Enterprise Financial Services Corp: Form 10-Q for the period ended Sep 30, 2023

RESULTS OF OPERATIONS

Forward Looking Statements

This Quarterly Report on Form 10-Q contains information and statements that are considered “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such forward-looking statements are based on management’s current expectations and beliefs concerning future developments and their potential effects on the Company, and include, without limitation, statements about the Company’s plans, strategies, goals, objectives, expectations, or consequences of statements about the future performance, operations, products and services of the Company and its subsidiaries, as well as statements about the Company’s expectations regarding revenue and asset growth, financial performance and profitability, loan and deposit growth, yields and returns, loan diversification and credit management, products and services, shareholder value creation and the impact of acquisitions. Forward-looking statements are typically identified with the use of terms such as “may,” “might,” “will,” “would,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “could,” “continue,” “intend,” and the negative and other variations of these terms and similar words and expressions, although some forward-looking statements may be expressed differently. Forward-looking statements are inherently subject to risks and uncertainties and our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. You should be aware that our actual results could differ materially from those contained in the forward-looking statements.

While there is no assurance that any list of risks and uncertainties or risk factors is complete, important factors that could cause actual results to differ materially from those in the forward-looking statements include the following, without limitation: our ability to efficiently integrate acquisitions into our operations, retain the customers of these businesses and grow the acquired operations; credit risk; changes in the appraised valuation of real estate securing impaired loans; our ability to recover our investment in loans; fluctuations in the fair value of collateral underlying loans; outcomes of litigation and other contingencies; exposure to general and local economic and market conditions, including risk of recession, high unemployment rates, higher inflation and its impacts (including U.S. federal government measures to address higher inflation), U.S. fiscal debt, budget and tax matters, and any slowdown in global economic growth; risks associated with rapid increases or decreases in prevailing interest rates; changes in business prospects that could impact goodwill estimates and assumptions; consolidation within the banking industry; competition from banks and other financial institutions; the ability to attract and retain relationship officers and other key personnel; burdens imposed by federal and state regulation; changes in legislative or regulatory requirements, as well as current, pending or future legislation or regulation that could have a negative effect on our revenue and businesses, including rules and regulations relating to bank products and financial services; changes in accounting policies and practices or accounting standards; changes in the method of determining LIBOR and the phase-out of LIBOR; natural disasters; terrorist activities, war and geopolitical matters (including the war in Israel and potential for a broader regional conflict and the war in Ukraine and the imposition of additional sanctions and export controls in connection therewith), or pandemics, or other health emergencies, and their effects on economic and business environments in which we operate, including the related disruption to the financial market and other economic activity; and other risks discussed under the caption “Risk Factors” under Part I, Item 1A of our 2022 Annual Report on Form 10-K, and other reports filed with the SEC, all of which could cause the Company’s actual results to differ from those set forth in the forward-looking statements. The Company cautions that the preceding list is not exhaustive of all possible risk factors and other factors could also adversely affect the Company’s results.

Readers are cautioned not to place undue reliance on our forward-looking statements, which reflect management’s analysis and expectations only as of the date of such statements. Forward-looking statements speak only as of the date they are made, and the Company does not intend, and undertakes no obligation, to publicly revise or update forward-looking statements after the date of this report, whether as a result of new information, future events or otherwise, except as required by federal securities law. You should understand that it is not possible to predict or identify all risk factors. Readers should carefully review all disclosures we file from time to time with the SEC which are available on our website at www.enterprisebank.com (http://www.enterprisebank.com) under “Investor Relations.”

Introduction

The following discussion describes the significant changes to the financial condition of the Company that have occurred during the first nine months of 2023 compared to the financial condition as of December 31, 2022. In addition, this discussion summarizes the significant factors affecting the results of operations of the Company for the three months ended September 30, 2023, compared to the linked second quarter of 2023 (“linked quarter”) and the results of operations, liquidity and cash flows for the nine months ended September 30, 2023 compared to the same period in 2022 (“prior year quarter”). In light of the nature of the Company’s business, which is not seasonal, the Company’s management believes that the comparison to the linked quarter is the most relevant to understand the financial results from management’s perspective. For purposes of the Quarterly Report on Form 10-Q, the Company is presenting a comparison to the corresponding year-to-date period in 2022. This discussion should be read in conjunction with the accompanying condensed consolidated financial statements included in this report and our Annual Report on Form 10-K for the year ended December 31, 2022.

Critical Accounting Policies and Estimates

The Company’s critical accounting policies are considered important to the understanding of the Company’s financial condition and results of operations. These accounting policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experience. If different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected.

A full description of our critical accounting policies and the impact and any associated risks related to those policies on our business operations are discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.

The Company has prepared the consolidated financial information in this report in accordance with GAAP. The Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. Such estimates include the valuation of loans, goodwill, intangible assets, and other long-lived assets, along with assumptions used in the calculation of income taxes, among others. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using loss experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in estimates resulting from continuing changes in the economic environment will be reflected in the financial statement in future periods. There can be no assurances that actual results will not differ from those estimates.

