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

This Quarterly Report on Form 10-Q should be read in conjunction with the more detailed and comprehensive disclosures included in our Annual Report on Form 10-K for the year ended December 31, 2022. In addition, please read this section in conjunction with our Consolidated Financial Statements and Notes to Consolidated Financial Statements contained herein.

FORWARD LOOKING INFORMATION

Statements and financial analysis contained in this Quarterly Report on Form 10-Q that are based on other than historical data are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations or forecasts of future events and include, among others:

• statements with respect to the beliefs, plans, objectives, goals, guidelines, expectations, anticipations, and future financial condition, results of operations and performance of Financial Institutions, Inc. (the “Parent” or “FII”) and its subsidiaries (collectively, the “Company,” “we,” “our” or “us”); and
• statements preceded by, followed by or that include the words “may,” “could,” “should,” “would,” “believe,” “continue,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “projects” or similar expressions.

These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date. Forward-looking statements involve significant risks and uncertainties and actual results may differ materially from those presented, either expressed or implied, in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended December 31, 2022 (the “Form 10-K”), including, but not limited to, those presented in the Management’s Discussion and Analysis of Financial Condition and Results of Operations. Factors that might cause such material differences include, but are not limited to:

• We are subject to interest rate risk, and fluctuations in market interest rates may affect our interest margins and income,

demand for our products, defaults on loans, loan prepayments and the fair value of our financial instruments;

• The soundness of other financial institutions could adversely affect us;
• Our business may be adversely affected by conditions in the financial markets and economic conditions generally;
• Recent events involving the failure of three financial institutions may adversely affect our business and the market price of our common stock;
• Downgrades of the U.S. credit rating and uncertain credit and financial market conditions may affect the stability of securities issued or guaranteed by the federal government, which may affect the valuation or liquidity of our investment securities portfolio and increase future borrowing costs;
• If we experience greater credit losses than anticipated, earnings may be adversely impacted;
• Geographic concentration may unfavorably impact our operations;
• Our commercial business and mortgage loans increase our exposure to credit risks;
• If our regulators impose limitations on our commercial real estate lending activities, earnings could be adversely affected;
• Our indirect and consumer lending involves risk elements in addition to normal credit risk;
• Lack of seasoning in portions of our loan portfolio could increase risk of credit defaults in the future;
• We accept deposits that do not have a fixed term, and which may be withdrawn by the customer at any time for any reason;
• We are subject to environmental liability risk associated with our lending activities;
• We operate in a highly competitive industry and market area;
• Regulatory scrutiny of bank provision of BaaS solutions and related technology considerations has recently increased;
• We have implemented a program to provide financial products and services to customers that do business in the cannabis industry and the strict enforcement of federal laws and regulations regarding cannabis could result in our inability to continue to provide financial products and services to these customers and we could have legal action taken against us by the federal government and exposure to additional liabilities and regulatory compliance costs;
• Legal and regulatory proceedings and related matters, such as the action brought by a class of consumers against us as described in Part II, Item 1, “Legal Proceedings,” could adversely affect us and the banking industry in general;
• Any future FDIC insurance premium increases, or special assessment may adversely affect our earnings;
• We are highly regulated, and any adverse regulatory action may result in additional costs, loss of business opportunities, and reputational damage;
• The policies of the Federal Reserve have a significant impact on our earnings;
• Our insurance brokerage subsidiary is subject to risk related to the insurance industry;
• Our investment advisory and wealth management operations are subject to risk related to the regulation of the financial services industry and market volatility;
• Loss of key employees may disrupt relationships with certain customers;
• We make certain assumptions and estimates in preparing our financial statements that may prove to be incorrect, which could significantly impact our results of operations, cash flows and financial condition, and we are subject to new or changing accounting rules and interpretations, and the failure by us to correctly interpret or apply these evolving rules and interpretations could have a material adverse effect;
• The value of our goodwill and other intangible assets may decline in the future;
• We may be unable to successfully implement our growth strategies, including the integration and successful management of newly-acquired businesses;
• The introduction of new products and services may subject us to increased regulation and regulatory scrutiny and may affect our reputation;
• Acquisitions may disrupt our business and dilute shareholder value;
• Our tax strategies and the value of our deferred tax assets and liabilities could adversely affect our operating results and regulatory capital ratios;
• Liquidity is essential to our businesses;
• We rely on dividends from our subsidiaries for most of our revenue;
• If our risk management framework does not effectively identify or mitigate our risks, we could suffer losses;
• Public health emergencies, like the COVID-19 outbreak, may have an adverse impact on our business and results of operations;
• We may need to raise additional capital in the future and such capital may not be available on acceptable terms or at all;
• We face competition in staying current with technological changes and banking alternatives to compete and meet customer demands;
• We rely on other companies to provide key components of our business infrastructure;
• A breach in security of our or third-party information systems, including the occurrence of a cyber incident or a deficiency in cybersecurity, or a failure by us to comply with New York State cybersecurity regulations, may subject us to liability, result in a loss of customer business or damage our brand image;
• We may not pay or may reduce the dividends on our common stock;
• We may issue debt and equity securities or securities convertible into equity securities, any of which may be senior to our common stock as to distributions and in liquidation, and which could dilute our current shareholders or negatively affect the value of our common stock;
• Our certificate of incorporation, our bylaws, and certain banking laws may have an anti-takeover effect;
• The market price of our common stock may fluctuate significantly in response to a number of factors;
• We may not be able to attract and retain skilled people;
• We use financial models for business planning purposes that may not adequately predict future results;
• We depend on the accuracy and completeness of information about or from customers and counterparties;
• Severe weather, natural disasters, public health emergencies and pandemics, acts of war or terrorism, and other external events could significantly impact our business;
• Negative public opinion could damage our reputation and impact business operations and revenues; and
• Environmental, social and governance matters, and any related reporting obligations may impact our business.

We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and advise readers that various factors, including those described above, could affect our financial performance and could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected. See also Item 1A, Risk Factors, in the Annual Report on Form 10-K for the year ended December 31, 2022, and Item 1A. Risk Factors in our subsequent Quarterly Reports on Form 10-Q for further information. Except as required by law, we do not undertake, and specifically disclaim any obligation to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

GENERAL

The Parent is a financial holding company headquartered in New York State, providing diversified financial services through its operating subsidiaries, Five Star Bank (the “Bank”), SDN Insurance Agency, LLC (“SDN”) and Courier Capital, LLC (“Courier Capital”). The Company offers a broad array of deposit, lending and other financial services to individuals, municipalities and businesses in Western and Central New York through its wholly-owned New York-chartered banking subsidiary, the Bank. The Bank also has commercial loan production offices in Ellicott City (Baltimore), Maryland, and Syracuse, New York, serving the Mid-Atlantic and Central New York regions. Our indirect lending network includes relationships with franchised automobile dealers in Western and Central New York, the Capital District of New York and Northern and Central Pennsylvania. SDN provides a broad range of insurance services to personal and business clients. Courier Capital provides customized investment advice, wealth management, investment consulting and retirement plan services to individuals, businesses, institutions, foundations and retirement plans. In May 2023, the Company announced the completion of the merger of HNP Capital, LLC (“HNP Capital”) with and into Courier Capital.

Our primary sources of revenue are net interest income (interest earned on our loans and securities, net of interest paid on deposits and other funding sources) and noninterest income, particularly fees and other revenue from insurance, investment advisory and financial services provided to customers or ancillary services tied to loans and deposits. Business volumes and pricing drive revenue potential, and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth, and competitive conditions within the marketplace. We are not able to predict market interest rate fluctuations with certainty and our asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on our results of operations and financial condition.

