First US Bancshares, Inc.: Form 10-Q for the period ended Sep 30, 2023

DESCRIPTION OF THE BUSINESS

First US Bancshares, Inc., a Delaware corporation (“Bancshares” and, together with its subsidiaries, the “Company”), is a bank holding company with its principal offices in Birmingham, Alabama. Bancshares operates one commercial banking subsidiary, First US Bank (the “Bank”). As of September 30, 2023, the Bank operated and served its customers through 15 banking offices located in Birmingham, Butler, Calera, Centreville, Gilbertown, Grove Hill, Harpersville, Jackson, Thomasville, Tuscaloosa and Woodstock, Alabama; Knoxville and Powell, Tennessee; and Rose Hill, Virginia. In addition, the Bank operates loan production offices in Mobile, Alabama and the Chattanooga, Tennessee area. The Bank provides a wide range of commercial banking services to small- and medium-sized businesses, property managers, business executives, professionals and other individuals. The Bank also performs indirect lending through third-party retailers and currently conducts this lending in 17 states, including Alabama, Arkansas, Florida, Georgia, Indiana, Iowa, Kansas, Kentucky, Mississippi, Missouri, Nebraska, North Carolina, Oklahoma, South Carolina, Tennessee, Texas and Virginia.

The Bank owns all of the stock of Acceptance Loan Company, Inc., an Alabama corporation (“ALC”). ALC is a finance company headquartered in Mobile, Alabama. During the third quarter of 2021, ALC ceased new business development and permanently closed its 20 branch lending locations in Alabama and Mississippi to the public. Through the third quarter of 2023, ALC continued to service its remaining portfolio of loans from its headquarters. Effective October 1, 2023, all of ALC’s remaining loans were sold to the Bank in an intercompany transaction. The Bank intends to manage the remaining portfolio through final resolution.

Delivery of the best possible financial services to customers remains an overall operational focus of the Company. The Company recognizes that attention to detail and responsiveness to customers’ desires are critical to customer satisfaction. The Company continues to upgrade technology, both in its financial services and in the training of its 156 full-time equivalent employees (as of September 30, 2023), to ensure customer satisfaction and convenience.

The preparation of the Company’s consolidated financial statements requires management to make subjective judgments associated with estimates. These estimates are necessary to comply with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and general banking practices. These estimates include accounting for the allowance for credit losses, the right-of-use asset and lease liability, the value of other real estate owned and certain collateral-dependent loans, consideration related to goodwill impairment testing and deferred tax asset valuation. A description of these estimates, which significantly affect the determination of the Company’s consolidated financial position, results of operations and cash flows, is set forth in Note 2, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements in the Company's 2022 Form 10-K, as amended in 2023 by the adoption of ASC 326, Measurement of Credit Losses on Financial Instruments, as discussed in Note 2, “Basis of Presentation,” in the Notes to the Interim Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.

The emphasis of this discussion is a comparison of assets, liabilities and shareholders’ equity as of September 30, 2023 to December 31, 2022, while comparing income and expense for the nine months ended September 30, 2023 and 2022. All yields and ratios presented and discussed herein are recorded and presented on the accrual basis and not on the tax-equivalent basis, unless otherwise indicated.

This information should be read in conjunction with the Company’s unaudited interim condensed consolidated financial statements and related notes appearing elsewhere in this report and Management’s Discussion and Analysis of Financial Condition and Results of Operations appearing in Bancshares’ the Company's 2022 Form 10-K. As used in the following discussion, the words “we,” “us,” “our” and the “Company” refer to Bancshares and its consolidated subsidiaries, unless the context indicates otherwise.

RECENT MARKET CONDITIONS

During the nine months ended September 30, 2023 the banking industry saw a significant level of volatility due to notable banking failures that began during the first quarter of 2023, as well as ongoing increases in interest rates that have generally led to contraction of net interest margin throughout the industry. While year-over-year inflation levels have eased from 40-year highs that were reached during 2022, inflation remains elevated over the Federal Reserve Bank's ("FRB") long run target. In its ongoing effort to reduce inflation levels, the FRB has continued to raise the target federal funds rate, with four additional increases of 25 basis points during the first nine months of 2023. As of September 30, 2023, the target federal funds rate was a range of 5.25% to 5.50%.

As interest rates have increased, competitive pressures have also increased, particularly related to deposit pricing. Due primarily to the rising cost of funding, net interest margin compressed significantly throughout the banking industry during the nine months ended September 30, 2023. The substantial pace and magnitude of changes in interest rates introduced a higher level of uncertainty throughout the industry, and the impact that such change will have on the Company’s future operating results cannot be predicted with certainty. During this still-ongoing and still-volatile transition period, the yield curve has become significantly inverted at times, indicating substantial economic uncertainty, including the possibility of economic recession. The unusual yield curve effects, including inversion, may continue. Further, if the rate of inflation remains elevated or accelerates, the Company’s operations could be impacted by, among other things, accelerating cost of goods and services, including the cost of salaries and benefits. Additionally, the Company’s borrowers could be negatively impacted by rising expense levels, leading to deterioration of credit quality and/or reductions in the Company’s lending activity. The higher interest rate environment has also led to unrealized losses in the Company's investment portfolio, which consists primarily of fixed-rate instruments.