Allowance for Credit Losses

Utilizing the CECL methodology, the Company maintains separate allowances for funded loans, unfunded loans, and held-to-maturity securities, collectively the ACL. The ACL is a valuation account to adjust the cost basis to the amount expected to be collected, based on management’s estimate of experience, current conditions, and reasonable and supportable forecasts. For purposes of determining the allowance for funded and unfunded loans, the portfolios are segregated into pools that share similar risk characteristics and are then further segregated by credit grades. Loans that do not share similar risk characteristics are evaluated on an individual basis and are not included in the collective evaluation. The Company estimates the amount of the allowance based on loan loss experience, adjusted for current and forecasted economic conditions, including unemployment, changes in GDP, and commercial and residential real estate prices. The Company’s forecast of economic conditions uses internal and external information and considers a weighted average of a baseline, upside, and downside scenarios. Because economic conditions can change and are difficult to predict, the anticipated amount of estimated loan defaults and losses, and therefore the adequacy of the allowance, could change significantly and have a direct impact on the Company’s credit costs. The Company’s allowance for credit losses on loans was $142.1 million at September 30, 2023 based on the weighting of the different economic scenarios. As a hypothetical example, if the Company had only used the upside scenario, the allowance would have decreased $27.4 million. Conversely, the allowance would have increased $44.5 million using only the downside scenario.

Executive Summary

Below are highlights of the Company’s financial performance for the periods indicated.

(in thousands, except per share data)

33

Financial results and other notable items include:

• PPNR1 of $65.1 million for the third quarter 2023 and $209.0 million for the nine months ended September 30, 2023, decreased $3.8 million and increased $28.6 million, from the linked quarter and prior year-to-date period, respectively. The decrease from the linked quarter was primarily due to a decrease in noninterest income and an increase in noninterest expense. The increase from the prior year-to-date period was primarily due to an increase in net interest income, partially offset by an increase in noninterest expense.

1 PPNR is a non-GAAP measure. Refer to discussion and reconciliation of these measures in the accompanying financial tables.

• Net interest income of $141.6 million for the third quarter 2023 and $421.9 million for the nine months ended September 30, 2023, increased $0.9 million and $86.8 million from the linked and prior year-to-date period, respectively. The NIM was 4.33% for the third quarter 2023 and 4.50% for the nine months ended September 30, 2023, compared to 4.49% and 3.64% for the linked and prior year-to-date period, respectively. Net interest income benefited from higher average loan and investment balances and expanding yields on earning assets, partially offset by higher deposit interest expense. NIM decreased 16 basis points from the linked quarter, primarily due to an increase in deposit interest expense. NIM increased 86 basis points from the prior year-to-date period, primarily due to an increase in market interest rates and organic growth in earning assets.
• Noninterest income of $12.1 million for the third quarter 2023 and $43.3 million for the nine months ended September 30, 2023, decreased $2.2 million from the linked quarter and increased $1.0 million from the prior year-to-date period. The decline from the linked quarter was primarily due to a decrease in tax credit and community development income, partially offset by a gain on the sale of SBA loans. The increase from the prior year-to-date period was primarily due to an increase in the sale of assets (SBA loans, securities, and OREO) and other miscellaneous income, partially offset by a decline in deposit service charges and card services revenue. The Durbin Amendment cap on debit card income has decreased card services revenue since July 1, 2022.
• Noninterest expense of $88.6 million for the third quarter 2023 and $255.6 million for the nine months ended September 30, 2023, increased $2.7 million and $58.5 million from the linked quarter and prior year-to-date period, respectively. The increase from the linked quarter was primarily due to an increase in variable deposit costs. The increase from the prior year-to-date period was due to deposit costs, employee compensation and benefits due to merit increases and headcount, and other expense primarily due to FDIC assessments and operational losses.

Balance sheet highlights:

• Loans – Total loans increased $879.7 million, or 9.0%, to $10.6 billion at September 30, 2023, compared to $9.7 billion at December 31, 2022. Average loans totaled $10.2 billion for the nine months ended September 30, 2023 compared to $9.1 billion for the nine months ended September 30, 2022.
• Deposits – Total deposits increased $1.1 billion, to $11.9 billion at September 30, 2023 from $10.8 billion at December 31, 2022. Total estimated insured deposits, which includes collateralized deposits, reciprocal deposits and accounts that qualify for pass through insurance, totaled $8.5 billion at September 30, 2023, compared to $4.9 billion at December 31, 2022. Average deposits totaled $11.4 billion for both the nine months ended September 30, 2023 and 2022. Noninterest deposit accounts represented 32.3% of total deposits and the loan to deposit ratio was 89.1% at September 30, 2023, compared to 42.0% and 84.6%, respectively, for the comparable prior year period.
• Asset quality – The allowance for credit losses on loans to total loans was 1.34% at September 30, 2023, compared to 1.41% at December 31, 2022. Nonperforming assets to total assets was 0.40% at September 30, 2023 compared to 0.08% at December 31, 2022. A provision for credit losses of $8.0 million and $18.6 million was recorded in the third quarter of 2023 and the nine months ended September 30, 2023,

respectively. This compares to $6.3 million in the linked quarter and a benefit of $2.7 million in the comparable prior year period.

