First Financial Bankshares Inc: Form 10-Q for the period ended Sep 30, 2023

Forward-Looking Statements

This Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. When used in this Form 10-Q, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “predict,” “project,” “could,” “may,” or “would” and similar expressions, as they relate to us or our management, identify forward-looking statements. These forward-looking statements are based on information currently available to our management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors, including, but not limited, to those discussed in Part I, Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2022, under the heading “Risk Factors,” and the following:

• general economic conditions, including our local, state and national real estate markets and employment trends;
• the effects of and changes in trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”);
• effect of severe weather conditions, including hurricanes, tornadoes, flooding and droughts;
• volatility and disruption in national and international financial and commodity markets;
• government intervention in the U.S. financial system including the effects of recent legislative, tax, accounting and regulatory actions and reforms, including the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the Jumpstart Our Business Startups Act, the Consumer Financial Protection Bureau (“CFPB”), the Inflation Reduction Act of 2022, the capital ratios of Basel III as adopted by the federal banking authorities and the Tax Cuts and Jobs Act;
• political or social unrest and economic instability;
• the ability of the federal government to address the national economy;
• changes in our competitive environment from other financial institutions and financial service providers;
• the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board (“PCAOB”), the Financial Accounting Standards Board (“FASB”) and other accounting standard setters;
• effect of the coronavirus (“COVID”) on our Company, the communities where we have our branches, the state of Texas and the United States, related to the economy and overall financial stability, including disruptions to supply channels and labor availability;
• government and regulatory responses to the COVID pandemic;
• the effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which we and our subsidiaries must comply;
• the costs, effects and results of regulatory examinations, investigations or reviews and the ability to obtain required regulatory approvals;
• changes in the demand for loans, including loans originated for sale in the secondary market;
• fluctuations in the value of collateral securing our loan portfolio and in the level of the allowance for credit losses;
• the accuracy of our estimates of future credit losses;
• the accuracy of our estimates and assumptions regarding the performance of our securities portfolio, including securities with a current unrealized loss;
• inflation, interest rate, market and monetary fluctuations;
• soundness of other financial institutions with which we have transactions;
• changes in consumer spending, borrowing and savings habits;
• changes in commodity prices (e.g., oil and gas, cattle, and wind energy);
• our ability to attract deposits, maintain and/or increase market share;
• changes in our liquidity position; including a result of a reduction in the amount of sources of liquidity we currently have;
• fluctuations in the market value and liquidity of the investment securities we have classified as held-for-sale ("HFS"), including the effects of changes in market interest rates;
• changes in the reliability of our vendors, internal control system or information systems;
• cyber-attacks on our technology information systems, including fraud from our customers and external third-party vendors;
• our ability to attract and retain qualified employees;
• acquisitions and integration of acquired businesses;
• the possible impairment of goodwill and other intangibles associated with our acquisitions;
• consequences of continued bank mergers and acquisitions in our market area, resulting in fewer but much larger and stronger competitors;
• expansion of operations, including branch openings, new product offerings and expansion into new markets;
• changes in our compensation and benefit plans;
• acts of God or of war or terrorism;
• the impact of changes to the global climate and its effect on our operations and customers;
• potential risk of environmental liability associated with lending activities; and
• our success at managing the risk involved in the foregoing items.

In addition, financial markets and global supply chains may continue to be adversely affected by the current or anticipated impact of military conflict, including the current Russian invasion of Ukraine and the conflict in the Middle East, terrorism or other geopolitical events.

Such forward-looking statements reflect the current views of our management with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to our operations, results of operations, growth strategies and liquidity. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by this paragraph. We undertake no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise (except as required by law).

Introduction

As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, gain on sale of mortgage loans and service charges and fees on deposit accounts. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, N.A. Our largest expenses are salaries and related employee benefits. We measure our performance by calculating our return on average assets, return on average equity, regulatory capital ratios, net interest margin and efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income.

The following discussion and analysis of operations and financial condition should be read in conjunction with the financial statements and accompanying footnotes included in Item 1 of this Form 10-Q as well as those included in the Company’s 2022 Annual Report on Form 10-K.

Critical Accounting Policies

We prepare consolidated financial statements based on generally accepted accounting principles (“GAAP”) and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions.

We deem a policy critical if (i) the accounting estimate requires us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (ii) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements.

We deem our most critical accounting policies to be (i) our allowance for credit losses and our provision for credit losses and (ii) our valuation of financial instruments. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (i) our allowance for credit losses and our provision for credit losses and (ii) our valuation of financial instruments is included in Note 1 to our Consolidated Financial Statements beginning on page 10.

Stock Repurchase

On July 27, 2021, the Company’s Board of Directors authorized the repurchase of up to 5 million common shares through July 31, 2023. On July 25, 2023, the Company's Board of Directors renewed the prior authorization through July 31, 2024.The stock repurchase plan authorizes management to repurchase and retire the stock at such time as repurchases are considered beneficial to the Company and its stockholders. Any repurchase of stock will be made through the open market, block trades or in privately negotiated transactions in accordance with applicable laws and regulations. Under the repurchase plan, there is no minimum number of shares that the Company is required to repurchase. Under the prior authorization, 244,559 shares were repurchased and retired (all during the months of June and July 2022) at an average price of $38.61 per share. Under the current authorization, the Company has repurchased and retired 101,337 shares (all during September 2023) at an average price of $26.99 per share.

