.3% of total loans are expected within one year based on contractual terms, adjusted for expected prepayments, and approximately $291.4 million or 9.6% of total securities are scheduled to be paid down within one year based on contractual terms, adjusted for expected prepayments.

For additional information and the available balances on various lines of credit, please refer to Note 6 “Borrowings” in Part I, Item 1 of this Quarterly Report. In addition to lines of credit, the Bank may also borrow additional funds by purchasing certificates of deposit through a nationally recognized network of financial institutions. For additional information and outstanding balances on purchased certificates of deposits, please refer to “Deposits” within this Item 2. For additional information on cash requirements for known contractual and other obligations, please refer to “Capital Resources” within this Item 2.

Cash Requirements

The Company’s cash requirements, outside of lending transactions, consist primarily of borrowings, debt and capital instruments which are used as part of the Company’s overall liquidity and capital management strategy. Cash required to repay these obligations will be sourced from future debt and capital issuances and from other general liquidity sources as described above under “Liquidity” within this Item 2.

The following table presents the Company’s contractual obligations related to its major cash requirements and the scheduled payments due at the various intervals over the next year and beyond as of September 30, 2023 (dollars in thousands):

(1) Excludes related unamortized premium/discount and interest payments.

(2) Represents lease payments due on non-cancellable operating leases at September 30, 2023. Excluded from these tables are variable lease payments or renewals.

For more information pertaining to the previous table, reference Note 5 “Leases” and Note 6 “Borrowings” in Part I, Item 1 of this Quarterly Report.

Loan Portfolio

LHFI, net of deferred fees and costs, totaled $15.3 billion at September 30, 2023 and $14.4 billion at December 31, 2022. Commercial real estate and commercial and industrial loans represented the Company’s largest loan categories at both September 30, 2023 and December 31, 2022.

The following table presents the remaining maturities, based on contractual maturity, by loan type, and by rate type (variable or fixed), net of deferred fees and costs, as of September 30, 2023 (dollars in thousands):

The Company remains committed to originating soundly underwritten loans to qualifying borrowers within its markets. The Company seeks to mitigate risks attributable to our most highly concentrated portfolios—commercial real estate, commercial and industrial, and construction and land development—through its credit underwriting and monitoring processes, including oversight by a centralized credit administration function and credit policy and risk management committee, as well as through its seasoned bankers that focus on lending to borrowers with proven track records in markets with which the Company is familiar.

Asset Quality

Overview

At September 30, 2023 and December 31, 2022, NPAs as a percentage of LHFI totaled 0.19% and included nonaccrual LHFI of $28.6 million and $27.1 million, respectively. Net charge-offs were $6.4 million for the nine months ended September 30, 2023, compared to net charge offs of $1.5 million for the same period in the prior year. The ACL at September 30, 2023 increased $16.5 million from December 31, 2022 to $140.9 million, due to continued uncertainty in the economic outlook and net loan growth.

The Company continues to experience historically low levels of NPAs; however, the economic environment in the Company’s footprint could be impacted as persistent inflation, higher interest rates, and the threat of a recession persists, which could increase NPAs in future periods. The Company continues to refrain from originating or purchasing loans from foreign entities. The Company selectively originates loans to higher risk borrowers. The Company’s loan portfolio generally does not include exposure to option adjustable rate mortgage products, high loan-to-value ratio mortgages, interest only mortgage loans, subprime mortgage loans, or mortgage loans with initial teaser rates, which are all considered higher risk instruments.

Nonperforming Assets

At September 30, 2023, NPAs totaled $28.8 million, an increase of $1.7 million or 6.1% from December 31, 2022. NPAs as a percentage of total outstanding LHFI at September 30, 2023 and December 31, 2022 were 0.19%, respectively.

The following table shows a summary of asset quality balances and related ratios as of and for the quarters ended (dollars in thousands):

NPAs include nonaccrual LHFI, which totaled $28.6 million at September 30, 2023, a net increase of $1.6 million or 5.9% from December 31, 2022. The following table shows the activity in nonaccrual LHFI for the quarters ended (dollars in thousands):

The following table presents the composition of nonaccrual LHFI and the coverage ratio, which is the ALLL expressed as a percentage of nonaccrual LHFI, as of (dollars in thousands):

(1) Represents the ALLL divided by nonaccrual LHFI.