• Shareholders’ equity – Total shareholders’ equity was $1.61 billion at September 30, 2023, compared to $1.52 billion at December 31, 2022, and the tangible common equity to tangible assets ratio2 was 8.51% at September 30, 2023 compared to 8.43% at December 31, 2022. The Company and the Bank’s regulatory capital ratios exceeded the “well-capitalized” level at September 30, 2023.

The Company’s Board of Directors approved a quarterly dividend of $0.25 per common share, payable on December 29, 2023 to shareholders of record as of December 15, 2023. The Board of Directors also declared a cash dividend of $12.50 per share of Series A Preferred Stock (or $0.3125 per depositary share) representing a 5% per annum rate for the period commencing (and including) September 15, 2023 to (but excluding) December 15, 2023. The dividend will be payable on December 15, 2023 to shareholders of record on November 30, 2023.

2 Tangible common equity to tangible assets ratio is a non-GAAP measure. Refer to discussion and reconciliation of these measures in the accompanying financial tables.

RESULTS OF OPERATIONS

Net Interest Income and Net Interest Margin

Average Balance Sheet

The following tables present, for the periods indicated, certain information related to our average interest-earning assets and interest-bearing liabilities, as well as the corresponding interest rates earned and paid, all on a tax equivalent basis.

(in thousands)

36

(in thousands)

37

Rate/Volume

The following table sets forth, on a tax-equivalent basis for the periods indicated, a summary of the changes in interest income and interest expense resulting from changes in yield/rates and volume.

(in thousands)

(1) Change in volume multiplied by yield/rate of prior period.

(2) Change in yield/rate multiplied by volume of prior period.

(3) Nontaxable income is presented on a tax equivalent basis.

NOTE: The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the absolute dollar amounts of the change in each.

Net interest income for the third quarter 2023 and the nine months ended September 30, 2023 was $141.6 million and $421.9 million, respectively, an increase of $0.9 million and $86.8 million compared to the linked quarter and prior year period, respectively. Net interest income on a tax equivalent basis of $143.7 million for the quarter ended September 30, 2023 and $428.0 million for the nine months ended September 30, 2023, increased $0.9 million and $87.9 million, from the linked quarter and prior year-to-date period respectively. The increase from the linked quarter and the prior year-to-date period reflects the benefit of higher market interest rates on the Company’s asset sensitive balance sheet combined with organic growth. The effective federal funds rate for the third quarter 2023 was 5.26%, an increase of 27 basis points, compared to the linked quarter. The effective federal funds rate for the first nine months of 2023 was 4.93%, an increase of 389 basis points, compared to first nine months of 2022.

Interest income increased $13.0 million during the third quarter 2023 primarily due to an increase of $10.1 million in loan interest income and a $2.4 million increase in interest on cash accounts. Loan interest income has increased from continued loan growth and higher loan yields. Interest on loans benefited from a 16 basis point increase in yield and a $237.1 million increase in average loans, compared to the linked quarter. The average interest rate of new loan originations in the third quarter 2023 was 7.89%. Interest on cash accounts increased due to a 49 basis point increase in yield and a $162.0 million increase in average balances.

Year-to-date, interest income increased $199.5 million over the prior year period due to a $186.3 million increase in loan interest and a $13.2 million increase in interest on securities and interest earning cash. Loan yields in the first nine months of 2023 increased 195 basis points to 6.60%, compared to 4.65% in the prior year period. Average loans increased $1.1 billion, or 12% over the prior year period. Average securities increased $230.7 million, or 11% over the prior year period. Average interest-earning deposits declined $1.1 billion in the first nine months of 2023 compared to the prior year period. However, a 430 basis point increase in yield to 5.06% in 2023 more than offset the interest income impact of the decreased balance.

Interest expense increased $12.1 million in the third quarter 2023 primarily due to a $14.0 million increase in deposit interest expense. This increase was partially offset by a $1.1 million decrease in interest expense on other borrowings. The increase in deposit interest expense reflects a shift in the deposit mix from demand deposits to interest-bearing deposits, particularly money market accounts and certificates of deposit, as well as higher rates paid on deposits. The average cost of interest-bearing deposits was 2.77%, an increase of 51 basis points over the linked quarter. The increase in rate was primarily due to higher rates paid on commercial money market accounts, certificates of deposit and interest-bearing demand accounts, which increased 58 basis points, 45 basis points, and 41 basis points, respectively. The total cost of deposits, including noninterest-bearing demand accounts, was 1.84% during the third quarter 2023, compared to 1.46% in the linked quarter. The decrease in interest expense on other borrowings was primarily due to a decline in average borrowings, which were reduced due to the increase in liquidity from the growth in core deposits.