Our business strategy has been to maintain a community bank philosophy, which consists of focusing on and understanding the individualized banking and other financial needs of individuals, municipalities and businesses of the local communities surrounding our primary service area. We believe this focus allows us to be more responsive to our customers’ needs and provide a high level of personal service that differentiates us from larger competitors, resulting in long-standing and broad-based banking relationships. Our core customers are primarily small- to medium-sized businesses, individuals and community organizations who prefer to build banking, insurance and wealth management relationships with a community bank that combines high quality, competitively-priced products and services with personalized service. Because of our identity and origin as a locally operated bank, we believe that our level of personal service provides a competitive advantage over larger banks, which tend to consolidate decision-making authority outside local communities.

A key aspect of our current business strategy is to foster a community-oriented culture where our customers and employees establish long-standing and mutually beneficial relationships. We believe that we are well-positioned to be a strong competitor within our market area because of our focus on community banking needs and customer service, our comprehensive suite of deposit, loan, insurance and wealth management products typically found at larger banks, our highly experienced management team and our strategically located banking centers.

We have evolved to meet changing customer needs by opening what we refer to as financial solution center branches. These financial solution center branches have a smaller footprint than our traditional branches, focus on technology to provide solutions that fit our customer preferences for transacting business with us, and these branches are staffed by certified personal bankers who are trained to meet a broad array of customer needs. We expanded our footprint into the Mid-Atlantic region with the opening of a loan production office in Baltimore, Maryland in February 2022, and further expanded our footprint in Central New York with the opening of a commercial loan production office in Syracuse, New York in January 2023. Additionally, we are focused on the continued expansion of product delivery channels and are investing in our digital banking platform to allow for greater flexibility in the customer experience. We believe that the foregoing factors all help to grow our core deposits, which support a central element of our business strategy – the growth of a diversified and high-quality loan portfolio.

Our Banking-as-a-Service (“BaaS”) business offers banking capabilities to non-bank financial service providers and other financial technology firms (“FinTechs”), allowing them to provide banking services to their end users. With the help of the Bank’s partners, we can offer banking services and products beyond our traditional footprint, creating new fee-based revenue opportunities through service, interchange and other fees, coupled with cost effective deposit gathering opportunities. We are primarily focused on five key BaaS client types where we see strong opportunity: business-to-business, where we help FinTechs innovate solutions while creating new market opportunities and efficiencies; affinity groups, where we help empower traditionally under-banked communities with expanded financial services access; sustainable finance, where we meet customer-led environmental demands by partnering with early movers in the green banking space; cannabis-related businesses, where we can tap into the multi-billion dollar cannabis market by leveraging regulatory and risk experience for sustained operations; and wealth management, which enables wealth managers to meet accelerating client demand for banking services.

Cannabis Banking

The Marijuana Regulation and Taxation Act was signed into law on March 31, 2021, legalizing the possession and sale of recreational marijuana in New York State for adults aged 21 or older and the state has issued adult-use cannabis cultivation, processing and retail dispensary licenses. We have implemented a program to provide financial products and services to legal cannabis-related businesses and partner with other financial institutions who provide such services.

Offering financial products and services to the cannabis industry presents a unique set of regulatory risks due to the conflict between state and federal laws, as marijuana remains illegal at the federal level. In January 2018, the U.S. Department of Justice (the “DOJ”) rescinded the “Cole Memo” and related memoranda which characterized the enforcement of the Controlled Substances Act against persons and entities complying with state regulatory systems permitting the use, manufacture and sale of medical marijuana as an inefficient use of their prosecutorial resources and discretion. The impact of the DOJ’s rescission of the Cole Memo and related memoranda is unclear, but in the future may result in increased enforcement actions against the regulated cannabis industry generally. More recently, the United States Attorney General has indicated that the DOJ, under his leadership, does not intend to pursue cases against parties who comply with the laws in states which have legalized and are effectively regulating marijuana. However, enforcement policies and practices may be highly variable between political administrations. In addition, federal prosecutors have significant discretion and there can be no assurance that the federal prosecutor for any district in which we operate will not choose to strictly enforce the federal laws governing cannabis. In the future, enforcement actions may be taken against cannabis-related businesses or financial services providers that are viewed as aiding and abetting such activities.

The Financial Crimes Enforcement Network (“FinCEN”) published guidelines in 2014 for financial institutions servicing state-legal cannabis businesses. These guidelines were issued for the explicit purpose so “that financial institutions can provide services to marijuana-related businesses in a manner consistent with their obligations to know their customers and to report possible criminal activity.” The Bank has and will continue to follow this and other FinCEN guidance in the areas of cannabis banking.

EXECUTIVE OVERVIEW

Summary of 2023 Third Quarter Results

Net income increased $168 thousand to $14.0 million for the third quarter of 2023 compared to $13.9 million for the third quarter of 2022. Net income available to common shareholders for the third quarter of 2023 was $13.7 million, or $0.88 per diluted share, compared with $13.5 million, or $0.88 per diluted share, for the third quarter of 2022. Return on average common equity was 13.15% and return on average assets was 0.92% for the third quarter of 2023 compared to 12.72% and 0.98%, respectively, for the third quarter of 2022.

Net interest income totaled $41.7 million in the third quarter of 2023, a decrease of $1.4 million compared to $43.1 million in the third quarter of 2022. Average interest-earning assets for the third quarter of 2023 were $473.3 million higher than the third quarter of 2022 due to a $591.4 million increase in average loans and a $20.5 million increase in the average balance of Federal Reserve interest-earning cash, partially offset by a $138.6 million decrease in average investment securities.

Net interest margin was 2.91% for the third quarter of 2023 compared to 3.28% in the third quarter of 2022, primarily as a result of higher funding costs amid the rising interest rate environment, partially offset by an increase in the average yield on interest-earning assets.

The provision for credit losses was $966 thousand in the third quarter of 2023 compared to $4.3 million in the third quarter of 2022. Net charge-offs during the recent quarter were $1.6 million, representing 0.14% of average loans on an annualized basis, compared to $2.2 million, or an annualized 0.22% of average loans, in the third quarter of 2022. See the “Allowance for Credit Losses – Loans” and “Non-Performing Assets and Potential Problem Loans” sections of this Management’s Discussion and Analysis for further discussion regarding the provision for credit losses and net charge-offs.

Noninterest income totaled $10.5 million in the third quarter of 2023, compared to $12.7 million in the third quarter of 2022. The decrease in noninterest income for the third quarter of 2023 included decreases of $1.9 million in company owned life insurance income, and $390 thousand in service charges on deposits, partially offset by a $326 thousand increase in income from investments in limited partnerships. The third quarter of 2022 included a $2.0 million enhancement from the surrender and redeployment of $25.5 million in cash surrender value of company owned life insurance, which was offset by approximately $1.5 million of incremental income tax expense during the third quarter of 2022. The decrease in service charges on deposits reflected a reduction in nonsufficient fees as a result of January 2023 changes implemented in January 2023 to our consumer overdraft program that align with trends in community banking.

Noninterest expense totaled $34.7 million in the third quarter of 2023, compared to $32.8 million in the third quarter of 2022. The increase in noninterest expense was primarily the result of increases in computer and data processing expense, FDIC assessments expense, and other expenses. The increase in computer and data processing expense was primarily due to investments in data efficiency and marketing technology. FDIC assessments expense increased in part, due to the increase in the base deposit insurance assessment rate schedules by two basis points, coupled with balance sheet growth. The increase in other expense was driven in part by interest charges related to collateral held for derivative transactions.