EXECUTIVE OVERVIEW

Strategic Focus and Impact on Asset Quality

During the third quarter of 2021, the Company executed strategic initiatives that were designed to improve operating efficiency, focus the Company’s loan growth activities, and fortify asset quality. The most significant component of these initiatives was the cessation of new business at ALC. This initiative, which included the closure of ALC’s branch lending locations in September 2021, served to significantly decrease the Company’s non-interest expense, and has led to substantial improvement in the Company’s consumer lending asset quality as ALC’s remaining loans pay down. Historically, ALC’s loans have produced significantly higher levels of charge-offs than the Bank’s other loan portfolios.

As of September 30, 2023, remaining loans at ALC totaled $12.1 million, compared to $20.2 million as of December 31, 2022. In 2023, as ALC’s loans have continued to decrease, the Company has realized substantially lower levels of net charge-offs on the portfolio compared to prior periods. Net charge-offs on ALC loans totaled $0.3 million, or 2.09% of average loans, during the nine months ended September 30, 2023, compared to $1.5 million, or 6.38% of average loans, during the nine months ended September 30, 2022. As of September 30, 2023, $0.2 million, or 1.3% of ALC's loans, were past due, compared to $0.8 million, or 3.8%, as of December 31, 2022.

Effective October 1, 2023, the Company sold all of ALC’s remaining loans to the Bank in an intercompany transaction. The Bank will continue to manage the remaining loans in the portfolio through final resolution. It is expected that all other assets and liabilities of ALC will be transferred to the Bank via an intercompany transaction by the end 2023.

Financial Highlights

The Company earned net income of $2.1 million, or $0.33 per diluted common share, during the three months ended September 30, 2023, compared to $1.9 million, or $0.29 per diluted common share, for the three months ended September 30, 2022. For the nine months ended September 30, 2023, net income totaled $6.2 million, or $0.97 per diluted common share, compared to $4.6 million, or $0.71 per diluted common share, for the nine months ended September 30, 2022.

Summarized condensed consolidated statements of operations are included below for the three and nine months ended September 30, 2023 and 2022.

(Dollars in Thousands, Except Per Share Data)

The discussion that follows summarizes the most significant activity that drove changes in the Company’s net income during the nine months ended September 30, 2023, as compared to the nine months ended September 30, 2022.

Net Interest Income and Margin

Net interest income increased by $1.2 million, or 4.4%, comparing the nine months ended September 30, 2023 to the nine months ended September 30, 2022. The increase was primarily attributable to growth in loans which averaged $795.0 million during the nine months ended September 30, 2023, compared to $713.0 million during the nine months ended September 30, 2022. The average rate on earning assets totaled 5.41% for the nine months ended September 30, 2023, compared to 4.37% for the nine months ended September 30, 2022.

While yields on earning assets increased significantly in 2023, rates on interest-bearing liabilities increased at a faster pace, causing margin compression. Net interest margin was 3.93% for the nine months ended September 30, 2023, compared to 4.00% for the nine months ended September 30, 2022. The Company’s total funding costs, including the cost of interest and non-interest deposits, as well as borrowings, increased to 1.53% during the nine months ended September 30, 2023, compared to 0.39% during the nine months ended September 30, 2022.

Provision for Credit Losses

The provision for credit losses was $0.8 million during the nine months ended September 30, 2023, compared to $2.8 million during the nine months ended September 30, 2022. The reduction resulted primarily from reduced charge-off levels comparing the two periods, mostly related to ALC’s loans which continued to reduce following implementation of the cessation of business strategy. The Company’s net charge-offs totaled $0.7 million during the nine months ended September 30, 2023, compared to $1.7 million during the nine months ended September 30, 2022. The reduction included a decrease of $1.3 million in net charge-offs associated with ALC’s portfolio, partially offset by an increase in net charge-offs associated with the indirect consumer portfolio totaling $0.3 million. The Company’s net charge-offs as a percentage of average loans totaled 0.12% during the nine months ended September 30, 2023, compared to 0.24% during the nine months ended September 30, 2022.

Non-interest Income

Non-interest income totaled $2.5 million for the nine months ended September 30, 2023, compared to $2.8 million for the nine months ended September 30, 2022. The reduction resulted primarily from gains on the sale of premises and equipment that occurred during the third quarter of 2022, but were not repeated in 2023.

Non-interest Expense

Non-interest expense totaled $21.7 million for the nine months ended September 30, 2023, compared to $21.0 million for the nine months ended September 30, 2022. The increase resulted primarily from nonrecurring gains on the sale of OREO properties that offset non-interest expense in 2022, but were not repeated in 2023.

Balance Sheet Levels

As of September 30, 2023, the Company’s assets totaled $1,065.2 million, compared to $994.7 million as of December 31, 2022, an increase of 7.1%.

