OFG Bancorp: Form 10-Q for the period ended Jun 30, 2022

Please read the following discussion and analysis of our financial condition and results of operations together with the “Selected Financial Data” and our consolidated financial statements and related notes included under Item I, “Financial Statements” of this Quarterly Report on Form 10-Q. This discussion and analysis contains forward-looking statements. Please see “Forward-Looking Statements,” “Risk Factors,” and “Quantitative and Qualitative Disclosures about Market Risk” in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2022 and set forth in our Form 10-K for the year ended December 31, 2021 (the “2021 Form 10-K”), as supplemented and amended by any subsequent Quarterly Reports on Form 10-Q, for a discussion of the uncertainties, risks and assumptions associated with these statements. We have omitted discussion of 2020 results where it would be redundant to the discussion previously included in Item 2 of our Form 10-Q for the quarter ended June 30, 2021.

Other factors not identified above, including those described under the headings in our 2021 Form 10-K and any subsequent Quarterly Reports on Form 10-Q may also cause actual results to differ materially from those described in our forward-looking statements.

INTRODUCTION

OFG is a publicly-owned financial holding company that provides wide range of banking and financial services such as commercial, consumer, auto, and mortgage lending, financial planning, insurance sales, money management, investment banking and securities brokerage services, as well as corporate and individual trust services. OFG operates through three major business segments: Banking, Wealth Management, and Treasury, and distinguishes itself based on quality service. OFG conducts its business through its main office in San Juan, Puerto Rico, forty-five branches in Puerto Rico and two branches in the U.S. Virgin Islands (the “USVI”). OFG has three subsidiaries with operations in Puerto Rico: the Bank, Oriental Financial Services and Oriental Insurance; three subsidiaries in the United States, OPC, OFG USA and OFG Ventures; and one subsidiary in the Cayman Islands, OFG Reinsurance. OFG’s long-term goal is to strengthen its banking and financial services franchise by expanding its lending businesses, increasing the level of integration in the marketing and delivery of banking and financial services, continuously improving our already effective asset-liability management, growing non-interest revenue from banking and financial services, and achieving greater operating efficiencies.

OFG’s diversified mix of businesses and products generates both the interest income traditionally associated with a banking institution and non-interest income traditionally associated with a financial services institution (generated by such businesses as securities brokerage, fiduciary services, investment banking, insurance agency, reinsurance and retirement plan administration). Although all of these businesses, to varying degrees, are affected by interest rate and financial market fluctuations and other external factors, OFG’s commitment is to continue producing a balanced and growing revenue stream.

RECENT DEVELOPMENTS

Capital Actions

In January 2022, OFG announced that its Board of Directors approved the increase of its regular quarterly cash dividend by 25%, to $0.15 per common share from $0.12 per share, beginning on the quarter ended March 31, 2022. Subsequently, in July 2022, OFG announced that its Board of Directors approved a new increase of its regular quarterly cash dividend by 33%, to $0.20 per common share, beginning on the quarter ended September 30, 2022.

In January 2022, the Board of Directors also approved a new stock repurchase program to purchase $100 million of its common stock in the open market, which OFG expects to complete during the 2022 fiscal year. At June 30, 2022, OFG has repurchased 2.4 million shares of common stock for $64.1 million.

Covid-19 Pandemic and Economic Conditions

Since March 2020, the Covid-19 pandemic has adversely affected our communities and the way we do business, as well as economic activity globally, nationally and locally. Among other things, interest rates declined, unemployment increased, and economic output slowed dramatically during 2020.

Within the last year, as restrictions related to the pandemic eased in the United States, employment increased and pent-up demand was released, which together with Covid-19 lockdowns in foreign jurisdictions created global supply chain issues and shortages of goods, which in turn has triggered price inflation. In an effort to address inflation, the Federal Open Market Committee of the Board of Governors of the Federal Reserve System (“FRB”) has tightened monetary policy and has increased the federal funds rate four times during fiscal year 2022, with the latest increases of 75 basis points each made on June 15, 2022 and July 27, 2022. The current federal funds target rate range is 2.25% to 2.5% but FRB officials forecast the federal funds target rate will end 2022 at a range of 3.25% to 3.5%. The FRB has also scaled back its asset purchase program that provided liquidity to the bond markets.

Adding to economic uncertainty and increased inflationary pressures are military actions taken by Russia against Ukraine commencing in February 2022, which have added stress to existing supply chain concerns and placed upward pressure on commodities such as oil and natural gas prices, which have further exacerbated the global macroeconomic uncertainty and increased inflationary pressures. However, we believe that the macroeconomic outlook for Puerto Rico continues to show strength. Recent data show that the Puerto Rico Economic Activity Index, as published by the Economic Development Bank for Puerto Rico, has been increasing for over a year; therefore, signaling a stable upward trend as employment gains remain solid. Our commercial clients are experiencing a higher demand for their products and services. Consumer demand also remains strong and, following five years of bankruptcy proceedings under Title III of PROMESA, the Puerto Rico central government has begun to implement the plan of adjustment approved by the Title III bankruptcy court on January 18, 2022, setting the stage for its exit from bankruptcy. Nevertheless, there remain several public instrumentalities whose debt obligations have not been restructured under the mechanisms provided by PROMESA and any recovery of the Puerto Rico economy could be adversely impacted by macroeconomic developments within the United States and across the globe. The global macroeconomic outlook continues to remain uncertain and, at this time, OFG cannot reasonably estimate the scope, term or intensity of any possible adverse impact on our financial position, operations or liquidity, resulting from economic disruption and uncertainty related to Covid-19 variants, economic recessions, trade and supply chain disruption, continuing inflationary pressures, labor shortages, armed conflicts such as the ongoing military actions against Ukraine, and the uncertainty of the timing and extent of potential actions that might be taken by the FRB. However, we believe that the high levels of reconstruction and stimulus funds being channeled towards the Puerto Rico economy are mitigating the foregoing negative effects.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in accordance with GAAP requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the consolidated financial statements. Understanding our accounting policies and the extent to which we use management judgment and estimates in applying these policies is integral to understanding our financial statements. We provide a summary of our significant accounting policies in “Note 1—Summary of Significant Accounting Policies” of our 2021 Form 10-K.

In the “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” section of our 2021 Form 10-K, we identified the Allowance for Credit Losses related to loans collectively evaluated for impairment as a critical accounting policy and estimate, because it involves significant estimation uncertainty that has or is reasonably likely to have a material impact on our financial condition or results of operations.

We evaluate our critical accounting estimates and judgments on an ongoing basis and update them as necessary based on changing conditions. There have been no material changes in the methods used to formulate these critical accounting estimates from those discussed in our 2021 Form 10-K.

FINANCIAL HIGHLIGHTS

During the quarter ended June 30, 2022, OFG had another strong quarterly performance in all its core businesses. Loans and deposits grew, net interest margin expanded, and banking and wealth management income rebounded. All this confirms an overall increase in business activity, driven by OFG’s solid strategic position and continuously improving customer experience. This quarter we increased our number of self-service banking kiosks and introduced digital commercial account opening. We also repurchased $30.6 million of shares, completing $64.1 million of our current $100 million stock buyback program. Capital metrics remain high. Further on a macroeconomic level, despite global headwinds, we believe that the Puerto Rico economic environment continues to trend positively.

Earnings per share diluted was $0.84 compared to $0.76 in the first quarter of 2022 and $0.78 in the second quarter of 2021.

Net interest income was $115.1 million compared to $105.2 million in the first quarter of 2022 and $102.3 million in the second quarter of 2021. Net interest margin expanded to 4.80% from 4.47% in the first quarter of 2022 due to increased volume of loans and investments and FRB federal funds rate hikes.

Interest income was $122.2 million compared to $112.9 million in the first quarter of 2022 and $113.5 million in the second quarter of 2021. Compared to the first quarter of 2022, the second quarter of 2022 interest income benefited from higher yields on higher average balances of loans and of investment securities, and higher average yields on cash.

Total interest expense was $7.1 million compared to $7.8 million in the first quarter of 2022 and $11.2 million in the second quarter of 2021. Compared to the first quarter of 2022, the second quarter of 2022 interest expense primarily reflected lower average balances and cost of borrowings.

Non-interest income was $36.2 million compared to $31.6 million in the first quarter of 2022 and $32.2 million in the second quarter of 2021. Compared to the first quarter of 2022, the second quarter of 2022 non-interest income primarily reflected higher banking service and wealth management revenues, lower mortgage banking revenues, and a $4.7 million gain on sale of a legacy branch building.