The regulatory Common Equity Tier 1 Ratio and Total Risk-Based Capital Ratio were 9.58%, and 11.91%, respectively, at September 30, 2023. See the “Liquidity and Capital Management” section of this Management’s Discussion and Analysis for further discussion regarding regulatory capital and the Basel III capital rules.

RESULTS OF OPERATIONS

Net Interest Income and Net Interest Margin

Net interest income is our primary source of revenue, comprising approximately 80% of revenue during both the three and nine months ended September 30, 2023. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of interest-earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities and repricing frequencies.

We use interest rate spread and net interest margin to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on interest-earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds (“net free funds”), principally noninterest-bearing demand deposits and shareholders’ equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis.

The following table reconciles interest income per the consolidated statements of income to interest income adjusted to a fully taxable equivalent basis (dollars in thousands):

Analysis of Net Interest Income for the Three Months Ended September 30, 2023 and 2022

Net interest income on a taxable equivalent basis for the three months ended September 30, 2023, was $41.8 million, a decrease of $1.4 million versus the comparable quarter last year of $43.2 million. The decrease in net interest income consisted of a $25.4 million increase in interest expense, primarily as a result of an increase in higher-cost borrowings and time deposits coupled with continued repricing of deposits, as customers responded to the rising interest rate environment, partially offset by a $24.0 million increase in interest income, resulting primarily from the impact of market interest rate increases having a positive impact on yields, as well as an increase in average loans of $591.4 million, or 15%, and a $20.5 million increase in the average balance of Federal Reserve interest-earning cash, partially offset by decrease in average investment securities of $138.6 million, or 10%.

Our net interest margin for the third quarter of 2023 was 2.91%, 37-basis points lower than 3.28% for the same period in 2022 as a result of higher funding costs amid the rising interest rate environment, as well as seasonality and repricing within the deposit portfolio, partially offset by an increase in the average yield on interest-earning assets.

For the third quarter of 2023, the average yield on average interest earning assets of 5.21% was 135-basis points higher than the third quarter of 2022 of 3.86% due to the increase in market interest rates. Average loan yields increased 153-basis points during the third quarter of 2023 to 6.15% from 4.62% for the third quarter of 2022. The average yield on investment securities increased 7-basis points during the third quarter of 2023 to 1.88% from 1.81% for the third quarter of 2022. Overall, a favorable volume variance increased interest income by $7.9 million during the third quarter of 2023, and the average loan yield changes increased interest income by $16.1 million which collectively drove a $24.0 million increase in interest income.

Average interest-earning assets were $5.70 billion for the third quarter of 2023 compared to $5.23 billion for the third quarter of 2022, an increase of $473.3 million, or 9%, from the comparable quarter last year, with average loans up $591.4 million from $3.82 billion for the third quarter of 2022 to $4.41 billion for the third quarter of 2023, and a $20.5 million increase in average Federal Reserve interest-earning cash, partially offset by a decrease in average securities of $138.6 million from $1.37 billion for the third quarter of 2022 to $1.23 billion for the third quarter of 2023. Loans comprised 77% of average interest-earning assets during the third quarter of 2023 compared to 73% during the third quarter of 2022. The increase in average loans was primarily due to organic growth in commercial mortgages. Loans generally have significantly higher yields compared to other interest-earning assets and, as such, have a more positive effect on the net interest margin. The average yield on average loans was 6.15% for the third quarter of 2023, an increase of 153-basis points compared to 4.62% for the comparable quarter in 2022 due to the impact of the increase in market interest rates. An increase in the volume of average loans resulted in a $7.9 million increase in interest income and rate changes increased interest income by $16.1 million. Securities represented 22% of average interest-earning assets during the third quarter of 2023 compared to 26% during the third quarter of 2022. The decrease in average investment securities was due to the redeployment of excess liquidity intended to benefit interest income with the intent of reducing net interest margin compression relative to interest earned on federal funds sold and interest-earning deposits.

For the third quarter of 2023, the average cost of average interest-bearing liabilities of 2.96% was 219-basis points higher than the third quarter of 2022 and the average cost of interest-bearing deposits of 2.84% was 221-basis points higher than the third quarter of 2022 due to the rising interest rate environment that occurred in 2022 and continued into 2023.

Average interest-bearing liabilities were $4.43 billion for the third quarter of 2023, compared to $3.91 billion for the third quarter of 2022, an increase of $513.9 million, or 13% driven by increases in both average balances of interest-bearing deposits and average total borrowings. Total average borrowings increased to $347.3 million, up $136.6 million from the third quarter of 2022. On average, interest-bearing deposits grew $377.3 million from $3.70 billion for the third quarter of 2022 to $4.08 billion for the current quarter while noninterest-bearing demand deposits (a principal component of net free funds) decreased $93.3 million to $1.02 billion for the third quarter of 2023. The increase in average interest-bearing deposits was primarily due to growth in reciprocal, non-public, and brokered deposits, partially offset by a decline in public deposits. For further discussion of the reciprocal deposit programs, refer to the “Funding Activities – Deposits” section of this Management’s Discussion and Analysis. Overall, interest-bearing deposit rate changes resulted in a $21.3 million increase in interest expense during the third quarter of 2023, primarily due to the higher rate market conditions.

Analysis of Net Interest Income for the Nine Months Ended September 30, 2023 and 2022

Net interest income on a taxable equivalent basis for the nine months ended September 30, 2023, was $126.2 million, an increase of $1.5 million versus the comparable period in 2022 of $124.6 million. The increase in net interest income was primarily due to a $71.2 million increase in interest income, resulting primarily from the impact of the market interest rate increases having a positive impact on yields, as well as an increase in average loans of $523.9 million, or 14%, partially offset by a decrease in average investment securities of $134.7 million, or 10%. The increase in interest income was partially offset by an increase in interest expense of $69.7 million. The increase in interest expense was primarily the result of continued repricing of deposits at higher rates, as well as an increase in higher cost borrowings and time deposits.

Our net interest margin for the nine months ended September 30, 2023 was 2.99%, 20-basis points lower than 3.19% for the same period in 2022 as a result of a shift in our deposit mix from lower cost transactional accounts to higher cost time deposits, as well as repricing within the deposit portfolio.

For the nine months ended September 30, 2023, the average yield on average interest earning assets of 4.98% was 143-basis points higher than the nine months ended September 30, 2022 of 3.55%. The average yield on loans increased 138-basis points during the nine months ended September 30, 2023, to 5.90% from 4.52% for the comparable period last year. The average yield on investment securities increased 10-basis points to 1.89% for the nine months ended September 30, 2023 compared to 1.79% for the nine months ended September 30, 2022. Overall, volume variances in average interest-earning assets and average interest-bearing liabilities increased net interest income by $18.1 million during the nine months ended September 30, 2023, and the impact of the interest rate increases in 2022 and 2023 had an overall positive impact on yields, contributing another $53.1 million to interest income.

Average interest-earning assets were $5.63 billion for the nine months ended September 30, 2023 compared to $5.22 billion for the nine months ended September 30, 2022, an increase of $413.1 million, or 8%, with average loans up $523.9 million from $3.76 billion for the nine months ended September 30, 2022 to $4.29 billion for the nine months ended September 30, 2023, partially offset by a decrease in average securities of $134.7 million from $1.40 billion for the nine months ended September 30, 2022 to $1.27 billion for the nine months ended September 30, 2023. Securities represented 23% of average interest-earning assets during the nine months ended September 30, 2023 compared to 27% during the nine months ended September 30, 2022. Loans comprised 76% of average interest-earning assets during the nine months ended September 30, 2023 compared to 72% during the nine months ended September 30, 2022. The increase in average loans was primarily due to organic growth in commercial mortgages. Loans generally have significantly higher yields compared to other interest-earning assets and, as such, have a more positive effect on the net interest margin. An increase in the volume of average loans resulted in a $19.9 million increase in interest income and higher interest rates increased interest income by $53.1 million.