Year-to-date, interest expense increased $112.7 million over the prior year period, primarily due to a $106.0 million increase in deposit interest expense and a $6.7 million increase on borrowed funds. The cost of interest bearing deposits increased 193 basis points year-over-year, while the cost of total interest bearing liabilities increased 192 basis points during the same period. The total cost of deposits, including noninterest-bearing demand accounts, was 1.42% in the first nine months of 2023, compared to 0.18% in the prior year-to-date period.

NIM, on a tax equivalent basis, was 4.33% in the third quarter 2023 and 4.50% for the first nine months of 2023, a decrease of 16 basis points and an increase of 86 basis points from the linked quarter and the prior year-to-date period, respectively.

Noninterest Income

The following table presents a comparative summary of the major components of noninterest income for the periods indicated.

(in thousands)

Total noninterest income for the third quarter 2023 was $12.1 million, a $2.2 million decrease from the linked quarter, primarily due to a decrease in tax credit income. Tax credit income is typically highest in the fourth quarter of each year and will vary in other periods based on transaction volumes and fair value changes on credits carried at fair value. The increase in other income of $0.3 million was primarily due to a $1.5 million gain on the sale of SBA loans, partially offset by a decline in income from community development investments.

Total noninterest income for the nine months ended September 30, 2023 was $43.3 million, an increase from the prior year period of $1.0 million which was primarily due to a $5.1 million increase in other income, partially offset by a decline in deposit service charges and card services revenue. The Durbin Amendment cap on debit card income has limited card services revenue since July 1, 2022. The increase in other income was primarily due to the sale of assets (SBA loans, securities, and OREO), income from private equity investments and loan and swap fees.

Noninterest Expense

The following table presents a comparative summary of the major components of noninterest expense for the periods indicated.

(in thousands)

Noninterest expense was $88.6 million for the third quarter 2023, an increase of $2.7 million from $86.0 million in the linked quarter. Employee compensation and benefits decreased $0.9 million from the linked quarter primarily due to lower claims on self-insured medical policies. Deposit costs relate to certain specialized deposit businesses that are impacted by higher interest rates as well as increasing average balances. Deposit costs increased $4.0 million from the linked quarter primarily due to higher average balances and an increase in expenses related to the earnings credit earned on these accounts. Other expense decreased $0.7 million from the linked quarter, primarily due to a $0.9 million decrease in operational losses.

Total noninterest expense of $255.6 million for the first nine months of 2023 increased $58.5 million from the prior year period, primarily related to a $43.0 million increase in variable deposit costs, and a $16.1 million increase in compensation and benefits.

In May 2023, the FDIC issued a Notice of Proposed Rulemaking which would implement a special assessment to recover the cost associated with protecting uninsured depositors following the closure of FDIC insured banks earlier in 2023. The FDIC is proposing to collect a special assessment at an annual rate of approximately 12.5 basis points over eight quarterly assessment periods. As proposed, the estimated impact of the special assessment is approximately $2.2 million and will be recognized when the rule is finalized.

Income Taxes

The Company’s effective tax rate was 21.7% for both the third quarter 2023 and the nine months ended September 30, 2023. This compares to an effective tax rate of 21.6% and 21.9% for the linked quarter and prior year-to-date period, respectively.

Summary Balance Sheet

(in thousands)

Total assets were $14.0 billion at September 30, 2023, an increase of $970.9 million from December 31, 2022. Cash and cash equivalents increased due to deposit growth exceeding loan growth, while loan production increased the loan portfolio. Securities decreased primarily due to an decrease in the fair value of available for sale investments, partially offset by an increase in securities primarily due to the reinvestment of cash flows. Total liabilities of $12.4 billion, increased $881.3 million from December 31, 2022. A $1.1 billion increase in deposits, partially offset by a $241.7 million net decrease in FHLB advances and other borrowings, was the primary driver of the increase in total liabilities.

Investments

At September 30, 2023, investment securities were $2.2 billion, or 16%, of total assets, which is comparable to the Company’s historical percentage dating back to 2019. At December 31, 2022, investment securities were $2.2 billion, or 17%, of total assets.

The table below sets forth the carrying value of investment securities, excluding the allowance for credit losses:

($ in thousands)

($ in thousands)

Investment securities decreased $27.9 million from the prior year end, primarily due to a decrease in the fair value of the available-for-sale securities, partially offset by an increase from the reinvestment of portfolio cash flows. Investment purchases in 2023 had a weighted average, tax equivalent yield of 5.0%. In January 2023, $28.4 million of available-for-sale investment securities with a tax equivalent yield of 4.0% were sold at a net gain of $0.4 million and were reinvested in securities with a 4.5% yield.

The average duration of the investment portfolio was 5.6 years at September 30, 2023. The Company leverages the investment portfolio to lengthen the overall duration of the balance sheet, primarily using high-quality municipal securities. The expected cash flow from pay downs, maturities and interest over the next 12 months is approximately $270 million.

Loans by Type

The Company has a diversified loan portfolio, with no particular concentration of credit in any one economic sector; however, a substantial portion of the portfolio, including the C&I category, is secured by real estate. The ability of the Company’s borrowers to honor their contractual obligations is partially dependent upon the local economy and its effect on the real estate market.