Provision for credit losses was $6.7 million compared to $1.6 million in the first quarter of 2022 and a recapture of $8.3 million in the second quarter of 2021. The second quarter of 2022 reflected a provision of $5.1 million due to the growth in loan balances and a provision of $4.8 million related to commercial-specific loan reserves as a result of two commercial loans placed in non-accrual, partly offset by a reduction of $4.9 million in qualitative adjustment and loss factors due to the improvement in the performance of loan portfolios and economic conditions in Puerto Rico.

Non-interest expenses were $85.3 million compared to $81.2 million in the first quarter of 2022 and $82.7 million in the second quarter of 2021. The $4.1 million increase from the first quarter of 2022 primarily reflected higher compliance related professional services expenses due to greater levels of business activity, as well as higher technology expenses related to digital transformation.

Loans held for investment were $6.70 billion compared to $6.55 billion at March 31, 2022 and $6.50 billion at June 30, 2021. Loans grew $154.7 million from March 31, 2022, primarily reflecting increases in commercial loans as well as increases in consumer and auto loans.

New loan origination was $587.2 million compared to $623.2 million in the first quarter of 2022 and $673.6 million in the second quarter of 2021, which included $32.7 million of PPP loans. The second quarter of 2022 reflected continued high levels of auto and consumer lending as well as commercial lending in Puerto Rico and the United States mainland.

Total investments were $1.73 billion compared to $1.26 billion at March 31, 2022 and $643.5 million at June 30, 2021. Investments grew $468.5 million from March 31, 2022, taking advantage of the higher yield environment.

Customer deposits were $9.02 billion compared to $8.97 billion at March 31, 2022 and $9.08 billion at June 30, 2021. Core deposits grew by $51.3 million from March 31, 2022, reflecting increases in commercial and retail accounts.

Total assets were $10.25 billion compared to $10.19 billion at March 31, 2022 and $10.46 billion at June 30, 2021.

Capital: CET1 ratio at June 30, 2022 was 12.80% compared to 13.24% at March 31, 2022 and 13.95% at June 30, 2021. The decline from March 31, 2022 reflected common stock repurchased during the quarter and an increase in risk weighted assets, partially offset by an increase in retained earnings. Tangible book value per share was $18.86 compared to $18.90 at March 31, 2022 and $18.13 at June 30, 2021. The slight decline from March 31, 2022 reflected the repurchase of common stock and a reduction in other comprehensive income, partially offset by the increase in retained earnings.

Selected income statement and balance sheet data and key performance indicators are presented in the tables below:

(In thousands, except per share data)

66

ANALYSIS OF RESULTS OF OPERATIONS

The following tables show major categories of interest-earning assets and interest-bearing liabilities, their respective interest income, expenses, yields and costs, and their impact on net interest income due to changes in volume and rates for the quarters and six-month periods ended June 30, 2022 and 2021.

TABLE 1 - ANALYSIS OF NET INTEREST INCOME AND CHANGES DUE TO VOLUME/RATE

FOR THE QUARTERS ENDED JUNE 30, 2022 AND 2021

(Dollars in thousands)

68

(Dollars in thousands)

C - CHANGES IN NET INTEREST INCOME DUE TO:

(In thousands)

69

TABLE 1A - ANALYSIS OF NET INTEREST INCOME AND CHANGES DUE TO VOLUME/RATE

FOR THE SIX-MONTH PERIODS ENDED JUNE 30, 2022 AND 2021

(Dollars in thousands)

70

(Dollars in thousands)

71

C - CHANGES IN NET INTEREST INCOME DUE TO:

(In thousands)

Net Interest Income

Net interest income is a function of the difference between rates earned on OFG’s interest-earning assets and rates paid on its interest-bearing liabilities (interest rate spread) and the relative amounts of its interest earning assets and interest-bearing liabilities (interest rate margin). OFG constantly monitors the composition and re-pricing of its assets and liabilities to maintain its net interest income at adequate levels.

Net interest income of $115.1 million increased $12.8 million from $102.3 million. Tax equivalent basis net interest income of $118.1 million increased $13.7 million, or 13.1%, from $104.4 million.

Interest rate spread increased 59 basis points to 4.78% from 4.19% and net interest margin increased 58 basis points to 4.80% from 4.22%. This increase reflects an increase of 42 basis points in the total average yield of interest-earning assets and a reduction in the average cost of interest-bearing liabilities of 17 basis points. Net interest income was positively impacted by:

• An increase of $5.2 million in interest income from investments securities related to purchases of available-for-sale and held-to-maturity securities during 2022 and 2021;
• Lower interest expense by $4.1 million, driven by both a reduced cost and lower average balance of total deposits and borrowings, which resulted in an increase in net interest income of approximately $2.9 million and $1.2 million, respectively;
• An increase of $2.3 million in interest income from interest bearing cash and money market investments related to the increase in federal fund rates. The FRB target rates increased from a range of 0% to 0.25% in the second quarter of 2021 to a range of 1.50% to 1.75% for the second quarter of 2022; and
• An increase of $1.3 million in interest income from loans driven by increased yields on higher balances of loans.

Comparison of the six-month periods ended June 30, 2022 and 2021

Net interest income of $220.3 million increased $19.9 from $200.4 million. Tax equivalent basis net interest income of $225.8 million increased $21.0 million, or 10.25%, from $204.8 million.

Interest rate spread increased 41 basis points to 4.61% from 4.20% and net interest margin increased 40 basis points to 4.64% from 4.24%. This increase reflects an increase of 21 basis points in the total average yield of interest-earning assets and a reduction in the average cost of interest-bearing liabilities of 20 basis points.

Net interest income was positively impacted by:

• Lower interest expense by $9.1 million, reflecting both a reduced cost and lower average balances of total deposits and borrowings, which resulted in an increase in net interest income of approximately $6.1 million and $3.0 million, respectively;
• A $7.5 million increase in interest income from investment securities related to purchases of available-for-sale and held-to-maturity securities during 2022 and 2021;
• A $2.6 million increase in interest income from interest bearing cash and money market related to the increase in federal fund rates; and
• A $662 thousand increase in interest income from loans driven by increased yields on new loans originated during the period.

TABLE 2 - NON-INTEREST INCOME SUMMARY

(In thousands)

(In thousands)

Non-Interest Income

Non-interest income is affected by fees generated from loans and deposit accounts, the amount of assets under management of the Bank’s trust department, transactions generated by clients’ financial assets serviced by OFG’s securities broker-dealer, insurance agency and reinsurance subsidiaries, the level of mortgage banking activities, and gains on sales of assets.

OFG recorded non-interest income, net, in the amount of $36.2 million, compared to $32.2 million, an increase of 12.5%, or $4.0 million. The increase in non-interest income was mainly due to:

• A $3.9 million increase in other non-interest income, primarily related to a $4.7 million gain recognized on the sale of a branch building during the second quarter of 2022.

Comparison of the six-month periods ended June 30, 2022 and 2021

OFG recorded non-interest income, net, in the amount of $67.8 million, compared to $62.6 million, an increase of 8.3%, or $5.2 million. The increase in non-interest income was mainly due to:

• An increase of $1.0 million in banking service revenues, primarily related to an increase of $404 thousand in credit life insurance commissions, $325 thousand in checking and saving account fees, $319 thousand in servicing and prepayment loan fees, and $180 thousand in international transaction fees. These variances were partially offset by a decrease of $344 thousand in electronic banking fees;
• An increase of $476 thousand in wealth management revenue, primarily related to the new reinsurance business income of $1.8 million, partially offset by decreases of $849 thousand in broker-dealer revenues, $192 thousand in trust division fees, $184 thousand in insurance income from annuities and other commissions, and $33 thousand in OPC revenues;
• An increase of $472 thousand in mortgage-banking activities, primarily related to lower losses on repurchase loans and other mortgage banking activities by $2.9 million and higher servicing fees of $725 thousand, offset by a $3.1 million decrease in gains on loans sold and securitization due to decrease in sales; and
• An increase of $3.3 million in other non-interest income, primarily related to a $4.7 million gain recognized on the sale of a branch building during the first six months of 2022.

TABLE 3 - NON-INTEREST EXPENSES SUMMARY

(In thousands)

(In thousands)

Non-Interest Expenses

Non-interest expense was $85.3 million, representing an increase of 3.1%, or $2.6 million, compared to $82.7 million. The increase in non-interest expense was mainly due to:

• Increase in professional and service fees by $2.0 million, reflecting higher compliance related expenses due to greater levels of business activity;
• Increase in compensation and employee benefits by $1.8 million, mainly due to increases in minimum hourly wages and annual salaries; and
• Increase in electronic banking charges by $406 thousand driven by increase in debit and credit card billing fees, ATM-related expenses, and merchant fees due to higher transaction volumes during the quarter ended June 30, 2022.

