Stock Yards Bancorp, Inc.: Form 10-Q for the period ended Jun 30, 2021

The consolidated financial statements include the accounts of Stock Yards Bancorp, Inc. and its wholly owned subsidiaries, SYB and the Captive, collectively referred to as “Bancorp” or the “Company.” All significant inter-company transactions and accounts have been eliminated in consolidation.

Bancorp is a FHC headquartered in Louisville, Kentucky. Established in 1904, SYB is a state-chartered non-member financial institution that provides services in Louisville, central, eastern and northern Kentucky, as well as the Indianapolis, Indiana and Cincinnati, Ohio metropolitan markets through 63 full-service banking center locations. The captive is a Nevada-based, wholly-owned insurance subsidiary of the Company, which was retained in conjunction with the KB acquisition and will provide insurance coverage not currently provided by Bancorp’s commercial policies to Bancorp and SYB as well as a group of third-party insurance captives upon renewal of related policies during the third quarter of 2021.

This section presents management’s perspective on our financial condition and results of operations. Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the consolidated financial statements and accompanying footnotes presented in Part 1 Item 1 “Financial Statements” and other information appearing in Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020. To the extent that this discussion describes prior performance, the descriptions relate only to the periods listed, which may not be indicative of Bancorp’s future financial outcomes. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause results to differ materially from management’s expectations.

Cautionary Statement Regarding Forward-Looking Statements

This document contains statements relating to future results of Bancorp that are considered “forward-looking” as defined by Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The forward-looking statements are principally, but not exclusively, contained in Part I Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause actual results, performance, or achievements to be materially different from future results, performance, or achievements expressed or implied by the statement. These statements are often, but not always, made through the use of words or phrases such as “anticipate,” “believe,” “aim,” “can,” “conclude,” “continue,” “could,” “estimate,” “expect,” “foresee,” “goal,” “intend,” “may,” “might,” “outlook,” “possible,” “plan,” “predict,” “project,” “potential,” “seek,” “should,” “target,” “will,” “will likely,” “would,” or other similar expressions. These forward-looking statements are not historical facts and are based on current expectations, estimates and projections about our industry, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control. Forward-looking statements detail management’s expectations regarding the future and are based on information known to management only as of the date the statements are made and management undertakes no obligation to update forward-looking statements to reflect events or circumstances that occur after the date forward-looking statements are made, except as required by applicable law.

There is no assurance that any list of risks and uncertainties or risk factors is complete. Factors that could cause actual results to differ materially from those expressed or implied in forward-looking statements include, among other things:

• impact of COVID-19 on Bancorp’s business, including the impact of the actions taken by governmental authorities to try and contain the pandemic or address the impact of the pandemic on the U.S. economy (including, without limitation, the CARES Act and other relief efforts), and the resulting effect of all of such items on our operations, liquidity and capital position, and on the financial condition of Bancorp’s borrowers and other customers;
• changes in or forecasts of future political and economic conditions;
• accuracy of assumptions and estimates used in establishing the ACL on loans, ACL for off-balance sheet credit exposures and other estimates;
• impairment of investment securities, goodwill, MSRs, other intangible assets or DTAs;
• ability to effectively navigate an economic slowdown or other economic or market disruptions;
• changes in laws and regulations or the interpretation thereof;
• changes in fiscal, monetary, and/or regulatory policies;
• changes in tax polices including but not limited to changes in federal and state statutory rates;
• behavior of securities and capital markets, including changes in market volatility and liquidity;
• ability to effectively manage capital and liquidity;
• long-term and short-term interest rate fluctuations, as well as the shape of the U.S. Treasury yield curve;
• the magnitude and frequency of changes to the FFTR implemented by the Federal Open Market Committee of the FRB;
• competitive product and pricing pressures;
• projections of revenue, expenses, capital expenditures, losses, EPS, dividends, capital structure, etc.;
• descriptions of plans or objectives for future operations, products, or services;
• integration of acquired financial institutions;
• changes in the credit quality of Bancorp’s customers and counterparties, deteriorating asset quality and charge-off levels;
• changes in technology instituted by Bancorp, its counterparties or competitors;
• changes to or the effectiveness of Bancorp’s overall internal control environment;
• adequacy of Bancorp’s risk management framework, disclosure controls and procedures and internal control over financial reporting;
• changes in applicable accounting standards, including the introduction of new accounting standards;
• changes in investor sentiment or consumer/business spending or savings behavior;
• ability to appropriately address social, environmental and sustainability concerns that may arise from business activities;
• integration of acquired businesses or future acquisitions;
• occurrence of natural or man-made disasters or calamities, including health emergencies, the spread of infectious diseases, pandemics or outbreaks of hostilities, and Bancorp’s ability to deal effectively with disruptions caused by the foregoing;
• ability to maintain the security of its financial, accounting, technology, data processing and other operational systems and facilities;
• ability to withstand disruptions that may be caused by any failure of its operational systems or those of third parties;
• ability to effectively defend itself against cyberattacks or other attempts by unauthorized parties to access information of Bancorp or its customers or to disrupt systems; and
• other risks and uncertainties reported from time-to-time in Bancorp’s filings with the SEC, including Part I Item 1A “Risk Factors” of Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.

Bancorp executed a definitive Agreement and Plan of Merger (“agreement”), dated as of August 3, 2021, to acquire Commonwealth Bancshares, Inc. and its subsidiary Commonwealth Bank & Trust Company (collectively referred to as “Commonwealth”). This document also contains statements regarding the proposed acquisition transaction that are not statements of historical fact and are considered forward-looking statements within the criteria described above. These statements are likewise subject to various risks and uncertainties that may cause actual results and outcomes of the proposed transaction to differ, possibly materially, from the anticipated results or outcomes expressed or implied in these forward-looking statements. In addition to factors disclosed in reports filed by Bancorp with the SEC, risks and uncertainties for Bancorp, Commonwealth and the combined company include, but are not limited to: the possibility that some or all of the anticipated benefits of the proposed merger will not be realized or will not be realized within the expected time period; the risk that integration of Commonwealth’s operations with those of Bancorp will be materially delayed or will be more costly or difficult than expected; the parties’ inability to meet expectations regarding the timing, completion and accounting and tax treatments of the merger; the inability to complete the merger due to the failure of Commonwealth’s shareholders to adopt the merger agreement; the failure to satisfy other conditions to completion of the merger, including receipt of required regulatory and other approvals; the failure of the proposed transaction to close for any other reason; diversion of management's attention from ongoing business operations and opportunities due to the merger; the challenges of integrating and retaining key employees; the effect of the announcement of the merger on Bancorp’s, Commonwealth’s or the combined company’s respective customer and employee relationships and operating results; the possibility that the merger may be more expensive to complete than anticipated, including as a result of unexpected factors or events; dilution caused by Bancorp’s issuance of additional shares of common stock in connection with the merger; the magnitude and duration of the COVID-19 pandemic and its impact on the global economy and financial market conditions and the business, results of operations and financial condition of Bancorp, Commonwealth and the combined company; and general competitive, economic, political and market conditions and fluctuations.

Acquisition of Kentucky Banchares, Inc.

On May 31, 2021, Bancorp completed its acquisition of Kentucky Bancshares, Inc. and its wholly owned subsidiary, Kentucky Bank, collectively defined as “KB,” a commercial bank and trust company operating 19 branches throughout central and eastern Kentucky with approximately $1.3 billion in assets, $755 million in loans, $396 million in AFS debt securities and $1.0 billion in deposits at the time of acquisition. Kentucky Bancshares, Inc. was also the holding company for an insurance captive, which Bancorp acquired and retained. Bancorp acquired all outstanding common stock of Kentucky Bancshares, Inc. in a combined stock and cash transaction that resulted in total consideration paid to Kentucky Bancshares, Inc. shareholders of $233 million.

As a result of the completion of the acquisition, Bancorp recorded goodwill of $124 million and incurred pre-tax merger related expenses totaling $18.1 million and $18.5 million for the three and six months ended June 30, 2021, respectively. Net income from the Kentucky Bancshares, Inc. acquisition is expected to be accretive to Bancorp’s overall operating results beginning in 2022.

The acquisition of KB had a significant impact on the ACL and loan loss provisioning for the quarter ending June 30, 2021. The ACL on loans was also increased $6.8 million as a result of the PCD loan portfolio added as a result of the acquisition, with the corresponding offset recorded to goodwill (as opposed to provision expense). In addition, credit loss expense on loans associated with the acquired non-PCD loan portfolio totaled $7.4 million for both the three and six month periods ended June 30, 2021. In total, acquisition-related activity served to increase the ACL $14.2 million during the second quarter.

Pending Acquisition of Commonwealth Banchsares, Inc. and its Subsidiary Commonwealth Bank & Trust Company

Effective August 3, 2021, Bancorp executed a definitive Agreement and Plan of Merger (“agreement”), pursuant to which Bancorp will acquire all of the outstanding common stock of privately-owned Commonwealth Bancshares, Inc. (“Commonwealth”). Commonwealth Bancshares Inc., headquartered in Louisville, Kentucky, is the holding company for Commonwealth Bank & Trust Company (collectively referred to as “Commonwealth”), which operates 16 retail branches, including 10 in Jefferson County, four in Shelby County and two in northern Kentucky.

Under the terms of the Agreement, the Company will acquire all outstanding common stock in a combined stock and cash transaction, resulting in total consideration to Commonwealth’s shareholders of approximately $151 million. Bancorp will fund the cash payment portion of the acquisition through existing resources on-hand.

The acquisition is expected to close during the fourth quarter of 2021, subject to customary regulatory approval and completion of customary closing conditions. As of June 30, 2021, Commonwealth reported approximately $1.3 billion in assets, $733 million in loans, $1.1 billion in deposits and $86 million in tangible common equity. Commonwealth also maintains a Wealth Management and Trust Department with total assets under management of $2.6 billion at June 30, 2021. The combined franchise will serve customers through 78 branches with total assets of approximately $7.4 billion, $4.9 billion in gross loans, $6.4 billion in deposits and over $7.0 billion in trust assets under management.

Issued but Not Yet Effective Accounting Standards Updates

For disclosure regarding the impact to Bancorp’s financial statements of issued-but-not-yet-effective ASUs, see the footnote titled “Summary of Significant Accounting Policies” of Part I Item 1 “Financial Statements.”

Business Segment Overview

Bancorp is divided into two reportable segments: Commercial Banking and WM&T:

Commercial Banking provides a full range of loan and deposit products to individual consumers and businesses in all its markets through retail lending, mortgage banking, deposit services, online banking, mobile banking, private banking, commercial lending, treasury management services, merchant services, international banking, correspondent banking and other banking services. The Bank also offers securities brokerage services via its banking center network through an arrangement with a third party broker-dealer in the Commercial Banking segment.

WM&T provides investment management, financial & retirement planning and trust & estate services, as well as retirement plan management for businesses and corporations in all markets in which Bancorp operates. The magnitude of WM&T revenue distinguishes Bancorp from other community banks of similar asset size.

Overview – Impact of the COVID-19 Pandemic on Financial Condition and Results of Operations

The COVID-19 pandemic in the U.S. and efforts to contain both the virus and the related economic fallout have had a complex and significant impact on the economy, the banking industry and Bancorp. While the distribution of vaccinations, continued easing of restrictions on public commerce and business activities, and stabilizing unemployment levels have been positive developments in recent months, the impact of the pandemic upon Bancorp, the Bank and its customers remains uncertain.

Bancorp’s financial condition and results of operations for the three and six months ended June 30, 2021 have been significantly impacted by the following pandemic-related factors, among others:

• The sustained low interest rate environment and related NIM compression
• Significant participation in the SBA’s PPP
• Federal stimulus action for individuals, including stimulus checks and enhanced unemployment benefits, among many other factors
• Overall excess balance sheet liquidity
• The FRB’s Seasonally Adjusted National Civilian Unemployment Rate forecast and the resulting impact to the ACL on loans and off balance sheet credit exposures

The FRB’s decision to lower the FFTR 150 bps in March of 2020 in response to the pandemic lowered the FFTR to a range of 0%-0.25% and Prime to 3.25%, where both remained as of June 30, 2021. Consistent with the rate drops, key benchmark rates, such as the five-year treasury rate and one-month LIBOR, declined dramatically and generally remained low through the first and second quarters of 2021. While the interest rate environment has improved through the first half of 2021, key rates remain well below pre-pandemic levels.