Loans

Total loans increased by $41.4 million, or 5.4%, as of September 30, 2023, compared to December 31, 2022. Loan volume increases during the first nine months of 2023 were driven primarily by growth in indirect consumer and commercial construction loans. Growth in indirect consumer lending was consistent with continued demand for the products collateralized through the Company's indirect program, including recreational vehicles, campers, boats, horse trailers and cargo trailers. Indirect loan growth tends to be seasonal due to its emphasis on outdoor recreational products, with growth typically more pronounced in the spring and early summer months. The increase in commercial construction (construction, land development and other land loans) was primarily attributable to continued growth in construction fundings on multi-family residential projects. The loan growth during the first nine months of 2023 was partially offset by decreases in the residential real estate (including 1-4 family and multi-family) and commercial and industrial categories, as well as the direct consumer and branch retail consumer categories. Loans in direct consumer and branch retail were expected to decrease as they comprise the majority of ALC’s remaining loan balances.

Deposit Growth

Deposits totaled $927.0 million as of September 30, 2023, compared to $870.0 million as of December 31, 2022. The year-to-date growth included an increase of $69.2 million in interest-bearing deposits, partially offset by a decrease of $12.2 million in noninterest-bearing deposits. The year-to-date shift to interest-bearing deposits is consistent with deposit holders seeking to maximize interest earnings on their accounts. In addition, deposit growth for the first nine months of 2023 included growth of $30.2 million in wholesale brokered deposits that were acquired in order to further enhance the Company’s liquidity position following the bank failures that began during the first quarter of 2023. As of September 30, 2023, core deposits, which exclude time deposits of $250 thousand or more and all brokered deposits, totaled $786.8 million, or 84.9% of total deposits, compared to $778.1 million, or 89.4% of total deposits, as of December 31, 2022.

Deployment of Funds

Management seeks to deploy earning assets in an efficient manner to maximize net interest income while maintaining appropriate levels of liquidity to protect the safety and soundness of the organization. Management’s decisions during the first nine months of 2023, particularly following the bank failures that occurred, were focused on maintaining the Company’s strong liquidity position. As part of this focus, management elected to hold higher levels of cash and cash equivalents. Cash and cash equivalents totaled $66.1 million as of September 30, 2023, compared to $30.2 million as of December 31, 2022. Investment securities, including both the available-for-sale and held-to-maturity portfolios, totaled $127.8 million as of September 30, 2023, compared to $132.7 million as of December 31, 2022. The expected average life of securities in the investment portfolio was 3.9 years as of September 30, 2023, compared to 3.5 years as of December 31, 2022. Management will continue to evaluate opportunities to invest excess cash balances within the context of anticipated loan and deposit growth and current liquidity needs.

Shareholders’ Equity

Shareholders’ equity increased by $2.3 million, or 2.7%, as of September 30, 2023, compared to December 31, 2022. The increase in shareholders’ equity resulted from earnings, net of dividends paid, partially offset by the CECL transition adjustment which reduced retained earnings by $1.8 million, net of tax, as well as a net increase in accumulated other comprehensive loss of $1.7 million associated with fair value declines in the available-for-sale investment portfolio and reclassification adjustments associated with terminated interest rate swaps.

Cash Dividends

The Company declared cash dividends totaling $0.15 per share on its common stock during the nine months ended September 30, 2023, compared to cash dividends totaling $0.09 per share on its common stock during the nine months ended September 30, 2022.

Regulatory Capital

During the nine months ended September 30, 2023, the Bank continued to maintain capital ratios at higher levels than required to be considered a “well-capitalized” institution under applicable banking regulations. As of September 30, 2023, the Bank’s common equity Tier 1 capital and Tier 1 risk-based capital ratios were each 10.81%. Its total capital ratio was 12.06%, and its Tier 1 leverage ratio was 9.09%.

Liquidity

As of September 30, 2023, the Company continued to maintain excess funding capacity sufficient to provide adequate liquidity for loan growth, capital expenditures and ongoing operations. The Company benefits from a strong core deposit base, a liquid investment securities portfolio and access to funding from a variety of sources, including federal funds lines, FHLB advances and brokered deposits. In addition, the Company has access to the FRB's discount window and its Bank Term Funding Program (BTFP), the latter of which was established in response to the recent liquidity events that have occurred in the banking industry. Both the discount window and the BTFP allow borrowing on pledged collateral that includes eligible investment securities and, in certain circumstances, eligible loans. In response to heightened liquidity concerns in the banking industry, during 2023 management undertook measures designed to enhance the Company’s liquidity position. These procedures included holding higher levels of on-balance sheet cash, as well as enhancing the availability of off-balance sheet borrowing capacity. As part of these efforts, during the third quarter of 2023, the Company completed the establishment of additional borrowing capacity through the FRB's discount window, primarily via the pledging of the majority of the Company’s indirect loan portfolio as collateral. Due to these efforts, the Company’s immediate borrowing capacity based on collateral pledged through the discount window increased to $146.6 million as of September 30, 2023, compared to $1.2 million as of December 31, 2022.