The increase in non-interest expense was partially offset by improvements in foreclosed real estate and other repossessed assets income by $1.7 million reflecting an increase of $1.3 million in gains on sales of foreclosed real estate and a decrease of $652 thousand in credit-related expenses.

The efficiency ratio was 58.27% and improved from 62.02%. The efficiency ratio measures how much of OFG’s revenues is used to pay operating expenses. OFG computes its efficiency ratio by dividing non-interest expenses by the sum of its net interest income and non-interest income, but excluding gains on the sale of investment securities, derivatives gains or losses, other gains and losses, and other income that may be considered volatile in nature. Management believes that the exclusion of those items permits consistent comparability. Amounts presented as part of non-interest income that are excluded from the adjusted efficiency ratio computation for the quarters ended June 30, 2022 and 2021 amounted to $5.0 million and $1.1 million, respectively.

Comparison of the six-month periods ended June 30, 2022 and 2021

Non-interest expense was $166.4 million, representing an increase of 3.8%, or $6.1 million, compared to $160.3 million.

Non-interest expenses were positively impacted by:

• Increase in compensation and employee benefits by $4.0 million, primarily related to a one-time $1.3 million pandemic employee tax credit in prior year period, and increases in minimum hourly wages and annual salaries in the current period;
• Increase in professional and service fees expenses by $2.8 million, reflecting higher compliance related expenses due to greater levels of business activity; and
• Increase in electronic banking charges by $2.0 million mainly due an increase in debit and credit card billing fees, ATM-related expenses and merchant fees due to higher transaction volumes.

The increase in non-interest expense was partially offset by:

• Improvements in foreclosed real estate and other repossessed assets income by $3.2 million reflecting $1.9 million increase in gains on sales of foreclosed real estate, $680 thousand increase in net gain on sale of other repossessed assets, and $605 thousand decrease in credit-related expenses;
• Decrease in pandemic-related expenses by $1.3 million due to lower security, supplies and sanitation services expenses compared to prior period; and
• Decrease in occupancy, equipment and infrastructure costs by $879 thousand reflecting lower rent, building maintenance, utilities and other expenses related to branch consolidations.

The efficiency ratio was 58.86% and improved from 61.44%. Amounts presented as part of non-interest income that are excluded from the efficiency ratio computation for the six-month periods ended June 30, 2022 and 2021 amounted to $5.4 million and $2.1 million, respectively.

Provision for Credit Losses

Comparison of quarters ended June 30, 2022 and 2021

Provision for credit losses increased by $15.0 million to $6.7 million from a recapture of $8.3 million. The provision for credit losses for the quarter ended June 30, 2022 includes a provision of $5.1 million due to the growth in loan balances and a provision of $4.8 million in commercial-specific loan reserves as a result of two commercial loans placed in non-accrual, partly offset by a $3.9 million recapture associated with qualitative adjustments due to the improvement in the performance of loan portfolios and economic conditions in Puerto Rico. The provision for credit losses for the prior-year quarter included $2.1 million net charge-offs and a $10.4 million recapture, which reflected continued improvement in asset quality trends.

Comparison of the six-month periods ended June 30, 2022 and 2021

Provision for credit losses decreased by $10.2 million to $8.2 million from a recapture of $2.0 million. The provision for credit losses for the six-month period ended June 30, 2022 reflected a provision of $9.1 million related to the growth in loan balances and a provision of $9.5 million related to commercial-specific loan reserves due to certain commercial loans placed in non-accrual, offset by a $9.6 million recapture associated with qualitative adjustments due to the improvement in the performance of loan portfolios and economic conditions in Puerto Rico. Prior-year period recapture reflected continued improvement in asset quality trends.

Income Tax Expense

OFG’s ETR was 31.9% in 2022 compared to 32.0% in 2021. The decrease in ETR is mainly related to an increase in US Treasury bills and other exempt investments during the quarter.

Comparison of the six-month periods ended June 30, 2022 and 2021

OFG’s ETR was 31.3% in 2022 compared to 32.0% in 2021. The decrease in ETR is related to an increase in US Treasury bills and other exempt investments and a discrete tax windfall on stock options during the six-month period ended June 30, 2022.

Business Segments

OFG segregates its businesses into the following major reportable segments: Banking, Wealth Management, and Treasury. Management established the reportable segments based on the internal reporting used to evaluate performance and to assess where to allocate resources. Other factors such as OFG’s organization, nature of its products, distribution channels and economic characteristics of its services were also considered in the determination of the reportable segments. OFG measures the performance of these reportable segments based on pre-established goals of different financial parameters such as net income, net interest income, loan production, and fees generated. OFG’s methodology for allocating non-interest expenses among segments is based on several factors such as revenue, employee headcount, occupied space, dedicated services or time, among others. Following are the results of operations and the selected financial information by operating segment for the quarters and six-month periods ended June 30, 2022 and 2021.

(In thousands)

78

(In thousands)

79

Banking

OFG’s banking segment net income before taxes decreased by $10.5 million from $55.6 million to $45.1 million, mainly reflecting:

• An increase in provision for credit losses of $14.4 million. The provision for the current quarter reflected increases due to growth of loan balances and commercial-specific loan reserves from commercial loans placed in non-accrual, partly offset by a reduction in qualitative adjustment due to the improvement in the performance of loan portfolios and economic conditions in Puerto Rico. The provision for the prior-year quarter included a release related to improvements in asset quality; and
• An increase in non-interest expenses of $3.0 million, mainly due to: (i) higher compensation and employee benefits by $2.5 million due to increases in minimum hourly wages and annual salaries, (ii) higher compliance related professional expenses by $1.8 million due to greater levels of business activity, and (iii) higher electronic banking charges by $406 thousand due to higher transaction volume; partially offset by improvements in foreclosed real estate and other repossessed assets income by $1.7 million reflecting an increase of $1.3 million in gains on sales of foreclosed real estate.

These variances were partially offset by:

• Lower interest expense by $4.4 million from both, reduced costs and lower average balances of core deposits; and
• An increase of $3.6 million in non-interest income, primarily related to a $4.7 million gain recognized on the sale of a legacy branch building during the quarter ended June 30, 2022.

Wealth Management

Wealth management segment revenue consists of commissions and fees from fiduciary activities, securities brokerage and insurance activities. Net income before taxes from this segment increased by $0.6 million reflecting higher non-interest income of $434 thousand mainly due to $1.0 million in income from a new reinsurance business which began operations during the last quarter of 2021, partially offset by a $644 thousand decrease in revenues subject to commissions from the broker-dealer subsidiary.

Treasury

Treasury segment net income before taxes increased by $9.2 million, mainly reflecting an increase in interest income from the purchases of available-for-sale and held-to-maturity securities during the current period.

Comparison of six-month periods ended June 30, 2022 and 2021

Banking

OFG’s banking segment net income before taxes decreased by $3.6 million from $94.7 million to $91.1 million, mainly reflecting:

• An increase in provision for credit losses of $9.5 million. The provision for the current period reflected increases due to growth in loan balances and commercial-specific loan reserves from commercial loans placed in non-accrual, partly offset by a reduction in qualitative adjustment due to the improvement in the performance of loan portfolios and economic conditions in Puerto Rico. The provision for the prior-year period included releases related to improvements in asset quality;
• An increase in non-interest expenses of $5.0 million, mainly due to: (i) a $4.4 million increase in compensation and employee benefits reflecting a one-time $1.3 million pandemic employee tax credit in the prior-year period and increases in minimum hourly wages and annual salaries; (ii) a $2.4 million increase in compliance related professional expenses due to greater levels of business activity; a $2.0 million increase in electronic banking charges due to higher transaction volume; and (iii) a $721 thousand increase in advertising and marketing; partially offset by improvements in foreclosed real estate and other repossessed assets income by $3.2 million reflecting: (i) a $1.9 million increase in gains on sales of foreclosed real estate, (ii) a $680 thousand increase in net gain on sale of other repossessed assets, and (iii) a $605 thousand decrease in credit-related expenses.

The increases in the banking segment’s net income were partially offset by:

• Lower interest expense by $9.2 million, mainly related to both, reduced costs and lower average balances of core deposits; and
• An increase of $4.3 million in non-interest income primarily related to a $4.7 million gain recognized on the sale of a legacy branch building during the quarter ended June 30, 2022.