Bancorp’s participation in the PPP has resulted in approximately 5,500 PPP loan originations totaling $887 million (net of unearned deferred fees and costs) since the program’s inception as part of the CARES Act, which was signed into law in March 2020. While the first round of PPP expired in August 2020, legislative action created a second round of funding for the program and subsequently extended the program to May 31, 2021.

As part of the first round of the PPP, Bancorp originated approximately 3,400 PPP loans totaling $637 million (net of unearned deferred fees and costs). As of June 30, 2021, 82% of the dollars originated in the first round have been forgiven and another 10% are in the process of being forgiven by the SBA. Further, approximately 95% of the $19.6 million in net fees received for this round have been recognized life to date. These borrowers are required to begin making payments in July, which will likely further accelerate forgiveness submissions for the remaining loans in coming months.

As part of the second round of the PPP, Bancorp originated over 2,100 PPP loans totaling $250 million (net of unearned deferred fees and costs). As of June 30, 2021, 3% of the dollars originated in the second round have been forgiven and 11% of the $11.4 million in net fees received for this round have been recognized life to date. As these borrowers are not required to make payments for 16 months, Bancorp expects a significant portion of these borrowers will seek forgiveness in early to mid-2022 in connection with their tax return preparation.

As of June 30, 2021, PPP loans originated by Kentucky Bank and acquired by Bancorp totaled $16 million.

Interest and fee income earned on the PPP portfolio totaled $6.9 million and $13.9 million for the three and six month periods ending June 30, 2021, respectively, representing increases of $3.5 million and $10.5 million over the same periods of the prior year. Forgiveness activity that accelerated the recognition of related fee income drove a $6.6 million, or 18%, and $9.2 million, or 13%, increase in total interest income for the three and six month periods ended June 30, 2021 compared to the same periods of 2020. As of June 30, 2021, Bancorp had $11.6 million of net unearned deferred fees that have yet to be recognized and as a result, PPP loan forgiveness will have a major impact on operating results for the remainder of 2021 and the first part of 2022.

As a result of the PPP originations, forgiveness activity, record deposit levels and historically low interest rates, excess liquidity has created NIM compression, as well as challenges associated with deploying idle cash. Bancorp has made substantial investment in the AFS debt securities portfolio over the past several months in an effort to deploy excess liquidity, however, prepayment activity within the MBS portfolio has made it challenging to grow the portfolio.

The ACL for loans (excluding acquisition related activity) was reduced $3.9 million between December 31, 2020 and June 30, 2021, a stark contrast from the $11.1 million reserve build recorded between December 31, 2019 and June 30, 2020, which were separate and subsequent to the increases recorded effective January 1, 2020 in relation to the initial adoption of CECL. The pandemic had a material impact on ACL calculations in 2020, as provisioning surged amidst changes in forecasted economic conditions, especially the FRB’s Seasonally Adjusted National Civilian Unemployment Rate. After peaking towards the middle of last year, unemployment forecasts have improved, as have other underlying CECL model factors, resulting in the provision reduction recorded during the first and second quarters of 2021.

While separate from the ACL on loans and recorded in other liabilities on the consolidated balance sheets, the ACL on off balance sheet credit exposures also experienced a decrease between December 31, 2020 and June 30, 2021. A net benefit of was recorded as provision for credit losses on off balance sheet exposures during the first half of 2021, as loss factors associated with the calculation similarly improved in recent months despite line of credit utilization, while improving some, remained at low levels. The ACL for off balance sheet credit exposures stood at $4.8 million as of June 30, 2021 compared to $5.4 million as of December 31, 2020.

Bancorp has not incurred any significant challenges to its ability to maintain its systems and controls in light of the measures taken to prevent the spread of COVID-19 and has not incurred significant resource constraints through the implementation of its business continuity plans and does not anticipate incurring such issues in the future. Bancorp has not made, and at this time does not expect to make, any material staffing or compensation changes as a result of the pandemic.

Overview – Operating Results (FTE)

The following table presents an overview of Bancorp’s financial performance for the three months ended June 30, 2021 and 2020:

(dollars in thousands, except per share data)

Additional discussion follows under the section titled “Results of Operations.”

General highlights for the three months ended June 30, 2021 compared to June 30, 2020:

• Bancorp completed its acquisition of Kentucky Bancshares, Inc. during the second quarter. At the time of acquisition, KB had approximately $1.3 billion in assets, $755 million in loans, $396 million in AFS debt securities and $1.0 billion in deposits.
• Net income totaled $4.2 million, resulting in diluted EPS of $0.17 for the three months ended June 30, 2021, a 71% decrease over $0.59 for the same period of 2020. Significant factors affecting the results for the three months ended June 30, 2021 and 2020 include:
• The acquisition of Kentucky Bancshares included $18.1 million in merger expenses and $7.4 million in purchase accounting adjustments (mainly provision expense) for the three months ended June 30, 2021.
• Total provision for credit losses was elevated for both the three months ended June 30, 2021 and 2020, respectively, albeit for different reasons. The adoption of CECL (ASC 326) effective January 1, 2020 and subsequent pandemic-related developments, such as elevated unemployment and historic declines in line of credit utilization amidst the evolving pandemic resulted in a total provision for credit losses of $7.0 million for the three months ended June 30, 2020. While a cumulative net benefit of $3.3 million was recorded for credit losses on loans and off balance sheet credit exposures during the three months ended June 30, 2021 as a result generally improving CECL model factors, including a substantially improved unemployment forecast, a provision of $7.4 million was recorded in relation to the acquisition of Kentucky Bancshares.
• Net interest income increased $8.1 million, or 24%, for the three months ended June 30, 2021 compared to the same period of 2020 as PPP forgiveness activity accelerated fee recognition and strong growth in the non-PPP loan portfolio, both organic and through acquisition, drove a $6.6 million, or 18%, increase in total interest income. Further, a $1.5 million, or 49%, decrease in interest expense was driven by the lowering of deposit rates in tandem with FRB interest rate actions to levels at or below those offered during the Great Recession , where the remained as of June 30 ,2021.
• NIM increased 9 bps to 3.36% for the three months ended June 30, 2021 compared to 3.27% for the same period in 2020 as a result of elevated PPP income associated with forgiveness activity and lowering deposit rates to levels at or below those offered during the Great Recession, where they remain as of June 30, 2021. Both periods reflected the full effects of the FRB lowering the FFTR to a range of 0%-0.25% and Prime to 3.25% last year, where both respectively remained as of June 30, 2021. The five-year treasury rate and one-month LIBOR tumbled in tandem with these cuts as well, and while the five-year treasury has staged a recovery over the first half of 2021, it remains well below pre-pandemic levels.
• Total loans (excluding PPP loans) increased $995 million, or 35%, compared to June 30, 2020, $726 million of which was attributed to the acquisition. Average loans (excluding PPP loans) increased $466 million, or 16%, for the three months ended June 30, 2021 compared to the same period in 2020, $232 million of which was attributed to the acquisition. While increases were experienced in most loan segments between June 30, 2020 and June 30, 2021, growth over the period was highlighted by the CRE and Residential Real Estate portfolios.
• Deposit balances have remained elevated for several quarters and finished at record levels as of June 30, 2021. PPP funding, multiple federal stimulus packages and general economic uncertainty surrounding the pandemic have led to customers holding higher levels of liquidity.
• Total non-interest income increased $3.2 million, or 25%, for the three month period ended June 30, 2021 compared to the same period of 2020. While the quarter benefitted from one month of activity related to the acquisition, which totaled approximately $1.3 million, record levels were experienced across most non-interest revenue streams, highlighted by growth in WM&T income and increases in card income and Treasury management fees.
• Non-interest expenses increased $24.8 million, or 106%, for the quarter ended June 30, 2021 compared to the same period of 2020, driven by merger expenses of $18.1 million and one month of activity related to the acquisition, totaling approximately $2.4 million. Further, growth in FTEs, increased technology-related expenses associated with expanded data storage and the hosted core system, as well as an early termination penalty relating to paying off FHLB advances during the quarter also contributed the increase over the three months ended June 30, 2020.

The following table presents an overview of Bancorp’s financial performance for the six months ended June 30, 2021 and 2020:

(dollars in thousands, except per share data)

General highlights for the six months ended June 30, 2021 compared to June 30, 2020:

• As noted in the section above, Bancorp’s acquisition of Kentucky Bancshares, Inc. was completed during the second quarter.
• Net income totaled $26.9 million, resulting in diluted EPS of $1.13 for the six months ended June 30, 2021, a 3% decrease over $1.17 for the same period of 2020. Significant factors affecting the results for the six months ended June 30, 2021 and 2020 include:
• The acquisition of Kentucky Bancshares included $18.5 million in merger expenses and $8.0 million purchase accounting adjustments (mainly provision expense) for the six months ended June 30, 2021.
• Total provision for credit losses was $2.7 million for the six months ended June 30, 2021, representing a $10.3 million, or 79%, decrease compared to the same period of 2020. The adoption of CECL (ASC 326) effective January 1, 2020 and subsequent pandemic-related developments, such as elevated unemployment and historic declines in line of credit utilization amidst the evolving pandemic drove elevated provisioning for the six months ended June 30, 2020. While a cumulative net benefit of $4.7 million was recorded for credit losses on loans and off balance sheet credit exposures during the six months ended June 30, 2021 as a result generally improving CECL model factors, including a substantially improved unemployment forecast, a provision of $7.4 million was recorded in relation to the acquisition of Kentucky Bancshares.
• Net interest income increased $13.4 million, or 20%, for the six months ended June 30, 2021 compared to the same period of 2020, as PPP forgiveness activity accelerated fee recognition and strong growth in the non-PPP loan portfolio, both organic and through acquisition, drove a $9.2 million, or 13%, increase in total interest income. Further, a $4.2 million, or 57%, decrease in interest expense was driven by the lowering of deposit rates in tandem with FRB interest rate actions to levels at or below those offered during the Great Recession, where the remained as of June 30 ,2021.
• NIM decreased 9 bps to 3.38% for the six months ended June 30, 2021 compared to 3.47% for the same period in 2020. Despite a $13.4 million, or 20%, increase in net interest income for the six months ended June 30, 2021 compared to the same period of 2020, which was driven largely by accelerated fee recognition associated PPP forgiveness activity, yields on earning assets have eroded consistent with the FRB lowering the FFTR a total of 150 bps in March 2020 in response to the pandemic. These rate drops drove the FFTR to a range of 0%-0.25% and Prime to 3.25%, where both respectively remained as of June 30, 2021. The five-year treasury rate and one-month LIBOR tumbled in tandem with these cuts as well, and while the five-year treasury has staged a recovery over the first six months of 2021, it remains well below pre-pandemic levels. Given the timing of the cuts, the full effects of the dramatically lower interest rate environment were not felt in the first quarter of last year, benefitting NIM for the six months ended June 30, 2020 compared to the same period of this year.
• Total loans (excluding PPP loans) increased $995 million, or 35%, compared to June 30, 2020, $726 million of which was attributed to the acquisition. Average loans (excluding PPP loans) increased $277 million, or 10%, for the six months ended June 30, 2021 compared to the same period in 2020, $117 million of which was attributed to the acquisition. While increases were experienced in most loan segments between June 30, 2020 and June 30, 2021, growth over the period was highlighted by the CRE and Residential Real Estate portfolios.
• Deposit balances have been elevated for several months and finished at record levels as of June 30, 2021. PPP funding, multiple federal stimulus packages and general economic uncertainty surrounding the pandemic have led to customers holding higher levels of liquidity.
• Total non-interest income increased $4.5 million, or 18%, for the six month period ended June 30, 2021 compared to the same period of 2020. Every non-interest income revenue stream experienced an increase over the prior year period, led most notably by WM&T income, card income and Treasury management fees. Non-interest income attributed to the acquisition totaled $1.3 million for the six months ended June 30, 2021, which represents one month of acquisition-related activity.
• Non-interest expenses increased $26.2 million, or 56%, for the six months ended June 30, 2021 compared to the same period of 2020. Merger expenses of $18.5 million drove the large increase along with additional acquisition-related non-interest expenses of $2.4 million, the latter of which represents one month of acquisition-related activity. Further, growth in FTEs, increased technology-related expenses associated with expanded data storage and the hosted core system, as well as an early termination penalty relating to paying off FHLB advances during six months ended June 30, 2021 also contributed the increase over the three months ended June 30, 2020.