RESULTS OF OPERATIONS

Net Interest Income

Net interest income is calculated as the difference between interest and fee income generated from earning assets and the interest expense paid on deposits and borrowed funds. Fluctuations in interest rates, as well as volume and mix changes in earning assets and interest-bearing liabilities, can materially impact net interest income. The Company’s earning assets consist of loans, taxable and tax-exempt investments, Federal Home Loan Bank stock, federal funds sold by the Bank and interest-bearing deposits in banks. Interest-bearing liabilities consist of interest-bearing demand deposits and savings and time deposits, as well as short- and long-term borrowings.

The following tables show the average balances of each principal category of assets, liabilities and shareholders’ equity for the three and nine months ended September 30, 2023 and 2022. Additionally, the tables provide an analysis of interest revenue or expense associated with each category, along with the accompanying yield or rate percentage. Net interest margin is calculated for each period presented as net interest income divided by average total interest-earning assets.

48

49

The following tables summarize the impact of variances in volume and rate of interest-earning assets and interest-bearing liabilities on components of net interest income.

(Dollars in Thousands)

Interest income increased by $9.3 million, comparing the nine months ended September 30, 2023 to the nine months ended September 30, 2022. Of the increase, $6.4 million was attributable to higher average yields on interest-earning assets, while $2.9 million was attributable to growth in average loan volume comparing the two periods. The increase in average yield was attributable to the rise in market interest rates that began in 2022 and has continued in 2023. The increase in interest income associated with loan volume increases was attributable to loan growth during the nine months ended September 30, 2023 of $41.4 million, or 5.4%.

The increase in interest income was partially offset by an increase in interest expense of $8.1 million, comparing the nine months ended September 30, 2023 to the nine months ended September 30, 2022. Of the increase, $7.7 million was attributable to the rise in market interest rates, while $0.4 million was attributable to growth in interest-bearing liabilities, primarily time deposits and borrowings. During the latter half of 2022 and through the first nine months of 2023, the Company has focused a portion of its deposit marketing efforts on growth in time deposits of various maturities in an effort to increase the predictability of funding cash flows. Additionally, the Company has utilized wholesale brokered deposits and short-term FHLB borrowings to a larger extent, particularly during the nine months ended September 30, 2023, in order to enhance the Company’s on-balance sheet liquidity position. Efforts to enhance the Company’s on-balance sheet liquidity were taken primarily as precautionary measures in the wake of liquidity events that impacted the banking industry during 2023.

The rising market interest rate environment has had, and continues to have, a significant impact on the Company and the banking industry in general. Beginning in March 2022 and through September 30, 2023, the FRB raised the federal funds rate by a total of 525 basis points. Statements by FRB officials have indicated that further interest rate increases are possible to address ongoing inflationary pressures. While the Company has generally been positioned to benefit from the rising interest rate environment that has occurred, the Company’s net interest margin began to decline during the nine months ended September 30, 2023 as the cost of interest-bearing liabilities increased at a faster pace than interest-earning assets. Further, in connection with the liquidity events that have occurred in the banking industry, competition for deposits has intensified significantly. This increased competition, coupled with the volatility of the industry, has introduced additional uncertainty into the market. Should market interest rates continue to rise or reduce at significant levels, the Company’s net interest income could be negatively impacted.

Provision for Credit Losses

The provision for credit losses was $0.8 million during the nine months ended September 30, 2023, compared to $2.8 million during the nine months ended September 30, 2022. The year-to-date decrease in 2023 compared to 2022 was primarily the result of the cessation of business strategy at ALC, which has led to significantly reduced net charge-offs as ALC’s loans have paid down. Net charge-offs on ALC loans totaled $0.3 million, or 2.09% of average loans, during the nine months ended September 30, 2023, compared to $1.5 million, or 6.38% of average loans, during the nine months ended September 30, 2022.

While the Company experienced improved charge-off metrics during the nine months ended September 30, 2023, compared to the nine months ended September 30, 2022, the timing of charge-offs, economic developments, and other factors that could impact the provision for credit losses cannot be fully predicted with certainty. Sustained levels of high inflation, combined with the recent rapid rise in market interest rates, could negatively impact the Company’s borrowers, which could lead to increased provisions for credit losses in the future.

Effective January 1, 2023, the Company adopted the CECL model to account for credit losses on financial instruments, including loans and leases, unfunded commitments and held-to-maturity securities. The adoption of the CECL model resulted in a transition adjustment totaling $2.4 million, increasing the Company’s allowance for credit losses on loans and leases by $2.1 million, and establishing a reserve for unfunded commitments of $0.3 million. As of September 30, 2023, the Company’s allowance for credit losses totaled 1.40% of total loans, compared to 1.22% as of December 31, 2022. While management believes that the allowance for credit losses on loans and leases, as well as the reserve for unfunded commitments, was sufficient to absorb life-of-loan credit losses based on circumstances existing as of the balance sheet date, combined with reasonable and supportable forecasts, the determination of the allowance is complex and requires judgment by management about the effects of matters that are inherently uncertain. Changing economic circumstances or forecasts, or changes in management’s judgments and estimates, could result in additional credit loss expense in future periods.