For the nine months ended September 30, 2023, the average cost of average interest-bearing liabilities of 2.57% was 209-basis points higher than the nine months ended September 30, 2022 of 0.48% with the average cost of average interest-bearing deposits of 2.42% increasing 207-basis points from 0.35% for the nine months ended September 30, 2022 due to the rising interest rate environment that occurred in 2022 and continued into 2023.

Average interest-bearing liabilities of $4.35 billion in the nine months ended September 30, 2023 were $431.6 million, or 11%, higher than the nine months ended September 30, 2022. The increase was driven by increases in both total borrowings and interest-bearing deposits. Total average borrowings increased to $342.4 million for the nine months ended September 30, 2023, up $182.8 million from the nine months ended September 30, 2022. On average, interest-bearing deposits grew $248.8 million from $3.76 billion for the nine months ended September 30, 2022 to $4.01 billion for the current period, while noninterest-bearing demand deposits (a principal component of net free funds) decreased $60.4 million to $1.04 billion for the nine months ended September 30, 2023. The increase in average deposits was primarily due to growth in brokered, non-public and reciprocal deposits, partially offset by a decrease in public deposits. For further discussion of the reciprocal deposit programs, refer to the “Funding Activities – Deposits” section of this Management’s Discussion and Analysis. Overall, interest-bearing deposit rate changes resulted in a $59.7 million increase in interest expense during the nine months ended September 30, 2023, primarily due to the rising interest rate environment.

The following tables set forth certain information relating to the consolidated balance sheets and reflects the average yields earned on interest-earning assets, as well as the average rates paid on interest-bearing liabilities for the periods indicated (dollars in thousands). Average balances were derived from daily balances.

(1) Investment securities are shown at amortized cost.

(2) The interest on tax-exempt securities is calculated on a tax-equivalent basis assuming a Federal income tax rate of 21%.

(3) Annualized.

(4) Loans include net unearned income, net deferred loan fees and costs and non-accruing loans. Net deferred loan fees (costs) included in interest income were as follows (in thousands):

MANAGEMENT'S DISCUSSION AND ANALYSIS

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MANAGEMENT'S DISCUSSION AND ANALYSIS

(1) Investment securities are shown at amortized cost.

(2) The interest on tax-exempt securities is calculated on a tax-equivalent basis assuming a Federal income tax rate of 21%.

(3) Annualized.

(4) Loans include net unearned income, net deferred loan fees and costs and non-accruing loans. Net deferred loan fees (costs) included in interest income were as follows (in thousands):

The following table presents, on a tax-equivalent basis, the relative contribution of changes in volumes and changes in rates to changes in net interest income for the periods indicated. The change in interest income not solely due to changes in volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each (in thousands). No out-of-period adjustments were included in the rate/volume analysis.

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Provision for Credit Losses

The provision for credit losses for the three and nine months ended September 30, 2023 was $966 thousand and $8.4 million, respectively, compared to $4.3 million and $7.2 million for the corresponding periods in 2022. The decrease to the loan loss provision in the third quarter of 2023 reflected a modest decrease in the national unemployment forecast, coupled with sustained low levels of overall net charge-offs, driven in the current quarter by the payoff of one commercial loan that we previously recorded a partial charge-off for, and a decline in the level of unfunded commitments. The increase in the loan loss provision for the nine months ended September 30, 2023 was primarily due to a $2.0 million recovery in connection with the pay-off of a commercial loan that was downgraded to non-performing status with a partial charge-off in the second quarter of 2021 being included in the nine months ended September 30, 2022.

See the “Allowance for Credit Losses – Loans” and “Non-Performing Assets and Potential Problem Loans” sections of this Management’s Discussion and Analysis for further discussion.

Noninterest Income

The following table details the major categories of noninterest income for the periods presented (in thousands):

Service charges on deposits decreased $390 thousand, or 24%, to $1.2 million for the third quarter of 2023 compared to $1.6 million for the third quarter of 2022. For the first nine months of 2023, service charges on deposits decreased $946 thousand, or 21%, to $3.5 million compared to $4.4 million for the first nine months of 2022. The decrease for both periods was primarily driven by a reduction in nonsufficient funds fees as a result of January 2023 changes in our consumer overdraft program that align with trends in community banking.

Income from company owned life insurance decreased $1.9 million, or 65%, to $1.0 million for the third quarter of 2023 compared to $3.0 million for the third quarter of 2022. For the first nine months of 2023, income from company owned life insurance decreased $1.7 million, or 36% to $3.0 million compared to $4.7 million for the first nine months of 2022. Included in the third quarter of 2022 was a $2.0 million enhancement from the surrender and redeployment of $25.5 million in cash surrender value of company owned life insurance.

Investments in limited partnerships income increased $326 thousand to $391 thousand for the third quarter of 2023 compared to $65 thousand for the third quarter of 2022. Investments in limited partnerships income for the first nine months of 2023 of $1.1 million was relatively flat compared to the first nine months of 2022. The Company has made several investments in limited partnerships, primarily small business investment companies, and accounts for these investments under the equity method. Income from these investments fluctuates based on the maturity and performance of the underlying investments.

Net gain on sale of loans held for sale was $115 thousand for the third quarter of 2023 compared to $308 thousand for the third quarter of 2022. For the first nine months of 2023, net gain on sale of loans held for sale was $349 thousand compared to $1.0 million for the first nine months of 2022. Included in the first nine months of 2022 was a gain of $586 thousand related to the sale of a $31.2 million portfolio of indirect loans in the second quarter of 2022.

Net loss on tax credit investments was $333 thousand for the third quarter of 2023, compared to $385 thousand for the third quarter of 2022. For the first nine months of 2023, net loss on tax credit investments was $45 thousand compared to $704 thousand for the first nine months of 2022. The net losses include amortization of tax credit investments, partially offset by New York investment tax credits that are refundable and recorded in noninterest income.

Noninterest Expense

The following table details the major categories of noninterest expense for the periods presented (in thousands):

Salaries and employee benefits expense increased $210 thousand, or 1%, to $18.2 million for the third quarter of 2023 compared to $18.0 million for the third quarter of 2022. For the first nine months of 2023, salaries and employee benefits expense increased $2.5 million, or 5%, to $54.0 million compared to $51.5 million for the first nine months of 2022. The increase in the first nine months of 2023 was primarily the result of investments in personnel and wage pressures driven by the current labor market, along with an increase in health insurance benefit expense due to higher medical claims.

Computer and data processing expense increased $700 thousand, or 16%, to $5.1 million for the third quarter of 2023 compared to $4.4 million for the third quarter of 2022. For the first nine months of 2023, computer and data processing expense increased $1.6 million, or 12%, to $14.5 million compared to $13.0 million for the first nine months of 2022. The increase for the 2023 periods was a result of our strategic investments in data efficiency and marketing technology.

FDIC assessments expense increased $581 thousand, or 89%, to $1.2 million for the third quarter of 2023 compared to $651 thousand for the third quarter of 2022. For the first nine months of 2023, FDIC assessments expense increased $1.8 million to $3.6 million compared to $1.8 million for the first nine months of 2022. The increases were due in part to the impact of an increase in base deposit insurance assessment rate schedules by two basis points, coupled with balance sheet growth.