Results of Operations

Net Interest Income - Overview

As is the case with most banks, Bancorp’s primary revenue sources are net interest income and fee income from various financial services provided to customers. Net interest income is the difference between interest income earned on loans, investment securities and other interest earning assets less interest expense on deposit accounts and other interest bearing liabilities. Loan volume and interest rates earned on those loans are critical to overall profitability. Similarly, deposit volume is crucial to funding loans and rates paid on deposits directly impact profitability. New business volume is influenced by economic factors including market interest rates, business spending, consumer confidence and competitive conditions within the marketplace.

Comparative information regarding net interest income follows:

(dollars in thousands)

(dollars in thousands)

NIM and net interest spread calculations above exclude the sold portion of certain participation loans. These sold loans are recorded on Bancorp’s balance sheet as required by GAAP because Bancorp retains some form of effective control; however, Bancorp receives no net interest income on the sold portion. These participation loans sold are excluded from analysis, as Bancorp believes it provides a more accurate depiction of the performance of its loan portfolio.

At June 30, 2021, Bancorp’s loan portfolio was composed of approximately 72% fixed and 28% variable rate loans, with the fixed rate portion pricing (excluding PPP loans) generally based on a spread to the five-year treasury curve at the time of origination and the variable portion pricing based on an on-going spread to Prime (approximately 56%) or one-month LIBOR (approximately 44%). Excluding PPP loans, Bancorp’s loan portfolio at June 30, 2021 was composed of approximately 69% fixed and 31% variable rate loans, respectively.

Benchmark rates such as the five-year treasury and one-month LIBOR currently remain well below pre-pandemic levels and as a result, the average interest rate environment experienced for the three and six month periods ended June 30, 2021 was substantially lower than that experienced for the same periods of 2020. The following table details the volatility experienced within the interest rate environment over the past twelve months by comparing period end and quarterly average rates:

With 56% of the variable rate loan portfolio tied to Prime and the majority with floor rates of 4.00%, short-term rates would have to increase over 75 bps for these loans to move above their floor rates given Prime is at 3.25% as of June 30, 2021. Beyond potential ongoing pricing pressure/competition and the absolute low level of rates, the current economic outlook and prospects of a sustained low-rate environment continues to pose challenges regarding potential ongoing NIM compression.

Net Interest Income (FTE) – Three months ended June 30, 2021 compared to June 30, 2020

Net interest spread and NIM were 3.29% and 3.36%, for the three months ended June 30, 2021 compared to 3.10% and 3.27% for the same period in 2020, respectively. NIM during the three months ended June 30, 2021 was significantly impacted by the following:

• A sustained low interest rate environment, driven by the lowering of the FFTR in mid-March 2020 to a range of 0% - 0.25%, which resulted in Prime dropping to 3.25%, where it remained as of June 30, 2021.
• PPP originations, which began in the second quarter of 2020 and continued through expiration of the program on May 31, 2021, as well as the related forgiveness activity, which accelerates the recognition of fee income on these loans and continues to have a significant effect on NIM. The PPP portfolio contributed a 20 bps benefit to NIM during the second quarter of 2021, as a result of the forgiveness-driven fee recognition. By comparison, the PPP portfolio had a negative impact of 11 bps on NIM for the second quarter of 2020 due to the large amount of originations that occurred over the three month period ended June 30, 2020 and the affect that these low-yielding, 1% stated rate notes had on NIM for that period.
• Overall excess balance sheet liquidity, which contributed approximately 18 bps of NIM compression for the three months ended June 30, 2021. By comparison, excess balance sheet liquidity contributed approximately 19 bps of NIM compression for the same period of 2020. Excess liquidity within the banking system in general has also led to a competitive loan rate environment.
• Substantial balance sheet growth, both organic and acquisition-related, which has resulted total average earning asset growth of $849 million, or 21%, and average interest-bearing liability growth of $527 million, or 20%, for the three months ended June 30, 2021 compared to the same period of 2020.
• The lowering of deposit rates in tandem with FRB interest rate actions and beyond to levels at or below rates offered during the Great Recession, where they remained as of June 30, 2021.

Net interest income increased $8.1 million, or 24%, for the three months ended June 30, 2021 compared to the same period of 2020, due to interest and fee income associated with the PPP portfolio, substantial growth in the non-PPP loan portfolio and AFS debt securities portfolio, and the aforementioned lowering of deposit rates.

Total average interest earning assets increased $849 million, or 21%, to $5.0 billion for the three months ended June 30, 2021, as compared to the same period of 2020, with the average rate earned on total interest earning assets contracting 8 bps to 3.48%.

• Average loan balances increased $448 million, or 13%, for the three months ended June 30, 2021 compared to the same period of 2020, $232 million of which was attributed to the acquisition, the remainder being driven by strong organic growth. Average non-PPP loan growth of $466 million, or 16%, was partially offset by $18 million, or 3%, of contraction in the PPP portfolio for the three months ended June 30, 2021 compared to the same period of 2020, as forgiveness activity increased.
• Average AFS debt securities grew $381 million, or 92%, for the three months ended June 30, 2021 compared to the same period of 2020, $84 million of which was attributed to the acquisition, as cash was deployed into AFS debt securities in an effort to invest excess liquidity.

Total interest income increased $6.6 million, or 18%, to $43.2 million for the three months ended June 30, 2021, as compared to the same period of 2020.

• Interest and fee income on loans increased $6.0 million, or 18%, to $40.2 million and the yield on the total loan portfolio increased 15 bps to 4.19% for the three months ended June 30, 2021 compared to the same period of 2020, attributed largely to fee income associated with the PPP portfolio. While average balances on the non-PPP loan portfolio grew substantially and interest income on the non-PPP loan portfolio increased $2.5 million, or 8%, for the three months ended June 30, 2021 compared to the same period of 2020, the yield on the non-PPP loan portfolio decreased 31 bps to 4.00% as a result of the substantially lower interest rate environment.
• Despite significant growth in average AFS debt securities and a $676 million increase interest income on the portfolio for the three months ended June 30, 2021 compared to the same period of 2020, the lower interest rate environment experienced over the past twelve months weighed heavily on fixed income security yields, which decreased 67 bps, or 32%.

Total average interest bearing liabilities increased $527 million, or 20%, to $3.1 billion for the three month period ended June 30, 2021 compared with the same period in 2020, with the total average cost declining 27 bps to 0.19%.

• Average interest bearing deposits increased $555 million, or 22%, for the three months ended June 30, 2021 compared to the same period in 2020, with interest-bearing demand deposits accounting for $347 million of the increase. Interest bearing deposits added as a result of the KB acquisition drove $232 million of the increase along with continued federal stimulus action, such as PPP funding, which has propelled deposit balances to record levels over the past 12 months. Further, general economic uncertainty surrounding the pandemic has resulted in the customer base maintaining higher levels of liquidity, similar to customer behavior seen during the Great Recession.
• Consistent with the higher interest bearing deposit balances noted above, average SSUAR balances increased $14 million, or 34%, for the three months ended June 30, 2021 compared to the same period of 2020. SSUAR balances added as a result of the KB acquisition accounted for $4 million of the increase.
• Average FHLB advances decreased $45 million, or 70%, for the three months ended June 30, 2021 compared to the same period of 2020, as advances have continued to mature without renewal or replacement, including a $20 million three month advance relating to a cash flow hedge interest rate swap. In addition, Bancorp elected to pay down certain advances during the first quarter of 2021 prior to maturity without incurring pre-payment penalties. During the second quarter of 2021, Bancorp chose to payoff $14 million of term advances, with a weighted average cost of 2.03%, prior to their maturity incurring an early-termination fee of $474,000, recorded as a component non-interest expense. Bancorp made this decision due to its excess liquidity driven by the substantial deposit growth it achieved over the past 12 months, combined with the near-term outlook for low interest rates.

Total interest expense decreased $1.5 million, or 49%, for the three months ended June 30, 2021 compared to the same period of 2020, a direct result of deposit rate reductions implemented in response to the falling interest rate environment and to a lesser extent, the reduction in interest expense on FHLB advances.

• Total interest bearing deposit expense decreased $1.2 million, or 45%, driving a 23 bps decrease in the cost of average total interest bearing deposits.
• Interest expense on FHLB advances declined $287,000, or 80%, as a result of the substantial reduction in average FHLB advances outstanding.

Net Interest Income (FTE) – Six months ended June 30, 2021 compared to June 30, 2020

Net interest spread and NIM were 3.30% and 3.38%, for the six months ended June 30, 2021 compared to 3.27% and 3.47% for the same period in 2020, respectively. NIM during the six months ended June 30, 2021 was significantly impacted by the following:

• A sustained low interest rate environment, driven by the lowering of the FFTR in mid-March 2020 to a range of 0% - 0.25%, which resulted in Prime dropping to 3.25%, where it remained as of June 30, 2021.
• PPP originations, which began in the second quarter of 2020 and continued through expiration of the program on May 31, 2021, as well as the related forgiveness activity, which accelerates the recognition of fee income on these loans and continues to have a significant effect on NIM. The PPP portfolio contributed a 22 bps benefit to NIM for the six months ended June 30, 2021 as a result of the forgiveness-driven fee recognition. In comparison, the PPP portfolio had a negative impact of 7 bps on NIM for the six months ended June 30, 2020 due to the large amount of originations that occurred during the second quarter of 2020 and the affect that these low-yielding, 1% stated rate notes had on NIM for the period.
• Overall excess balance sheet liquidity, which contributed approximately 16 bps of NIM compression for the six months ended June 30, 2021. By comparison, excess balance sheet liquidity contributed approximately 13 bps of NIM compression for the same period of 2020. Excess liquidity within the banking system in general has led to a competitive loan rate environment.
• Substantial balance sheet growth, both organic and acquisition-related, which has resulted total average earning asset growth of $928 million, or 24%, and average costing liability growth of $498 million, or 20%, for the six months ended June 30, 2021 compared to the same period of 2020.
• The lowering of deposit rates in tandem with FRB interest rate actions and beyond to levels at or below rates offered during the Great Recession, where they remained as of June 30, 2021.

Net interest income increased $13.5 million, or 20%, for the six months ended June 30, 2021 compared to the same period of 2020, due to interest and fee income associated with the PPP portfolio, substantial growth in the non-PPP loan portfolio and AFS debt securities portfolio, and the aforementioned lowering of deposit rates.

Total average interest earning assets increased $928 million, or 24%, to $4.8 billion for the six months ended June 30, 2021, as compared to the same period of 2020, with the average rate earned on total interest earning assets contracting 35 bps to 3.51%.

• Average loans increased $582 million, or 18%, for the six months ended June 30, 2021 compared to the same period of 2020. While the bulk of the increase was driven by the addition of the PPP portfolio, the acquisition and strong organic growth also contributed significantly to the increase. Average non-PPP loan balances grew $277 million, or 10%, for the six months ended June 30, 2021 compared to the same period of 2020, $117 million of which was attributed to the acquisition, the remaining increase being the result of the aforementioned organic growth.
• Average AFS debt securities grew $298 million, or 69%, for the six months ended June 30, 2021 compared to the same period of 2020. The vast majority of this increase was attributed to strategic efforts to deploy excess liquidity through AFS debt security purchases, while $33 million of the increase was attributed to the acquisition.

Total interest income increased $9.3 million, or 13%, to $82.7 million for the six months ended June 30, 2021, as compared to the same period of 2020.

• Interest and fee income on loans increased $9.3 million, or 14%, to $77.2 million for the six months ended June 30, 2021 compared to the same period of 2020, driven mainly by income associated with the PPP portfolio, as forgiveness activity accelerated the recognition of the related fee income. While average balances on the non-PPP loan portfolio grew substantially, interest income on the non-PPP loan portfolio decreased $1.3 million, or 2%, for the six months ended June 30, 2021 compared to the same period of 2020, dragging on the yield of the total loan portfolio, which experienced a 16 bps, or 4%, contraction.
• Despite significant growth in average AFS debt securities and a $530,000 increase interest income on the portfolio for the six months ended June 30, 2021 compared to the same period of 2020, the lower interest rate environment experienced over the past twelve months weighed heavily on fixed income security yields, which decreased 73 bps, or 34%.