Results of Operations

Performance Summary. Net earnings for the third quarter of 2023 were $49.56 million compared to earnings of $59.34 million for the third quarter of 2022. Diluted earnings per share was $0.35 for the third quarter of 2023 and $0.41 for the third quarter of 2022.

The return on average assets was 1.53% for the third quarter of 2023, as compared to 1.76% for the third quarter of 2022. The return on average equity was 14.51% for the third quarter of 2023 as compared to 17.31% for the third quarter of 2022.

Net earnings for the nine-months ended September 30, 2023 were $153.00 million compared to earnings of $175.81 million for the same period in 2022. Diluted earnings per share was $1.07 for the nine-months ended September 30, 2023, as compared to $1.23 for the same period in 2022.

The return on average assets was 1.59% for the nine-months ended September 30, 2023, as compared to 1.77% for the same period a year ago. The return on average equity was 15.22% for the nine-months ended September 30, 2023, as compared to 15.88% for the same period in 2022.

Net Interest Income. Net interest income is the difference between interest income on earning assets and interest expense on liabilities incurred to fund those assets. Our earning assets consist primarily of loans and investment securities. Our liabilities to fund those assets consist primarily of noninterest-bearing and interest-bearing deposits.

Tax-equivalent net interest income was $96.97 million for the third quarter of 2023, as compared to $106.96 million for the same period last year. The decrease in 2023 tax equivalent net interest income compared to 2022 was largely attributable to the increases in the rates paid on deposits and borrowings and a change in the mix of interest earning assets primarily derived from a decrease in taxable and tax-exempt investment securities offset by an increase in average loans. Average earning assets were $11.96 billion for the third quarter of 2023, as compared to $12.54 billion during the third quarter of 2022. The decrease of $578.99 million in average earning assets in 2023 when compared to 2022 was primarily a result of (i) a decrease in taxable investment securities of $609.82 million, (ii) a decrease in tax-exempt securities of $586.17 million, (iii) a decrease in short-term investments of $194.42 million, offset by (iv) the increase of average loans of $811.42 million, when compared to the three months ended September 30, 2022 average balances. Average interest-bearing liabilities were $7.88 billion for the third quarter of 2023, as compared to $7.77 billion in the same period in 2022. The yield on earning assets increased 89 basis points while the rate paid on interest-bearing liabilities increased 158 basis points for the third quarter of 2023 compared to the third quarter of 2022.

Tax-equivalent net interest income was $295.20 million for the nine-months ended September 30, 2023, as compared to $309.05 million for the same period last year. The decrease in 2023 tax equivalent net interest income compared to 2022 was largely attributable to the increases in the rates paid on deposits and borrowings and a change in the mix of interest earning assets primarily derived from a decrease in taxable and tax-exempt investment securities offset by an increase in average loans. Average earning assets were $12.03 billion for the nine-months ended September 30, 2023, as compared to $12.51 billion during same period last year. The decrease of $485.85 million in average earning assets in 2023 when compared to 2022 was primarily a result of (i) a decrease in tax-exempt securities of $722.51 million, (ii) the decrease of taxable securities of $560.81 million, (iii) a decrease in short-term investments of $130.68 million, offset by (iv) the increase of average loans of $928.16 million, when compared to the nine-months ended September 30, 2022 average balances. Average interest-bearing liabilities were $7.78 billion for the nine-months ended September 30, 2023, as compared to $7.74 billion for the nine-months ended September 30, 2022, respectively. The yield on earning assets increased 93 basis points while the rate paid on interest-bearing liabilities increased 146 basis points for the nine-months ended September 30, 2023 compared to the nine-months ended September 30, 2022.

Table 1 allocates the change in tax-equivalent net interest income between the amount of change attributable to volume and to rate.

Table 1 - Changes in Interest Income and Interest Expense (dollars in thousands):

(1) Computed on a tax-equivalent basis assuming a marginal tax rate of 21%.

(2) Nonaccrual loans are included in loans.

The net interest margin, on a tax equivalent basis, was 3.22% for the third quarter of 2023, a decrease of 16 basis point from the same period in 2022. The net interest margin, on a tax equivalent basis, was 3.28% for the first nine-months of 2023, a decrease of two basis points from the same period in 2022. We continued to experience downward pressure on our net interest margin in 2023 compared to 2022 primarily due to (i) the effects of the Federal Reserve's accelerated rate of raising interest rates in 2022 and 2023, which was preceded by the extended period of historically low levels of short-term interest rates leading up to the first quarter of 2022, and (ii) the shift in the mix of interest-earning assets and interest-bearing deposits. The Federal Reserve began increasing interest rates by raising rates 25 basis points in March 2022, 50 basis points in May 2022, and 75 basis points in June, July, September and November 2022, respectively, 50 basis points in December 2022, and 25 basis points in February, March, May, and July 2023, respectively, resulting in a target rate range of 5.25% to 5.50% at September 30, 2023.

Loan rates on variable loans have increased as the majority of such loans are indexed to the applicable prime rate (currently 8.50% at September 30, 2023), subject to underlying floors. With the latest increase in the federal funds rate, the majority of variable rate loans have increased (see additional discussion beginning on page 49).