The following table sets forth the composition of the loan portfolio by type of loans

(in thousands)

The following table provides additional information on select specialty lending detail:

(in thousands)

Loans totaled $10.6 billion at September 30, 2023 compared to $9.7 billion at December 31, 2022. The increase was driven primarily by C&I, CRE investor owned, construction and specialty loans. The increase in specialty loans was primarily in the sponsor finance and life insurance areas. Average line draw utilization was 42.7% for the first nine months of 2023, compared to 41.8% for the full year of 2022.

Specialty lending products, including sponsor finance, life insurance premium financing, and tax credits, consist primarily of C&I loans. These loans are sourced through relationships developed with estate planning firms and private equity funds and are not bound geographically by our markets. These specialized loan products offer opportunities to expand and diversify geographically by entering new markets. The Company continues to focus on originating high-quality C&I relationships, as they typically have variable interest rates and allow for cross selling opportunities involving other banking products. Life insurance premium financing and tax credits are typically lower risk products due to the high collateral value securing the loans.

SBA loans are also generated on a national basis, and primarily consist of loans collateralized by first lien, owner-occupied real estate properties. These loans predominantly have a 75% guarantee from the SBA. The Company may sell the guaranteed portion of the loan and retain servicing rights, and in the first nine months of 2023, SBA loans totaling $42.1 million were sold.

Provision and Allowance for Credit Losses

The following table presents the components of the provision for credit losses:

(in thousands)

The provision for credit losses, which includes a provision for losses on unfunded commitments, is a charge to earnings to maintain the ACL at a level consistent with management’s assessment of expected losses in the loan portfolio at the balance sheet date. A provision for credit losses on both available-for-sale and held-to-maturity investment securities is recognized in certain circumstances. The Company also records reversals of interest on nonaccrual loans and interest recoveries directly through the provision of credit losses.

A provision for credit losses of $8.0 million for the third quarter 2023 and $18.6 million for the nine months ended September 30, 2023, increased $1.7 million and $21.3 million from the linked quarter and prior year-to-date period, respectively. The provision in the third quarter 2023 was primarily related net charge-offs, an increase in nonperforming loans and loan growth, partially offset by an improvement in forecasted economic factors. The provision in the linked quarter was primarily related to loan growth, and to a lesser extent, net charge-offs. The provision for credit losses in the first nine months of 2023 was primarily due to loan growth, net charge-offs and the increase in nonperforming loans. The provision for credit losses in 2023 also included the impact of the impairment of an available-for-sale investment security. The available-for-sale investment impairment was related to a subordinated debt security in a publicly-traded bank that failed in the first quarter of 2023. The provision benefit in the prior year-to-date period, was primarily due to an improvement in economic factors and the recovery of accrued interest on nonperforming loans.

The following table summarizes the allocation of the ACL on loans:

(in thousands)

The ACL on loans was 1.34% of loans at September 30, 2023, compared to 1.41% of loans at December 31, 2022. The decrease in the ACL on loans is due to improvement in the economic forecast and the charge-off of impaired loans, partially offset by the increase in nonperforming loans. Excluding guaranteed loans, the ACL to total loans was 1.47% at September 30, 2023, compared to 1.56% at December 31, 2022.

The following table is a summary of net charge-offs (recoveries) to average loans for the periods indicated:

(in thousands)

(1) Excludes loans held for sale.

(2) Annualized.

(in thousands)

To the extent the Company does not recognize charge-offs and economic forecasts improve in future periods, the Company could recognize provision reversals. Conversely, if economic conditions and the Company’s forecast worsens and charge-offs increase, the Company could recognize elevated levels of provision for credit losses. The provision is also reflective of charge-offs (recoveries) in the period.

Nonperforming assets

The following table presents the categories of nonperforming assets and other ratios, excluding government guaranteed portions, as of the dates indicated.

(in thousands)

45

Nonperforming loans based on loan type were as follows:

(in thousands)

The following table summarizes the changes in nonperforming loans:

(in thousands)

Deposits

(in thousands)

46

The following table shows the average balance and average rate of the Company’s deposits by type:

(in thousands)

(in thousands)

Total deposits excluding brokered certificates of deposits, were $11.2 billion at September 30, 2023, an increase of $504.2 million from December 31, 2022. The mix of the deposit portfolio shifted from noninterest-bearing demand deposits to higher yielding categories in the current year due to the competitive rate environment. Brokered certificates of deposit increased $576.6 million, to $695.6 million at September 30, 2023. Brokered certificates of deposit were used as a stable funding source to support loan growth in the first half of 2023. This strategy helped preserve wholesale borrowing capacity and liquidity measures. As customer deposits increased in the third quarter 2023, brokered certificates of deposit declined $198.3 million in the current quarter. The Company has a specialty deposit portfolio focusing on property management, community associations, and escrow industries, in addition to deposits related to its specialty lending products. These deposits totaled $3.2 billion at September 30, 2023 and $2.5 billion at December 31, 2022.