Total average interest bearing liabilities increased $498 million, or 20%, to $3.0 billion for the six month period ended June 30, 2021 compared with the same period in 2020, with the total average cost declining 38 bps to 0.21%.

• Average interest bearing deposits increased $528 million, or 22%, for the six months ended June 30, 2021 compared to the same period in 2020, with interest-bearing demand deposits accounting for $365 million of the increase. Interest bearing deposits added as a result of the KB acquisition accounted for $112 million of the increase along with continued federal stimulus action, such as PPP funding, which has propelled deposit balances to record levels over the past 12 months. Further, general economic uncertainty surrounding the pandemic has resulted in the customer base maintaining higher levels of liquidity, similar to customer behavior seen during the Great Recession.
• Consistent with the higher interest bearing deposit balances noted above, average SSUAR balances increased $13.9 million, or 37%, for the six months ended June 30, 2021 compared to the same period of 2020. SSUAR added as a result of the KB acquisition drove $1.5 million of the increase.
• Average FHLB advances decreased $45 million, or 65%, for the six months ended June 30, 2021 compared to the same period of 2020, as advances have continued to mature without renewal or replacement, including a $20 million three month advance relating to a cash flow hedge interest rate swap. In addition, Bancorp elected to pay down certain advances during the first quarter of 2021 prior to maturity without incurring pre-payment penalties. During the second quarter of 2021, Bancorp chose to payoff $14 million of term advances, with a weighted average cost of 2.03%, prior to their maturity incurring an early-termination fee of $474,000, recorded as a component non-interest expense. Bancorp made this decision due to its excess liquidity driven by the substantial deposit growth it achieved over the past 12 months, combined with the near-term outlook for low interest rates.

Total interest expense decreased $4.2 million, or 57%, for the six months ended June 30, 2021 compared to the same period of 2020, a direct result of deposit rate reductions implemented in response to the falling interest rate environment and to a lesser extent, the reduction in interest expense on FHLB advances.

• Total interest bearing deposit expense decreased $3.6 million, or 55%, driving a 35 bps decrease in the cost of average total interest bearing deposits.
• Interest expense on FHLB advances declined $540,000, or 68%, as a result of the substantial reduction in average FHLB advances outstanding.

Average Balance Sheets and Interest Rates (FTE) – Three-Month Comparison

(dollars in thousands)

76

Average Balance Sheets and Interest Rates (FTE) – Six Month Comparison

(dollars in thousands)

77

Supplemental Information - Average Balance Sheets and Interest Rates (FTE)

• Average loan balances include the principal balance of non-accrual loans, as well as unearned income such as loan premiums, discounts, fees/costs and exclude participation loans accounted for as secured borrowings. Participation loans averaged $5 million and $9 million for the three month periods ended June 30, 2021 and 2020, respectively, and $7 million and $8 million for the six month periods ended June 30, 2021 and 2020, respectively.
• Interest income on a FTE basis includes additional amounts of interest income that would have been earned if investments in certain tax-exempt interest earning assets had been made in assets subject to federal taxes yielding the same after-tax income. Interest income on municipal securities and tax-exempt loans has been calculated on a FTE basis using a federal income tax rate of 21%. Approximate tax equivalent adjustments to interest income were $77,000 and $45,000 for the three month periods ended June 30, 2021 and 2020, respectively, and $126,000 and $92,000 for the six month periods ended June 30, 2021 and 2020, respectively.
• Interest income includes loan fees of $6.2 million ($5.6 million associated with the PPP) and $2.4 million ($2.1 million associated with the PPP) for the three month periods ended June 30, 2021 and 2020, respectively, and $12.2 million ($11.1 million associated with the PPP) and $2.8 million ($2.1 million associated with the PPP) for the six month periods ended June 30, 2021 and 2020, respectively. Interest income on loans may be impacted by the level of prepayment fees collected and accretion related to purchased loans.
• Net interest income, the most significant component of Bancorp's earnings, represents total interest income less total interest expense. The level of net interest income is determined by mix and volume of interest earning assets, interest bearing deposits and borrowed funds, and changes in interest rates.
• NIM represents net interest income on a FTE basis as a percentage of total average interest earning assets.
• Net interest spread (FTE) is the difference between taxable equivalent rates earned on total interest earning assets less the cost of interest bearing liabilities.
• The fair market value adjustment on investment securities resulting from ASC 320, “Investments – Debt and Equity Securities” is included as a component of other assets.

Asset/Liability Management and Interest Rate Risk

Managing interest rate risk is fundamental for the financial services industry. The primary objective of interest rate risk management is to neutralize effects of interest rate changes on net income. By considering both on and off-balance sheet financial instruments, management evaluates interest rate sensitivity with the goal of optimizing net interest income within the constraints of prudent capital adequacy, liquidity needs, market opportunities and customer requirements.

Interest Rate Simulation Sensitivity Analysis

Bancorp uses an earnings simulation model to estimate and evaluate the impact of an immediate change in interest rates on earnings in a one-year forecast. The simulation model is designed to reflect dynamics of interest earning assets and interest bearing liabilities. By estimating effects of interest rate fluctuations, the model can approximate interest rate risk exposure. This simulation model is used by management to gauge approximate results given a specific change in interest rates at a given point in time. The model is therefore a tool to indicate earnings trends in given interest rate scenarios and may not indicate actual or expected results.

Bancorp’s interest rate simulation sensitivity analysis details that increases in interest rates of 100 and 200 bps would have a negative effect on interest income, respectively. These results are attributed to over half of the variable rate loan portfolio being currently at or near floor rates, as these yields will not increase until short-term rates exceed these floor rates. For example, a significant portion of the variable rate loan portfolio is tied to Prime, with floor rates of 4.00%. Given Prime is at 3.25% as of June 30, 2021, short-term rates would have to increase over 75 bps for these loans to move above their floor rates.

The slight decrease in net interest income in the rising rate scenarios is primarily due to variable rate loans and short-term investments repricing slower than deposits and short-term borrowings. Asset balances subject to immediate repricing cause an estimated decline in net interest income in the down 100 bps scenario, as rates on non-maturity deposits cannot be lowered sufficiently to offset declining interest income. These estimates are summarized below.

Bancorp’s loan portfolio is currently composed of approximately 72% fixed and 28% variable rate loans, with the fixed rate portion pricing (excluding PPP loans) generally based on a spread to the five-year treasury curve at the time of origination and the variable portion pricing based on an on-going spread to Prime (approximately 56%) or one-month LIBOR (approximately 44%). Bancorp’s loan portfolio (excluding PPP loans) at June 30, 2021 was composed of approximately 69% fixed and 31% variable rate loans with the fluctuation in the C&I portfolio driving down variable rate percentage over the past year.

Periodically, Bancorp enters into interest rate swap transactions with borrowers who desire to hedge exposure to rising interest rates, while at the same time entering into an offsetting interest rate swap, with substantially matching terms, with another approved independent counterparty. These are undesignated derivative instruments and are recognized on the balance sheet at fair value, with changes in fair value recorded in other non-interest income as interest rates fluctuate. Because of matching terms of offsetting contracts, in addition to collateral provisions which mitigate the impact of non-performance risk, changes in fair value subsequent to initial recognition have a minimal effect on earnings, and are therefore not included in the simulation analysis results above. For additional information, see the footnote titled “Assets and Liabilities Measured and Reported at Fair Value.”

In addition, Bancorp uses derivative financial instruments as part of its interest rate risk management, including interest rate swaps. These interest rate swaps are designated as cash flow hedges as described in the footnote titled “Derivative Financial Instruments.” For these derivatives, the effective portion of gains or losses is reported as a component of OCI, and is subsequently reclassified into earnings as an adjustment to interest expense in periods in which the hedged forecasted transaction impacts earnings.

Provision for Credit Losses

An analysis of the changes in the ACL on loans, including provision, and selected ratios follow:

(dollars in thousands)

(1) Ratios are not annualized

(2) See the section titled “Non-GAAP Financial Measures” for reconcilement of Non-GAAP to GAAP measures

The ACL on loans totaled $59 million as of June 30, 2021 compared to $52 million at December 31, 2020, representing an ACL to total loans ratio of 1.41% and 1.47% for those periods, respectively. The ACL to total loans (excluding PPP loans) was 1.55% at June 30, 2021 compared to 1.74% at December 31, 2020. Based on the 100% SBA guarantee of the PPP loan portfolio, which totaled $377 million (net of unamortized deferred fees) at June 30, 2021 and $550 million at December 31, 2020, Bancorp did not reserve generally for potential losses for these loans within the ACL. See the section titled “Non-GAAP Financial Measures” for reconcilement of non-GAAP to GAAP measures.

Upon adoption of ASC 326 effective January 1, 2020, Bancorp recorded an increase of $8.2 million to the ACL on loans and a corresponding decrease to retained earnings, net of the DTA impact. In addition, non-accretable yield marks of $1.6 million related to formerly classified PCI loans were reclassed between the amortized cost basis of loans and corresponding ACL, which were subsequently charged-off in the third quarter of 2020 with no resulting impact to provision expense. The adjustment upon adoption of ASC 326 raised the ACL on loans balance to $37 million on January 1, 2020.

Provision for credit losses on loans totaled $4.7 million and $3.5 million for the three and six month periods ended June 30, 2021, respectively, representing decreases of $853,000, or 15%, and $7.6 million, or 68%, compared to the same periods of 2020. Due to continued improvement in the unemployment forecast, updates to Bancorp’s CECL modeling and strong historic credit metrics, benefits of $2.7 million and $3.9 million were recorded for the three and six month periods ended June 30, 2021. Offsetting these improvements however, was credit loss expense on loans associated with the non-PCD loan portfolio added as a result of the KB acquisition, which totaled $7.4 million for both the three and six month periods ended June 30, 2021. While the acquisition drove provision for credit loss expense on loans for the three and six month periods ended June 30, 2021, higher expense recorded for the same periods of 2020 stemmed from the adoption of CECL effective January 1, 2020 and the subsequent pandemic-related developments experienced in the first half of last year, including elevated unemployment.

Provision for credit losses on loans at June 30, 2021 represents the amount of expense that, based on Management’s judgment, is required to maintain the ACL on loans at an appropriate level under the CECL model. The determination of the amount of the ACL on loans is complex and involves a high degree of judgment and subjectivity. See the footnote titled “Basis of Presentation and Summary of Significant Accounting Policies” for detailed discussion regarding Bancorp’s ACL methodology by loan segment in this document and Bancorp’s Annual Report on Form 10-K for the year ended December 31, 2020.

In addition to loan provisioning recorded through the first six months of 2021, the ACL on loans was also increased $6.8 million as a result of the PCD loan portfolio added through the KB acquisition, with the corresponding offset recorded to goodwill (as opposed to provision expense). Partially offsetting these increases were net charge offs totaling $2.7 million for both the three and six month periods ended June 30, 2021, which served to decrease the overall ACL on loans. Net charge offs for the period were driven by the charge off of $3.1 million relating to a CRE relationship that was fully reserved for in 2020 (and thus had no 2021 income statement impact) and partially offset by a $555,000 recovery on a note acquired in the 2019 KSB acquisition that had been fully allocated for in 2019 and charged off in 2020.

While separate from the ACL on loans and recorded in other liabilities on the consolidated balance sheets, the ACL on off balance sheet credit exposures experienced a decrease between December 31, 2020 and June 30, 2021. Net benefits were recorded for the three and six month periods ended June 30, 2021, respectively, as nearly all applicable loan segments experienced declines in their reserve loss percentage consistent with generally improving model factors and improvement in line of credit utilization was experienced during the second quarter of 2021. The ACL for off balance sheet credit exposures stood at $4.8 million as of June 30, 2021 compared to $5.4 million as of December 31, 2020.

Bancorp’s loan portfolio is diversified with no significant concentrations of credit. Geographically, most loans are extended to borrowers in Louisville, central, eastern and northern Kentucky, as well as the Indianapolis and Cincinnati metropolitan markets. The adequacy of the allowance is monitored on an ongoing basis and it is the opinion of management that the balance of the allowance at June 30, 2021 is adequate to absorb probable losses inherent in the loan portfolio as of the financial statement date.