Wealth Management

Wealth management segment revenue consists of commissions and fees from fiduciary activities, securities brokerage and insurance activities. Net income before taxes from this segment decreased by $0.8 million reflecting an increase in non-interest expenses by $1.5 million, primarily related to higher claims expenses as a result of a $1.2 million reversal from a case settled during the prior year period. The decrease in net income before taxes was partially offset by a $909 thousand increase in non-interest income related to $1.8 million in income from the new reinsurance business, partially offset by decreases of $849 thousand in broker-dealer revenues.

Treasury

Treasury segment net income before taxes increased by $13.1 million, mainly reflecting:

• Increase in interest income by $13.3 million, reflecting the purchase of agency MBS and US Treasury securities during the current period; and
• Decrease in interest expense by $96 thousand reflecting the cancellation of $33.1 million of FHLB advances during 2021 and the early redemption of $36.1 million subordinated capital notes during the six-month period ended June 30, 2022.

ANALYSIS OF FINANCIAL CONDITION

Assets Owned

At June 30, 2022, OFG’s total assets amounted to $10.248 billion, for an increase of $348.1 million, when compared to $9.900 billion at December 31, 2021.

The investment portfolio increased by $831.4 million, or 92.8%, primarily related to the purchase of available for sale agency mortgage-backed securities and held-to-maturity US Treasury securities amounting to $719.0 million and $196.7 million, respectively, during the six-month period ended June 30, 2022. OFG’s strategy is to invest its liquidity in highly liquid securities and designate them as available for sale or held-to-maturity after taking into account the investment’s characteristics with respect to yield and term and the current market environment.

OFG’s loan portfolio is comprised of residential mortgage loans, commercial loans secured by real estate, other commercial and industrial loans, consumer loans, and auto loans and leases. At June 30, 2022, OFG’s net loan portfolio increased by $255.9 million, or 4.0%, reflecting increases in commercial, consumer and auto loans, partially offset by $54.0 million PPP loans forgiven by the Small Business Administration and the sale of $21.9 million of past due mortgage loans sold during the six-month period ended June 30, 2022.

Cash and due from banks of $1.302 billion decreased by $712.3 million, reflecting cash used to purchase available for sale agency mortgage-backed securities and held-to-maturity US Treasury securities, disbursements for loans originated during the six-month period ended June 30, 2022, and the redemption of $36.1 million in 3.23% variable rate subordinated notes, partially offset by an increase in commercial and government-related deposits.

Financial Assets Managed

OFG’s financial assets include those managed by OFG’s trust division, retirement plan administration subsidiary, and assets gathered by its securities broker-dealer and insurance agency subsidiaries. OFG’s trust division offers various types of individual retirement accounts (“IRAs”) and manages 401(k) and Keogh retirement plans and custodian and corporate trust accounts, while the retirement plan administration subsidiary manages private retirement plans. At June 30, 2022, the total assets managed by OFG’s trust division and retirement plan administration subsidiary amounted to $3.365 billion, compared to $3.759 billion at December 31, 2021. OFG’s broker-dealer subsidiary offers a wide array of investment alternatives to its client base, such as tax-advantaged fixed income securities, mutual funds, stocks, bonds and money management wrap-fee programs. At June 30, 2022, total assets gathered by the securities broker-dealer and insurance agency subsidiaries from their customers’ investment accounts amounted to $2.078 billion, compared to $2.466 billion at December 31, 2021. Changes in trust and broker-dealer related assets primarily reflect changes in portfolio balances and differences in market value.

Goodwill

OFG’s goodwill is not amortized to expense but is tested at least annually for impairment. A quantitative annual impairment test is not required if, based on a qualitative analysis, OFG determines that the existence of events and circumstances indicate that it is more likely than not that goodwill is not impaired. OFG completes its annual goodwill impairment test as of October 31 of each year. OFG tests for impairment by first allocating its goodwill and other assets and liabilities, as necessary, to defined reporting units. A fair value is then determined for each reporting unit. If the fair values of the reporting units exceed their book values, no write-down of the recorded goodwill is necessary. If the fair values are less than the book values, an additional valuation procedure is necessary to assess the proper carrying value of the goodwill.

As of June 30, 2022 and December 31, 2021, OFG had $86.1 million of goodwill allocated as follows: $84.1 million to the banking segment and $2.0 million to the wealth management segment. Please refer to Note 9 – Goodwill and Other Intangible Assets to our consolidated financial statements for more information on the annual goodwill impairment test.

TABLE 4 - ASSETS SUMMARY AND COMPOSITION

(In thousands)

83

TABLE 5 - LOAN PORTFOLIO COMPOSITION

(In thousands)

OFG’s loan portfolio is composed of mortgage, commercial, consumer, and auto loans. As shown in Table 5 above, total loans, net, amounted to $6.585 billion at June 30, 2022 and $6.329 billion at December 31, 2021. OFG’s loans held-for-investment portfolio composition and trends were as follows:

• Commercial loan portfolio amounted to $2.596 billion (38.7% of the gross loan portfolio) compared to $2.379 billion (37.2% of the gross loan portfolio) at December 31, 2021.

Commercial loan production, excluding PPP loans, decreased 28.4%, or $93.2 million, to $234.7 million in the quarter ended June 30, 2022 from $327.9 million for the same period in 2021, and increased 13.6%, or $62.1 million, to $518.7 million in the six-month period ended June 30, 2022 from $456.6 million for the same period in 2021.

During the second quarter and six-month period ended June 30, 2021, OFG originated $32.7 million and $159.0 million, respectively, of PPP loans. There were no originations of PPP loans during the quarter and six-month period ended June 30, 2022, as the program concluded in 2021.

• Mortgage loan portfolio amounted to $1.808 billion (27.0% of the gross loan portfolio) compared to $1.907 billion (29.8% of the gross originated loan portfolio) at December 31, 2021.

Mortgage loan production totaled $62.8 million and $126.7 million for the quarter and six-month period ended June 30, 2022, respectively, which represents a decrease of 39.5% and 36.5% from $103.8 million and $199.7 million for the same periods in 2021. Mortgage loans included delinquent loans in the GNMA buy-back option program amounting to $33.4 million and $14.5 million at June 30, 2022 and December 31, 2021, respectively. Under the GNMA program, issuers such as OFG have the option but not the obligation to repurchase loans that are 90 days or more past due. For accounting purposes, these loans subject to the repurchase option are required to be reflected (rebooked) on our financial statements with an offsetting liability.

• Consumer loan portfolio amounted to $499.1 million (7.4% of the gross loan portfolio) compared to $409.7 million (6.4% of the gross loan portfolio) at December 31, 2021. Consumer loan production increased 153.9% and 195.6% to $96.6 million and $193.7 million in the quarter and six-month period ended June 30, 2022, respectively, from $38.0 million and $65.5 million for the same periods in 2021.
• Auto and leasing portfolio amounted to $1.800 billion (26.9% of the gross loan portfolio) compared to $1.706 billion (26.7% of the gross originated loan portfolio) at December 31, 2021. Auto loans production increased 12.8% and 15.9% to $193.0 million and $371.3 million in the quarter and six-month period ended June 30, 2022, respectively, compared to $171.1 million and $320.5 million for the same periods in 2021.

TABLE 6 - PUERTO RICO GOVERNMENT RELATED LOANS

June 30, 2022

(In thousands)

At June 30, 2022, OFG has $86.3 million of direct credit exposure to the Puerto Rico government, a $1.0 million decrease from December 31, 2021. At December 31, 2021, total loan exposure to the Puerto Rico government included a $1.1 million PCD loan granted to a public corporation classified as non-accrual, which was repaid during the six-month period ended June 30, 2022.

Credit Risk Management

Allowance for Credit Losses

On January 1, 2020, OFG adopted an accounting standard that requires the measurement of the allowance for credit losses to be based on management’s best estimate of future expected credit losses inherent in OFG’s relevant financial assets.

Tables 7 through 9 set forth an analysis of activity in the allowance for credit losses and present selected credit loss statistics for the quarters and six-month periods ended June 30, 2022 and 2021 and as of June 30, 2022 and December 31, 2021. In addition, Table 5 sets forth the composition of the loan portfolio.

Please refer to the “Provision for Credit Losses” and “Critical Accounting Policies and Estimates” sections in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section and Note 7 – Allowance for Credit Losses of this Quarterly Report for a more detailed analysis of provisions and allowance for credit losses.