During 2022, we increased rates on each of the primary depository products in response to the increasing federal funds rate. Additionally, we have approximately $883 million of municipal and related deposits which are indexed to short-term treasury rates which have continued to increase with the changes in the applicable rate index. Average municipal and related deposits totaled $1.48 billion and $1.45 billion for the nine-months ended September 30, 2023 and 2022, respectively, with an average rate paid of 2.95% and 1.50%, for the respective nine-months then ended.

The net interest margin, which measures tax-equivalent net interest income as a percentage of average earning assets, is illustrated in Table 2.

Table 2 - Average Balances and Average Yields and Rates (dollars in thousands, except percentages):

(1) Short-term investments are comprised of federal funds sold, interest-bearing deposits in banks and interest-bearing time deposits in banks.

(2) Average balances include unrealized gains and losses on available-for-sale securities.

(3) Includes tax equivalent yield adjustment of approximately $2.82 million and $3.81 million in the third quarters of 2023 and 2022, respectively, using an effective tax rate of 21% for both periods.

(4) Includes nonaccrual loans.

(5) Calculations for 2022 have been adjusted to remove the effect of TEFRA disallowance.

(1) Short-term investments are comprised of federal funds sold, interest-bearing deposits in banks and interest-bearing time deposits in banks.

(2) Average balances include unrealized gains and losses on available-for-sale securities.

(3) Includes tax equivalent yield adjustment of approximately $8.90 million and $11.67 million in the first nine months of 2023 and 2022, respectively, using an effective tax rate of 21% for both periods.

(4) Includes nonaccrual loans.

(5) Calculations for 2022 have been adjusted to remove the effect of TEFRA disallowance.

Noninterest Income. Noninterest income for the third quarter of 2023 was $28.07 million compared to $30.94 million in the same quarter of 2022. Debit card fees for the third quarter of 2023 decreased by $546 thousand from the third quarter of 2022 due to the recognition of $988 thousand of volume incentive income in the third quarter of 2022 compared to $375 thousand in the third quarter of 2023. Mortgage related income was $3.44 million in the third quarter of 2023 compared to $4.07 million in the third quarter of 2022 due to lower overall origination volumes and margins on loan sales primarily because of the significant increase in mortgage interest rates. Available for sale securities totaling $113.13 million with an average book yield of 3.53% were sold in the third quarter of 2023 resulting in a loss on sales of securities of $972 thousand compared to a gain on sales of securities of $334 thousand in the third quarter of 2022.The proceeds from the sales of these securities are being used to fund organic loan growth that is yielding around 8%, resulting in an anticipated earn back period of less than six months.

Noninterest income for the nine-months ended September 30, 2023 was $86.03 million compared to $103.14 million in the same period in 2022. Debit card fees for the nine-months ended September 30, 2023 were $16.70 million compared to $24.38 million during the nine-months ended September 30, 2022 due to the impact of the Bank becoming subject to regulations imposed by the Federal Reserve that limits debit card interchange revenue (also known as the "Durbin Amendment") which became effective for the Company as of July 1, 2022, and is consistent with our previously disclosed expectations. Mortgage related income was $9.95 million in the nine-months ended September 30, 2023 compared to $16.13 million in the nine-months ended September 30, 2022 due to lower overall origination volumes and margins on loan sales as a result of the increases in mortgage interest rates. During the nine-months ended September 30, 2023, losses on sales of available-for-sale securities was $914 thousand, compared to a gain on sales of available-for-sale securities of $2.01 million during the same period in 2022. Net gain on sale of foreclosed assets was $23 thousand for the nine-months ended September 30, 2023, compared to $1.45 million for the same period in 2022. Recoveries of interest on previously charged-off or nonaccrual loans totaled $1.52 million for the nine-months ended September 30, 2023, compared with $2.60 million for the same period in 2022.

Debit card fees are charges that merchants pay to us and other card-issuing banks for processing electronic payment transactions. Debit card fees consist of income from debit card usage, point of sale income for debit card transactions and ATM service fees. Federal Reserve Board rules applicable to financial institutions that have assets of $10 billion or more provide that the maximum permissible interchange fee for an electronic debit transaction is limited to the sum of 21 cents per transaction plus 5 basis points multiplied by the value of the transaction. Based on the applicable Federal Reserve Board rules, the Company became subject to the limitation effective July 1, 2022, which reduced debit card fees in 2023 compared to 2022, as discussed above.

Table 3 - Noninterest Income (dollars in thousands):

Noninterest Expense. Total noninterest expense for the third quarter of 2023 was $59.54 million, compared to $59.44 million for the same period of 2022. An important measure in determining whether a financial institution effectively manages noninterest expense is the efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax-equivalent basis and noninterest income. Lower ratios indicate better efficiency since more income is generated with a lower noninterest expense total. Our efficiency ratio was 47.62% for the third quarter of 2023 compared to 43.10% for the same quarter in 2022.

Salaries, commissions and employee benefits for the third quarter of 2023 totaled $32.94 million, compared to $33.89 million for the same period in 2022. The net decrease reflected lower profit sharing expenses of $583 thousand and a $310 thousand decrease in mortgage salaries and incentive compensation expenses.