To provide customers a deposit product with enhanced FDIC insurance, the Company participates in several programs through third parties that provide full FDIC insurance on deposit amounts by exchanging or reciprocating larger depository relationships with other member banks. Total reciprocal deposits were $1.1 billion at September 30, 2023, compared to $205.8 million at December 31, 2022. The Company considers reciprocal accounts as customer-related deposits due to the customer relationship that generated the transaction.

At September 30, 2023, estimated uninsured/uncollateralized deposits totaled $3.4 billion, or 29% of total deposits, compared to $5.9 billion, or 55% of total deposits, at December 31, 2022. The decrease in estimated uninsured deposits was the result of an increase in reciprocal deposits and accounts that qualify for pass-through insurance.

As rates increase, deposit balances may decline or the composition of the deposit portfolio may continue to shift to higher-yielding deposit products, such as money market accounts or certificates of deposit. The total cost of deposits was 1.84% for the current quarter, compared to 1.46% for the linked quarter. For the year-to-date period in 2023, the total cost of deposits was 1.42%, compared to 0.18% in the prior year period.

Shareholders’ Equity

Shareholders’ equity totaled $1.6 billion at September 30, 2023, an increase of $89.6 million from December 31, 2022. Significant activity during the first nine months of 2023 was as follows:

• increase from net income of $149.5 million,
• net decrease in fair value of securities and cash flow hedges of $37.5 million, and
• decrease from dividends paid on common and preferred stock of $30.8 million.

Liquidity and Capital Resources

Liquidity

The objective of liquidity management is to ensure we have the ability to generate sufficient cash or cash equivalents in a timely and cost-effective manner to meet our commitments as they become due. Typical demands on liquidity are changes in deposit levels, maturing time deposits which are not renewed, and fundings under credit commitments to customers. Funds are available from a number of sources, such as the core deposit base and loan and security repayments and maturities.

Additionally, liquidity is provided from lines of credit with the FHLB, the Federal Reserve, and correspondent banks; the ability to acquire large and brokered deposits, sales of the securities portfolio, and the ability to sell loans or loan participations to other banks. These alternatives are an important part of our liquidity plan and provide flexibility and efficient execution of the asset-liability management strategy. To the extent that other banks tighten their lending capacity, this may impact our ability to sell loan participations.

The Company’s Asset-Liability Management Committee oversees our liquidity position, the parameters of which are approved by the Bank’s Board of Directors. Our liquidity position is monitored daily. Our liquidity management framework includes measurement of several key elements, such as the loan to deposit ratio, a liquidity ratio, and a dependency ratio. The Company’s liquidity framework also incorporates contingency planning to assess the nature and volatility of funding sources and to determine alternatives to these sources. While core deposits and loan and investment repayments are principal sources of liquidity, funding diversification is another key element of liquidity management and is achieved by strategically varying depositor types, terms, funding markets, and instruments.

Liquidity from assets is available primarily from cash balances and the investment portfolio. Cash and interest-bearing deposits with other banks totaled $370.7 million at September 30, 2023 and $291.4 million at December 31, 2022. Recent increases in short term interest rates, a tightening of monetary policy by the Federal Reserve and bank failures in early 2023 have led to competitive pricing pressures and a reduction of deposits in the industry. To enhance liquidity, the Company reduced reinvestment of investment portfolio cash flows for a short period during the nine months ended September 30, 2023. However, investment securities are an important tool to the Company’s liquidity objectives and reinvestment of cash flows resumed as the market stabilized.

Available on- and off-balance sheet liquidity sources include the following items:

(in thousands)

The Company also has a portfolio of SBA guaranteed loans, a portion of which could be sold in the secondary market to generate earnings and liquidity. SBA loans totaling $42.1 million were sold during 2023.

In the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company’s various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company’s liquidity. The Company has $3.2 billion in unused commitments to extend credit as of September 30, 2023. However, the nature of these commitments is such that the likelihood of funding them in the aggregate at any one time is low.

At the holding company level, the primary funding sources are dividends and payments from the Bank and proceeds from the issuance of equity (i.e. stock option exercises, stock offerings) and debt instruments. The main use of this liquidity is to provide the funds necessary to pay dividends to shareholders, service debt, invest in subsidiaries as necessary, and satisfy other operating requirements. The holding company maintains a revolving line of credit for an aggregate amount up to $25 million, all of which was available at September 30, 2023. The line of credit has a one-year term and was renewed in February 2023 for an additional one-year term. The proceeds can be used for general corporate purposes.

The Company has an effective automatic shelf registration statement on Form S-3 allowing for the issuance of various forms of equity and debt securities. The Company’s ability to offer securities pursuant to the registration statement depends on market conditions and the Company’s continuing eligibility to use the Form S-3 under rules of the SEC.