Non-performing Assets

OFG’s non-performing assets include non-performing loans, foreclosed real estate, and other repossessed assets (see Tables 10 and 12). At June 30, 2022, OFG had $98.2 million of non-accrual loans, including $10.3 million PCD loans, compared to $101.9 million at December 31, 2021.

At June 30, 2022 and December 31, 2021, loans whose terms have been extended and which were classified as troubled-debt restructurings that were not included in non-accrual loans amounted to $150.0 million and $125.9 million, respectively, as they were performing under their modified terms.

Delinquent residential mortgage loans insured or guaranteed under applicable Federal Housing Administration (“FHA”) and United States Department of Veterans Affairs (“VA”) programs are classified as non-performing loans when they become 90 days or more past due but are not placed in non-accrual status until they become 12 months or more past due, since they are insured loans. Therefore, those loans are included as non-performing loans but excluded from non-accrual loans.

At June 30, 2022, OFG’s non-performing assets decreased by 2.5% to $125.8 million (1.23% of total assets) from $129.0 million (1.30% of total assets) at December 31, 2021. Foreclosed real estate and other repossessed assets amounting to $15.1 million and $2.5 million, respectively, at June 30, 2022, increased from $15.0 million and $1.9 million, respectively, at December 31, 2021, recorded at fair value. OFG does not expect non-performing loans to result in significantly higher losses. At June 30, 2022, the allowance coverage ratio to non-performing loans was 147.0% (139.2% at December 31, 2021).

Upon adoption of the current expected credit losses (“CECL”) methodology, OFG elected to maintain pools of loans that were previously accounted for under ASC 310-30 and will continue to account for these pools as a unit of account. As such, for PCD loans the determination of nonaccrual or accrual status is made at the pool level, not the individual loan level. Upon adoption of CECL, the allowance for credit losses was determined for each pool and added to the pool’s carrying amount to establish a new amortized cost basis. The difference between the unpaid principal balance of the pool and the new amortized cost basis is the non-credit premium or discount which will be amortized interest income over the remaining life of the pool. On a quarterly basis, management will monitor the composition and behavior of the pools to assess the ability for cash flow estimation and timing. If based on the analysis performed the pool is classified as non-accrual, the accretion/amortization of the non-credit (discount) premium will cease.

OFG follows a conservative residential mortgage lending policy with more than 90% of its residential mortgage portfolio consisting of fixed-rate, fully amortizing, fully documented loans that do not have the level of risk associated with subprime loans offered by certain major U.S. mortgage loan originators. Furthermore, OFG has never been active in negative amortization loans or offered adjustable rate mortgage loans with teaser rates.

The following items comprise non-performing loans held for investment, including Non-PCD and PCDs:

Commercial loans - At June 30, 2022, OFG’s non-performing commercial loans amounted to $57.3 million (52.9% of OFG’s non-performing loans), an 14.2% increase from $50.1 million at December 31, 2021 (44.8% of OFG’s non-performing loans). Non-PCD commercial loans are placed on non-accrual status when they become 90 days or more past due and are written down, if necessary, based on the specific evaluation of the underlying collateral, if any.

Mortgage loans - At June 30, 2022, OFG’s non-performing mortgage loans totaled $33.6 million (31.1% of OFG’s non-performing loans), a 15.4% decrease from $39.7 million (35.5% of OFG’s non-performing loans) at December 31, 2021. Non-PCD mortgage loans are placed on non-accrual status when they become 90 days or more past due and are written-down, if necessary, based on the specific evaluation of the collateral underlying the loan, except for FHA and VA insured mortgage loans which are placed in non-accrual when they become 12 months or more past due.

Consumer loans - At June 30, 2022, OFG’s non-performing consumer loans amounted to $2.0 million (1.8% of OFG’s non-performing loans), a 13.7% decrease from $2.3 million at December 31, 2021 (2.1% of OFG’s non-performing loans). Non-PCD consumer loans are placed on non-accrual status when they become 90 days past due and written-off when payments are delinquent 120 days in personal loans and 180 days in credit cards and personal lines of credit.

Auto loans and leasing - At June 30, 2022, OFG’s non-performing auto loans and leases amounted to $15.3 million (14.2% of OFG’s total non-performing loans), a decrease of 22.7% from $19.8 million at December 31, 2021 (17.6% of OFG’s total non-performing loans). Non-PCD auto loans and leases are placed on non-accrual status when they become 90 days past due, partially written-off to collateral value when payments are delinquent 120 days, and fully written-off when payments are delinquent 180 days.

OFG has two mortgage loan modification programs. These are the Loss Mitigation Program and the Non-Conforming Mortgage Loan Program. Both programs are intended to help responsible homeowners to remain in their homes and avoid foreclosure, while also reducing OFG’s losses on non-performing mortgage loans.

The Loss Mitigation Program helps mortgage borrowers who are or will become financially unable to meet the current or scheduled mortgage payments. Loans that qualify under this program are those guaranteed by FHA, VA, RURAL, PRHFA, conventional loans guaranteed by Mortgage Guaranty Insurance Corporation (MGIC), conventional loans sold to FNMA and FHLMC, and conventional loans retained by OFG. The program offers diversified alternatives such as regular or reduced payment plans, payment moratorium, mortgage loan modification, partial claims (only FHA), short sale, and deed in lieu of foreclosure.

The Non-Conforming Mortgage Loan Program is for non-conforming mortgages, including balloon payment, interest only/interest first, variable interest rate, adjustable interest rate and other qualified loans. Non-conforming mortgage loan portfolios are segregated into the following categories: performing loans that meet secondary market requirement and are refinanced under the credit underwriting guidelines of FHA/VA/FNMA/ FHLMC, and performing loans not meeting secondary market guidelines processed pursuant OFG’s current credit and underwriting guidelines. OFG achieved an affordable and sustainable monthly payment by taking specific, sequential, and necessary steps such as reducing the interest rate, extending the loan term, capitalizing arrearages, deferring the payment of principal or, if the borrower qualifies, refinancing the loan.

In order to apply for any of our loan modification programs, if the borrower is active in Chapter 13 bankruptcy, it must request an authorization from the bankruptcy trustee to allow for the loan modification. Borrowers with discharged Chapter 7 bankruptcies may also apply. Loans in these programs are evaluated by designated credit underwriters for troubled-debt restructuring classification if OFG grants a concession for legal or economic reasons due to the debtor’s financial difficulties.

TABLE 7 - ALLOWANCE FOR CREDIT LOSSES BREAKDOWN

(In thousands)

88

TABLE 8 - ALLOWANCE FOR CREDIT LOSSES SUMMARY

(Dollars in thousands)

(Dollars in thousands)

89

TABLE 9 — NET CREDIT LOSSES STATISTICS ON LOAN AND LEASES

(Dollars in thousands)

(Dollars in thousands)

90

TABLE 9 — NET CREDIT LOSSES STATISTICS ON LOAN AND LEASES (CONTINUED)

(Dollars in thousands)

(Dollars in thousands)

TABLE 10 — NON-PERFORMING ASSETS

(Dollars in thousands)

91

(In thousands)

(In thousands)

TABLE 11 - NON-ACCRUAL LOANS

(Dollars in thousands)

92

TABLE 12 - NON-PERFORMING LOANS

(Dollars in thousands)

93

TABLE 13 - LIABILITIES SUMMARY AND COMPOSITION

(Dollars in thousands)

Liabilities and Funding Sources

As shown in Table 13 above, at June 30, 2022, OFG’s total liabilities were $9.233 billion, 4.6% higher than the $8.831 billion reported at December 31, 2021. Deposits and borrowings, OFG’s funding sources, amounted to $9.057 billion at June 30, 2022 compared to $8.668 billion at December 31, 2021. Deposits, excluding accrued interest payable, increased 5.0% mainly from higher commercial and retail deposits by $510.8 million, offset by a decrease of $84.4 million in time deposits from maturities, with the majority of them transferred into demand deposit and savings accounts.

As of June 30, 2022 borrowings consist of FHLB advances amounting to $27.6 million. Borrowings decreased by $37.0 million, when compared to $64.6 million at December 31, 2021, reflecting the redemption of all $36.1 million variable rate subordinated capital notes before maturity during the six-month period ended June 30, 2022.

Stockholders’ Equity

At June 30, 2022, OFG’s total stockholders’ equity was $1.015 billion, a 5% decrease when compared to $1.069 billion at December 31, 2021. This reduction in stockholders’ equity reflects a decrease of $60.6 million from additional treasury stock and a decrease in additional paid-in capital of $2.4 million, as a result of repurchases of common stock in the aggregate amount of $64.1 million in connection with the $100 million stock buyback program adopted during the first quarter of 2022. It also reflects a decrease in accumulated other comprehensive income, net of tax, of $54.7 million from changes in the market value of available-for-sale securities. The decrease was offset by an increase in retained earnings of $55.6 million and legal surplus of $7.7 million, mainly due to $78.0 million in net income, partially offset by $14.6 million common stock dividends issued during the six-month period ended June 30, 2022.