All other categories of noninterest expense for the third quarter of 2023 totaled $26.60 million, compared to $25.55 million in the same quarter a year ago. Noninterest expense, excluding salary related costs, for the three-months ended September 30, 2023 increased primarily due to increases in FDIC insurance premiums of $656 thousand due to the increased FDIC insurance base assessment rate effective January 1, 2023, compared to the three-months ended September 30, 2022.

Total noninterest expense for the first nine months of 2023 was $174.41 million, a decrease of $2.59 million, or 1.46%, as compared to the same period in 2022. Our efficiency ratio was 45.75% for the first nine months of 2023 compared to 42.94% for the same period in 2022.

Salaries, commissions and employee benefits for the first nine months of 2023 totaled $96.16 million, compared to $101.18 million for the same period in 2022. The net decrease reflected lower profit sharing expenses of $3.49 million, a $2.02 million decrease in mortgage salaries and incentive compensation expenses and a $1.02 million decrease in medical expenses, offset by annual merit-based and other market-based pay increases that were effective March 1, 2023.

All other categories of noninterest expense for the first nine months of 2023 totaled $78.25 million, compared to $75.82 million for the same period in 2022. Noninterest expense, excluding salary related costs, for the nine-months ended September 30, 2023 increased primarily due to increases in FDIC insurance premiums of $1.95 million due to the increased FDIC insurance base assessment rate effective January 1, 2023.

Table 4 - Noninterest Expense (dollars in thousands):

Balance Sheet Review

Loans. Our portfolio is comprised of loans made to businesses, professionals, individuals, and farm and ranch operations located in the primary trade areas served by our subsidiary bank. As of September 30, 2023, total loans held-for-investment were $6.99 billion, an increase of $552.83 million, as compared to December 31, 2022. Total PPP loans outstanding were $122 thousand at September 30, 2023, which are included in the Company’s commercial loan totals.

As compared to year-end 2022 balances, total real estate loans increased $363.35 million, total commercial loans increased $188.19 million, agricultural loans increased $4.93 million, and total consumer loans decreased $3.65 million. Loans averaged $6.89 billion for the third quarter of 2023, an increase of $811.42 million over the prior year third quarter average balances. Loans averaged $6.69 billion for the first nine months of 2023, an increase of $928.16 million from the prior year nine-month period average balances.

Our loan portfolio segments include C&I, Municipal, Agricultural, Construction and Development, Farm, Non-Owner Occupied and Owner Occupied CRE, Residential, Consumer Auto and Consumer Non-Auto. This segmentation allows for a more precise pooling of loans with similar credit risk characteristics and credit monitor procedures for the Company’s calculation of its allowance for credit losses.

Table 5 outlines the composition of the Company’s held-for-investment loans by portfolio segment.

Table 5 - Composition of Loans Held-for-Investment (dollars in thousands):

* All disclosures for the C&I loan segment include PPP loan balances, net of deferred fees and costs, as disclosed on the face of the consolidated balance sheet.

Loans held-for-sale, consisting of secondary market mortgage loans, totaled $12.23 million, $18.82 million, and $11.97 million at September 30, 2023 and 2022, and December 31, 2022, respectively. At September 30, 2023 and 2022, and December 31, 2022, $321 thousand, $2.92 million and $1.47 million, respectively, are valued using the lower of cost or fair value, and the remaining amounts are valued under the fair value option.

The following tables summarize maturity information of our loan portfolio as of September 30, 2023. The tables also presents the portion of loans that have fixed interest rates or variable interest rates that fluctuate over the life of the loans in accordance with changes in an interest rate index.

Maturity Distribution and Interest Sensitivity of Loans at September 30, 2023 (dollars in thousands):

49

Of the $4.04 billion of variable interest rate loans shown above, loans totaling $1.6 billion mature or reprice over the next twelve months. Of this amount, approximately $1.4 billion will reprice immediately upon changes in the underlying index rate (primarily U.S. prime rate) with the remaining $188 million being subject to floors above or ceilings below the current index.

Asset Quality. Our loan portfolio is subject to periodic reviews by our centralized independent loan review group as well as periodic examinations by bank regulatory agencies. Loans are placed on nonaccrual status when, in the judgment of management, the collectability of principal or interest under the original terms becomes doubtful. Nonaccrual, past due 90 days or more and still accruing, and foreclosed assets were $39.70 million at September 30, 2023, as compared to $24.62 million at September 30, 2022 and $24.33 million at December 31, 2022. As a percent of loans held-for-investment and foreclosed assets, these assets were 0.57% at September 30, 2023, 0.39% at September 30, 2022, and 0.38% at December 31, 2022. As a percent of total assets, these assets were 0.31% at September 30, 2023, as compared to 0.19% at September 30, 2022 and December 31, 2022, respectively. We believe the level of these assets to be manageable and are not aware of any material classified credits not properly disclosed as nonperforming at September 30, 2023.

Table 6 – Nonaccrual, Past Due 90 Days or More and Still Accruing, and Foreclosed Assets (dollars in thousands, except percentages):

(1) With the adoption of ASU 2022-02, effective January 1, 2023, TDR accounting has been eliminated.

We record interest payments received on nonaccrual loans as reductions of principal. Prior to the loans being placed on nonaccrual, we recognized interest income on these loans of approximately $963 thousand for the year ended December 31, 2022. If interest on these loans had been recognized on a full accrual basis during the year ended December 31, 2022, such income would have been approximately $2.32 million. Such amounts for the 2023 and 2022 interim periods were not significant.