Past Due Loans

At September 30, 2023, past due LHFI still accruing interest totaled $40.6 million or 0.27% of total LHFI, compared to $30.0 million or 0.21% of total LHFI at December 31, 2022. Of the total past due LHFI still accruing interest, $11.9 million or 0.08% of total LHFI were loans past due 90 days or more at September 30, 2023, compared to $7.5 million or 0.05% of total LHFI at December 31, 2022.

Troubled Loan Modifications

The Company adopted ASU 2022-02, Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures, effective January 1, 2023 on a prospective basis. Refer to Note 1 “Summary of Significant Accounting Policies” in Part I, Item 1 of this Quarterly Report for information on the Company’s accounting policy for loan modifications to borrowers experiencing financial difficulty and how the Company defines TLMs. As of September 30, 2023, the Company had TLMs totaling $29.4 million.

Troubled Debt Restructurings

After the adoption of ASU 2022-02, the Company no longer has TDRs. The below information is presented for December 31, 2022, prior to adoption of ASU 2022-02.

A modification of a loan’s terms constituted a TDR if the creditor granted a concession that it would not have otherwise considered to the borrower for economic or legal reasons related to the borrower’s financial difficulties. Management strove to identify borrowers in financial difficulty early and work with them to modify their loan to more affordable terms before their loan reached nonaccrual status. These modified terms may have included rate reductions, extension of terms that were considered to be below market, conversion to interest only, principal forgiveness and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral.

The total recorded investment in TDRs at December 31, 2022 was $14.2 million of which $9.3 million or 65.3% were considered performing, while the remaining $4.9 million were considered nonperforming.

Net Charge-offs

For the third quarter of 2023, net charge-offs were $294,000 or 0.01% of total average LHFI on an annualized basis, compared to net charge-offs of $587,000 or 0.02% for the same quarter last year. For the nine months ended September 30, 2023, net charge-offs were $6.4 million or 0.06% of total average LHFI on an annualized basis, compared to net charge-offs of $1.5 million or 0.02% for the same period last year. For the nine months ended September 30, 2023, the majority of the net charge-offs related to two commercial loans within the commercial and industrial and commercial real estate portfolios that took place during the first quarter of 2023.

Provision for Credit Losses

The Company recorded a provision for credit losses of $5.0 million for the third quarter of 2023, a decrease of $1.4 million compared to the provision for credit losses of $6.4 million recorded during the same quarter of 2022. The provision for credit losses for the third quarter of 2023 reflected a provision of $5.2 million for loan losses and a $246,000 release of the provision for unfunded commitments. The Company recorded a provision for credit losses of $22.9 million for the nine months ended September 30, 2023, an increase of $10.1 million compared to the provision for credit losses of $12.8 million recorded during the same period in 2022. The provision for credit losses for the nine months ended September 30, 2023 reflected a provision of $21.3 million for loan losses and a $1.6 million provision for unfunded commitments. The increased provision for credit losses is due to continued uncertainty in the economic outlook and loan growth throughout 2023.

Allowance for Credit Losses

At September 30, 2023, the ACL was $140.9 million and included an ALLL of $125.6 million and a reserve for unfunded commitments of $15.3 million. The ACL at September 30, 2023 increased $16.5 million from December 31, 2022, due to continued uncertainty in the economic outlook and loan growth throughout 2023.

The ACL as a percentage of LHFI was 0.92% at September 30, 2023, compared to 0.86% at December 31, 2022.

The following table summarizes the ACL during the quarters ended (dollars in thousands):

The following table summarizes net-charge off activity by loan segment for the periods indicated (dollars in thousands):

(1) Annualized

The following table summarizes the ACL activity by loan segment and the percentage of the LHFI portfolio that the related ACL covers as of the quarters ended (dollars in thousands):

(1) The percentage represents the loan balance divided by total loans.

The increase in the ACL for the commercial loan segment is due to continued uncertainty in the macroeconomic outlook and the impact of loan growth throughout 2023. The decrease in the consumer loan segment was primarily driven by the continued run off of the Company’s third-party lending and auto portfolios.

Deposits

As of September 30, 2023, total deposits were $16.8 billion, an increase of $854.8 million or 7.2% annualized from December 31, 2022. Total interest-bearing deposits consist of interest checking accounts, money market, savings, time deposit account balances, and brokered deposits. Total time deposit balances of $2.6 billion accounted for 20.93% of total interest-bearing deposits at September 30, 2023, compared to $1.8 billion and 16.3% at December 31, 2022.