Regulatory Capital

OFG and the Bank are subject to regulatory capital requirements established by the Federal Reserve Board and the FDIC. The current risk-based capital standards applicable to OFG and the Bank (“Basel III capital rules”) are based on the final capital framework for strengthening international capital standards, known as Basel III, of the Basel Committee on Banking Supervision. As of June 30, 2022, the capital ratios of OFG and the Bank continue to exceed the minimum requirements for being “well-capitalized” under the Basel III capital rules.

On January 1, 2020, OFG implemented CECL using the modified retrospective approach, with an impact to capital of $25.5 million, net of its corresponding deferred tax effect. On March 27, 2020, in response to the Covid-19 pandemic, U.S. banking regulators issued an interim final rule that OFG adopted to delay for two years the initial adoption impact of CECL on regulatory capital, followed by a three-year transition period to phase out the aggregate amount of the capital benefit provided during 2020 and 2021 (i.e., a five-year transition period). During the two-year delay, OFG added back to common equity tier 1 (“CET1”) capital 100% of the initial adoption impact of CECL plus 25% of the cumulative quarterly changes in the allowance for credit losses (i.e., quarterly transitional amounts). After two years, starting on January 1, 2022, the quarterly transitional amounts along with the initial adoption impact of CECL will be phased out of CET1 capital over a three-year period.

During the six-month period ended June 30, 2022, OFG redeemed all of its $36.1 million subordinated capital notes and, as a result, OFG’s tier 1 capital was reduced by the corresponding $35.0 million qualified trust preferred securities, which were previously included in tier 1 capital.

The risk-based capital ratios presented in Table 14, which include common equity tier 1, tier 1 capital, total capital and leverage capital as of June 30, 2022 and December 31, 2021, are calculated based on the Basel III capital rules related to the measurement of capital, risk-weighted assets and average assets.

The following are OFG’s consolidated capital ratios under the Basel III capital rules at June 30, 2022 and December 31, 2021:

TABLE 14 — CAPITAL, DIVIDENDS AND STOCK DATA

96

From December 31, 2021 to June 30, 2022, leverage capital ratio decreased from 9.69% to 9.46%, tier 1 risk-based capital ratio decreased from 14.27% to 12.80%, total risk-based capital ratio decreased from 15.52% to 14.05%, common equity tier 1 capital ratio decreased from 13.77% to 12.80%, and tangible common equity to tangible total assets decreased from 9.69% to 8.85%. The decreases in capital ratios reflected common stock repurchases of $64.1 million during the six-month period ended June 30, 2022 and an increase in risk-weighted assets, partially offset by increase in retained earnings. Risk-weighted assets increased, mainly from the increase in loan and investment portfolios during the six-month period ended June 30, 2022. Also, during the six-month period ended June 30, 2022, OFG completed the redemption and cancellation of subordinated capital notes, further reducing tier 1 risk-based capital and total risk-based capital by $35.0 million. Tangible common equity was also affected by a $54.7 million other comprehensive loss during the six-month period ended June 30, 2022 from available for sale securities as a result of changes in market interest rates from recent developments in the U.S. economy.

The following table presents a reconciliation of OFG’s total stockholders’ equity to tangible common equity and total assets to tangible assets at June 30, 2022 and December 31, 2021:

(In thousands, except share or per share information)

The tangible common equity ratio and tangible book value per common share are non-GAAP measures and, unlike tier 1 capital and common equity tier 1 capital, are not codified in the federal banking regulations. Management and many stock analysts use the tangible common equity ratio and tangible book value per common share in conjunction with more traditional bank capital ratios to compare the capital adequacy of banking organizations. Neither tangible common equity nor tangible assets or related measures should be considered in isolation or as a substitute for stockholders’ equity, total assets or any other measure calculated in accordance with GAAP. Moreover, the manner in which OFG calculates its tangible common equity, tangible assets and any other related measures may differ from that of other companies reporting measures with similar names.

Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited. To mitigate these limitations, OFG has procedures in place to calculate these measures using the appropriate GAAP or regulatory components. Although these non-GAAP financial measures are frequently used by stakeholders in the evaluation of a company, they have limitations as analytical tools and should not be considered in isolation or as a substitute for analyses of results as reported under GAAP.

The following table presents OFG’s capital adequacy information under the Basel III capital rules:

98

The Bank is considered “well capitalized” under the regulatory framework for prompt corrective action. The table below shows the Bank’s regulatory capital ratios at June 30, 2022 and December 31, 2021:

OFG’s common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “OFG.” At June 30, 2022 and December 31, 2021, OFG’s market capitalization for its outstanding common stock was $1.208 billion ($25.40 per share) and $1.318 billion ($26.56 per share), respectively.

The following table provides the high and low prices and dividends per share of OFG’s common stock for each quarter of the last three calendar years:

99

In January 2022, OFG announced the approval by the Board of Directors of a stock repurchase program to purchase $100 million of its outstanding shares of common stock. The shares of common stock repurchased are held by OFG as treasury shares. During the six-month period ended June 30, 2022, OFG repurchased 2,351,868 shares for a total of $64.1 million at an average price of $27.04 per share. OFG did not repurchase any shares of its common stock during the six-month period ended June 30, 2022, other than through its publicly announced stock repurchase program. During the six-month period ended June 30, 2021, OFG did not repurchase any shares.

At June 30, 2022 the number of shares that may yet be purchased under the $100 million stock buyback program is estimated at 1,412,984 and was calculated by dividing the remaining balance of $35.9 million by $25.40 (closing price of OFG’s common stock at June 30, 2022).

Impact of Inflation and Changing Prices

The financial statements and related data presented herein (except for certain non-GAAP measures as previously indicated) have been prepared in accordance with GAAP which require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation.

Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution’s performance than the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or with the same magnitude as the prices of goods and services since such prices are affected by inflation.

Background

OFG’s risk management policies are established by its Board of Directors (the “Board”) and implemented by management through the adoption of a risk management program, which is overseen and monitored by the Chief Risk and Compliance Officer, the Board’s Risk and Compliance Committee, the executive Risk and Compliance Team, the executive Credit Risk Team, and the executive Asset/Liability Team (“ALT”). OFG has continued to refine and enhance its risk management program by strengthening policies, processes and procedures necessary to maintain effective risk management.

All aspects of OFG’s business activities are susceptible to risk. Consequently, risk identification and monitoring are essential to risk management. As more fully discussed below, OFG’s primary risk exposures include market, interest rate, credit, liquidity, operational and concentration risks.

Market Risk

Market risk is the risk to earnings or capital arising from adverse movements in market rates or prices, such as interest rates or prices. OFG evaluates market risk together with interest rate risk. OFG’s financial results and capital levels are constantly exposed to market risk. The Board and management are primarily responsible for ensuring that the market risk assumed by OFG complies with the guidelines established by policies approved by the Board. The Board has delegated the management of this risk to the ALT which is composed of certain executive officers from the business, treasury and finance areas. One of ALT’s primary goals is to ensure that the market risk assumed by OFG is within the parameters established in such policies.

Interest Rate Risk

Interest rate risk is the exposure to decline in earnings or capital due to changes in interest rates. To actively monitor the interest rate risk, the Board of Directors has created the ALT whose principal responsibilities consist in overseeing the management of the Bank’s assets and liabilities to balance its risk exposures. In executing its responsibilities, ALT considers different methods to enhance profitability while maintaining acceptable levels of interest rate risks by implementing investment, pricing and financial strategies that helps managing OFG vulnerability to changes in interest rates.

On a quarterly basis, OFG performs net interest income simulation analysis on a consolidated basis to estimate the potential change in future earnings from projected changes in interest rates. These simulations are carried out over a five-year time horizon, assuming certain upward and downward interest rate movements, achieved during a twelve-month period. Market scenarios that include instantaneous and parallel interest rate movements as well as other scenarios with gradual interest rate ramps, speed of interest rate changes, and changes in the slope of the yield curve are also modeled. In addition to the change in interest rates, the results of the analysis could be affected by prepayments, caps, and floors. Management exercises its best judgment in formulating assumptions regarding events that management can influence such as non-maturity deposits repricing, as well as events outside management’s control such as customer behavior on loans and deposits activity and the effects that competition has on both lending and deposits pricing. These assumptions are subjective and, as a result, net interest income simulation results will differ from actual results due to the timing, magnitude and frequency of interest rate changes, changes in market conditions, customer behavior and management strategies, among other factors.