Allowance for Credit Losses. The allowance for credit losses is the amount we determine as of a specific date to be appropriate to absorb current expected credit losses on existing loans. For a discussion of our methodology, see our accounting policies in Note 1 to the Consolidated Financial Statements (unaudited).

The provision for loan losses of $3.82 million for the three-months ended September 30, 2023 is combined with the reversal of provision for unfunded commitments of $1.55 million and reported in the net aggregate of $2.28 million under the provision for credit losses in the consolidated statements of earnings for the three-months ended September 30, 2023. The provision for loan losses of $15.05 million for the nine-months ended September 30, 2023 is combined with the reversal of provision for unfunded commitments of $4.42 million and reported in the net aggregate of $10.63 million under the provision for credit losses in the consolidated statements of earnings for the nine-months ended September 30, 2023.

The provision for loan losses of $1.06 million for the three-months ended September 30, 2022 is combined with the provision for unfunded commitments of $2.16 million and reported in the aggregate of $3.22 million under the provision for credit losses in the consolidated statements of earnings for the three-months ended September 30, 2022. The provision for loan losses of $8.91 million for the nine-months ended September 30, 2022 is combined with the provision for unfunded commitments of $4.44 million and reported in the aggregate of $13.35 million under the provision for credit losses in the consolidated statements of earnings for the nine-months ended September 30, 2022.

As a percent of average loans, net loan charge-offs were 0.04% for the third quarter of 2023, as compared to net loan recoveries of 0.07% for the third quarter of 2022. As a percent of average loans, net loan charge-offs were 0.02% for the first nine months of 2023, as compared to net loan recoveries of 0.04% for the first nine months of 2022. The allowance for credit losses as a percent of loans held-for-investment was 1.28% as of September 30, 2023, as compared to 1.18% as of September 30, 2022 and December 31, 2022, respectively.

Table 7 - Loan Loss Experience and Allowance for Credit Losses (dollars in thousands, except percentages):

Interest-Bearing Demand Deposits in Banks. The Company had interest-bearing deposits in banks of $180.01 million at September 30, 2023 compared to $138.48 million at September 30, 2022 and $37.39 million at December 31, 2022, respectively. At September 30, 2023, interest-bearing deposits in banks included $179.18 million maintained at the Federal Reserve Bank of Dallas and $832 thousand on deposit with the FHLB.

Available-for-Sale Securities. At September 30, 2023, securities with a fair value of $4.65 billion were classified as securities available-for-sale. As compared to December 31, 2022, the available-for-sale portfolio at September 30, 2023 reflected (i) an increase of $2.90 million in U.S. Treasury securities, (ii) a decrease of $434.86 million in obligations of states and political subdivisions, and (iv) a decrease of $388.85 million in mortgage-backed securities, and (iv) a decrease of $1.01 million in corporate bonds and other securities. Fluctuations in the available-for-sale securities portfolio balances were primarily driven by sales, calls, and maturities, and changes in unrealized losses during the first nine months of 2023. Our mortgage related securities are backed by GNMA, FNMA or FHLMC or are collateralized by securities backed by these agencies.

See the below table and Note 2 to the Consolidated Financial Statements (unaudited) for additional disclosures relating to the maturities and fair values of the investment portfolio at September 30, 2023 and 2022, and December 31, 2022.

Table 8 - Maturities and Yields of Available-for-Sale Securities Held at September 30, 2023 (dollars in thousands, except percentages):

All yields are computed on a tax-equivalent basis assuming a marginal tax rate of 21%. Yields on available-for-sale securities are based on amortized cost. Maturities of mortgage-backed securities are based on contractual maturities and could differ due to prepayments of underlying mortgages. Maturities of other securities are reported at the earlier of maturity date or call date.

As of September 30, 2023, the investment portfolio had an overall tax equivalent yield of 2.22%, a weighted average life of 7.94 years and modified duration of 6.42 years.

Deposits. Deposits held by our subsidiary bank represent our primary source of funding. Total deposits were $10.72 billion as of September 30, 2023, as compared to $11.14 billion as of September 30, 2022 and $11.01 billion as of December 31, 2022.

Table 9 provides a breakdown of average deposits and rates paid over the three and nine month periods ended September 30, 2023 and 2022, respectively.

Table 9 - Composition of Average Deposits (dollars in thousands, except percentages):

The estimated amount of uninsured and uncollateralized deposits including related accrued and unpaid interest is approximately $5.16 billion as of September 30, 2023.

Borrowings. Included in borrowings were federal funds purchased, securities sold under repurchase agreements, advances from the FHLB and other borrowings of $751.54 million, $774.58 million and $642.51 million at September 30, 2023 and 2022, and December 31, 2022, respectively. Securities sold under repurchase agreements are generally with significant customers of the Company that require short-term liquidity for their funds for which we pledge certain securities that have a fair value equal to at least the amount of the short-term borrowings. The average balance of federal funds purchased, securities sold under repurchase agreements, advances from the FHLB and other borrowings were $621.19 million and $768.10 million in the third quarters of 2023 and 2022, respectively. The weighted average interest rates paid on these borrowings were 3.22% and 0.40% for the third quarters of 2023 and 2022, respectively. The average balance of federal funds purchased, securities sold under repurchase agreements, advances from the FHLB and other borrowings were $653.78 million and $759.91 million for the nine-months ended September 30, 2023 and 2022, respectively. The weighted average interest rates paid on these borrowings were 2.85% and 0.21% for the nine-months ended September 30, 2023 and 2022, respectively.