Non-interest Income

(dollars in thousands)

Total non-interest income increased $3.2 million, or 25%, and $4.5 million, or 18%, for the three and six month periods ended June 30, 2021 compared to the same periods of 2020, respectively. Non-interest income comprised 27.5% and 27.2% of total revenues, defined as net interest income and non-interest income, for the three and six month periods ended June 30, 2021 compared to 27.3% and 27.6% for the same periods of 2020, respectively. WM&T services comprised 43.4% and 44.2% of total non-interest income for the three and six month periods ended June 30, 2021 compared to 45.4% and 47.5% for the same periods of 2020, respectively. The KB acquisition added $1.3 million in total non-interest income for the three and six month periods ended June 30, 2021.

WM&T Services:

The magnitude of WM&T revenue distinguishes Bancorp from other community banks of similar asset size. WM&T revenue increased $1.1 million, or 20%, and $1.2 million, or 10%, for the three and six month periods ended June 30, 2021, as compared with the same periods of 2020, respectively. The stock market appreciation noted above, coupled with new business development, drove the substantial revenue increases for these periods. WM&T income of $122,000 was recorded in relation to the KB acquisition for the three and six month periods ended June 30, 2021.

Recurring fees earned for managing accounts are based on a percentage of market value of AUM and are typically assessed on a monthly basis. Recurring fees, which generally comprise the vast majority of WM&T revenue, increased $1.1 million, or 19% and $1.5 million, or 14% for the three and six month periods ended June 30, 2021, as compared with the same periods of 2020. The increases for the three and six month periods stem from significant stock market appreciation experienced in addition to both organic and acquisition-related growth in net new business.

A portion of WM&T revenue, most notably executor, insurance and some employee benefit plan-related fees, are non-recurring in nature and the timing of these revenues corresponds with the related administrative activities. For this reason, such fees are subject to greater period over period fluctuation. Total non-recurring fees increased $37,000, or 37%, and decreased 372,000, or 56%, for the three and six month periods ended June 30, 2021, as compared with the same periods of 2020. The increase for the three month period is attributed to estate fees recorded during the second quarter of 2021, while the large decrease for the six month period was driven by a large estate fee recorded in the first quarter of 2020.

AUM, stated at market value, totaled $4.4 billion at June 30, 2021compared with $3.2 billion at June 30, 2020 and $3.9 billion at December 31, 2020. The large increase in AUM between June 30, 2020 and June 30, 2021 is attributed mainly to significant stock market appreciation experienced in addition to growth in net new business and AUM of $235 million added through the KB acquisition.

Contracts between WM&T and their customers do not permit performance based fees and accordingly, none of the WM&T revenue is performance based. Management believes the WM&T department will continue to factor significantly in Bancorp’s financial results and provide strategic diversity to revenue streams.

Detail of WM&T Service Income by Account Type:

(in thousands)

The preceding table demonstrates that WM&T fee revenue is concentrated within investment advisory and personal trust accounts. WM&T fees are predominantly based on AUM and tailored for individual/company accounts and/or relationships with fee structures customized based on account type and other factors with larger relationships paying a lower percentage of AUM in fees. For example, recurring AUM fee structures are in place for investment management, irrevocable trusts, revocable trusts, personal investment retirement accounts and accounts holding only fixed income securities. Company retirement plan services can consist of a one-time conversion fee with recurring AUM fees to follow. While there are also fee structures for estate settlements, income received is often non-recurring in nature. Fee structures are agreed upon at the time of account opening and any subsequent revisions are communicated in writing to the customer. Fees earned are not performance-based nor are they based on investment strategy or transactions.

Assets Under Management by Account Type:

AUM (not included on balance sheet) increased from $3.9 billion at December 31, 2020 to $4.4 billion at June 30, 2021 as follows:

(in thousands)

(1) Non-managed assets represent those for which the WM&T department does not hold investment discretion.

As of both June 30, 2021 and December 31, 2020, approximately 80%, respectively, of AUM were actively managed. Company retirement plan accounts primarily consist of participant-directed assets. The amount of custody and safekeeping accounts are insignificant.

Managed Trust Assets under Management by Class of Investment:

(in thousands)

(1) Includes client directed instruments including rights, warrants, annuities, insurance policies, unit investment trusts, and oil and gas rights.

Managed assets are invested in instruments for which market values can be readily determined, the majority of which are sensitive to market fluctuations and consist of approximately 68% in equities and 32% in fixed income securities as of June 30, 2021 compared to 64% and 36% as of December 31, 2020. This composition is relatively consistent from period to period and the WM&T Department holds no proprietary mutual funds.

Additional Sources of Non-interest income:

Deposit service charges, which consist of non-sufficient funds charges and to a lesser extent, other activity based charges, increased $433,000, or 54%, and $94,000, or 5%, for the three and six month periods ended June 30, 2021, as compared with the same periods of 2020, respectively. Deposit service charge income of $260,000 was added for the three and six month periods ended June 30, 2021 as a result of the KB acquisition. Consistent with the industry, customer behavior and transaction volume have been impacted by the pandemic and continued government efforts to minimize its impact on the economy, such as stimulus payments, PPP funding and more lucrative unemployment compensation. Deposit balances have remained at or near record levels for several months as a result, which has in turn led to fewer overdrawn accounts. These trends have significantly exacerbated the industry-wide decline in the volume of fees earned on overdrawn checking accounts experienced over the past several years. While Bancorp has experienced notable improvement since first experiencing significant pandemic-related declines in transaction volume in April 2020, Management is not able to predict when, or if, this revenue stream will return to pre-pandemic levels.

Debit and credit card income consists of interchange revenue, ancillary fees and incentives received from card processors. Debit and credit card revenue increased $1.2 million, or 59%, and $1.5 million, or 37%, for the three and six month periods ended June 30, 2021, as compared with the same periods of 2020, as a result of increased transaction volume and continued expansion of the customer bases. In addition, debit and credit card revenue totaling $415,000 was added for the three and six month periods ended June 30, 2021 as a result of the KB acquisition. Total debit card income increased $839,000, or 55%, and $1.1 million, or 38%, and total credit card income increased $382,000, or 71%, and $447,000, or 37%, for the three and six month periods ended June 30, 2021 compared the same periods of the prior year.

Treasury management fees primarily consist of fees earned for cash management services provided to commercial customers. This category continues to stand out as a consistent, growing source of revenue for Bancorp and increased $481,000, or 39%, and $737,000, or 29%, for the three and six month periods ending June 30, 2021, as compared with the same periods of 2020, respectively. New product sales and expansion of its customer base have helped Bancorp’s Treasury Management department overcome challenges presented by the pandemic. Demand for Bancorp’s treasury products has increased during the pandemic, as these products allow customers to operate more efficiently in a decentralized environment. In addition, sales efforts involving existing customers has led to increases in online services, reporting, ACH origination, remote deposit and fraud mitigation services during the first half of 2021. Bancorp anticipates this income category will continue to increase based on continued customer base growth and the expanding suite of services offered within Bancorp’s treasury management platform. Treasury management income associated with the KB acquisition was immaterial for the three and six month periods ended June 30, 2021.

Mortgage banking income primarily includes gains on sales of mortgage loans and loan servicing income offset by MSR amortization. Bancorp’s mortgage banking department predominantly originates residential mortgage loans to be sold in the secondary market, primarily to FNMA. Interest rates on the mortgage loans sold are locked with the borrower and investor prior to loan closing, thus Bancorp bears no interest rate risk related to loans held for sale. Bancorp offers conventional, VA and FHA financing for purchases and refinances, as well as programs for first-time homebuyers. Interest rates on mortgage loans directly influence the volume of business transacted by the mortgage-banking department. Mortgage banking revenue decreased $319,000, or 20%, and increased $279,000, or 11%, for the three and six month periods ended June 30, 2021, as compared with the same periods of 2020, respectively. Mortgage banking revenue of $262,000 was added for the three and six month periods ended June 30, 2021 as a result of the KB acquisition.

Sustained low long-term rates have incentivized refinancing and purchasing activity, which has resulted in elevated mortgage banking income over the past year. Including the gain on sale earned, Bancorp sold $56 million and $142 million loans during the three and six month periods ending June 30, 2021 compared to $65 million and $97 million for the same periods of 2020, respectively. Bancorp expects volume to normalize over time, as the pool of potential customers who have yet to refinance shrinks and interest rates rise above the absolute low levels experienced over the past year.

Beginning in the fourth quarter of 2020, the Bank elected to retain a select portion of FNMA qualified secondary market single family residential real estate loan production from the mortgage banking department on balance sheet in an effort to deploy a portion of excess liquidity in lieu of buying mortgage-backed securities within the AFS debt securities portfolio. Continuing into 2021, approximately $53 million in 15 and 30 year fixed rate loans yielding approximately 2.88% were retained in the first six months of 2021 as part of this strategy, forgoing approximately $1.9 million in gain on sale that would typically have been recognized in Mortgage banking income.

Net investment product sales commissions and fees are generated primarily on stock, bond and mutual fund sales, as well as wrap fees on brokerage accounts. Wrap fees represent charges for investment programs that bundle together a suite of services, such as brokerage, advisory, research and management and are based on a percentage of assets. Bancorp deploys its financial advisors primarily through its branch network via an arrangement with a third party broker-dealer, while larger managed accounts are serviced by Bancorp’s WM&T Department. Net investment product sales commissions and fees increased $154,000, or 39%, and $152,000, or 18%, for the three and six month periods ended June 30, 2021, as compared with the same periods of 2020, respectively. Net investment product sales commissions and fees associated with the KB acquisition totaled $59,000 for the three and six month periods ended June 30, 2021.

BOLI assets represent the cash surrender value of life insurance policies on certain key employees who have provided consent for Bancorp to be the beneficiary for a portion of such policies. The related change in cash surrender value and any death benefits received under the policies are recorded as non-interest income. This income serves to offset the cost of various employee benefits. BOLI income increased $30,000, or 17%, and $12,000, or 3%, for the three and six month periods ending June 30, 2021 compared to the same periods of the prior year. BOLI income associated with the KB acquisition totaled $42,000 for the three and six month periods ended June 30, 2021.

Other non-interest income increased $34,000, or 6%, and $524,000, or 60%, for the three and six month periods ended June 30, 2021 as compared with the same periods of 2020, respectively. Other non-interest income associated with the KB acquisition totaled $72,000 for the three and six month periods ended June 30, 2021. While the increase for the three month period was driven by acquisition-related activity, the large increase for the six month period was driven by large swap fees received during the first quarter and appreciation in the value of certain life insurance policies outside of the traditional BOLI program.

Non-interest Expenses

(dollars in thousands)

Total non-interest expenses increased $24.8 million and $26.2 million for the three and six month periods ended June 30, 2021 compared to the same periods of 2020, respectively. Compensation and employee benefits comprised 39.5% and 48.0% of Bancorp’s total non-interest expenses for the three and six month periods ended June 30, 2021, compared to 62.5% and 63.9% for the same periods of 2020, respectively. Excluding merger expenses, compensation and employee benefits comprised 63.3% and 64.3% of total non-interest expenses for the three and six month periods ended June 30, 2021. On-going non-interest expense totaling $2.3 million were added for the three and six month periods ended June 30, 2021 as a result of the KB acquisition (excluding merger expenses).

Compensation, which includes salaries, incentives, bonuses and stock based compensation, increased $3.9 million, or 33%, and $4.5 million, or 19%, for the three and six month periods ended June 30, 2021, as compared with the same periods of 2020, respectively. The increases were attributed to growth in full time equivalent employees, annual merit-based salary increases and higher incentive compensation expense. Further, a large reduction of expense totaling $510,000 was recorded in the second quarter of 2020 stemming from the deferred costs associated with PPP loan originations. Net full time equivalent employees totaled 823 at June 30, 2021 compared to 641 at December 31, 2020 and 620 at June 30, 2020, the large increase compared to prior periods being attributed to the addition of 189 FTEs as a result of the KB acquisition. Compensation expense totaling $973,000 was recorded for the three and six month periods ended June 30, 2021 as a result of the acquisition.