OFG uses a software application to project future movements in OFG’s balance sheet and income statement. The starting point of the projections generally corresponds to the actual values of the balance sheet on the date of the simulations.

The following table presents the results of the simulations for the most likely scenarios at June 30, 2022. The left of the table presents an analysis of our interest rate risk as measured by the estimated changes in net interest income resulting from an instantaneous and parallel shift in the yield curve over a 12-month horizon. The base case scenario assumes that the current interest rate environment is held constant throughout the forecast period for a static balance sheet and the instantaneous shocks are performed against that yield curve. The right side of the table, presents an analysis of our interest rate risk as measured by the estimated changes in net interest income resulting from parallel gradual interest rates ramps over a 12-month horizon.

(Dollars in thousands)

The scenarios above are both instantaneous shocks and gradual interest rate ramps that assume balance sheet management will mirror the base case. Even if interest rates change in the designated amounts, there can be no assurance that our assets and liabilities would perform as anticipated. Additionally, a change in the U.S. Treasury rates in the designated amounts accompanied by a change in the shape of the U.S. Treasury yield curve would cause significantly different changes to net interest income than indicated above. OFG strategic management of the balance sheet would be adjusted to accommodate these movements. As with any method of measuring interest rate risk, certain shortcomings are inherent in the methods of analysis presented above. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag changes in market rates. Also, the ability of many borrowers to service their debts may decrease in the event of an interest rate increase. ALT strategies consider all these factors as part of the monitoring of the exposure to interest rate risk.

Future net interest income could be affected by OFG’s investments in callable securities, prepayment risk related to mortgage loans and mortgage-backed securities, and advances from the FHLB in which it may enter into from time to time. As part of the strategy to limit the interest rate risk and reduce the re-pricing gaps of OFG’s assets and liabilities, OFG has executed, in the past, certain transactions which include extending the maturity and the re-pricing frequency of the liabilities to longer terms and using hedge-designated swaps to hedge the variability of future interest cash flows of forecasted wholesale borrowings that only consist of advances from the FHLB still outstanding as of June 30, 2022.

OFG maintains an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. OFG’s goal is to manage interest rate sensitivity by modifying the repricing or maturity characteristics of certain balance sheet assets and liabilities so that the net interest margin is not, on a material basis, adversely affected by movements in interest rates. As a result of interest rate fluctuations, hedged fixed-rate assets and liabilities will appreciate or depreciate in market value. Also, for some fixed-rate assets or liabilities, the effect of this variability in earnings is expected to be substantially offset by OFG’s gains and losses on the derivative instruments that are linked to the forecasted cash flows of these hedged assets and liabilities. OFG considers its strategic use of derivatives to be a prudent method of managing interest-rate sensitivity as it reduces the exposure of earnings and the market value of its equity to undue risk posed by changes in interest rates. The effect of this unrealized appreciation or depreciation is expected to be substantially offset by OFG’s gains or losses on the derivative instruments that are linked to these hedged assets and liabilities. Another result of interest rate fluctuation is that the contractual interest income and interest expense of hedged variable-rate assets and liabilities, respectively, will increase or decrease.

Derivative instruments that are used as part of OFG’s interest rate risk management strategy include interest rate swaps and option contracts that have indices related to the pricing of specific balance sheet assets and liabilities. Interest rate swaps generally involve the exchange of fixed and variable-rate interest payments between two parties based on a common notional principal amount and maturity date. Interest rate options represent contracts that allow the holder of the option to (i) receive cash or (ii) purchase, sell, or enter into a financial instrument at a specified price within a specified period. Some purchased option contracts give OFG the right to enter into interest rate swaps and cap and floor agreements with the writer of the option.

Following is a summary of certain strategies, including derivative activities, currently used by OFG to manage interest rate risk:

Interest rate swaps and borrowings — OFG uses interest rate swaps to hedge the variability of interest cash flows of certain advances from the FHLB that are tied to a variable rate index. The interest rate swaps effectively fix OFG’s interest payments on these borrowings. As of June 30, 2022, OFG had $27.6 million in interest rate swaps at an average rate of 2.42% designated as cash flow hedges for $27.6 million in advances from the FHLB that reprice or are being rolled over on a monthly basis. A derivative liability of $21 thousand was recognized at June 30, 2022 related to the valuation of these swaps.

Credit Risk

Credit risk is the possibility of loss arising from a borrower or counterparty in a credit-related contract failing to perform in accordance with its terms. The principal source of credit risk for OFG is its lending activities. In Puerto Rico, OFG’s principal market, we believe that recent macroeconomic conditions continue to show strength, however, as was demonstrated by the January 2020 earthquakes and hurricanes Irma and Maria in 2017, Puerto Rico is susceptible to natural disasters, which can have a disproportionate impact because of the logistical difficulties of bringing relief to an island far from the United States mainland. The effects of climate change may further increase the risk of natural disasters in the future and the correlative risk that the physical impact of such events could adversely affect our customers, operations, and business. Moreover, the Puerto Rico government’s fiscal challenges and Puerto Rico’s unique relationship with the United States also complicate any relief efforts after a natural disaster. These events increase credit risk as debtors may no longer be capable of operating their businesses and the collateral securing OFG’s loans may suffer significant damages.

OFG manages its credit risk through a comprehensive credit policy which we believe establishes sound underwriting standards by monitoring and evaluating loan portfolio quality, and by the constant assessment of reserves and loan concentrations. OFG also employs proactive collection and loss mitigation practices.

OFG may also encounter risk of default in relation to its securities portfolio. The securities held by OFG are mostly agency mortgage-backed securities. Thus, these instruments are guaranteed by mortgages, a U.S. government-sponsored entity, or the full faith and credit of the U.S. government.

OFG’s executive Credit Risk Team, composed of its Chief Operating Officer, Chief Risk and Compliance Officer, and other senior executives, has primary responsibility for setting strategies to achieve OFG’s credit risk goals and objectives. Those goals and objectives are set forth in OFG’s Credit Policy as approved by the Board.

Liquidity Risk

Liquidity risk is the risk of OFG not being able to generate sufficient cash from either assets or liabilities to meet obligations as they become due without incurring substantial losses. The Board has established a policy to manage this risk. OFG’s cash requirements principally consist of deposit withdrawals, contractual loan funding, repayment of borrowings as these mature, and funding of new and existing investments as required.

OFG’s business requires continuous access to various funding sources. While OFG is able to fund its operations through deposits as well as through advances from the FHLB and other alternative sources, OFG’s business may at times need to rely upon other external wholesale funding sources. OFG has selectively reduced its use of certain wholesale funding sources, such as repurchase agreements, subordinated notes and brokered deposits. As of June 30, 2022, OFG had $11.4 million in brokered deposits.

Brokered deposits are typically offered through an intermediary to small retail investors. OFG’s ability to continue to attract brokered deposits is subject to variability based upon a number of factors, including volume and volatility in the global securities markets, OFG’s credit rating, and the relative interest rates that it is prepared to pay for these liabilities. Brokered deposits are generally considered a less stable source of funding than core deposits obtained through retail bank branches. Investors in brokered deposits are generally more sensitive to interest rates and will generally move funds from one depository institution to another based on small differences in interest rates offered on deposits. As a result of the increase in core deposits, OFG has been limiting the offering of brokered deposits.

Commitments to extend credit are agreements to lend to customers as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates, bear variable interest rate and may require payment of a fee. Since the commitments may expire unexercised, the total commitment amounts do not necessarily represent future cash requirements. OFG evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by OFG upon extension of credit, is based on management’s credit evaluation of the customer. Loan commitments, which represent unused lines of credit, increased to $1.367 billion at June 30, 2022 ($248.0 million with maturity of one year or less and $1.119 billion with maturity over one year) compared to $1.365 billion at December 31, 2021 ($280.6 million with maturity of one year or less and $1.085 billion with maturity over one year), while letters of credit provided to customers increased to $28.7 million compared to $25.2 million at December 31, 2021. Loans sold with recourse at June 30, 2022 and December 31, 2021 amounted to $115.6 million and $121.8 million, respectively.

In the case of loans serviced by OFG for FNMA, OFG is required to advance to the owners the payment of principal and interest on a scheduled basis for six months even when such payment was not collected from the borrower due to payment forbearance granted or payment delinquency. Such amounts advanced are recorded as a receivable by OFG and are expected to be collected from the borrower and/or government agency (FNMA).