Interest Rate Risk

Interest rate risk results when the maturity or repricing intervals of interest-earning assets and interest-bearing liabilities are different. Our exposure to interest rate risk is managed primarily through our strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. We use no off-balance-sheet financial instruments to manage interest rate risk.

Our subsidiary bank has an asset liability management committee that monitors interest rate risk and compliance with investment policies. The subsidiary bank utilizes an earnings simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model quantifies the effects of various interest rate scenarios on projected net interest income and net income over the next twelve months. The model measures the impact on net interest income relative to a base case scenario of hypothetical fluctuations in interest rates over the next twelve months. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the re-pricing and maturity characteristics of the existing and projected balance sheet.

The following analysis depicts the estimated impact on net interest income of immediate changes in interest rates at the specified levels for the periods presented.

The results for the net interest income simulations as of September 30, 2023 and 2022, and December 31, 2022 resulted in an asset sensitive position. These are good faith estimates and assume that the composition of our interest sensitive assets and liabilities existing at each year-end will remain constant over the relevant twelve-month measurement period and that changes in market interest rates are instantaneous and sustained across the yield curve regardless of duration of pricing characteristics on specific assets or liabilities. Also, this analysis does not contemplate any actions that we might undertake in response to changes in market interest rates. We believe these estimates are not necessarily indicative of what actually could occur in the event of immediate interest rate increases or decreases of this magnitude. As interest-bearing assets and liabilities reprice in different time frames and proportions to market interest rate movements, various assumptions must be made based on historical relationships of these variables in reaching any conclusion. Since these correlations are based on competitive and market conditions, we anticipate that our future results will likely be different from the foregoing estimates, and such differences could be material.

Should we be unable to maintain a reasonable balance of maturities and repricing of our interest-earning assets and our interest-bearing liabilities, we could be required to dispose of our assets in an unfavorable manner or pay a higher than market rate to fund our activities. Our asset liability management committee oversees and monitors this risk.

The fair value of our investment securities classified as available-for-sale totaled $4.65 billion at September 30, 2023. During the nine months ended September 30, 2023, the corresponding unrealized loss before taxes on the portfolio of $677.99 million at December 31, 2022, changed to an unrealized loss before taxes of $810.65 million at September 30, 2023, which is recorded net of taxes in accumulated other comprehensive earnings (loss) in shareholders' equity. The unrealized gains or losses, net of taxes, on the portfolio are excluded from the calculation of all regulatory capital ratios. The changes in the fair value were driven by changes in interest rates based on expected actions by the Federal Reserve Board and other market conditions. The overall valuation of the portfolio is most correlated to the 5-year U.S. Treasury rates based on the composition and duration of the portfolio. At September 30, 2023, the 5-year U.S. Treasury rate was 4.60% compared to 4.01% at December 31, 2022, representing a 59 basis point increase during the first nine months of 2023. As of September 30, 2023, an increase of 100 basis points in the 5-year U.S. Treasury rate would result in an increase to unrealized losses by approximately $258 million before taxes, while a 100 basis point decrease in the same rate would result in a decrease to unrealized losses by approximately $246 million before taxes. We believe that we have the ability to hold these securities based on our overall liquidity and intent to hold the portfolio.

Capital and Liquidity

Capital. We evaluate capital resources by our ability to maintain adequate regulatory capital ratios to do business in the banking industry. Issues related to capital resources arise primarily when we are growing at an accelerated rate but not retaining a significant amount of our profits or when we experience significant asset quality deterioration.

Total shareholders’ equity was $1.24 billion, or 9.71% of total assets at September 30, 2023, as compared to $1.13 billion, or 8.64% of total assets at September 30, 2022, and $1.27 billion, or 9.76% of total assets at December 31, 2022. Included in shareholders' equity at September 30, 2023, and 2022, and December 31, 2022 were $639.93 million, $632.42 million and $535.23 million, respectively, in unrealized losses on investment securities available-for-sale, net of related income taxes, although such amount is excluded from and does not impact regulatory capital. For the third quarter of 2023, total shareholders’ equity averaged $1.36 billion, or 10.58% of average assets, as compared to $1.36 billion, or 10.17% of average assets, during the same period in 2022. For the first nine months of 2023, total shareholders’ equity averaged $1.34 billion, or 10.44% of average assets, as compared to $1.48 billion, or 11.12% of average assets, during the same period in 2022.

Banking regulators measure capital adequacy by means of the risk-based capital ratios and the leverage ratio under the Basel III rules and prompt corrective action regulations. The risk-based capital rules provide for the weighting of assets and off-balance-sheet commitments and contingencies according to prescribed risk categories. Regulatory capital is then divided by risk-weighted assets to determine the risk-adjusted capital ratios. The leverage ratio is computed by dividing shareholders’ equity less intangible assets by quarter-to-date average assets less intangible assets.