Employee benefits consists of all personnel-related expense not included in compensation, with the most significant items being health insurance, payroll taxes and employee retirement plan contributions. Employee benefits increased $496,000 or 17%, and $590,000, or 10%, for the three and six month periods ended June 30, 2021, as compared with the same periods of 2020, consistent with the overall increase in full time equivalent employees noted above. Employee benefits expense totaling $209,000 was recorded in relation to the KB acquisition.

Net occupancy and equipment expenses primarily include depreciation, rent, property taxes, utilities and maintenance. Costs of capital asset additions flow through the statement of income over the lives of the assets in the form of depreciation expense. Net occupancy increased $207,000, or 10%, and $421,000, or 11%, for the three and six month periods ended June 30, 2021, as compared with the same periods of 2020, respectively. Net occupancy and equipment expense related to the KB acquisition totaled $229,000 for the three and six month periods ended June 30, 2021 and resulted in the addition of 19 locations throughout central and eastern Kentucky. The increase for the three month period was directly attributed to the acquisition, while the increase for the six month period was attributed to the acquisition in addition to a favorable lease accounting system forecast adjustment that resulted in a credit to expense in the first quarter of last year and organic branch expansion in the latter half of 2020.

Technology and communication expenses include computer software amortization, equipment depreciation and expenditures related to investments in technology needed to maintain and improve the quality of customer delivery channels, information security and internal resources. Technology expense increased $671,000, or 34%, and $954,000, or 23%, for the three and six month periods ended June 30, 2021, as compared with the same periods of 2020, consistent with expanded data storage and increased expense associated with the transition to a hosted core environment, which Bancorp migrated to in the third quarter of 2020. Additional expense of $307,000 was recorded as a result of the KB acquisition for the three and six month periods ended June 30, 2021.

Bancorp outsources processing for debit and commercial credit card operations, which generate significant revenue for the Company. These expenses fluctuate consistent with transaction volumes. Debit and credit card processing expense increased $373,000, or 62%, and $422,000, or 34%, for the three and six month periods ending June 30, 2021 compared to the same period of last year, correlating in part with the increase in transaction volume and customer base expansion that served to increase debit and credit card non-interest income. Related expense associated with the KB acquisition totaled $217,000 for the three and six month periods ended June 30, 2021.

Marketing and business development expenses include all costs associated with promoting Bancorp including community support, retaining customers and acquiring new business. Marketing and business development expenses increased $357,000, or 77%, and $321,000, or 31%, for the three and six month periods ending June 30, 2021, as compared to the same periods of 2020. The increases correspond with more physical customer interaction as a result of continued easing of pandemic-related restrictions, which has led to increased travel and entertainment expense compared to the first half of 2020. Marketing and business development expense associated with the KB acquisition totaled $51,000 for the three and six months ended June 30, 2021.

Legal and professional fees increased $38,000, or 6%, and decreased $123,000, or 10%, for the three and six month periods ended June 30, 2021 compared to the same periods of last year, respectively. Legal and professional expenses attributable to the KB acquisition were included in merger expenses (discussed below) for the three and six months ended June 30, 2021.

FDIC insurance increased $19,000, or 6%, and $295,000, or 64%, for the three and six month periods ended June 30, 2021, as compared to the same period of 2020. Total FDIC insurance expense related to the KB acquisition totaled $30,000 for the three and six month periods ended June 30, 2021. While the three month period increase was attributed largely to the acquisition, the six month period increase was driven by both a PPP-driven larger balance sheet in addition to the first quarter of 2020 benefitting from the last portion of small institution credits first issued by the FDIC in 2019 upon the national FDIC Reserve Ratio reaching its targeted level.

Tax credit partnerships generate federal income tax credits, and for each of Bancorp’s investments in tax credit partnerships, the tax benefit, net of related expenses, results in a positive effect on net income. Amounts of credits and corresponding expenses can vary widely depending upon the timing and magnitude of the underlying investments. Amortization expense associated with these investments increased $178,000, or 336%, and $173,000, or 194%, for the three and six month periods ending June 30, 2021 compared to the same period of last year. No tax credit amortization was recorded in relation to the KB acquisition of the three and six month periods ended June 30, 2021.

Capital and deposit based taxes decreased $698,000, or 57%, and $1.3 million, or 56%, for the three and six month periods ended June 30, 2021 compared to the same periods of 2020 consistent with the state of Kentucky transitioning financial institutions from a capital-based franchise tax to the Kentucky corporate income tax effective January 1, 2021. Capital and deposit based tax expense related to the KB acquisition was immaterial for the three and six month periods ended June 30, 2021.

Merger expenses represent non-recurring expenses associated with completion of the KB acquisition and consist primarily of investment banker fees, various compensation-related expenses, legal fees, early termination fees relating to various contracts and system conversion expenses. Merger expenses totaled $18.1 million and $18.5 million for the three and six month periods ended June 30, 2021.

An early termination fee of $474,000 was recorded during the second quarter of 2021 in relation to the pre-payment of FHLB advances totaling $14 million prior to their respective contractual maturities. Bancorp chose to payoff these term advances, with a weighted average cost of 2.03%, due to its excess liquidity driven by the substantial deposit growth it achieved over the past 12 months, combined with the near-term outlook for low interest rates.

Other non-interest expenses increased $618,000, or 62%, and $912,000, or 51%, for the three and six month periods ended June 30, 2021, as compared to the same periods of 2020. These increases are attributed mainly to large credits to expense associated with a gain on a bank-owned property sold in the first quarter of 2020 and the reversal of an accrual in the second quarter of 2020 related to a potential IRS penalty that was ultimately dismissed. Other non-interest expense related to the KB acquisition totaled $223,000 for the three and six month periods ended June 30, 2021.

Income Tax Expense

A comparison of income tax expense and ETR follows:

(dollars in thousands)

Fluctuations in the ETR are primarily attributed to the following:

• Bancorp invests in certain partnerships that yield federal income tax credits. Taken as a whole, the tax benefit of these investments exceeds amortization expense, resulting in a positive impact on net income. The timing and magnitude of these transactions may vary widely from period to period. The ETR for 2020 included the anticipated full year benefit of a large historic tax credit project that was completed in December of last year, serving to reduce the ETR by 5.9% for the six months ended June 30, 2020.
• The stock based compensation component of the ETR fluctuates consistent with the level of SAR exercise activity. The six months ended June 30, 2021 reflected significantly more exercise activity as compared to the same period of 2020, serving to reduce the overall ETR by 3.2%.
• The state of Kentucky passed legislation in 2019 that required financial institutions to transition from a capital based franchise tax to the Kentucky corporate income tax beginning in 2021 and allows entities filing a combined Kentucky income tax return to share certain tax attributes, including net operating loss carryforwards. These changes served to increase the ETR 3.1% for the six months ended June 30, 2021.
• The Captive is anticipated to lower Bancorp’s ETR by approximately 1% on a 12 month basis.

Financial Condition – June 30, 2021 Compared to December 31, 2020

Overview

Total assets increased $1.5 billion, or 32%, to $6.1 billion at June 30, 2021 from $4.6 billion at December 31, 2020. Total assets of $1.3 billion were added as a result of the KB acquisition, including total loans of $755 million and total AFS debt securities of $396 million. In addition, goodwill of $124 million was recorded in relation to the transaction. Further, total loans (excluding loans added through the acquisition and the PPP portfolio) grew $122 million between December 31, 2020 and June 30, 2021.

Total liabilities increased $1.3 billion, or 30%, to $5.4 billion at June 30, 2021 from $4.2 billion at December 31, 2020. Total liabilities of $1.2 billion were assumed as a result of the KB acquisition, including total deposits of $1.0 billion. Excluding deposits assumed through the acquisition, deposit balances remained at record levels as of June 30, 2021, as federal stimulus efforts have bolstered personal and commercial deposits and uncertainty surrounding the pandemic has resulted in Bancorp’s customer base maintaining higher balances in general over the past several months.

Cash and Cash Equivalents

Cash and cash equivalents increased $222 million, or 70%, ending at $540 million at June 30, 2021 compared to $318 million at December 31, 2020. The average balance of cash and cash equivalents increased $55 million, or 20%, over the past twelve months. Bancorp continues to maintain higher levels of liquidity attributable to the PPP, growth in deposits and the overall interest rate environment.

AFS Debt Securities

AFS debt securities increased $420 million, or 72%, to $1.0 billion at June 30, 2021 compared to $587 million at December 31, 2020. AFS debt securities totaling $396 million were added as a result of the KB acquisition, approximately $91 million of which were sold shortly after acquisition. In addition, Bancorp continued actively growing the investment securities portfolio during the first six months of 2021 in an effort to deploy a portion of excess liquidity, a strategy enacted in the latter half of 2020, by purchasing $202 million of AFS debt securities for the six months ended June 30, 2021. Partially offsetting growth associated with purchasing activity was scheduled amortization and elevated prepayment activity, largely within the MBS portfolio, as well as market depreciation stemming largely from an upward move in the interest rate environment experienced over the first half of 2021.

Premises and Equipment

Premises and equipment are presented on the consolidated balance sheets net of related depreciation on the respective assets as well as fair value adjustments associated with purchase accounting. As result of the KB acquisition, which added 19 locations throughout central and eastern Kentucky, premises and equipment increased $20 million, or 34%, to $78 million at June 30, 2021 from $58 million at December 31, 2020.

Goodwill

At June 30, 2021, Bancorp had $137 million in goodwill recorded on its balance sheet, including $124 million recorded during the second quarter of 2021 associated with the acquisition of KB. As permitted under GAAP, management has up to 12 months following the date of acquisition to finalize the fair values of the acquired assets and assumed liabilities related to the KB acquisition. During this measurement period, Bancorp may record subsequent adjustments to goodwill for provisional amounts recorded at the acquisition date.

BOLI

Bank-owned life insurance assets increased $19 million, or 58%, to $52 million at June 30, 2021, compared to $33 million at December 31, 2020, the increase stemming directly from life insurance assets added as a result of the KB acquisition.

Other Assets and Other Liabilities

Other assets increased $16 million, or 22%, to $87 million at June 30, 2021. Other liabilities increased $4 million, or 4%, to $91 million at June 30, 2021, from $88 million at December 31, 2020.

The increase for other assets was attributed mainly to appreciation in the market value of interest rate swaps, MSR assets added as a result of the KB acquisition, additional investment in tax credit partnerships and increased pre-paid expenses associated with technological equipment and services. The increase for other liabilities was marginal between December 31, 2020 and June 30, 2021.

As of June 30, 2021, Bancorp did not incur any impairment with respect to its other intangible assets (MSRs and CDIs) or other long-lived assets.

Loans

Composition of loans, net of deferred fees and costs, by primary loan portfolio class follows:

(dollars in thousands)

(1) Total loans are presented inclusive of premiums, discounts, and net loan origination fees and costs.

Composition of loans, net of deferred fees and costs, by primary loan portfolio class and bifurcated between Bancorp’s historic loan portfolio and the loan portfolio acquired through the KB acquisition follows:

(dollars in thousands)

(1) Total loans are presented inclusive of premiums, discounts, and net loan origination fees and costs.

Total loans increased $675 million, or 19%, from December 31, 2020 to June 30, 2021. Loans totaling $755 million were added as a result of the KB acquisition, with outstanding acquired loan balances ending at $742 million as of June 30, 2021, resulting largely from forgiveness activity in the acquired PPP portfolio.

Excluding the loan portfolio acquired through the KB acquisition, loan contraction of $68 million, or 2%, was experienced between December 31, 2020 and June 30, 2021, as significant forgiveness activity resulted in PPP portfolio balances declining $189 million, or 34%, during the first six months of 2021. Partially offsetting the large decline in PPP balances was growth $110 million, or 8%, and $35 million, or 9%, within the CRE and residential real estate portfolios, respectively. Solid loan production for the first six months of 2021 drove the increase for the CRE portfolio, while the strategic retention of a portion of qualified secondary market single family residential real estate loan production from the mortgage banking department drove the increase for the residential real estate portfolio.