Non-Interest Income

Non-interest income represents fees and income derived from sources other than interest-earning assets. The following table presents the major components of non-interest income for the periods indicated:

(Dollars in Thousands)

(Dollars in Thousands)

51

The Company’s non-interest income decreased by $0.3 million comparing the nine months ended September 30, 2023 to the nine months ended September 30, 2022 due primarily to gains on the sale of premises and equipment that occurred during the third quarter of 2022, but were not repeated in 2023. In recent periods, the Company’s sources of non-interest revenue have not fluctuated significantly, with the exception of nonrecurring increases or decreases that have occurred from time to time due to gains or losses on sales of assets or other nonrecurring sources. The majority of the Company’s sources of non-interest income are relatively stable and are not expected to change significantly in the near term. However, non-interest revenues earned from service charges and other fees on deposit accounts have generally declined in recent years for a number of reasons, including a changing regulatory environment associated with these types of revenues. Management continues to evaluate opportunities to add non-interest revenue streams or grow existing streams; however, significant growth in non-interest income is not expected in the near term.

Non-Interest Expense

Non-interest expense represents expenses incurred from sources other than interest-bearing liabilities. The following table presents the major components of non-interest expense for the periods indicated:

(Dollars in Thousands)

(Dollars in Thousands)

The Company’s non-interest expense increased by 3.7% comparing the nine months ended September 30, 2023 to the nine months ended September 30, 2022. The majority of the increase resulted from nonrecurring gains on the sale of properties that reduced other real/estate expense in 2022, but were not repeated in 2023. In addition, the Company has experienced increases in other expense categories commensurate with the inflationary environment. Increases in certain categories of non-interest expense were partially offset by decreases in other categories, most notably salaries and employee benefits which decreased by 0.6% comparing the nine months ended September 30, 2023 to the nine months ended September 30, 2022. The reduction in salaries and benefits expense resulted from the impact of the strategic initiatives undertaken by the Company beginning in the third quarter of 2021 to, among other things, improve the Company’s operating efficiency. These initiatives reduced the Company’s expense profile significantly in 2022 and, in some expense areas such as salaries and benefits, continued to benefit the Company during the nine months ended September 30, 2023. However, the current inflationary environment is expected to continue to put upward pressure on non-interest expenses. Accordingly, management will remain focused on efforts to streamline business processes in an effort to continue to improve the Company’s overall efficiency levels.

Provision for Income Taxes

The provision for income taxes was $2.0 million and $1.4 million for the nine months ended September 30, 2023 and 2022, respectively, and the Company’s effective tax rate was 24.4% and 23.7%, respectively, for the same periods.

The effective tax rate is impacted by recurring items, such as changes in tax-exempt interest income earned from bank-qualified municipal bonds and loans and the cash surrender value of bank-owned life insurance. Management makes decisions about whether to invest in tax-exempt instruments on a case-by-case basis after considering a number of factors, including investment return, credit quality and the consistency of such investments with the Company’s overall strategy. The Company’s effective tax rate is expected to fluctuate commensurate with the level of these investments as compared to total pre-tax income.

BALANCE SHEET ANALYSIS

Investment Securities

The investment securities portfolio is used by management to provide liquidity, to generate interest income and for use as collateral for public deposits and wholesale funding. Risk and return can be adjusted by altering the duration, composition and/or balance of the portfolio. The expected average life of securities in the investment portfolio was 3.9 years and 3.5 years as of September 30, 2023 and December 31, 2022, respectively.

Available-for-sale securities are recorded at estimated fair value, with unrealized gains or losses recognized, net of taxes, in accumulated other comprehensive loss, a separate component of shareholders’ equity. As of September 30, 2023, available-for-sale securities totaled $126.6 million, or 99.0% of the total investment portfolio, compared to $130.8 million, or 98.6% of the total investment portfolio, as of December 31, 2022. Available-for-sale securities consisted of residential and commercial mortgage-backed securities, U.S. Treasury securities, corporate bonds, obligations of U.S. government-sponsored agencies, and obligations of state and political subdivisions.

Held-to-maturity securities are recorded at amortized cost and represent securities that the Company both intends and has the ability to hold to maturity. As of September 30, 2023, held-to-maturity securities totaled $1.3 million, or 1.0% of the total investment portfolio, compared to $1.9 million, or 1.4% of the total investment portfolio, as of December 31, 2022. Held-to-maturity securities consisted of commercial mortgage-backed securities, obligations of U.S. government-sponsored agencies, and obligations of state and political subdivisions.

Due to the increasing interest rate environment, during the nine months ended September 30, 2023, gross unrealized losses increased, particularly within the Company’s available-for-sale portfolio. Gross unrealized losses in the available-for-sale portfolio totaled $12.8 million as of September 30, 2023, compared to $11.1 million as of December 31, 2022. Unrealized losses within the available-for-sale portfolio were recognized, net of tax, in accumulated other comprehensive loss.