Beginning in January 2015, under the Basel III rules, the implementation of the capital conservation buffer was effective for the Company starting at the 0.625% level and increasing 0.625% each year thereafter, until it reached 2.50% on January 1, 2019. As of January 1, 2019, the capital conservation buffer Basel III was fully phased in. The capital conservation buffer is designed to absorb losses during periods of economic stress and requires increased capital levels for the purpose of capital distributions and other payments. Failure to meet the amount of the buffer will result in restrictions on the Company’s ability to make capital distributions, including dividend payments and stock repurchases, and to pay discretionary bonuses to executive officers.

As of September 30, 2023 and 2022, and December 31, 2022, we had a total risk-based capital ratio of 19.49%, 19.07% and 19.29%, a Tier 1 capital to risk-weighted assets ratio of 18.35%, 18.03% and 18.22%; a common equity Tier 1 to risk-weighted assets ratio of 18.35%, 18.03% and 18.22% and a Tier 1 leverage ratio of 12.00%, 10.79% and 10.96%, respectively. The regulatory capital ratios as of September 30, 2023 and 2022, and December 31, 2022 were calculated under Basel III rules.

The regulatory capital ratios of the Company and Bank under the Basel III regulatory capital framework are as follows:

In connection with the adoption of the Basel III regulatory capital framework, our subsidiary bank made the election to continue to exclude accumulated other comprehensive income from available-for-sale securities (“AOCI”) from capital in connection with its quarterly financial filing and, in effect, to retain the AOCI treatment under the prior capital rules.

Liquidity. Liquidity is our ability to meet cash demands as they arise. Such needs can develop from loan demand, deposit withdrawals or acquisition opportunities. Potential obligations resulting from the issuance of standby letters of credit and commitments to fund future borrowings to our loan customers are other factors affecting our liquidity needs. Many of these obligations and commitments are expected to expire without being drawn upon;

therefore, the total commitment amounts do not necessarily represent future cash requirements affecting our liquidity position. The potential need for liquidity arising from these types of financial instruments is represented by the contractual notional amount of the instrument. Asset liquidity is provided by cash and assets which are readily marketable, or which will mature in the near future. Liquid assets include cash, federal funds sold, and short-term investments in time deposits in banks. Liquidity is also provided by access to funding sources, which include core depositors and correspondent banks that maintain accounts with and sell federal funds to our subsidiary bank. Other sources of funds include our ability to borrow from short-term sources, such as purchasing federal funds from correspondent banks, sales of securities under agreements to repurchase and other borrowings (see below) and an unfunded $25.00 million revolving line of credit established with Frost Bank, a nonaffiliated bank, which matures on June 30, 2025 (see next paragraph). Our subsidiary bank also has federal funds purchased lines of credit with two non-affiliated banks totaling $130.00 million. At September 30, 2023, there were no amounts drawn on these lines of credit. Our subsidiary bank also has (i) an available line of credit with the FHLB totaling $2.54 billion at September 30, 2023, secured by portions of our loan portfolio and certain investment securities, and (ii) access to the Federal Reserve Bank of Dallas lending program, including the Bank Term Funding Program, secured by portions of certain investment securities. At September 30, 2023, there was $45 million used on the FHLB line advance for undisbursed commitments (letters of credit) used to secure public funds and $100 million in overnight borrowings at the Federal Reserve Bank discount window.

The Company renewed its loan agreement, effective June 30, 2023, with Frost Bank. Under the loan agreement, as renewed and amended, we are permitted to draw up to $25.00 million on a revolving line of credit. Prior to June 30, 2025, interest is paid quarterly at The Wall Street Journal Prime Rate and the line of credit matures June 30, 2025. If a balance exists at June 30, 2025, the principal balance converts to a term facility payable quarterly over five years and interest is paid quarterly at The Wall Street Journal Prime Rate. The line of credit is unsecured. Among other provisions in the credit agreement, we must satisfy certain financial covenants during the term of the loan agreement, including, without limitation, covenants that require us to maintain certain capital, loan loss reserve, non-performing asset and cash flow coverage ratios. In addition, the credit agreement contains certain operational covenants, which among others, restricts the payment of dividends above 55% of consolidated net income, limits the incurrence of debt (excluding any amounts acquired in an acquisition) and prohibits the disposal of assets except in the ordinary course of business. Since 1995, we have historically declared dividends as a percentage of our consolidated net income in a range of 36% (low) in 2021 and 2020 to 53% (high) in 2003 and 2006. The Company was in compliance with the financial and operational covenants at September 30, 2023. There was no outstanding balance under the line of credit as of September 30, 2023.

In addition, we anticipate that future acquisitions of financial institutions, expansion of branch locations or offerings of new products could also place a demand on our cash resources. Available cash and cash equivalents at our parent company which totaled $133.90 million at September 30, 2023, investment securities which totaled $2.12 million at September 30, 2023 and mature over 6 to 7 years, available dividends from our subsidiaries which totaled $375.18 million at September 30, 2023, utilization of available lines of credit, and future debt or equity offerings are expected to be the source of funding for these potential acquisitions or expansions.