While showing some improvement at the end of the second quarter, line of credit usage remained depressed through the first six months of 2021, as the availability of the more favorable PPP lending facility continued to disparage utilization until the program expired on May 31, 2021. Overall, total line of credit usage did increase to 39.2% at June 30, 2021 compared to 38.0% at December 31, 2020 and 38.6% at June 30, 2020, but usage remains well below historical norms, particularly within the C&I portfolio. C&I line of credit usage

PPP loans of $377 million ($389 million gross of unamortized deferred fees and costs) were outstanding at June 30, 2021, including $17 million ($16 million gross of unamortized deferred fees and costs) added as a result of the KB acquisition. Bancorp has $11.6 million in net unrecognized fees related to the PPP as of June 30, 2021, which would be recognized immediately once the loans are paid off or forgiven by the SBA. The timing of such forgiveness is expected to have a major impact on operating results for the remainder of 2021 and into early to mid-2022.

Bancorp originated $637 million PPP loans ($657 million gross of unamortized fees and costs) as part of round one of the program, which expired in August of 2020. As of June 30, 2021, 82% of the dollars originated in round one have been forgiven and $54 million is in process of being forgiven (equating to future total forgiveness of 92%). In addition, approximately 95% of the $19.6 million in fee income received for round one originations has been recognized life to date. These borrowers are required to begin making payments in July, which will likely further accelerate forgiveness submissions in the coming months.

Bancorp originated $250 million ($261 million gross of unamortized deferred fees and costs) as part of round two of the PPP program, which expired May 31, 2021. As of June 30, 2021, 3% of the dollars originated have been forgiven and 11% of the fees received for the second round of the program have been recognized life to date. As second round borrowers are not required to make payments for 16 months, it is probable that a significant portion of the borrowing base will seek forgiveness in early to mid-2022 in connection with tax return preparation.

In accordance with Section 4013 of the CARES Act and in response to requests from borrowers who experienced business interruptions related to the pandemic, Bancorp extended payment deferrals for those affected borrowers. Depending on the demonstrated need of the customer, Bancorp deferred either the full loan payment or the principal-only portion of respective loan payments for 90 or 180 days for some borrowers directly impacted by the pandemic. As of June 30, 2021 outstanding full payment loan deferrals totaled $8 million, representing 0.21% of the loan portfolio (excluding PPP loans), down from $37 million, or 1.24% of total loans (excluding PPP loans), at December 31, 2020.

Bancorp’s credit exposure is diversified with secured and unsecured loans to individuals and businesses. No specific industry concentration exceeds 10% of loans outstanding. While Bancorp has a diversified loan portfolio, a customer’s ability to honor contracts is somewhat dependent upon the economic stability and/or industry in which that customer does business. Loans outstanding and related unfunded commitments are primarily concentrated within Bancorp’s current market areas, which encompass Louisville, Kentucky, central and eastern Kentucky, Indianapolis, Indiana and Cincinnati, Ohio.

Bancorp occasionally enters into loan participation agreements with other banks to diversify credit risk. For certain participation loans sold, Bancorp has retained effective control of the loans, typically by restricting the participating institutions from pledging or selling their ownership share of the loan without permission from Bancorp. GAAP requires the participated portion of these loans to be recorded as secured borrowings. These participated loans are included in the C&I and CRE loan portfolio segments with a corresponding liability recorded in other liabilities. At June 30, 2021 and December 31, 2020, the total participated portion of loans of this nature totaled $5 million and $10 million, respectively.

Non-performing Loans and Non-performing Assets

Information summarizing non-performing loans and assets follows:

(dollars in thousands)

See the section titled “Non-GAAP Financial Measures” for reconcilement of non-GAAP to GAAP measures.

In total, non-performing assets as of June 30, 2021 were comprised of 63 loans, ranging in individual amounts up to $7 million, one accruing TDR loan and foreclosed real estate held for sale. Foreclosed real estate held at June 30, 2021 included five residential real estate properties. Non-performing assets totaling $3.4 million were added as a result of the KB acquisition, including foreclosed real estate held for sale of $580,000.

The following table presents the recorded investment in non-accrual loans by portfolio:

(in thousands)

As of June 30, 2021, non-accrual loans totaled $12.8 million, including $2.8 million added as a result of the KB acquisition. Excluding non-accrual loans added as a result of the acquisition, total non-accrual loans decreased $2.5 million between December 31, 2020 and June 30, 2021 as a result of the partial charge off of a large non-accrual CRE relationship that was fully reserved for in 2020 (and thus had no income statement impact for 2021).

The following table presents the amortized cost basis of non-performing loans and the amortized cost basis of loans on non-accrual status for which there were no related ACL losses:

(in thousands)

The increase in non-performing and non-accrual loans for which there were no related ACL losses stemmed from the partial charge off of the large non-accrual CRE relationship noted above, which was fully reserved for in 2020. The remaining balance of the loan no longer has an associated reserve.

Delinquent Loans

Delinquent loans (consisting of all loans 30 days or more past due) totaled $18 million at June 30, 2021 compared to $17 million at December 31, 2020, including $5 million of delinquent loans added as a result of the KB acquisition. Delinquent loans to total loans were 0.42% and 0.48% at June 30, 2021 and December 31, 2020, respectively. Delinquent loans to total loans (excluding PPP loans) were 0.47% at June 30, 2021 compared to 0.57% at December 31, 2020.

Allowance for Credit Losses

The ACL on loans is a valuation allowance for loans estimated at each balance sheet date in accordance with GAAP. When Bancorp deems all or a portion of a loan to be uncollectible, the appropriate amount is written off and the ACL is reduced by the same amount. Subsequent recoveries, if any, are credited to the ACL when received. See the footnote titled “Summary of Significant Accounting Policies” for discussion of Bancorp’s ACL methodology on loans. Allocations of the ACL may be made for specific loans, but the entire ACL on loans is available for any loan that, in Bancorp’s judgment, should be charged-off.

The following table sets forth the ACL by category of loan:

(dollars in thousands)

(2) Excludes the PPP loan portfolio, which was not reserved for based on the underlying 100% SBA guarantee. The allowance allocated for the commercial & industrial –term segment includes $813,000 related to PCD PPP loans.

Bancorp’s ACL on loans was $59 million as of June 30, 2021 compared to $52 million as of December 31, 2020. The change in the ACL on loans was driven by a number of competing factors, which resulted in the $7.5 million, or 14%, increase experienced for the first six months of 2021. Acquisition-related activity was responsible for a total increase to the ACL on loans of $14 million, comprised of a $7 million day one adjustment for specific reserves placed on acquired PCD loans (offset to goodwill) and $7 million of provision expense related to the remaining acquired non-PCD loan portfolio. Partially offsetting the acquisition-related increases was a net reduction of the ACL on loans of $3.9 million for the first six months of 2021 stemming from a normalized unemployment forecast and general improvement in other underlying CECL model factors compared to recent periods. Further reducing the ACL on loans, net charge offs of $2.7 million for the period were driven by the charge off of $3.1 million relating to a CRE relationship that was fully reserved for in 2020 (and thus had no 2021 income statement impact), which was partially offset by a $555,000 recovery on a note acquired in the 2019 KSB acquisition that had been charged off in 2020.

The FRB’s Seasonally Adjusted National Civilian Unemployment Rate is the primary loss driver within Bancorp’s CECL model and has steadily improved over the past several months after spiking to 14.8% in April of 2020, standing at 5.9% as of June 30, 2021. The pandemic has had a material impact on Bancorp’s quarterly ACL on loans calculations. While Bancorp has not yet experienced credit quality issues resulting in charge-offs related to the pandemic, the ACL on loans calculation and resulting credit loss expense is significantly impacted by changes in forecasted economic conditions. Should the forecast for economic conditions worsen, Bancorp could experience further increases in its required ACL on loans and record additional credit loss expense. While the execution of payment deferrals under the CARES ACT has assisted credit quality ratios, it is possible that asset quality could worsen at future measurement periods if the effects of the pandemic are prolonged.

While separate from the ACL on loans and recorded in other liabilities on the consolidated balance sheets, the ACL for off balance sheet credit exposures also experienced a decrease between December 31, 2020 and June 30, 2021. A net benefit was recorded for provision for credit losses on off balance sheet exposures during the first six months of 2021, as nearly all applicable loan segments experienced declines in their reserve loss percentage consistent with generally improving model factors and improvement in line of credit utilization was experienced during the second quarter of 2021. The ACL for off balance sheet credit exposures stood at $4.8 million as of June 30, 2021 compared to $5.4 million as of December 31, 2020.

Deposits

(dollars in thousands)

(1) Includes $49 million and $25 million in brokered deposits as of June 30, 2021 and December 31, 2020, respectively.

Composition of deposits, bifurcated between Bancorp’s historic deposit portfolio and the deposit portfolio acquired through the KB acquisition follows:

(dollars in thousands)

Total deposits increased $1.3 billion, or 32%, from December 31, 2020 to June 30, 2021. Deposits totaling $1.0 billion were assumed as a result of the KB acquisition. Excluding the deposits acquired through the KB acquisition, deposits grew $251 million, or 6%, during the first six months of 2021, with non-interest bearing balances representing $203 million of the increase. Average deposit balances have increased $908 million, or 27%, over the past 12 months, as federal programs such as the PPP, stimulus checks and enhanced unemployment benefits drove both ending and average deposit balances to record levels as of June 30, 2021 in addition to deposits added as a result of the acquisition, which contributed $112 million of the increase.

Securities Sold Under Agreements to Repurchase

SSUARs are collateralized by securities and are treated as financings; accordingly, the securities involved with the agreements are recorded as assets and are held by a safekeeping agent and the obligations to repurchase the securities are reflected as liabilities. All securities underlying the agreements are under the Bank’s control. The majority of SSUARs are indexed to immediately repricing indices such as the FFTR.

SSUARs totaled $64 million and $48 million at June 30, 2021 and December 31, 2020, respectively, as SSUAR totaling $11 million were assumed as part of the KB acquisition. The remaining increase in SSUAR is consistent with the general trend of customers maintaining elevated deposit balances.

FHLB Advances

FHLB advances decreased $22 million, or 68%, between December 31, 2020 and June 30, 2021 due to maturing advances not being renewed or replaced in addition to elective pay offs. During the first quarter of 2021, $4 million advances were paid off prior to maturity without penalty. During the second quarter of 2021, Bancorp paid off $14 million of term advances, with a weighted average cost of 2.03%, prior to their maturity incurring an early-termination fee of $474,000. Bancorp based this decision on its excess liquidity position driven by the substantial deposit growth it achieved during 2020 and the first half of 2021, combined with the then near-term outlook for low interest rates. Bancorp believes it will substantially “earn back” the early termination penalty through lower interest expense over the next two years assuming short-term interest rates remain at current low levels.

As a result of the KB acquisition, FHLB advances totaling $91 million were assumed and paid off immediately upon acquisition based on lack of necessity and current levels of excess liquidity. Early termination penalties totaling $2.5 million were incurred as a result of the payoffs, but had no income statement impact for the three and six month periods ended June 30, 2021 due to the fair value adjustment recorded through goodwill at acquisition.

Liquidity

The role of liquidity management is to ensure funds are available to meet depositors’ withdrawal and borrowers’ credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in supply of those funds. Liquidity is provided by short-term assets that can be converted to cash, AFS debt securities, various lines of credit available to Bancorp, and the ability to attract funds from external sources, principally deposits. Management believes it has the ability to increase deposits at any time by offering rates slightly higher than market rate.

Bancorp’s Asset/Liability Committee is comprised of senior management and has direct oversight responsibility for Bancorp’s liquidity position and profile. A combination of reports provided to management details internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, and exposure to contingent draws on Bancorp’s liquidity.

Bancorp’s most liquid assets are comprised of cash and due from banks, FFS and AFS debt securities. FFS and interest bearing deposits totaled $482 million and $275 million at June 30, 2021 and December 31, 2020, respectively. The large increase in FFS and interest bearing deposits experienced over the first six months of 2021 is attributed largely to PPP forgiveness activity, as cash received for the forgiveness of these notes has outpaced efforts to invest cash through the typical avenues, such as loan production and AFS debt security purchases. FFS normally have overnight maturities while interest-bearing deposits in banks are accessible on demand. These investments are used for general daily liquidity purposes.