Restructuring charges of $1.3 million for the first nine months of 2022 includes charges recognized in the second quarter of 2022 in connection with the write-down of real estate assets to fair market value based upon existing purchase offers and current market conditions for five locations that were closed in the second half of 2020.

Other expense increased $556 thousand, or 16%, to $4.0 million for the third quarter of 2023 compared to $3.4 million for the third quarter of 2022. For the first nine months of 2023, other expense increased $2.6 million, or 29%, to $11.5 million compared to $8.9 million for the first nine months of 2022. The increase for the 2023 periods was due to a combination of factors, including interest charges related to collateral held for derivative transactions, the timing of deposit account-related fraud charge-offs, higher insurance costs and the impact of inflationary pressures.

Our efficiency ratio for the third quarter of 2023 and the first nine months of 2023 was 66.47% and 64.25%, respectively, compared with 58.78% and 59.91% for the third quarter of 2022 and first nine months of 2022, respectively. The higher efficiency ratio for both periods in 2023 was primarily the result of an increase in noninterest expense in 2023 as described above. The efficiency ratio is calculated by dividing total noninterest expense by net revenue, defined as the sum of tax-equivalent net interest income and noninterest income before net gains on investment securities. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease indicates a more efficient allocation of resources. The efficiency ratio, a banking industry financial measure, is not required by GAAP. However, the efficiency ratio is used by management in its assessment of financial performance specifically as it relates to noninterest expense control. Management also believes such information is useful to investors in evaluating Company performance.

Income Taxes

For the three and nine months ended September 30, 2023, we recorded income tax expense of $2.4 million and $7.6 million, respectively, versus $4.7 million and $12.0 million for the same periods in the prior year. In the third quarter of 2023, we recognized federal and state tax benefits related to tax credit investments placed in service and/or amortized during the period resulting in a reduction in income tax expense of $731 thousand, versus $511 thousand for the same period in the prior year. The nine months ended September 30, 2023 and 2022 also included related benefits of $2.1 million and $1.6 million, respectively. Contributing to the third quarter 2022 income tax expense were approximately $1.5 million of incremental taxes associated with the previously mentioned company owned life insurance surrender and redeploy strategy, which was offset by a $2.0 million enhancement recorded as noninterest income.

Our effective tax rates for the three and nine months ended September 30, 2023 were 14.8% and 15.9%, respectively, versus 25.4% and 21.3%, respectively, for the same periods in the prior year. Effective tax rates are typically impacted by items of income and expense that are not subject to federal or state taxation. Our effective tax rates reflect the impact of these items, which include, but are not limited to, interest income from tax-exempt securities, earnings on company owned life insurance and the impact of tax credit investments. In addition, our effective tax rate for 2023 and 2022 reflects the New York State tax benefit generated by our real estate investment trust.

ANALYSIS OF FINANCIAL CONDITION

INVESTING ACTIVITIES

Investment Securities

The following table summarizes the composition of our investment securities portfolio as of the dates indicated (in thousands):

Our available for sale (“AFS”) investment securities portfolio decreased $65.9 million from December 31, 2022 to September 30, 2023. The AFS portfolio had a net unrealized loss of $207.0 million at September 30, 2023 and $172.7 million at December 31, 2022, respectively. The decline in the portfolio balance was primarily the result of the use of portfolio cash flow to fund loan originations.

Security Yields and Maturities Schedule

The following table sets forth certain information regarding the amortized cost (“Cost”), weighted average yields (“Yield”) and contractual maturities of our debt securities portfolio as of September 30, 2023. In this table, Yield is defined as the book yield weighted against the ending book value. Mortgage-backed securities are included in maturity categories based on their stated maturity date. Actual maturities may differ from the contractual maturities presented because borrowers may have the right to call or prepay certain investments. No tax-equivalent adjustments were made to the weighted average yields (dollars in thousands).

Impairment Assessment

For AFS securities in an unrealized loss position, we first assess whether (i) we intend to sell, or (ii) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis. If either case is affirmative, any previously recognized allowances are charged-off and the security’s amortized cost is written down to fair value through income. If neither case is affirmative, the security is evaluated to determine whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency and any adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an allowance for credit losses is recognized in other comprehensive income. Adjustments to the allowance are reported in our income statement as a component of credit loss expense. AFS securities are charged-off against the allowance or, in the absence of any allowance, written down through income when deemed uncollectible by management or when either of the aforementioned criteria regarding intent or requirement to sell is met. For the three and nine months ended September 30, 2023 and 2022, no allowance for credit losses was recognized on AFS securities in an unrealized loss position as management does not believe any of the securities are impaired due to reasons of credit quality.

LENDING ACTIVITIES

The following table summarizes the composition of our loan portfolio, excluding loans held for sale and including net unearned income and net deferred fees and costs, as of the dates indicated (dollars in thousands).

Total loans increased $380.7 million to $4.43 billion at September 30, 2023 from $4.05 billion at December 31, 2022. The increase in loans was primarily attributable to our organic growth initiatives.

Total commercial loans increased $352.7 million during the nine months ended September 30, 2023 and represented 60.9% of total loans as of September 30, 2023. The increase was primarily a result of our continued commercial business development efforts.

Total consumer loans increased $28.0 million to $1.73 billion and represented 39.1% of total loans as of September 30, 2023. During the first nine months of 2023, we originated $238.2 million in indirect automobile loans with a mix of approximately 27% new automobile and 73% used automobile loans. During the first nine months of 2022, we originated $383.9 million in indirect automobile loans with a mix of approximately 28% new automobile and 72% used automobile loans. Origination volumes and mix of new and used vehicles financed fluctuate depending on general market conditions.

Loans Held for Sale and Loan Servicing Rights

Loans held for sale (not included in the loan portfolio composition table) were entirely comprised of residential real estate loans and totaled $1.9 million and $550 thousand as of September 30, 2023 and December 31, 2022, respectively.

We sell certain qualifying newly originated or refinanced residential real estate loans on the secondary market. Residential real estate loans serviced for others, which are not included in the consolidated statements of financial condition, amounted to $270.1 million and $275.3 million as of September 30, 2023 and December 31, 2022, respectively.

Allowance for Credit Losses – Loans

The following table summarizes the activity in the allowance for credit losses – loans for the periods indicated (dollars in thousands).

Loans not analyzed for a specific reserve are segmented into “pools” of loans based upon similar risk characteristics. This is referred to as the “pooled loan” component of the allowance for credit losses estimate. The allowance for credit losses for pooled loans estimate is based upon periodic review of the collectability of the loans quantitatively correlating historical loan experience with reasonable and supportable forecasts using forward looking information. Adjustments to the quantitative evaluation may be made for differences in current or expected qualitative risk characteristics such as changes in: underwriting standards, delinquency level, regulatory environment, economic condition, Company management and the status of portfolio administration including the Company’s Loan Review function. The Company establishes a specific reserve for individually evaluated loans which do not share similar risk characteristics with the loans included in the forecasted allowance for credit losses. These individually evaluated loans are removed from the pooling approach discussed above for the forecasted allowance for credit losses, and include nonaccrual loans, and other loans deemed appropriate by management, collectively referred to as collateral dependent loans. See Note 5. Loans of the notes to the consolidated financial statements for further details on collateral dependent loans.

Assessing the adequacy of the allowance for credit losses – loans involves substantial uncertainties and is based upon management’s evaluation of the amounts required to meet estimated charge-offs in the loan portfolio after weighing a variety of factors, including the risk profile of our loan products and customers.

The adequacy of the allowance for credit losses – loans is subject to ongoing management review. While management evaluates currently available information in establishing the allowance for credit losses – loans, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution’s allowance for credit losses – loans. Such agencies may require the financial institution to increase the allowance based on their judgments about information available to them at the time of their examination.