As of September 30, 2023, the Company evaluated both the available-for-sale and held-to-maturity portfolios for credit loss in accordance with the revised accounting guidance of ASC 326. Based on these evaluations, management concluded that no credit losses were included in either portfolio and that the unrealized losses in both portfolios resulted from the prevailing interest rate environment.

Loans and Allowance for Credit Losses

The Company’s total loan portfolio increased by $41.4 million, or 5.4%, as of September 30, 2023, compared to December 31, 2022. The tables below summarize loan balances by portfolio category, as well as the allowance for credit losses, as of the end of each of the most recent five quarters as of September 30, 2023:

(Dollars in Thousands)

53

The tables below summarize changes in the allowance for credit losses on loans and leases for each of the most recent five quarters as of September 30, 2023:

(Dollars in Thousands)

The adoption of CECL was most impactful on the Company’s consumer indirect loan portfolio due primarily to the extension of the loss estimate period to the estimated life of loans in this category. As of January 1, 2023, the estimated average remaining life of the indirect portfolio was between four and five years. As of September 30, 2023, the estimated average remaining life of the indirect portfolio was between five and six years. The branch retail portfolio, which represents indirect lending conducted by ALC, was similarly impacted by the transition to CECL. In addition, the Company’s consumer portfolios were impacted by current economic forecasts using data provided by the Federal Reserve on inflation, unemployment, and the forecasted movement of interest rates.

Reserve for Unfunded Lending Commitments

In connection with the adoption of the CECL accounting model, the Company also reserved approximately $0.3 million in other liabilities for unfunded lending commitments. Unfunded lending commitments are off-balance sheet arrangements that represent unconditional commitments of the Company to lend to a borrower that are unfunded as of the balance sheet date. These may include unfunded loan commitments, standby letters of credit, and financial guarantees. The CECL accounting guidance requires that an estimate of expected credit loss be measured on commitments in which an entity is exposed to credit risk via a present contractual obligation to extend credit unless the obligation is unconditionally cancellable by the issuer. For the Company, unconditional lending commitments generally include unfunded term loan agreements, home equity lines of credit, lines of credit, and demand deposit account overdraft protection. As of September 30, 2023, the Company’s reserve for unfunded commitments, which is recorded in other liabilities in the Company’s consolidated balance sheets, totaled $0.5 million. No reserve for unfunded commitments was recorded by the Company as of December 31, 2022.

Nonperforming Assets

Nonperforming assets at the end of the five most recent quarters as of September 30, 2023 were as follows:

(Dollars in Thousands)

The increase in nonperforming assets during the third quarter of 2023 resulted primarily from one commercial real estate loan that moved into non-accrual status during the quarter.

Allocation of Allowance for Credit Losses

While no portion of the allowance for credit losses is in any way restricted to any individual loan or group of loans and the entire allowance is available to absorb losses from any and all loans, the following table shows an allocation of the allowance for credit losses as of September 30, 2023 and December 31, 2022:

(Dollars in Thousands)

Deposits

Total deposits increased to $927.0 million as of September 30, 2023, from $870.0 million as of December 31, 2022, an increase of 6.6%. Core deposits, which exclude time deposits of $250 thousand or more and all brokered deposits, provide a relatively stable funding source that supports earning assets. Core deposits totaled $786.8 million, or 84.9% of total deposits, as of September 30, 2023, compared to $778.1 million, or 89.4% of total deposits, as of December 31, 2022.

Core deposits, have historically been the Company’s primary source of funding and have enabled the Company to successfully meet both short-term and long-term liquidity needs. Management anticipates that core deposits will continue to be the Company’s primary source of funding in the future. Management will continue to monitor deposit levels closely to help ensure an adequate level of funding for the Company’s activities. However, various economic and competitive factors could affect this funding source in the future, including increased competition from other financial institutions in deposit gathering, national and local economic conditions and interest rate policies adopted by the FRB and other central banks.

Other Interest-Bearing Liabilities

Other interest-bearing liabilities consist of federal funds purchased, securities sold under agreements to repurchase, FHLB advances, and subordinated debt that are used by the Company as an alternative source of funds. As of September 30, 2023, other interest-bearing liabilities totaled 5.0% of total interest-bearing liabilities, compared to 4.2% as of December 31, 2022.

Shareholders’ Equity

As of September 30, 2023, shareholders’ equity totaled $87.4 million, or 8.2% of total assets, compared to $85.1 million, or 8.6% of total assets, as of December 31, 2022. The increase in shareholders’ equity resulted from earnings, net of dividends paid, partially offset by the CECL transition adjustment which reduced retained earnings by $1.8 million, net of tax, as well as a net increase in accumulated other comprehensive loss of $1.7 million associated with fair value declines in the available-for-sale investment portfolio and reclassification adjustments associated with terminated interest rate swaps.

During the nine months ended September 30, 2023, the Company declared dividends totaling $0.15 per common share, or approximately $0.9 million in aggregate amount, compared to $0.09 per common share, or approximately $0.5 million in aggregate amount, during the nine months ended September 30, 2022. Bancshares’ Board of Directors evaluates dividend payments based on the Company’s level of earnings and the desire to maintain a strong capital base, as well as regulatory requirements relating to the payment of dividends.