At June 30, 2022 and December 31, 2021, OFG maintained other non-credit commitments amounting to $21.8 million and $8.9 million, respectively, primarily for the acquisition of other investments. These cash requirements are expected to be satisfied with OFG’s unrestricted cash. In addition, as we continue to transform OFG with a focus on simplification and building a culture of excellence and customer service, we continue to invest in technology. Some of our technology investments are table stakes and required to continuously upgrade our systems. Others require us to focus our technology on investments that drive our strategy, namely digital, data analytics, cloud migration, cyber security, and our sales and service capabilities. At June 30, 2022 and December 31, 2021, OFG had commitments for capital expenditures in technology amounting to $8.9 million and $15.4 million, respectively, which are expected to be satisfied with OFG’s unrestricted cash.

Our liquidity risk management practices have allowed us to effectively manage the market stress that began in the first quarter of 2020 from the Covid-19 pandemic. Requests for loan payment deferrals rose in the second quarter of 2020. Nevertheless, most payment deferrals ended in the third quarter of 2020. Even though OFG’s liquidity was impacted by loan principal and interest payment deferrals that were granted for certain customers due to Covid-19, liquidity has been growing from the federal stimulus programs Puerto Rico is receiving following Hurricane Maria in 2017, the early 2020 earthquakes, and the Covid-19 pandemic. However, liquidity can be further affected by a number of factors such as, counterparty willingness or ability to extend credit, regulatory actions and customer preferences, some of which are beyond our control. With the current economic uncertainty resulting from the Covid-19 pandemic, inflation and the war in Ukraine, we continue monitoring our liquidity position, specifically cash on hand to meet customer demands.

Although OFG expects to have continued access to credit from the foregoing sources of funds, there can be no assurance that such financing sources will continue to be available or will be available on favorable terms. In a period of financial disruption or if negative developments occur with respect to OFG, the availability and cost of OFG’s funding sources could be adversely affected. In that event, OFG’s cost of funds may increase, thereby reducing its net interest income, or OFG may need to dispose of a portion of its investment portfolio, which depending upon market conditions, could result in realizing a loss or experiencing other adverse accounting consequences upon any such dispositions. OFG’s efforts to monitor and manage liquidity risk may not be successful to deal with dramatic or unanticipated changes in the global securities markets or other reductions in liquidity driven by OFG or market-related events. In the event that such sources of funds are reduced or eliminated and OFG is not able to replace these on a cost-effective basis, OFG may be forced to curtail or cease its loan origination business and treasury activities, which would have a material adverse effect on its operations and financial condition.

As of June 30, 2022, OFG had approximately $1.307 billion in unrestricted cash and cash equivalents, $1.476 billion in investment securities that are not pledged as collateral, and $605.6 million in borrowing capacity at the FHLB.

Operational Risk

Operational risk is the risk of loss from inadequate or failed internal processes, personnel and systems or from external events. All functions, products and services of OFG are susceptible to operational risk.

OFG faces ongoing and emerging risk and regulatory pressure related to the activities that surround the delivery of banking and financial products and services. Coupled with external influences such as the risk of natural disasters, market conditions, security risks, and legal risks, the potential for operational and reputational loss has increased. In order to mitigate and control operational risk, OFG has developed, and continues to enhance, specific internal controls, policies and procedures that are designed to identify and manage operational risk at appropriate levels throughout the organization. The purpose of these policies and procedures is to provide reasonable assurance that OFG’s business operations are functioning within established limits.

OFG classifies operational risk into two major categories: business specific and corporate-wide affecting all business lines. For business specific risks, a risk assessment group works with the various business units to ensure consistency in policies, processes and assessments. With respect to corporate-wide risks, such as information security, business recovery, legal and compliance, OFG has specialized groups, such as Information Security, Enterprise Risk Management, Corporate Compliance, Information Technology, Legal and Operations. These groups assist the lines of business in the development and implementation of risk management practices specific to the needs of the business groups. All these matters are reviewed and discussed in the executive Risk and Compliance Team and the executive Consumer Compliance Team. OFG also has a Business Continuity Plan to address situations where its capacity to perform critical functions is affected. Under such circumstances, a Crisis Management Team is activated to restore such critical functions within established timeframes.

OFG is subject to extensive United States federal and Puerto Rico regulations, and this regulatory scrutiny has been significantly increasing over the last several years. OFG has established and continues to enhance procedures based on legal and regulatory requirements that are reasonably designed to ensure compliance with all applicable statutory and regulatory requirements. OFG has a corporate compliance function headed by a Chief Risk and Compliance Officer who reports to the Chief Executive Officer and supervises the BSA Officer and Regulatory Compliance Officer. The Chief Risk and Compliance Officer is responsible for the oversight of regulatory compliance and implementation of a company-wide compliance program, including the Bank Secrecy Act/Anti-Money Laundering compliance program.

Concentration Risk

Most of OFG’s business activities and a significant portion of its credit exposure are concentrated in Puerto Rico. As a consequence, OFG’s profitability and financial condition may be adversely affected by an extended economic slowdown, adverse political, fiscal or economic developments in Puerto Rico, or the effects of a natural disaster, all of which could result in a reduction in loan originations, an increase in non-performing assets, an increase in foreclosure losses on mortgage loans, and a reduction in the value of its loans and loan servicing portfolio.

Disclosure Controls and Procedures

OFG’s management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation was carried out under the supervision and with the participation of OFG’s management, including the Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of OFG’s disclosure controls and procedures. Based upon such evaluation, the CEO and CFO have concluded that, as of the end of the period covered by this Quarterly Report on Form 10-Q, OFG’s disclosure controls and procedures provided reasonable assurance of effectiveness in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by OFG in the reports that it files or submits under the Securities Exchange Act of 1934. Notwithstanding the foregoing, a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that it will detect or uncover failures within OFG to disclose material information otherwise required to be set forth in OFG’s periodic reports.

Internal Control over Financial Reporting

There have not been any changes in OFG’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended June 30, 2022, that has materially affected, or is reasonably likely to materially affect, OFG’s internal control over financial reporting.

PART - II OTHER INFORMATION

Our 2021 Form 10-K and any subsequent Quarterly Reports on Form 10-Q describe market, credit, and business operations risk factors that could affect our businesses, results of operations or financial condition. On February 24, 2022, Russian forces launched significant military action against Ukraine, and sustained conflict and disruption in the region is ongoing. As these conditions and circumstances have evolved subsequent to our 2021 Form 10-K filing, the following supplements the risk factors described in our 2021 Form 10-K.

Terrorist attacks and armed conflicts of war may impact all aspects of our operations, revenues, costs and stock price.

The recent military actions taken by the Russian Federation against Ukraine, and the resulting geopolitical and macroeconomic uncertainty, are likely to have a significant negative impact on the European Union, the United Kingdom and other countries, including the United States. The expansion of this armed conflict beyond the borders of Ukraine and the escalation of tensions in Europe and elsewhere abroad may further exacerbate this negative impact, as well. The conflict between the Russian Federation and Ukraine has resulted in considerable volatility in the commodity markets, including through significant increases in the price of oil, natural gas and food, which have already occurred and are likely to continue putting additional inflationary pressures on central banks, including the FRB. We also expect that incremental interest rate hikes announced by the FRB will continue to occur throughout 2022, but the amount, timing, and frequency of such increases are not fully known at this time and could be impacted by the conflict between Russia and Ukraine. The risk of retaliatory actions by the Russian Federation, including through cyberattacks against financial institutions in the United States, is significant and could adversely affect the Bank and its customers. Additionally, the United States and European nations have imposed very significant financial sanctions on the Russian Republic, including targeted sanctions on Russian banks, state-owned enterprises and wealthy individuals, as well as taken measures to isolate the Russian economy, including through the halting of the certification of the Nord Stream 2 gas pipeline and the ban imposed on certain Russian banks from accessing the Society for Worldwide Interbank Financial Telecommunications system, or SWIFT. In response to the Russian military actions, many businesses headquartered in the Eurozone and the United States have altogether stopped doing business with Russia, which may negatively affect the profitability of those companies. The resulting international turmoil has already had and may continue to have a negative impact on the stock market generally and, in turn, on our stock price. The full impact of the recent actions by the Russian Federation regarding Ukraine are not known at this time, but they could result in economic disruption, heightened volatility in financial and commodity markets, and diminished consumer, business and investor confidence, among others, adversely impacting the financial services industry generally and our business, financial condition, results of operation, and stock price.