Our liquidity position is continuously monitored and adjustments are made to the balance between sources and uses of funds as deemed appropriate. Liquidity risk management is an important element in our asset/liability management process. We regularly model liquidity stress scenarios to assess potential liquidity outflows or funding problems resulting from economic disruptions, volatility in the financial markets, unexpected credit events or other significant occurrences deemed potentially problematic by management. These scenarios are incorporated into our contingency funding plan, which provides the basis for the identification of our liquidity needs. As of September 30, 2023, management is not aware of any events that are reasonably likely to have a material adverse effect on our liquidity, capital resources or operations. We are monitoring closely the impact to the financial system due to the recent failures of several banks. Given the diversified core deposit base and relatively low loan to deposit ratios maintained at our subsidiary bank, we consider our current liquidity position to be adequate to meet our short-term and long-term liquidity needs. In addition, management is not aware of any regulatory recommendations regarding liquidity that would have a material adverse effect on us.

Off-Balance Sheet (“OBS”)/Reserve for Unfunded Commitments. We are a party to financial instruments with OBS risk in the normal course of business to meet the financing needs of our customers. These financial instruments include unfunded lines of credit, commitments to extend credit and federal funds sold to correspondent banks and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in our consolidated balance sheets. At September 30, 2023, the Company’s reserve for unfunded commitments totaled $7.90 million which is recorded in other liabilities.

Our exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for unfunded lines of credit, commitments to extend credit and standby letters of credit is represented by the contractual notional amount of these instruments. We generally use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments.

Unfunded lines of credit and commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. These commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, as we deem necessary upon extension of credit, is based on our credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment and income-producing commercial properties.

Standby letters of credit are conditional commitments we issue to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The average collateral value held on letters of credit usually exceeds the contract amount.

Table 10 – Commitments as of September 30, 2023 (dollars in thousands):

We believe we have no other OBS arrangements or transactions with unconsolidated, special purpose entities that would expose us to liability that is not reflected on the face of the financial statements. The above table does not include balances related to the Company’s IRLC and forward mortgage-backed security trades. Total commercial commitments were $1.98 billion at September 30, 2023, compared to $2.00 billion at September 30, 2022, and $2.06 billion at December 31, 2022.

Parent Company Funding. Our ability to fund various operating expenses, dividends, and cash acquisitions is generally dependent on our own earnings (without giving effect to our subsidiaries), cash reserves and funds derived from our subsidiaries. These funds historically have been produced by intercompany dividends and management fees that are limited to reimbursement of actual expenses. We anticipate that our recurring cash sources will continue to include dividends and management fees from our subsidiaries. At September 30, 2023, $375.18 million was available for the payment of intercompany dividends by our subsidiaries without the prior approval of regulatory agencies. Our subsidiaries paid aggregate dividends of $97.50 million and $67.50 million for the nine-months ended September 30, 2023 and 2022, respectively.

Dividends. Our long-term dividend policy is to pay cash dividends to our shareholders of approximately 35% to 40% of annual net earnings while maintaining adequate capital to support growth. We are also restricted by a loan covenant within our line of credit agreement with Frost Bank to dividend no greater than 55% of net income, as defined in such loan agreement. The cash dividend payout ratios have amounted to 49.48% and 39.78% of net earnings for the first nine months of 2023 and 2022, respectively. Given our current capital position, projected earnings and asset growth rates, we do not anticipate any significant change in our current dividend policy. In July 2023, the Board of Directors declared an $0.18 per share cash dividend for the third quarter of 2023, a 5.88% increase over the dividend declared in the third quarter of 2022. The record date for this dividend was September 14, 2023, payable on October 2, 2023.

Our bank subsidiary, which is a national banking association and a member of the Federal Reserve System, is required by federal law to obtain the prior approval of the OCC to declare and pay dividends if the total of all dividends declared in any calendar year would exceed the total of (i) such bank’s net profits (as defined and interpreted by regulation) for that year plus (ii) its retained net profits (as defined and interpreted by regulation) for the preceding two calendar years, less any required transfers to surplus.

To pay dividends, we and our subsidiary bank must maintain adequate capital above regulatory guidelines and comply with the general requirements applicable to a Texas corporation. Generally, a Texas corporation may not pay a dividend to its shareholders if (i) after giving effect to the dividend, the corporation would be insolvent, or (ii) the amount of the dividend would exceed the surplus of the corporation. In addition, if the applicable regulatory authority believes that a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), the authority may require, after notice and hearing, that such bank cease and desist from the unsafe practice. The Federal Reserve, the FDIC and the OCC have each indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. The Federal Reserve, the OCC and the FDIC have issued policy statements that recommend that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.

Management considers interest rate risk to be a significant market risk for the Company. See “Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations — Interest Rate Risk” for disclosure regarding this market risk.

As of September 30, 2023, we carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934). Our management, which includes our principal executive officer and our principal financial officer, does not expect that our disclosure controls and procedures will prevent all errors and all fraud.

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls 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; over time, controls may become inadequate because of changes in conditions or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Our principal executive officer and principal financial officer have concluded, based on our evaluation of our disclosure controls and procedures, that our disclosure controls and procedures were effective at the reasonable assurance level as of September 30, 2023.

Subsequent to our evaluation, there were no significant changes in internal controls over financial reporting or other factors that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

There has been no material change in the risk factors previously disclosed under Part I, Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2022 and Part II, Item 1A of the Company's Quarterly Report on Form 10-Q for the quarter-ended March 31, 2023.