LIQUIDITY AND CAPITAL RESOURCES

The asset portion of the balance sheet provides liquidity primarily from the following sources: (1) excess cash and interest-bearing deposits in banks, (2) federal funds sold, (3) principal payments and maturities of loans and (4) principal payments and maturities from the investment portfolio. Loans maturing or repricing in one year or less amounted to $227.8 million as of September 30, 2023 and $212.5 million as of December 31, 2022. Investment securities forecasted to mature or reprice in one year or less were estimated to be $20.5 million and $7.1 million of the investment portfolio as of September 30, 2023 and December 31, 2022, respectively.

Although some securities in the investment portfolio have legal final maturities exceeding 10 years, a substantial percentage of the portfolio provides monthly principal and interest payments and consists of securities that are readily marketable and easily convertible into cash on short notice. The investment securities portfolio had an estimated average life of 3.9 years and 3.5 years as of September 30, 2023 and December 31, 2022, respectively. However, management does not rely solely upon the investment portfolio to generate cash flows to fund loans, capital expenditures, dividends, debt repayment and other cash requirements. These activities are also funded by cash flows from loan payments, as well as increases in deposits and short-term borrowings.

The liability portion of the balance sheet provides liquidity through interest-bearing and non-interest-bearing deposit accounts, which represent the Company’s primary sources of funds. In addition, federal funds purchased, FHLB advances, securities sold under agreements to repurchase and short-term and long-term borrowings are additional sources of available liquidity. Liquidity management involves the continual monitoring of the sources and uses of funds to maintain an acceptable cash position. Long-term liquidity management focuses on considerations related to the total balance sheet structure. The Bank manages the pricing of its deposits to maintain a desired deposit balance.

The Company had $30.0 million and $20.0 million of outstanding borrowings under FHLB advances as of September 30, 2023 and December 31, 2022, respectively. In addition, on October 1, 2021, the Company completed a private placement of $11.0 million in aggregate principal amount of fixed-to-floating rate subordinated notes that will mature on October 1, 2031. Net of unamortized debt issuance costs, the subordinated notes were recorded as long-term borrowings totaling $10.8 million and $10.7 million as of September 30, 2023 and December 31, 2022, respectively.

The Company had up to $260.3 million and $246.8 million in remaining unused credit from the FHLB (subject to available collateral, which may include eligible investment securities and loans) as of September 30, 2023 and December 31, 2022, respectively. In addition, the Company had $48.0 million and $45.0 million in unused established federal funds lines as of September 30, 2023 and December 31, 2022, respectively.

The Company also has access to the FRB’s discount window and its Bank Term Funding Program (BTFP), the latter of which was established in response to the recent liquidity events that have occurred in the banking industry. Both the discount window and the BTFP allow borrowing on pledged collateral that includes eligible investment securities and, in certain circumstances, eligible loans. In response to heightened liquidity concerns in the banking industry, during 2023 management undertook measures designed to enhance the Company’s liquidity position. These procedures included holding higher levels of on-balance sheet cash, as well as enhancing the availability of off-balance sheet borrowing capacity. As part of these efforts, during the third quarter of 2023, the Company completed the establishment of additional borrowing capacity through the FRB's discount window, primarily via the pledging of the majority of the Company’s indirect loan portfolio as collateral. Due to these efforts, the Company’s immediate borrowing capacity based on collateral pledged through the discount window increased to $146.6 million as of September 30, 2023, compared to $1.2 million as of December 31, 2022.

RESPONSE TO RECENT LIQUIDITY EVENTS

In response to heightened liquidity concerns for the banking industry during 2023, management undertook measures designed to enhance the Company’s liquidity position, including holding higher levels of on-balance sheet cash and enhancing the Company’s off-balance sheet borrowing capacity through both secured and unsecured sources. Although the liquidity events that have occurred in 2023 have strained the banking industry as a whole, the Company’s management remains confident in the stability of the Company’s core deposit base which has served as the Company’s primary funding source for many years. Excluding wholesale brokered deposits, as of September 30, 2023, the Company had over 29 thousand deposit accounts with an average balance of approximately $28.9 thousand per account. Estimated uninsured/uncollateralized deposits (calculated as deposit amounts per deposit holder in excess of $250 thousand, the maximum amount of federal deposit insurance, and excluding deposits secured by pledged assets) totaled $173.0 million, or 18.7% of total deposits, as of September 30, 2023, compared to $148.3 million, or 17.1% of total deposits, as of December 31, 2022.

The table below provides information on the Company’s on-balance sheet liquidity, as well as readily available off-balance sheet sources of liquidity as of both September 30, 2023 and December 31, 2022.