Net charge-offs of $1.6 million in the third quarter of 2023 represented 0.14% of average loans on an annualized basis compared to net charge-offs of $2.2 million, or 0.22% of average loans for the third quarter of 2022. For the nine months ended September 30, 2023, net charge-offs of $4.3 million represented 0.13% of average loans, compared to net charge-offs of $1.9 million, or 0.07% of average loans for the same period in 2022. Net charge-offs for the nine months ended September 30, 2022 included a $2.0 million recovery in connection with the pay-off of a commercial loan that was downgraded to non-performing status with a partial charge-off in the fourth quarter of 2021. The allowance for credit losses – loans was $49.6 million at September 30, 2023, compared with $44.1 million at September 30, 2022. The ratio of the allowance for credit losses – loans to total loans was 1.12% at September 30, 2023 and 1.14% at September 30, 2022. The ratio of allowance for credit losses – loans to non-performing loans was 521% at September 30, 2023, compared with 517% at September 30, 2022.

The following table sets forth the allocation of the allowance for credit losses – loans by loan category as of the dates indicated (dollars in thousands). The allocation is made for analytical purposes and is not necessarily indicative of the categories in which actual losses may occur. The total allowance is available to absorb losses from any segment of the loan portfolio.

Non-Performing Assets and Potential Problem Loans

The table below summarizes our non-performing assets at the dates indicated (dollars in thousands).

Non-performing assets include non-performing loans and foreclosed assets. Non-performing assets at September 30, 2023 were $9.7 million, a decrease of $534 thousand from the $10.2 million balance at December 31, 2022. The primary component of non-performing assets is non-performing loans, which were $9.5 million or 0.21% of total loans at September 30, 2023, down from $10.2 million or 0.25% of total loans at December 31, 2022 primarily due to a decline in non-accruing commercial mortgage loans as a result of pay-downs or payments received and applied to principal for the non-performing loans.

Approximately $2.0 million, or 21%, of the $9.5 million in non-performing loans as of September 30, 2023 were current with respect to payment of principal and interest but were classified as non-accruing because repayment in full of principal and/or interest was uncertain.

Foreclosed assets consist of real property formerly pledged as collateral for loans, which we have acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure. We had $162 thousand and $19 thousand of properties representing foreclosed asset holdings at September 30, 2023 and December 31, 2022, respectively.

Potential problem loans are loans that are currently performing, but information known about possible credit problems of the borrowers causes us to have concern as to the ability of such borrowers to comply with the present loan payment terms and may result in disclosure of such loans as nonperforming at some time in the future. These loans remain in a performing status due to a variety of factors, including payment history, the value of collateral supporting the credits, and/or personal or government guarantees. We consider loans classified as substandard, which continue to accrue interest, to be potential problem loans. We identified $38.3 million and $25.5 million in loans that continued to accrue interest which were classified as substandard as of September 30, 2023 and December 31, 2022, respectively.

Contractual Loan Maturity Schedule

The following table summarizes the contractual maturities of our loan portfolio at September 30, 2023. Loans, net of deferred loan origination costs, include principal amortization and non-accruing loans. Demand loans having no stated schedule of repayment or maturity and overdrafts as reported as due in one year or less (in thousands).

(1) Amounts include prepayment assumptions based on actual historical experience.

FUNDING ACTIVITIES

Deposits

The following table summarizes the composition of our deposits at the dates indicated (dollars in thousands):

As of September 30, 2023 and December 31, 2022, the aggregate amount of uninsured deposits (deposits in amounts greater than $250 thousand, which is the maximum amount for federal deposit insurance) was $1.82 billion and $1.76 billion, respectively. The portion of our time deposits by account that were in excess of the FDIC insurance limit was $258.3 million and $258.7 million at September 30, 2023 and December 31, 2022, respectively. The maturities of our uninsured time deposits at September 30, 2023 were as follows: $112.7 million in three months or less; $39.5 million between three months and six months; $65.7 million between six months and one year; and $40.4 million over one year. Approximately $1.09 billion and $1.05 billion of uninsured deposits were collateralized by government-backed securities as of September 30, 2023 and December 31, 2022, respectively.

We offer a variety of deposit products designed to attract and retain customers, with the primary focus on building and expanding long-term relationships. At September 30, 2023, total deposits were $5.32 billion, representing an increase of $386.5 million from December 31, 2022. The increase was primarily due to growth in reciprocal, brokered, and non-public deposits. Time deposits were approximately 28% and 26% of total deposits at September 30, 2023 and December 31, 2022, respectively.

Non-public deposits, the largest component of our funding sources, totaled $2.99 billion and $2.77 billion at September 30, 2023 and December 31, 2022, respectively, and represented 56% of total deposits as of each date. We have managed this segment of funding through a strategy of competitive pricing that minimizes the number of customer relationships that have only a single service high-cost deposit account.

As an additional source of funding, we offer a variety of public (municipal) deposit products to the towns, villages, counties and school districts within our market area. Public deposits generally range from 20% to 30% of our total deposits. There is a high degree of seasonality in this component of funding because the level of deposits varies with the seasonal cash flows for these public customers. We maintain the necessary levels of short-term liquidity to accommodate the seasonality associated with public deposits. Total public deposits were $1.09 billion and $1.12 billion at September 30, 2023 and December 31, 2022, respectively, and represented 20% and 23% of total deposits as of each date, respectively. The decrease in public deposits as of September 30, 2023 in comparison to December 31, 2022 was due largely due to a shift in customer demand.

We also participate in reciprocal deposit programs, which enable depositors to receive FDIC insurance coverage for deposits otherwise exceeding the maximum insurable amount. Through these programs, deposits in excess of the maximum insurable amount are placed with multiple participating financial institutions. Prior to the Economic Growth, Regulatory Relief and Consumer Protection Act (“EGRRCPA”) enacted on May 14, 2018, all reciprocal deposits were considered brokered deposits for regulatory reporting purposes. With the enactment of EGRRCPA, reciprocal deposits, subject to certain restrictions, are no longer required to be reported as brokered deposits. Reciprocal deposits totaled $846.6 million at September 30, 2023, compared to $696.1 million at December 31, 2022, as this product has been an attractive option for customers with more than $250 thousand on deposit desiring FDIC insurance. Reciprocal deposits represented 16% and 14% of total deposits as of each date, respectively.

Brokered deposits totaled $392.7 million and $347.2 million at September 30, 2023 and December 31, 2022, respectively, and represented 7% of total deposits as of each date.

Borrowings

The Company classifies borrowings as short-term or long-term in accordance with the original terms of the applicable agreement. Outstanding borrowings consisted of the following as of the dates indicated (in thousands):

Short-term Borrowings

Short-term Federal Home Loan Bank (“FHLB”) borrowings have original maturities of less than one year and include overnight borrowings which we typically utilize to address short term funding needs as they arise. Short-term FHLB borrowings at September 30, 2023 and December 31, 2022 consisted of $70.0 million and $205.0 million, respectively. In the second quarter of 2023, we borrowed $15.0 million under the Federal Reserve Bank (“FRB”) Bank Term funding program at a rate of 4.8%, which matures on May 8, 2024. Short-term borrowings and brokered deposits have historically been utilized to manage the seasonality of public deposits. As of September 30, 2023, $50.0 million of the short-term borrowings balance is designated as a cash-flow hedge, which became effective in April 2022, at a fixed rate of 0.787%, $30.0 million is designated as a cash-flow hedge, which became effective in January 2023, at a fixed rate of 3.669%, and $25.0 million is designated as a cash-flow hedge, which became effective in May 2023, at a fixed rate of 3.4615%.