Strong capital ratios, credit quality and core earnings are essential to retaining cost-effective access to the wholesale funding markets. Deterioration in any of these factors could have a negative impact on the Company’s ability to access these funding sources and, as a result, these factors are monitored on an ongoing basis as part of the liquidity management process. The Bank is subject to regulations and, among other things, may be limited in its ability to pay dividends or transfer funds to the parent company. Accordingly, consolidated cash flows as presented in the consolidated statements of cash flows may not represent cash immediately available for the payment of cash dividends to the Company’s shareholders or for other cash needs.

Through the normal course of operations, the Company has entered into certain contractual obligations and other commitments. Such obligations relate to funding operations through deposits or debt issuances, as well as leases for premises and equipment. As a financial services provider, the Company routinely enters into commitments to extend credit. While contractual obligations represent future cash requirements of the Company, a significant portion of commitments to extend credit may expire without being drawn upon. Such commitments are subject to the same credit policies and approval process accorded to loans made by the Company. The Company also enters into derivative contracts under which the Company either receives cash from or pays cash to counterparties depending on changes in interest rates. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. The fair value of these contracts changes daily as market interest rates change.

Capital Resources

The Company and the Bank are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and its bank affiliate must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The banking affiliate’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total, Tier 1, and common equity tier 1 capital to risk-weighted assets, and of Tier 1 capital to average assets. To be categorized as “well capitalized”, banks must maintain minimum total risk-based (10%), Tier 1 risk-based (8%), common equity tier 1 risk-based (6.5%), and Tier 1 leverage ratios (5%). In addition, the Company must maintain an additional CCB above the regulatory minimum ratio requirements. The CCB is designed to insulate banks from periods of stress and impose constraints on dividends, share repurchases and discretionary bonus payments when capital levels fall below prescribed levels. As of September 30, 2023, and December 31, 2022, the Company and the Bank met all capital adequacy requirements to which they are subject and exceeded the amounts required to be “well capitalized”.

The following table summarizes the Company’s various capital ratios:

(in thousands)

The Company believes the tangible common equity ratio is an important measure of capital strength, even though it is considered a non-GAAP measure. A reconciliation has been included in this section under the caption “Use of Non-GAAP Financial Measures.”

Use of Non-GAAP Financial Measures:

The Company’s accounting and reporting policies conform to generally accepted accounting principles in the United States (“GAAP”) and the prevailing practices in the banking industry. However, the Company provides other financial measures, such as tangible common equity, PPNR, core efficiency ratio, and the tangible common equity ratio, in this report that are considered “non-GAAP financial measures.” Generally, a non-GAAP financial measure is a numerical measure of a company’s financial performance, financial position, or cash flows that exclude (or include) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP.

The Company considers its tangible common equity, PPNR, core efficiency ratio, and the tangible common equity ratio, collectively “core performance measures,” presented in this report and the included tables as important measures of financial performance, even though they are non-GAAP measures, as they provide supplemental information by which to evaluate the impact of certain non-comparable items, and the Company’s operating performance on an ongoing basis. Core performance measures exclude certain other income and expense items, such as merger-related expenses, facilities charges, and the gain or loss on sale of investment securities, that the Company believes to be not indicative of or useful to measure the Company’s operating performance on an ongoing basis. The attached tables contain a reconciliation of these core performance measures to the GAAP measures. The Company believes that the tangible common equity ratio provides useful information to investors about the Company’s capital strength even though it is considered to be a non-GAAP financial measure and is not part of the regulatory capital requirements to which the Company is subject.

The Company believes these non-GAAP measures and ratios, when taken together with the corresponding GAAP measures and ratios, provide meaningful supplemental information regarding the Company’s performance and capital strength. The Company’s management uses, and believes that investors benefit from referring to, these non-GAAP measures and ratios in assessing the Company’s operating results and related trends and when forecasting future periods. However, these non-GAAP measures and ratios should be considered in addition to, and not as a substitute for or preferable to, ratios prepared in accordance with GAAP. In the attached tables, the Company has provided a reconciliation of, where applicable, the most comparable GAAP financial measures and ratios to the non-GAAP financial measures and ratios, or a reconciliation of the non-GAAP calculation of the financial measures for the periods indicated.

Core Efficiency Ratio

(in thousands)

51

Tangible Common Equity, Tangible Book Value per Share, and Tangible Common Equity Ratio

(in thousands)

Return on Average Tangible Common Equity (ROATCE)

(in thousands)

52

Pre-Provision Net Revenue (PPNR)

(in thousands)

Calculation of Estimated Insured Deposits

(in thousands)

The disclosures set forth in this item are qualified by the cautionary language regarding forward-looking statements in the introduction to Item 2 of Part I of this Quarterly Report on Form 10-Q and other cautionary statements set forth elsewhere in this report.

Interest Rate Risk

Our interest rate risk management practices are aimed at optimizing net interest income, while guarding against deterioration that could be caused by certain interest rate scenarios. Interest rate sensitivity varies with different types of interest-earning assets and interest-bearing liabilities. We attempt to maintain interest-earning assets, comprised primarily of both loans and investments, and interest-bearing liabilities, comprised primarily of deposits, maturing or repricing in similar time horizons in order to manage any impact from market interest rate changes according to our risk tolerances. The Company uses a simulation model to measure the sensitivity to changing rates on earnings.