(Dollars in Thousands)

(Unaudited)

(Unaudited)

The table calculates readily available sources of liquidity, including cash and cash equivalents, federal funds sold, and other liquidity sources. Certain of the measures have not been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”); however, management believes that the non-GAAP measures are beneficial to the reader as they enhance the overall understanding of the Company’s liquidity position and can be used as a supplement to GAAP-based measures of liquidity. Specifically, liquidity from pledgeable investment securities and total readily available liquidity are non-GAAP measures used by management and regulators to analyze a portion of the Company's liquidity. Pledgeable investment securities are considered by management as a readily available source of liquidity since the Company has the ability to pledge the securities with the FHLB or FRB to obtain immediate funding. Both available-for-sale and held-for-maturity securities may be pledged at fair value with the FHLB and through the FRB discount window. The amounts shown as liquidity from pledgeable investment securities represents total investment securities as recorded on the balance sheet, less reductions for securities already pledged and discounts expected to be taken by the lender to determine collateral value. The calculations are intended to reflect minimum levels of liquidity readily available to the Company through the pledging of investment securities, and do not contemplate the additional available liquidity that could be available from the FRB through the BTFP. The non-GAAP financial measures that are discussed in this Quarterly Report should not be considered in isolation or as a substitute for the most directly comparable or other financial measures calculated in accordance with GAAP.

Management believes that the Company has adequate sources of liquidity to cover its contractual obligations and commitments over the next twelve months.

The primary purpose of managing interest rate risk is to invest capital effectively and preserve the value created by the Company’s core banking business. This is accomplished through the development and implementation of lending, funding, pricing and hedging strategies designed to maximize net interest income performance under varying interest rate environments, subject to liquidity and interest rate risk guidelines. Effective interest rate sensitivity management ensures that both assets and liabilities respond to changes in interest rates within an acceptable timeframe, thereby minimizing the effect of such interest rate movements on short- and long-term net interest margin and net interest income.

Financial simulation models are the primary tools used by the Asset/Liability Committee of the Bank’s board of directors to measure interest rate exposure. Using a wide range of scenarios, management is provided with extensive information on the potential impact on net interest income caused by changes in interest rates. In these simulations, assumptions are made about the direction and volatility of interest rates, the slope of the yield curve and the changing composition of the Company’s balance sheet resulting from both strategic plans and customer behavior. Simulation models also incorporate management’s assumptions regarding such factors as loan and deposit growth, pricing, prepayment speeds and spreads between interest rates paid on deposits and charged on loans. Because of limitations inherent in any approach used to measure interest rate risk, simulation results are not intended as a forecast of the actual effect of a change in market interest rates on our results but rather as a means to better plan and execute appropriate asset-liability management strategies and manage our interest rate risk.

Assessing Short-Term Interest Rate Risk – Net Interest Margin Simulation

On a quarterly basis, management simulates how changes in short- and long-term interest rates will impact future profitability, as reflected by changes in the Bank’s net interest margin and net interest income. The tables below depict how, as of September 30, 2023, pre-tax net interest margin and net interest income are forecasted to change over timeframes of one year and two years under the six listed interest rate scenarios. The interest rate scenarios contemplate immediate and parallel shifts in short- and long-term interest rates.

Average Change in Net Interest Margin from Level Interest Rate Forecast (basis points, pre-tax):

Cumulative Change in Net Interest Income from Level Interest Rate Forecast (dollars in thousands, pre-tax):

59

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

Bancshares maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in Bancshares’ reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to Bancshares’ management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.

Bancshares’ management carried out an evaluation, under the supervision and with the participation of its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of Bancshares’ disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Exchange Act) as of September 30, 2023, pursuant to the evaluation of these controls and procedures required by Rule 13a-15 of the Exchange Act. Based on that evaluation, Bancshares’ management concluded, as of September 30, 2023, that Bancshares’ disclosure controls and procedures were effective at the reasonable assurance level to ensure that the information required to be disclosed in Bancshares’ periodic filings with the SEC is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Changes in Internal Control Over Financial Reporting

There were no changes in Bancshares’ internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) 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.

A list of factors that could materially affect the Company’s business, financial condition and/or operating results is included in Part I, Item 1A, “Risk Factors” in the Company's 2022 Form 10-K. There have been no material changes to such risk factors, except as set forth below. Additional risks and uncertainties not currently known to the Company or that the Company currently deems to be immaterial also may materially adversely affect the Company’s business, financial condition and/or operating results.

Adverse developments affecting the financial services industry, such as recent bank failures or concerns involving liquidity, may have a material effect on the Company’s operations.

Recent events relating to the failures of certain banking entities in March and April 2023, including Silicon Valley Bank, Signature Bank and First Republic Bank, have caused general uncertainty and concern regarding the liquidity adequacy of the banking sector as a whole. Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, banks, investment banks, mutual funds, and other institutional entities. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. Any such losses could be material and could materially and adversely affect our business, financial condition and results of operations. In addition, we anticipate increased regulatory scrutiny and new regulations directed towards regional banks, and potentially community banks of similar size to us, designed to address the recent negative developments in the banking industry, all of which may increase our costs of doing business and reduce our profitability. In addition, the cost of resolving recent bank failures may prompt the FDIC to increase its premium above the recently increased levels or to issue additional special assessments.