We have credit capacity with the FHLB and can borrow through facilities that include amortizing and term advances or repurchase agreements. We had approximately $446.1 million of immediate credit capacity with the FHLB as of September 30, 2023. We had approximately $579.5 million in secured borrowing capacity at the FRB discount window, none of which was outstanding at September 30, 2023. The FHLB and FRB credit capacity are collateralized by securities from our investment portfolio and certain qualifying loans. We had $165.0 million of credit available under unsecured federal funds purchased lines with various banks as of September 30, 2023, with no amounts outstanding. Additionally, we had approximately $200.2 million of unencumbered liquid securities available for pledging at September 30, 2023.

The Parent has a revolving line of credit with a commercial bank allowing borrowings up to $20.0 million in total as an additional source of working capital. At September 30, 2023, no amounts have been drawn on the line of credit.

Long-term Borrowings

As of September 30, 2023 we had a long-term advance payable to FHLB of $50.0 million. The advance matures on January 20, 2026 and bears interest at a fixed rate of 4.05%. FHLB advances are collateralized by securities from our investment portfolio and certain qualifying loans.

On October 7, 2020, we completed a private placement of $35.0 million in aggregate principal amount of fixed-to-floating rate subordinated notes to qualified institutional buyers and accredited institutional investors that were subsequently exchanged for subordinated notes with substantially the same terms (the “2020 Notes”) registered under the Securities Act of 1933, as amended. The 2020 Notes have a maturity date of October 15, 2030 and bear interest, payable semi-annually, at the rate of 4.375% per annum, until October 15, 2025. Commencing on that date, the interest rate will reset quarterly to an interest rate per annum equal to the then current three-month SOFR plus 4.265%, payable quarterly until maturity. The 2020 Notes are redeemable by us, in whole or in part, on any interest payment date on or after October 15, 2025, and we may redeem the Notes in whole at any time upon certain other specified events. We used the net proceeds for general corporate purposes, organic growth and to support regulatory capital ratios at Five Star Bank. Proceeds, net of debt issuance costs of $740 thousand, were $34.3 million. The 2020 Notes qualify as Tier 2 capital for regulatory purposes.

On April 15, 2015, we issued $40.0 million of subordinated notes (the “2015 Notes”) in a registered public offering. The 2015 Notes bear interest at a fixed rate of 6.0% per year, payable semi-annually, for the first 10 years. From April 15, 2025 to the April 15, 2030 maturity date, the interest rate will reset quarterly to an annual interest rate equal to the then current three-month CME Term SOFR plus 4.20561%. The 2015 Notes are redeemable by us at any quarterly interest payment date beginning on April 15, 2025 to maturity at par, plus accrued and unpaid interest. Proceeds, net of debt issuance costs of $1.1 million, were $38.9 million. The 2015 Notes qualify as Tier 2 capital for regulatory purposes.

LIQUIDITY AND CAPITAL MANAGEMENT

Liquidity

We continue to actively monitor our liquidity profile and funding concentrations in accordance with our Board approved Liquidity Policy. Management is actively monitoring customer activity by way of commercial and consumer line of credit utilization, as well as deposit flows. As of September 30, 2023, all structural liquidity ratios and early warning indicators remain in compliance, with what we believe are ample funding sources available in the event of a stress scenario.

The objective of maintaining adequate liquidity is to assure that we meet our financial obligations. These obligations include the withdrawal of deposits on demand or at their contractual maturity, the repayment of matured borrowings, the ability to fund new and existing loan commitments and the ability to take advantage of new business opportunities. We achieve liquidity by maintaining a strong base of both core customer funds and maturing short-term assets; we also rely on our ability to sell or pledge securities and lines-of-credit and our overall ability to access to the financial and capital markets.

Liquidity for the Bank is managed through the monitoring of anticipated changes in loans, the investment portfolio, deposits and wholesale funds. The strength of the Bank’s liquidity position is a result of its base of core customer deposits. These core deposits are supplemented by wholesale funding sources that include credit lines with other banking institutions, the FHLB, the FRB Discount Window and newly-established Bank Term Funding Program, and brokered deposit relationships. The primary source of our non-deposit short-term borrowings is FHLB advances, of which $55.0 million we had outstanding at September 30, 2023. In addition to this amount, we have additional collateralized wholesale borrowing capacity of approximately $1.19 billion as of September 30, 2023 from various funding sources which include the FHLB, the FRB and commercial banks that we can use to fund lending activities, liquidity needs, and/or to adjust and manage our asset and liability position.

The Parent’s funding requirements consist primarily of dividends to shareholders, debt service, income taxes, operating expenses, funding of non-bank subsidiaries, repurchases of our stock, and acquisitions. The Parent obtains funding to meet obligations from dividends received from the Bank, net taxes collected from subsidiaries included in the federal consolidated tax return, and the issuance of debt and equity securities. In addition, the Parent maintains a revolving line of credit with a commercial bank for an aggregate amount of up to $20.0 million, all of which was available at September 30, 2023. The line of credit has a one-year term and matures in May 2024. Funds drawn would be used for general corporate purposes and backup liquidity.

Cash and cash equivalents were $192.1 million as of September 30, 2023, up $61.6 million from $130.5 million as of December 31, 2022. Net cash provided by operating activities totaled $58.6 million and the principal source of operating activity cash flow was net income adjusted for noncash income and expense items. Net cash used in investing activities totaled $283.1 million, which primarily included outflows of $385.0 million for net loan originations, partially offset by $103.4 million net cash provided from investment securities. Net cash provided by financing activities of $286.2 million was primarily attributed to a $386.5 million net increase in deposits, and a $50.0 million net increase in long-term borrowings, partially offset by a $135.0 million net decrease in short-term borrowings, and $14.8 million in dividend payments.

Capital Management

We actively manage capital, commensurate with our risk profile, to enhance shareholder value. We also seek to maintain capital levels for the Company and the Bank at amounts in excess of the regulatory “well-capitalized” thresholds. Periodically, we may respond to market conditions by implementing changes to our overall balance sheet positioning to manage our capital position.

Banks and financial holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Failure to meet minimum capital requirements can result in certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material impact on our consolidated financial statements. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.

Shareholders’ equity was $408.7 million at September 30, 2023, an increase of $3.1 million from $405.6 million at December 31, 2022. Net income for the nine months ended September 30, 2023 increased shareholders’ equity by $40.5 million, offset by common and preferred stock dividends declared of $14.9 million. Accumulated other comprehensive loss included in shareholders’ equity decreased $23.9 million during the nine months ended September 30, 2023 due primarily to a decrease in net unrealized losses on securities available for sale.

The FRB and FDIC have adopted a system using risk-based capital guidelines to evaluate the capital adequacy of banks and bank holding companies. As of September 30, 2023, the Company’s capital levels remained characterized as “well-capitalized” under the Basel Committee on Banking Supervision’s (“BCBS”) capital guidelines for U.S. banks.

The following table reflects the ratios and their components (dollars in thousands):

(1) Includes unrealized gains and losses related to the Company’s reclassification of available for sale investment securities to the held to maturity category.

We have elected to apply the 2020 Current Expected Credit Losses (“CECL”) transition provision related to the impact of the CECL accounting standard on regulatory capital, as provided by the US banking agencies’ March 2020 interim final rule. Under the 2020 CECL transition provision, the regulatory capital impact of the Day 1 adjustment to the allowance for credit losses (after-tax) upon the January 1, 2020 CECL adoption date has been deferred, and has begun to phase into regulatory capital at 25% per year commencing January 1, 2022. For the ongoing impact of CECL, we were allowed to defer the regulatory capital impact of the allowance for credit losses in an amount equal to 25% of the change in the allowance for credit losses (pre-tax) recognized through earnings for each period between January 1, 2020, and December 31, 2021. The cumulative adjustment to the allowance for credit losses between January 1, 2020, and December 31, 2021, also began to phase into regulatory capital at 25% per year commencing January 1, 2022.

Basel III Capital Rules

Under the Basel III Capital Rules, the current minimum capital ratios, including an additional capital conservation buffer applicable to the Company and the Bank, are:

• 7.0% CET1 to risk-weighted assets;
• 8.5% Tier 1 capital (that is, CET1 plus Additional Tier 1 capital) to risk-weighted assets; and
• 10.5% Total capital (that is, Tier 1 capital plus Tier 2 capital) to risk-weighted assets.

Banking institutions with a capital conservation buffer below the minimum level will face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall. The Basel III Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and does not have any current applicability to the Company or the Bank. Strict eligibility criteria for regulatory capital instruments were also implemented under the Basel III Capital Rules.

The following table presents actual and required capital ratios as of September 30, 2023 and December 31, 2022 for the Company and the Bank under the Basel III Capital Rules. Capital levels required to be considered well capitalized are based upon prompt corrective action regulations, under the Basel III Capital Rules (dollars in thousands):

Dividend Restrictions

In the ordinary course of business, the Company is dependent upon dividends from the Bank to provide funds for the payment of dividends to shareholders and to provide for other cash requirements. Banking regulations may limit the amount of dividends that may be paid. Approval by regulatory authorities is required if the effect of dividends declared would cause the regulatory capital of the Bank to fall below specified minimum levels. Approval is also required if dividends declared exceed the net profits for that year combined with the retained net profits for the preceding two years.

Market risk refers to the potential impact on earnings or capital arising from movements in interest rates. The Bank’s market risk management framework has been developed to control both short-term and long-term exposure within Board approved policy limits and is monitored by the Asset-Liability Management Committee and Board of Directors. Quantitative and qualitative disclosures about market risk were presented at December 31, 2022 in Item 7A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2022, as filed with the Securities and Exchange Commission on March 9, 2023. The following is an update of the discussion provided therein.

Portfolio Composition

There was no material change in the composition of assets, deposit liabilities or borrowings from December 31, 2022 to September 30, 2023. See the section titled “Analysis of Financial Condition” in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of asset, deposit and borrowing activity during the period.

Net Interest Income at Risk

A primary tool used to manage interest rate risk is “rate shock” simulation to measure the rate sensitivity. Rate shock simulation is a modeling technique used to estimate the impact of changes in rates on net interest income as well as economic value of equity.

Net interest income at risk is measured by estimating the changes in net interest income resulting from instantaneous and sustained parallel shifts in interest rates of different magnitudes over a period of 12 months. The following table sets forth the estimated changes to net interest income over the 12-month period ending September 30, 2024 assuming instantaneous changes in interest rates for the given rate shock scenarios (dollars in thousands):

In the rising rate scenarios, the static model results indicate that net interest income is modeled to increase compared to the flat rate scenario over a one-year timeframe. This is a combination of an increase across the entire deposit portfolio, which has decreased wholesale borrowings and the higher cost associated with the borrowings. This simulation does not consider balance sheet growth or a change in the balance sheet mix. As intermediate and longer-term assets continue to mature and are replaced at higher yields, net interest income should improve over longer-term timeframes. Model results in the declining rate scenario show a decreasing in net interest income due to a combination of increases in the yield curve, as well as increases in higher yield public and nonpublic deposits, that will reprice downward slower due to market deposit competition.

In addition to the changes in interest rate scenarios listed above, other scenarios are typically modeled to measure interest rate risk. These scenarios vary depending on the economic and interest rate environment. Furthermore, given the static balance sheet approach, retained earnings are considered to be reinvested in a non-interest earning asset.

The simulation referenced above is based on our assumption as to the effect of interest rate changes on assets and liabilities and assumes a parallel shift of the yield curve. It also includes certain assumptions about the future pricing of loans and deposits in response to changes in interest rates. Further, it assumes that delinquency rates would not change as a result of changes in interest rates, although there can be no assurance that this will be the case. While this simulation is a useful measure as to net interest income at risk due to a change in interest rates, it is not a forecast of future results, does not measure the effect of changing interest rates on noninterest income and is based on many assumptions that, if changed, could cause a different outcome.

Economic Value of Equity At Risk

The economic (or “fair”) value of financial instruments on our balance sheet will also vary under the interest rate scenarios previously discussed. This variance is measured by simulating changes in our economic value of equity (“EVE”), which is calculated by subtracting the estimated fair value of liabilities from the estimated fair value of assets. Fair values for financial instruments are estimated by discounting projected cash flows (principal and interest) at current replacement rates for each account type, while fair values of non-financial assets and liabilities are assumed to equal book value and do not vary with interest rate fluctuations. An economic value simulation is a static measure for balance sheet accounts at a given point in time, but this measurement can change substantially over time as the characteristics of our balance sheet evolve and as interest rate and yield curve assumptions are updated.

The amount of change in economic value under different interest rate scenarios depends on the characteristics of each class of financial instrument, including the stated interest rate or spread relative to current market rates or spreads, the likelihood of prepayment, whether the rate is fixed or floating, and the maturity date of the instrument. As a general rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the greater the impact a rate change will have on its value. In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based on historical data (back-testing).

The analysis that follows presents the estimated EVE resulting from market interest rates prevailing at a given quarter-end (“Pre-Shock Scenario”), and under other interest rate scenarios (each a “Rate Shock Scenario”) represented by immediate, permanent, parallel shifts in interest rates from those observed at September 30, 2023 and December 31, 2022 (dollars in thousands). The analysis additionally presents a measurement of the interest rate sensitivity at September 30, 2023 and December 31, 2022. EVE amounts are computed under each respective Pre-Shock Scenario and Rate Shock Scenario. An increase in the EVE amount is considered favorable, while a decline is considered unfavorable. The following table sets forth the estimated changes to EVE assuming instantaneous changes in interest rates for the given rate shock scenarios (dollars in thousands):

The decrease in the Pre-Shock Scenario EVE at September 30, 2023 compared to December 31, 2022 is the result of a deposit mix shift from non-maturity to time-deposits and non-interest bearing deposits to interest bearing deposits, while rising rates have muted asset valuation, specifically on fixed assets. The sensitivity in the -100-basis point Rate Shock Scenario to EVE shifted negative at September 30, 2023 compared to December 31, 2022. This is a result of a concentrated effort to grow the deposit portfolio to decrease wholesale borrowings. As a result, the shift in mix of deposits previously noted have become less valuable when rates shock downward, most notably from money market accounts and time deposits, in comparison to December 31, 2022.

Evaluation of Disclosure Controls and Procedures

As of September 30, 2023, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15(b), as adopted by the SEC under the Securities Exchange Act of 1934, as amended (“Exchange Act”). Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.

Disclosure controls and procedures are the controls and other procedures that are designed to ensure that information required to be disclosed in the reports that the Company 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. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act 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.

Changes in Internal Control over Financial Reporting

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

During the quarter ended September 30, 2023, there have been no material changes to the risk factors as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2022, as supplemented by our quarterly reports on Form 10-Q for the quarters ended March 31, 2023 and June 30, 2023, each as filed with the SEC. Additional risks not presently known to us, or that we currently deem immaterial, may also adversely affect our business, financial condition or results of operations.