The following table presents the deposit balances by major category as of the quarters ended (dollars in thousands):

(1) Includes estimated uninsured deposits of $5.4 billion and $6.3 billion as of September 30, 2023 and December 31, 2022, respectively, and collateralized deposits of $872.2 million and $951.9 million as of September 30, 2023 and December 31, 2022, respectively.

The Company may also borrow additional funds by purchasing certificates of deposit through a nationally recognized network of financial institutions, and the Company utilizes this funding source as part of its overall liquidity management strategy. As of September 30, 2023 and December 31, 2022, the Company’s certificates of deposits included $111.0 million and $7.5 million, respectively, in purchased certificates of deposits.

Maturities of time deposits in excess of FDIC insurance limits as of September 30, 2023 and December 31, 2022 were as follows (dollars in thousands):

Capital Resources

Capital resources represent funds, earned or obtained, over which financial institutions can exercise greater or longer control in comparison with deposits and borrowed funds. The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to size, composition, and quality of the Company’s resources and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses, yet allow management to effectively leverage its capital to maximize return to shareholders.

Under the Basel III capital rules, the Company and the Bank must comply with the following minimum capital ratios: (i) a common equity Tier 1 capital ratio of 7.0% of risk-weighted assets; (ii) a Tier 1 capital ratio of 8.5% of risk-weighted assets; (iii) a total capital ratio of 10.5% of risk-weighted assets; and (iv) a leverage ratio of 4.0% of total assets. These ratios, with the exception of the leverage ratio, include a 2.5% capital conservation buffer, which is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of common equity Tier 1 to risk-weighted assets above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall.

On March 27, 2020, the banking agencies issued an interim final rule that allows the Company to phase in the impact of adopting the CECL methodology up to two years, with a three-year transition period to phase out the cumulative benefit to regulatory capital provided during the two-year delay. The Company is allowed to include the impact of the CECL transition, which is defined as the CECL Day 1 impact to capital plus 25% of the Company’s provision for credit losses during 2020, in regulatory capital through 2021. The Company elected to phase in the regulatory capital impact as permitted under the aforementioned interim final rule. The CECL transition amount is being phased out of regulatory capital over a three-year period that began in 2022 and ends in 2024.

The table summarizes the Company’s regulatory capital and related ratios for the periods presented (2) (dollars in thousands):

(1) Calculated by subtracting the regulatory minimum capital ratio requirements from the Company’s actual ratio results for Common equity, Tier 1, and Total risk-based capital. The lowest of the three measures represents the Company’s capital conservation buffer ratio.

(2) All ratios and amounts at September 30, 2023 are estimates and subject to change pending the Company’s filing of its FR Y9-C. All other periods are presented as filed.

(+) Refer to “Non-GAAP Financial Measures” within this Item 2 for more information about this non-GAAP financial measure, including a reconciliation of this measure to the most directly comparable financial measure calculated in accordance with GAAP.

For more information about our off-balance sheet obligations and cash requirements, refer to “Liquidity” within this Item 2.

NON-GAAP FINANCIAL MEASURES

In reporting the results as of and for the period ended September 30, 2023, the Company has provided supplemental performance measures on a tax-equivalent, tangible, operating, adjusted or pre-tax pre-provision basis. These non-GAAP financial measures are a supplement to GAAP, which is used to prepare the Company’s financial statements, and should not be considered in isolation or as a substitute for comparable measures calculated in accordance with GAAP. In addition, the Company’s non-GAAP financial measures may not be comparable to non-GAAP financial measures of other companies. The Company uses the non-GAAP financial measures discussed herein in its analysis of the Company’s performance. The Company’s management believes that these non-GAAP financial measures provide additional understanding of ongoing operations, enhance comparability of results of operations with prior periods and show the effects of significant gains and charges in the periods presented without the impact of items or events that may obscure trends in the Company’s underlying performance.

The Company believes net interest income (FTE) and total revenue (FTE), which are used in computing net interest margin (FTE), provide valuable additional insight into the net interest margin by adjusting for differences in the tax treatment of interest income sources. The entire FTE adjustment is attributable to interest income on earning assets, which is used in computing the yield on earning assets. Interest expense and the related cost of interest-bearing liabilities and cost of funds ratios are not affected by the FTE components.

The following table reconciles non-GAAP financial measures from the most directly comparable GAAP financial measures for each of the periods presented (dollars in thousands):

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Tangible assets and tangible common equity are used in the calculation of certain profitability, capital, and per share ratios. The Company believes tangible assets, tangible common equity and the related ratios are meaningful measures of capital adequacy because they provide a meaningful base for period-to-period and company-to-company comparisons, which the Company believes will assist investors in assessing the capital of the Company and its ability to absorb potential losses. The Company believes tangible common equity is an important indication of its ability to grow organically and through business combinations as well as its ability to pay dividends and to engage in various capital management strategies.

The following table reconciles non-GAAP financial measures from the most directly comparable GAAP financial measures for each of the periods presented (dollars in thousands):

Adjusted operating measures exclude, as applicable, strategic cost saving initiatives (principally composed of severance charges related to headcount reductions, costs related to modifying certain third party vendor contracts, and charges for exiting certain leases), merger-related costs, a legal reserve associated with an ongoing regulatory matter previously disclosed, strategic branch closing and related facility consolidation costs (principally composed of real estate, leases and other assets write downs, as well as severance and expense reduction initiatives), loss on sale of securities, gain on sale-leaseback transaction, and gain on sale of DHFB. The Company believes these non-GAAP adjusted measures provide investors with important information about the continuing economic results of the organization’s operations. The following table reconciles non-GAAP financial measures from the most directly comparable GAAP financial measures for each of the periods presented (dollars in thousands, except per share amounts):

Adjusted operating noninterest expense excludes, as applicable, the amortization of intangible assets, strategic cost saving initiatives (principally composed of severance charges related to headcount reductions, costs related to modifying certain third party vendor contracts, and charges for exiting certain leases), merger-related costs, a legal reserve associated with an ongoing regulatory matter previously disclosed, strategic branch closing and related facility consolidation costs (principally composed of real estate, leases and other assets write downs, as well as severance and expense reduction initiatives), and adjusted operating noninterest income excludes, as applicable, loss on sale of securities, gain on sale-leaseback transaction, and gain on sale of DHFB. These measures are similar to the measures used by the Company when analyzing corporate performance and are also similar to the measure used for incentive compensation.

The following table reconciles non-GAAP financial measures from the most directly comparable GAAP financial measures for each of the periods presented (dollars in thousands):

Interest Sensitivity

Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates, and equity prices. The Company’s market risk is composed primarily of interest rate risk. The Company’s ALCO is responsible for reviewing the interest rate sensitivity position and establishing policies to monitor and limit exposure to this risk. The Company’s Board of Directors reviews and approves the policies established by ALCO.

The Company monitors interest rate risk through the use of three complementary modeling tools: static gap analysis, earnings simulation modeling, and economic value simulation (net present value estimation). Each of these models measures changes in a variety of interest rate scenarios. While each of the interest rate risk models has limitations, taken together, they represent a reasonably comprehensive view of the magnitude of the Company’s interest rate risk, the distribution of risk along the yield curve, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships. The Company’s static gap analysis, which measures aggregate re-pricing values, is utilized less often because it does not effectively take into account the optionality embedded into many assets and liabilities and, therefore, the Company does not address it here. The Company uses earnings simulation and economic value simulation models on a regular basis, which more effectively measure the cash flow and optionality impacts, and these models are discussed below.

The Company determines the overall magnitude of interest sensitivity risk and then formulates policies and practices governing asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These decisions are based on management’s expectations regarding future interest rate movements, the states of the national, regional and local economies, and other financial and business risk factors. The Company uses simulation modeling to measure and monitor the effect of various interest rate scenarios and business strategies on net interest income. This modeling reflects interest rate changes and the related impact on net interest income and net income over specified time horizons.

Earnings Simulation Modeling

Management uses earnings simulation modeling to measure the sensitivity of net interest income to changes in interest rates. The model calculates an earnings estimate based on current and projected balances and rates. This method is subject to the accuracy of the assumptions that underlie the process, but the Company believes it provides a better analysis of the sensitivity of earnings to changes in interest rates than other analyses, such as the static gap analysis noted above.

The Company derives the assumptions used in the model from historical trends and management’s outlook, including expected loan growth, loan prepayment rates, deposit growth rates, changes to deposit product betas and non-maturity deposit decay rates, and projected yields and rates. These assumptions may not be realized and unanticipated events and circumstances may also occur that cause the assumptions to be inaccurate. The model also does not take into account any future actions of management to mitigate the impact of interest rate changes. The Company’s ALCO monitors the assumptions at least quarterly and periodically adjusts them as deemed appropriate. In the modeling, the Company assumed that all maturities, calls, and prepayments in the securities portfolio are reinvested in like instruments, and the Company based the MBS prepayment assumptions on industry estimates of prepayment speeds for portfolios with similar coupon ranges and seasoning. The Company also used different interest rate scenarios and yield curves to measure the sensitivity of earnings to changing interest rates. Interest rates on different asset and liability accounts move differently when the short-term market rate changes and these differences are reflected in the different rate scenarios. Deposit betas, decay rates and loan prepayment speeds are adjusted periodically in the Company’s models for non-maturity deposits and loans.

The Company uses its simulation model to estimate earnings in rate environments where rates are instantaneously shocked up or down around a “most likely” rate scenario, based on implied forward rates and futures curves. The analysis assesses the impact on net interest income over a 12-month time horizon after an immediate increase or “shock” in rates, of 100 bps up to 300 bps. The model, under all scenarios, does not drop the index below zero.

The following table represents the interest rate sensitivity on net interest income for the Company across the rate paths modeled for balances as of September 30, 2023, December 31, 2022, and September 30, 2022:

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If an institution is asset sensitive its assets reprice more quickly than its liabilities and net interest income would be expected to increase in a rising interest rate environment, and decrease in a falling interest rate environment. If an institution is liability sensitive its liabilities reprice more quickly than its assets and net interest income would be expected to decrease in a rising interest rate environment and increase in a falling interest rate environment.

From a net interest income perspective, the Company was less asset sensitive as of September 30, 2023, compared to its position as of September 30, 2022. This shift is in part due to the changing market characteristics of certain loan and deposit products and in part due to various other balance sheet strategies. The Company would expect net interest income to increase with an immediate increase or shock in market rates. In the decreasing interest rate environments, the Company would expect a decline in net interest income as interest-earning assets re-price more quickly than interest-bearing deposits.

Economic Value Modeling

Economic value simulation modeling is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. The Company calculates the economic values based on discounted cash flow analysis. The net economic value of equity is the economic value of all assets minus the economic value of all liabilities. The change in net economic value over different rate environments is an indication of the longer-term earnings capability of the balance sheet. The Company uses the same assumptions in the economic value simulation model as in the earnings simulation model. The economic value simulation model uses instantaneous rate shocks to the balance sheet.

The following chart reflects the estimated change in net economic value over different rate environments using economic value simulation for the balances at the quarterly periods ended September 30, 2023, December 31, 2022, and September 30, 2022:

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As of September 30, 2023, the Company’s economic value of equity is generally less asset sensitive in a rising interest rate environment compared to its position as of September 30, 2022 primarily due to the composition of the Consolidated Balance Sheets and due in part to the pricing characteristics and assumptions of certain deposits.

Evaluation of Disclosure Controls and Procedures

Management, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures as of September 30, 2023. The term “disclosure controls and procedures,” as defined in Rule 13a-15(e) under the Exchange Act, means controls and other procedures that are designed to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and to ensure that such information is accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of September 30, 2023, the Company’s disclosure controls and procedures were effective at the reasonable assurance level.

In designing and evaluating the Company’s disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

Changes in Internal Control Over Financial Reporting

Management has taken measures to maintain the internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended September 30, 2023. There have been no changes during the quarter ended September 30, 2023 that have materially affected, or are reasonably likely to materially affect, the internal control over financial reporting.

Except as set forth in Part II, Item 1A. “Risk Factors” of our Quarterly Report on Form 10-Q for the quarters ended March 31, 2023 and June 30, 2023, filed with the SEC on May 4, 2023 and August 3, 2023, respectively, and incorporated herein by reference, there have been no material changes from the risk factors previously disclosed under Part I, Item 1A. “Risk Factors” in our 2022 Form 10-K.

An investment in our securities involves risks. In addition to the other information set forth in this Quarterly Report, including the information addressed under “Forward-Looking Statements,” investors in our securities should carefully consider the risk factors discussed in our 2022 Form 10-K and Quarterly Report on Form 10-Q for the quarter ended March 31, 2023 and June 30, 2023. These factors could materially and adversely affect our business, financial condition, liquidity, results of operations, and capital position and could cause our actual results to differ materially from our historical results or the results contemplated by the forward-looking statements contained in this report, in which case the trading price of our securities could decline.