The fair value of the AFS debt security portfolio was $1.0 billion and $587 million at June 30, 2021 and December 31, 2020, respectively. The $420 million, or 72%, increase experienced over the first six months of 2021 is attributed to the KB acquisition and the strategic, aggressive growth of portfolio through security purchases in an effort to deploy excess liquidity. The portfolio includes maturities of $35 million and cash flows on amortizing AFS debt securities of approximately $218 million (based on assumed prepayment speeds as of June 30, 2021) expected over the next twelve months. Combined with FFS and interest bearing deposits from banks, AFS debt securities offer substantial resources to meet either loan growth or reductions in Bancorp’s deposit funding base. Bancorp pledges portions of its investment securities portfolio to secure public funds, cash balances of certain WM&T accounts and SSUAR. At June 30, 2021, total investment securities pledged for these purposes comprised 67% of the AFS debt securities portfolio, leaving approximately $331 million of unpledged AFS debt securities.

Bancorp has a large base of core customer deposits, defined as time deposits less than or equal to $250,000, demand, savings, money market deposit accounts and excludes brokered deposits. At June 30, 2021, such deposits totaled $5.1 billion and represented 97% of Bancorp’s total deposits, as compared with $3.9 billion, or 98% of total deposits at December 31, 2020. Because these core deposits are less volatile and are often tied to other products of Bancorp through long lasting relationships, they do not place undue pressure on liquidity. However, many of Bancorp’s individual depositors are currently maintaining historically high balances. These excess balances may be more sensitive to market rates, with potential decreases possibly straining Bancorp’s liquidity position.

As of June 30, 2021 and December 31, 2020, Bancorp held brokered deposits totaling $49 million and $25 million, respectively, the increase resulting from brokered deposits added as a result of the KB acquisition.

Included in total deposit balances at June 30, 2021 are $535 million in public funds generally comprised of accounts with local government agencies and public school districts in the markets in which Bancorp operates, including public funds deposits totaling $187 million added as a result of the KB acquisition. Bancorp consider these to be long-term relationships.

Bancorp is a member of the FHLB of Cincinnati. As a member of the FHLB, Bancorp has access to credit products of the FHLB. Bancorp views these borrowings as a potential low cost alternative to brokered deposits. At June 30, 2021 and December 31, 2020, available credit from the FHLB totaled $875 million and $804 million, respectively. The increase in available credit over the first six months of 2021 is due to increases in both eligible loans (those pledged for collateral-based borrowing capacity), the eligibility factor used by FHLB (used to calculate collateral-based borrowing capacity) and the payoff of advances prior to maturity during the first half of 2021. See the footnote titled “FHLB Advances” for additional detail. Additionally, Bancorp had unsecured available FFP lines with correspondent banks totaling $80 million at both June 30, 2021 and December 31, 2020.

During the normal course of business, Bancorp enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through Bancorp’s various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of Bancorp’s liquidity.

Bancorp’s principal source of cash revenue is dividends paid to it as the sole shareholder of the Bank. As discussed in the footnote titled “Commitments and Contingent Liabilities,” as of January 1st of any year, the Bank may pay dividends in an amount equal to the Bank’s net income of the prior two years less any dividends paid for the same two years. At June 30, 2021, the Bank could pay an amount equal to $21 million in dividends to Bancorp without regulatory approval subject to ongoing capital requirements of the Bank.

Sources and Uses of Cash

Cash flow is provided primarily through financing activities of Bancorp, which include raising deposits and borrowing funds from institutional sources such as advances from FHLB and FFP, as well as scheduled loan repayments and cash flows from AFS debt securities. These funds are primarily used to facilitate investment activities of Bancorp, which include making loans and purchasing securities for the investment portfolio. Another important source of cash is net income of the Bank from operating activities. For further detail regarding the sources and uses of cash, see the “Consolidated Statements of Cash Flows” in Bancorp’s consolidated financial statements.

Commitments

In the normal course of business, Bancorp is party to activities that contain credit, market and operational risk that are not reflected in whole or in part in Bancorp’s consolidated financial statements. Such activities include traditional off-balance sheet credit-related financial instruments, commitments under operating leases and long-term debt.

Bancorp provides customers with off-balance sheet credit support through loan commitments and standby letters of credit. Unused loan commitments increased $238 million as of June 30, 2021 compared to December 31, 2020, $183 million of which was attributed to the KB acquisition. Total average line of credit utilization improved to 39.2% at June 30, 2021 as compared to 38.0% at December 31, 2020 and 38.6% at June 30, 2020. While improving over the prior quarter, depressed C&I line of credit usage has driven the dramatic decline in utilization experienced over the past year as customers took advantage of the more favorable financing provided by the PPP. For reference, C&I line of credit utilization was 29.1% as of June 30, 2021 compared to the pre-pandemic average of 43.9% experienced in 2019.

Commitments to extend credit are agreements to lend to customers as long as collateral is available as agreed upon and there is no violation of any condition established in the contracts. Commitments generally have fixed expiration dates or other termination clauses. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Bancorp uses the same credit and collateral policies in making commitments and conditional guarantees as for on-balance sheet instruments. Bancorp evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, securities, equipment and real estate. However, should the commitments be drawn upon and should our customers default on their resulting obligation to us, our maximum exposure to credit loss, without consideration of collateral, is represented by the contractual amount of those instruments.

The ACL on off balance sheet credit exposures, which is separate from the ACL on loans and recorded in other liabilities on the consolidated balance sheets, stood at $4.8 million and $5.4 million as of June 30, 2021 and December 31, 2020, respectively. A net benefit of $825,000 was recorded as provision for credit losses on off balance sheet exposures during the first six months of 2021, as nearly all applicable loan segments experienced declines in their reserve loss percentage consistent with generally improving model factors.

Standby letters of credit are conditional commitments issued by Bancorp to guarantee the performance of a customer to a third party beneficiary. Those guarantees are primarily issued to support commercial transactions. Standby letters of credit generally have maturities of one to two years.

In addition to owned banking facilities, Bancorp has entered into long-term leasing arrangements for certain branch facilities. Bancorp also has required future payments for a non-qualified defined benefit retirement plan, FHLB advances and the maturity of time deposits.

See the footnote titled “Commitments and Contingent Liabilities” for additional detail.

Capital

At June 30, 2021, stockholders’ equity totaled $651 million, representing an increase of $210 million, or 48%, compared to December 31, 2020. The large increase over the first six months of 2021 was attributed mainly to stock issued in relation to the KB acquisition, which totaled $205 million. Further, net income of $26.9 million was partially offset by a larger negative change in AOCI and dividends declared during the first six months of 2021. AOCI consists of net unrealized gains or losses on AFS debt securities and hedging instruments, as well as a minimum pension liability, each net of income taxes. AOCI declined $7 million from December 31, 2020 to June 30, 2021, with the fluctuation stemming from the changing interest rate environment and corresponding valuation of the AFS debt securities portfolio. See the “Consolidated Statement of Changes in Stockholders’ Equity” for further detail of changes in equity.

In May 2021, Bancorp’s Board of Directors extended its share repurchase program authorizing the repurchase of up to 1 million shares, or approximately 4% of Bancorp’s total common shares outstanding at the time. The plan, which will expire in May 2023 unless otherwise extended or completed at an earlier date, does not obligate Bancorp to repurchase any specific dollar amount or number of shares prior to the plan’s expiration. Based on economic developments over the past year and the increased importance of capital preservation, no shares were repurchased in 2020 nor the first six months of 2021. Approximately 741,000 shares remain eligible for repurchase under the current repurchase plan.

Bank holding companies and their subsidiary banks are required by regulators to meet risk-based capital standards. These standards, or ratios, measure the relationship of capital to a combination of balance sheet and off-balance sheet risks. The value of both balance sheet and off-balance sheet items are adjusted to reflect credit risks. See the footnote titled “Regulatory Matters” for additional detail regarding regulatory capital requirements, as well as capital ratios of Bancorp and the Bank. The Bank exceeds regulatory capital ratios required to be well-capitalized. Regulatory framework does not define well capitalized for holding companies. Management considers the effects of growth on capital ratios as it contemplates plans for expansion.

The following table sets forth consolidated Bancorp’s and the Bank’s risk based capital ratios:

(1) Under regulatory risk-based capital guidelines, assets and credit-equivalent amounts of derivatives and off-balance sheet credit exposures are assigned to broad risk categories. The aggregate dollar amount in each risk category is multiplied by the associated risk weight of the category. Weighted values are added together, resulting in Bancorp's total risk-weighted assets. These ratios are computed in relation to average assets.

(2) Ratio is computed in relation to average assets.

Banking regulators have categorized the Bank as well-capitalized. To meet the definition of well-capitalized for prompt corrective action requirements, a bank must have a minimum 6.5% Common Equity Tier 1 Risk-Based Capital ratio, 8.0% Tier 1 Risk-Based Capital ratio, 10.0% Total Risk-Based Capital ratio and 5.0% Tier 1 Leverage ratio.

Additionally, in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, Bancorp and the Bank must hold a 2.5% capital conservation buffer composed of Common Equity Tier 1 Risk-Based Capital above the minimum risk-based capital requirements for the Common Equity Tier 1 Risk-Based Capital ratio, Tier 1 Risk-Based Capital ratio and Total Risk-Based Capital ratio necessary to be considered adequately-capitalized. At June 30, 2021, the adequately-capitalized minimums, including the capital conservation buffer, were a 6.0% Common Equity Tier 1 Risk-Based Capital ratio, 8.5% Tier 1 Risk-Based Capital ratio and 10.5% Total Risk-Based Capital ratio.

Bancorp continues to exceed the regulatory requirements for all calculations. Bancorp and the Bank intend to maintain a capital position that meets or exceeds the “well-capitalized” requirements as defined by the FRB and the FDIC, in addition to the capital conservation buffer.

As permitted by the interim final rule issued on March 27, 2020 by the federal banking regulatory agencies, Bancorp elected the option to delay the estimated impact on regulatory capital related to the adoption of ASC 326 “Financial Instruments – Credit Losses,” or CECL, which was effective January 1, 2020. The initial impact of adoption of ASC 326, as well as 25% of the quarterly increases in the ACL subsequent to adoption of ASC 326 (collectively the “transition adjustments”) were declared to be delayed for two years. After two years, the cumulative amount of the transition adjustments will become fixed and will be phased out of the regulatory capital calculations evenly over a three-year period, with 75% recognized in year three, 50% recognized in year four and 25% recognized in year five. After five years, the temporary regulatory capital benefits will be fully reversed. Had Bancorp not elected to defer the regulatory capital impact of CECL, the post ASC 326 adoption capital ratios of Bancorp and the Bank would have exceeded the well-capitalized level.

Non-GAAP Financial Measures

The following table provides a reconciliation of total stockholders’ equity in accordance with GAAP to tangible stockholders’ equity, a non-GAAP disclosure. Bancorp provides the tangible book value per share, a non-GAAP measure, in addition to those defined by banking regulators, because of its widespread use by investors as a means to evaluate capital adequacy.

(dollars in thousands, except per share data)

The ACL on loans to total non-PPP loans represents the ACL on loans, divided by total loans less PPP loans. Non-performing loans to total non-PPP loans represents non-performing loans, divided by total loans less PPP loans. Delinquent loans to total non-PPP loans represents delinquent loans (consisting of all loans 30 days or more past due), divided by total loans less PPP loans. Bancorp believes these non-GAAP ratios are important because they provide comparable ratios after eliminating PPP loans, which are fully guaranteed by the SBA and have not been allocated for within the ACL.

(dollars in thousands)

The efficiency ratio, a non-GAAP measure, equals total non-interest expenses divided by the sum of net interest income FTE and non-interest income. The ratio excludes net gains (losses) on sales, calls, and impairment of investment securities, if applicable. In addition to the efficiency ratio, Bancorp considers an adjusted efficiency ratio. Bancorp believes it is important because it provides a comparable ratio after eliminating the fluctuation in non-interest expenses related to amortization of investments in tax credit partnerships and non-recurring merger expenses.

Net interest income on a FTE basis includes the additional amount of interest income that would have been earned if investments in certain tax-exempt interest earning assets had been made in assets subject to federal, state and local taxes yielding the same after-tax income.

(dollars in thousands)

Information required by this item is included in Part I Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

As of the end of the period covered by this report, an evaluation was carried out by Stock Yards Bancorp, Inc.’s management, with the participation of its CEO and CFO, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based upon that evaluation, the Company’s CEO and CFO concluded that these disclosure controls and procedures were effective as of the end of the period covered by this report. In addition, no change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934) occurred during the fiscal quarter covered by this report that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.