The Company determines the sensitivity of its short-term future earnings to a hypothetical plus or minus 100 to 300 basis point parallel rate shock through the use of simulation modeling. The simulation includes the modeling of the balance sheet as an ongoing entity. Future business assumptions involving administered rate products, prepayments for future rate-sensitive balances, and the reinvestment of maturing assets and liabilities are included. These items are then modeled to project net interest income based on a hypothetical change in interest rates. The resulting net interest income for the next 12-month period is compared to the baseline amounts calculated using flat rates. The difference represents the Company’s sensitivity to a positive or negative 100 basis points parallel rate shock.

The following table summarizes the expected impact of interest rate shocks on net interest income at September 30, 2023:

In addition to the rate shocks shown in the table above, the Company models net interest income under various dynamic interest rate scenarios. In general, changes in interest rates are positively correlated with changes in net interest income.

The Company occasionally uses interest rate derivative instruments as an asset/liability management tool to hedge mismatches in interest rate exposure indicated by the net interest income simulation described above. They are used to modify the Company’s exposures to interest rate fluctuations and provide more stable spreads between loan yields and the rate on their funding sources. At September 30, 2023, the Company had derivative contracts to manage interest rate risk, including $250.0 million in notional value on derivatives to hedge the cash flows on floating rate loans and $62.0 million in notional value on derivative on floating rate debt. Derivative financial instruments are also discussed in “Item 1. Note 6 – Derivative Financial Instruments.”

The Financial Conduct Authority has announced that the most common USD LIBOR settings (overnight, 1-month. 3-month, 6-month and 12-month) will cease publication after September 30, 2024. However, LIBOR rates published after June 30, 2023 will be based on a “synthetic” methodology. LIBOR is commonly referenced in financial instruments. With the cessation of LIBOR, the Company has selected term SOFR as the replacement index for the majority of its variable rate loans and began providing customer notifications in early 2023. The Company ceased using LIBOR and International Exchange, Inc. swap rates in new contracts and began issuing SOFR based loans in December 2021.

The Company had $6.5 billion in variable rate loans at September 30, 2023. Of these loans, $4.1 billion have an interest rate floor and nearly all of those loans were at or above the floor. Variable rate loans include $2.8 billion indexed to the prime rate, $2.6 billion indexed to SOFR, $277.5 million indexed to LIBOR, and $797.0 million indexed to other rates.

At September 30, 2023, the Company’s available-for-sale and held-to-maturity investment securities totaled $1.5 billion and $730.7 million, respectively. These portfolios consist primarily of fixed-rate securities that are subject to changes in market value due to changes in interest rates. At September 30, 2023, net unrealized losses were $235.0 million and $108.8 million on the available-for-sale and held-to-maturity investment portfolios, respectively.

Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of the Company’s Chief Executive Officer (the “CEO”) and the Chief Financial Officer (the “CFO”), management has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15, as of September 30, 2023. Disclosure controls and procedures include without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to the issuer’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

Based on that evaluation, the CEO and CFO concluded the Company’s disclosure controls and procedures were effective as of September 30, 2023 to provide reasonable assurance of the achievement of the objectives described above.

Changes to Internal Controls

There were no changes during the period covered by this Quarterly Report on Form 10-Q in the Company’s internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, those controls.

For information regarding risk factors affecting the Company, please see the cautionary language regarding forward-looking statements in the introduction to Item 2 of Part I of this Quarterly Report on Form 10-Q, Part I, Item 1A of our Report on Form 10-K for the fiscal year ended December 31, 2022, and supplemented by the additional risk factor set forth below.

Adverse developments affecting the banking industry, and resulting media coverage, have eroded customer confidence in the banking system and could have a material effect on the Company’s operations and/or stock price.

The recent high-profile bank failures involving Silicon Valley Bank and Signature Bank have generated significant market volatility among publicly traded bank holding companies and, in particular, regional banks. These market developments have negatively impacted customer confidence in the safety and soundness of regional banks. As a result, customers may choose to maintain deposits with larger financial institutions or invest in higher yielding short-term fixed income securities, all of which could materially adversely impact our liquidity, cost of funding, loan funding capacity, net interest margin, capital and results of operations. In connection with high-profile bank failures, uncertainty and concern has been, and may be in the future, compounded by advances in technology that increase the speed at which deposits can be moved, as well as the speed and reach of media attention, including social media, and its ability to disseminate concerns or rumors, in each case potentially exacerbating liquidity concerns. While the Department of the Treasury, the Federal Reserve, and the FDIC have made statements ensuring that depositors of recently failed banks would have access to their deposits, including uninsured deposit accounts, there is no guarantee that such actions will be successful in restoring customer confidence in regional banks and the banking system more broadly. In addition, the banking operating environment and public trading prices of banking institutions can be highly correlated, in particular during times of stress, which could adversely impact the trading prices of our common stock and potentially our results of operations. For more information on the Company's liquidity position, please see the “Deposits” and “Liquidity and Capital Resources” sections of Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations.