Mercantile Bank Corp: Form 10-Q for the period ended Jun 30, 2023
Filed with the SEC on Aug 4, 2023 and accepted by EDGAR at Aug 4, 2023, 11:43 ET.
Management's discussion and analysis
As filed, 73,105 characters, with its headings, lists and tables. Extracted from the main document; charts and exhibits are in the original on sec.gov.
Forward Looking Statements
This report contains forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and our company. Words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “is likely,” “plans,” “projects,” “indicates,” “strategy,” “future,” “likely,” “may,” “should,” “will,” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“Future Factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. We undertake no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events (whether anticipated or unanticipated), or otherwise.
Future Factors include, among others, adverse changes in interest rates and interest rate relationships; increasing rates of inflation and slower growth rates or recession; significant declines in the value of commercial real estate; market volatility; demand for products and services; climate impacts; labor markets; the degree of competition by traditional and non-traditional financial services companies; changes in banking regulation or actions by bank regulators; changes in tax laws and other laws and regulations applicable to us; changes in prices, levies, and assessments; the impact of technological advances; potential cyber-attacks, information security breaches, and other criminal activities; litigation liabilities; governmental and regulatory policy changes; the outcomes of existing or future contingencies; trends in customer behavior as well as their ability to repay loans; changes in local real estate values; damage to our reputation resulting from adverse publicity, regulatory actions, litigation, operational failures, and the failure to meet client expectations and other facts; the transition from Libor to SOFR; changes in the national and local economies; unstable political and economic environments; disease outbreaks, such as the Covid-19 pandemic or similar public health threats, and measures implemented to combat them; and other risk factors, including those described in our annual report on Form 10-K for the year ended December 31, 2022. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement.
Introduction
The following discussion compares the financial condition of Mercantile Bank Corporation and its consolidated subsidiaries, including Mercantile Bank (“our bank”) and our bank’s subsidiaries, Mercantile Insurance Center, Inc., and Mercantile Community Partners, at June 30, 2023 and December 31, 2022 and the results of operations for the three months and six months ended June 30, 2023 and June 30, 2022. This discussion should be read in conjunction with the interim consolidated financial statements and footnotes included in this report. Unless the text clearly suggests otherwise, references in this report to “us,” “we,” “our” or “the company” include Mercantile Bank Corporation and its consolidated subsidiaries referred to above.
Critical Accounting Policies
Accounting principles generally accepted in the United States of America (“GAAP”) are complex and require us to apply significant judgment to various accounting, reporting and disclosure matters. We must use assumptions and estimates to apply these principles where actual measurements are not possible or practical. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited financial statements included in this report. For a discussion of our significant accounting estimates, see Note 1 of the Notes to our Consolidated Financial Statements included in our Form 10-K for the fiscal year ended December 31, 2022 (Commission file number 000-26719). Our critical accounting policies are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements, and actual results may differ from those estimates. We have reviewed the application of these policies with the Audit Committee of our Board of Directors.
Allowance for Credit Losses (“Allowance”): On January 1, 2022, we adopted ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 32): Measurement of Credit Losses on Financial Instruments, as amended, which replaced the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (“CECL”) methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost and certain off-balance sheet credit exposures.
The allowance is maintained at a level we believe is adequate to absorb estimated credit losses identified and inherent in the loan portfolio. Our evaluation of the adequacy of the allowance is an estimate based on past loan loss experience, the nature and volume of the loan portfolio, information about specific borrower situations and estimated collateral values, guidance from bank regulatory agencies, and assessments of the impact of current and anticipated economic conditions on the loan portfolio. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off. Credit losses are charged against the allowance when we believe the uncollectability of a loan is likely. The balance of the allowance represents our best estimate, but significant downturns in circumstances relating to loan quality or economic conditions could result in a requirement for an increased allowance in the future. Likewise, an upturn in loan quality or improved economic conditions may result in a decline in the required allowance in the future. In either instance, unanticipated changes could have a significant impact on the allowance and operating results. The allowance is increased through a provision charged to operating expense. Uncollectable loans are charged-off through the allowance, while recoveries of loans previously charged-off are added to the allowance.
See Note 1- Significant Accounting Policies in this Quarterly Report on Form 10-Q for further detailed descriptions of our estimation process and methodology related to the allowance. See also Note 3 – Loans and Allowance for Credit Losses in this Quarterly Report on Form 10-Q for further information regarding our loan portfolio and allowance.
Mortgage Servicing Rights: Mortgage servicing rights are recognized as assets based on the allocated fair value of retained servicing rights on loans sold. Servicing rights are carried at the lower of amortized cost or fair value and are expensed in proportion to, and over the period of, estimated net servicing income. We utilize a discounted cash flow model to determine the value of our servicing rights. The valuation model utilizes mortgage loan prepayment speeds, the remaining life of the mortgage loan pool, delinquency rates, our cost to service loans, and other factors to determine the cash flow that we will receive from servicing each grouping of loans. These cash flows are then discounted based on current interest rate assumptions to arrive at the fair value of the right to service those loans. Impairment is evaluated quarterly based on the fair value of the servicing rights, using groupings of the underlying loans classified by interest rates. Any impairment of a grouping is reported as a valuation allowance.
Goodwill: Accounting rules require us to determine the fair value of all the assets and liabilities of an acquired entity, and to record their fair value on the date of acquisition. We employ a variety of means in determining fair value, including the use of discounted cash flow analysis, market comparisons and projected future revenue streams. For those items for which we conclude that we have the appropriate expertise to determine fair value, we may choose to use our own calculation of fair value. In other cases, where the fair value is not readily determined, consultation with outside parties is used to determine fair value. Once valuations have been determined, the net difference between the price paid for the acquired entity and the fair value of the balance sheet is recorded as goodwill. Goodwill is assessed at least annually for impairment, with any such impairment recognized in the period identified. A more frequent assessment is performed if there are material changes in the market place or within the organizational structure.
Financial Overview
We reported net income of $20.4 million, or $1.27 per diluted share, for the second quarter of 2023, compared with net income of $11.7 million, or $0.74 per diluted share, during the second quarter of 2022. Net income for the first six months of 2023 totaled $41.3 million, or $2.58 per diluted share, compared to $23.2 million, or $1.47 per diluted share, during the first six months of 2022. The improved operating results were in large part driven by higher net interest income stemming from a higher net interest margin and ongoing loan growth, and continued strength in loan quality metrics providing for limited provision expense.
Commercial loans increased $56.8 million during the first six months of 2023, providing for an annualized growth rate of about 4%. While we experienced strong loan funding activities, the full pay-offs and partial paydowns of certain larger commercial lending relationships, primarily reflecting customers selling businesses and assets, refinancing debt on the secondary market, and using excess cash flows generated within their operations to make unscheduled principal payments and line of credit reductions, aggregated $174 million during the first six months of 2023. As a percentage of total commercial loans, commercial and industrial loans and owner occupied commercial real estate (“CRE”) loans combined equaled 58.7% as of June 30, 2023, compared to 58.2% as of December 31, 2022. The new commercial loan pipeline remains strong, and at June 30, 2023, we had $327 million in unfunded loan commitments on commercial construction and development loans that are in the construction phase.
Residential mortgage loans, excluding home equity lines of credit, increased $78.7 million during the first six months of 2023, representing a growth rate of about 22% on an annualized basis. With increased residential mortgage loan rates during 2022 and the first half of 2023, we have witnessed a shift in borrowers primarily selecting adjustable rate residential mortgage loans compared to fixed rate residential mortgage loans in the previous couple of years. Generally, we sell fixed rate residential mortgage loans to third-party investors, while we maintain adjustable rate residential mortgage loans on our balance sheet. During the first six months of 2023, approximately 40% of our residential mortgage loan production was comprised of longer-term fixed rate loans, compared to a similar level in 2022 but approaching 70% in 2021. The shift in production mix has resulted in residential mortgage loans comprising a larger percentage of total loans, increasing from about 13% at year-end 2021 to about 20% as of June 30, 2023. The shift in product mix also impacts the timing of revenue recognition; it takes an estimated 24 months for the amount of interest income earned on a residential mortgage loan that is retained on our balance sheet to approximate the amount of the immediately recorded gain on sale of a residential mortgage loan that has been sold to an investor.
The overall quality of our loan portfolio remains strong, with nonperforming loans equaling only 0.05% of total loans as of June 30, 2023. Accruing loans past due 30 to 89 days remain very low, and foreclosed properties excluding a former branch facility totaled less than $0.1 million as of June 30, 2023. Gross loan charge-offs totaled $0.6 million during the first six months of 2023, while recoveries of prior period loan charge-offs aggregated $0.5 million.
We recorded provisions for credit losses of $2.0 million and $2.6 million during the second quarter and first six months of 2023, respectively, compared to $0.5 million and $0.6 million during the respective time periods in 2022. The provisions made during the 2023 periods mainly reflect adjustments to historical baseline loss allocations to better represent our expectations for future credit losses. Changes to qualitative factors were limited to a reduction of the historical loss information factor which coincided with the adjustments to the historical baseline loss allocations. Reserve allocations associated with net loan growth during both 2023 periods were largely mitigated by lower reserve allocations stemming from modestly improved economic forecasts. The elimination of certain specific reserve allocations had a positive impact on provision expense during the second quarter of 2023.
Interest-earning deposits, primarily consisting of funds deposited at the Federal Reserve Bank of Chicago, are used to manage daily liquidity needs and interest rate risk sensitivity. During the first six months of 2023, the average balance of these funds equaled $48.1 million, or 1.0% of average earning assets, compared to $657 million, or 13.6% of average earning assets, during the first six months of 2022. Typically, we maintain interest-earning deposits at approximately $75 million, or about 2% of average earning assets. The elevated level during the first six months of 2022 primarily reflected increased local deposits stemming from Covid-19-related federal government stimulus payments and reduced business and consumer investing and spending during 2021 and into 2022. The level of interest-earning deposits was on a declining trend throughout 2022 as excess monies were used to fund loan growth and securities purchases, as well as out-of-area deposit and Federal Home Loan Bank of Indianapolis (“FHLBI”) advance maturities. We also experienced a decline in local deposits throughout 2022. Interest-earning deposits totaled $34.9 million at year-end 2022.
Interest-earning deposits totaled $139 million as of June 30, 2023, an increase of $104 million from December 31, 2022, and approximately $91 million higher than the average balance during the first six months of 2023. We obtained $111 million in brokered deposits and $90.0 million in FHLBI advances during the second quarter of 2023, combined with $70.0 million in FHLBI advances during the first quarter of 2023, to offset the impact of loan fundings and net deposit withdrawals during the first half of 2023, and to rebuild our on-balance sheet liquidity position.
Total deposits increased $44.0 million during the first six months of 2023, totaling $3.76 billion at June 30, 2023. Local deposits decreased $67.3 million, while out-of-area deposits increased $111 million. The reduction in local deposits largely occurred during the first few months of 2023, reflecting a typical level of customers’ tax and bonus payments and partnership distributions. Local deposits increased $47.5 million during the second quarter of 2023.
Net interest income increased $13.3 million and $30.7 million during the second quarter and first six months of 2023, respectively, compared to the respective time periods in 2022. Interest income was $26.4 million and $51.0 million higher during the second quarter and first six months of 2023, respectively, when compared to the same time periods in 2022, in large part reflecting an increasing rate environment. Interest expense was $13.1 million and $20.3 million higher during the second quarter and first six months of 2023, respectively, when compared to the respective time periods in 2022, primarily reflecting an increasing interest rate environment.
Noninterest income decreased $0.1 million and $2.4 million during the second quarter and first six months of 2023, respectively, compared to the respective time periods in 2022. Mortgage banking income was essentially unchanged during the second quarter of 2023 when compared to the second quarter of 2022; however, it declined $2.2 million during the first six months of 2023 when compared to the first six months of 2022, in large part reflecting increased residential mortgage loan rates beginning in late 2021 and continuing into 2022 which substantially reduced the volume of refinance activity starting during the latter half of the first quarter of 2022. We continued to record growth in treasury management-related fee income categories, such as credit and debit card income and payroll processing, while service charges on accounts have declined due to increased earnings credit rates on noninterest-bearing checking accounts.
Noninterest expense increased $0.9 million and $3.7 million during the second quarter and first six months of 2023, respectively, compared to the respective time periods in 2022. The increased costs primarily resulted from higher compensation costs, increased reserve allocations for unfunded loan commitments and higher interest rate swap cash collateral holding costs.
Financial Condition
Our total assets increased $265 million during the first six months of 2023, and totaled $5.14 billion as of June 30, 2023. Total loans were up $135 million, and interest-earning deposits increased $104 million. FHLBI advances were up $160 million, and total deposits increased $44.0 million.
Commercial loans increased $56.8 million during the first six months of 2023, providing for an annualized growth rate of about 4%. While we experienced strong loan funding activities, the full pay-offs and partial paydowns of certain larger commercial lending relationships, primarily reflecting customers selling businesses and assets, refinancing debt on the secondary market, and using excess cash flows generated within their operations to make unscheduled principal payments and line of credit reductions, aggregated $174 million during the first six months of 2023. Commercial and industrial loans increased $27.1 million, multi-family and residential rental property loans grew $20.8 million, owner-occupied CRE loans were up $20.0 million, and vacant land, land development and residential construction loans increased $10.8 million, while non-owner occupied CRE loans were down $22.0 million. As a percentage of total commercial loans, commercial and industrial loans and owner occupied CRE loans combined equaled 58.7% as of June 30, 2023, compared to 58.2% as of December 31, 2022. Commercial loans totaled $3.19 billion, or 78.7% of total loans, as of June 30, 2023, compared to $3.13 billion, or 80.0% of total loans, as of December 31, 2022.
As of June 30, 2023, we had $327 million in unfunded commitments on commercial construction and development loans that are in the construction phase which are expected to be drawn over the next 12 to 18 months. Our current pipeline reports indicate continued strong commercial loan funding opportunities in future periods, including approximately $351 million in new lending commitments, a majority of which we expect to be accepted and funded over the next 12 to 18 months. Our commercial lenders also report ongoing additional opportunities they are currently discussing with existing and potentially new borrowers. We remain committed to prudent underwriting standards that provide for an appropriate yield and risk relationship, as well as concentration limits we have established within our commercial loan portfolio. Usage of existing commercial lines of credit averaged 41% during the first six months of 2023, which was within our historical range of 40% to 45%.
Residential mortgage loans, excluding home equity lines of credit, increased $78.7 million during the first six months of 2023, representing a growth rate of about 22% on an annualized basis. With increased residential mortgage loan rates during 2022 and the first half of 2023, we have witnessed a shift in borrowers primarily selecting adjustable rate residential mortgage loans compared to fixed rate residential mortgage loans in the previous couple of years. Generally, we sell fixed rate residential mortgage loans to third-party investors, while we maintain adjustable rate residential mortgage loans on our balance sheet. During the first six months of 2023, approximately 40% of our residential mortgage loan production was comprised of longer-term fixed rate loans, compared to a similar level in 2022 but approaching 70% in 2021. The shift in production mix has resulted in residential mortgage loans comprising a larger percentage of total loans, increasing from about 13% at year-end 2021 to about 20% as of June 30, 2023. The shift in product mix also impacts the timing of revenue recognition; it takes an estimated 24 months for the amount of interest income earned on a residential mortgage loan that is retained on our balance sheet to approximate the amount of the immediately recorded gain on sale of a residential mortgage loan that has been sold to an investor.
Home equity lines of credit declined $0.6 million and other consumer-related loans increased $0.3 million during the first six months of 2023, and at June 30, 2023 totaled $36.8 million and $30.1 million, respectively, or an aggregate 1.7% of total loans. These loan segments equated to 1.7% of total loans as of December 31, 2022. We expect both loan portfolio segments to remain relatively steady in dollar amount but decline as a percent of total loans in future periods as the commercial and residential mortgage loan portfolios grow.
The following table summarizes our loan portfolio over the past twelve months:
| Commercial: | June 30, 2023 | March 31, 2023 | December 31, 2022 | September 30, 2022 | June 30, 2022 |
|---|---|---|---|---|---|
| Commercial & Industrial | $1,212,196,000 | $1,173,440,000 | $1,185,083,000 | $1,213,631,000 | $1,187,650,000 |
| Land Development & Construction | 72,682,000 | 66,233,000 | 61,873,000 | 60,970,000 | 57,808,000 |
| Owner Occupied Commercial RE | 659,201,000 | 630,187,000 | 639,192,000 | 643,577,000 | 598,593,000 |
| Non-Owner Occupied Commercial RE | 957,221,000 | 975,735,000 | 979,214,000 | 963,144,000 | 974,009,000 |
| Multi-Family & Residential Rental | 287,285,000 | 294,825,000 | 266,468,000 | 263,741,000 | 253,700,000 |
| Total Commercial | 3,188,585,000 | 3,140,420,000 | 3,131,830,000 | 3,145,063,000 | 3,071,760,000 |
| Retail: | |||||
| 1-4 Family Mortgages | 833,198,000 | 795,007,000 | 755,036,000 | 705,441,000 | 623,599,000 |
| Other Consumer Loans | 30,060,000 | 30,101,000 | 29,753,000 | 30,454,000 | 28,441,000 |
| Total Retail | 863,258,000 | 825,108,000 | 784,789,000 | 735,895,000 | 652,040,000 |
| Total | $4,051,843,000 | $3,965,528,000 | $3,916,619,000 | $3,880,958,000 | $3,723,800,000 |
Our credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to provide effective loan portfolio administration. The credit policies and procedures are meant to minimize the risk and uncertainties inherent in lending. In following these policies and procedures, we must rely on estimates, appraisals and evaluations of loans and the possibility that changes in these could occur quickly because of changing economic conditions or other factors. Identified problem loans, which exhibit characteristics (financial or otherwise) that could cause the loans to become nonperforming or require modification in the future, are included on an internal watch list. Senior management and the Board of Directors review this list regularly. Market value estimates of collateral on nonperforming loans, as well as on foreclosed and repossessed assets, are reviewed periodically. We also have a process in place to monitor whether value estimates at each quarter-end are reflective of current market conditions. Our credit policies establish criteria for obtaining appraisals and determining internal value estimates. We may also adjust outside and internal valuations based on identifiable trends within our markets, such as recent sales of similar properties or assets, listing prices and offers received. In addition, we may discount certain appraised and internal value estimates to address distressed market conditions.
Nonperforming loans totaled $2.1 million, or 0.1% of total loans, as of June 30, 2023, compared to $7.7 million, or 0.2% of total loans, as of December 31, 2022. Nonperforming assets, comprised of nonaccrual loans, loans past due 90 days or more and accruing interest and foreclosed properties, totaled $2.8 million (0.1% of total assets) as of June 30, 2023, compared to $7.7 million (0.2% of total assets) as of December 31, 2022. The volume of nonperforming assets has remained under 0.3% of total assets since year-end 2015. Given the low levels of nonperforming loans and accruing loans 30 to 89 days delinquent, combined with what we believe are strong credit administration practices, we are pleased with the overall quality of the loan portfolio.
The following tables provide a breakdown of nonperforming assets by collateral type:
NONPERFORMING LOANS
| Residential Real Estate: | June 30, 2023 | March 31, 2023 | December 31, 2022 | September 30, 2022 | June 30, 2022 |
|---|---|---|---|---|---|
| Land Development | $2,000 | $8,000 | $29,000 | $30,000 | $30,000 |
| Construction | 0 | 0 | 124,000 | 0 | 0 |
| Owner Occupied / Rental | 1,732,000 | 1,891,000 | 1,304,000 | 1,138,000 | 1,508,000 |
| 1,734,000 | 1,899,000 | 1,457,000 | 1,168,000 | 1,538,000 | |
| Commercial Real Estate: | |||||
| Land Development | 0 | 0 | 0 | 0 | 0 |
| Construction | 0 | 0 | 0 | 0 | 0 |
| Owner Occupied | 116,000 | 229,000 | 248,000 | 0 | 0 |
| Non-Owner Occupied | 0 | 0 | 0 | 0 | 0 |
| 116,000 | 229,000 | 248,000 | 0 | 0 | |
| Non-Real Estate: | |||||
| Commercial Assets | 249,000 | 5,654,000 | 6,023,000 | 248,000 | 248,000 |
| Consumer Assets | 0 | 0 | 0 | 0 | 1,000 |
| 249,000 | 5,654,000 | 6,023,000 | 248,000 | 249,000 | |
| Total | $2,099,000 | $7,782,000 | $7,728,000 | $1,416,000 | $1,787,000 |
OTHER REAL ESTATE OWNED & REPOSSESSED ASSETS
| Residential Real Estate: | June 30, 2023 | March 31, 2023 | December 31, 2022 | September 30, 2022 | June 30, 2022 |
|---|---|---|---|---|---|
| Land Development | $0 | $0 | $0 | $0 | $0 |
| Construction | 0 | 0 | 0 | 0 | 0 |
| Owner Occupied / Rental | 61,000 | 61,000 | 0 | 0 | 0 |
| 61,000 | 61,000 | 0 | 0 | 0 | |
| Commercial Real Estate: | |||||
| Land Development | 0 | 0 | 0 | 0 | 0 |
| Construction | 0 | 0 | 0 | 0 | 0 |
| Owner Occupied | 600,000 | 600,000 | 0 | 0 | 0 |
| Non-Owner Occupied | 0 | 0 | 0 | 0 | 0 |
| 600,000 | 600,000 | 0 | 0 | 0 | |
| Non-Real Estate: | |||||
| Commercial Assets | 0 | 0 | 0 | 0 | 0 |
| Consumer Assets | 0 | 0 | 0 | 0 | 0 |
| 0 | 0 | 0 | 0 | 0 | |
| Total | $661,000 | $661,000 | $0 | $0 | $0 |
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The following tables provide a reconciliation of nonperforming assets:
NONPERFORMING LOANS RECONCILIATION
| 2nd Qtr 2023 | 1st Qtr 2023 | 4th Qtr 2022 | 3rd Qtr 2022 | 2nd Qtr 2022 | |
|---|---|---|---|---|---|
| Beginning balance | $7,782,000 | $7,728,000 | $1,416,000 | $1,787,000 | $1,612,000 |
| Additions, net of transfers to ORE | 273,000 | 662,000 | 6,368,000 | 0 | 309,000 |
| Returns to performing status | 0 | (31,000) | 0 | (160,000) | 0 |
| Principal payments | (5,525,000) | (515,000) | (56,000) | (211,000) | (134,000) |
| Loan charge-offs | (431,000) | (62,000) | 0 | 0 | 0 |
| Total | $2,099,000 | $7,782,000 | $7,728,000 | $1,416,000 | $1,787,000 |
OTHER REAL ESTATE OWNED & REPOSSESSED ASSETS RECONCILIATION
| 2nd Qtr 2023 | 1st Qtr 2023 | 4th Qtr 2022 | 3rd Qtr 2022 | 2nd Qtr 2022 | |
|---|---|---|---|---|---|
| Beginning balance | $661,000 | $0 | $0 | $0 | $0 |
| Additions | 0 | 661,000 | 0 | 0 | 0 |
| Sale proceeds | 0 | 0 | 0 | 0 | 0 |
| Valuation write-downs | 0 | 0 | 0 | 0 | 0 |
| Total | $661,000 | $661,000 | $0 | $0 | $0 |
Loan charge-offs totaled $0.5 million during the second quarter of 2023, and aggregated $0.6 million during the first six months of 2023, while recoveries of prior period loan charge-offs equaled $0.3 million and $0.5 million during the respective time periods. Net loan charge-offs, as a percentage of average total loans, equaled an annualized 0.02% and 0.01% during the second quarter and first six months of 2023, respectively. We continue our collection efforts on charged-off loans, and expect to record recoveries in future periods; however, given the nature of these efforts, it is not practical to forecast the dollar amount and timing of the recoveries.
The primary risk elements with respect to commercial loans are the financial condition of the borrower, the sufficiency of collateral, and timeliness of scheduled payments. We have a policy of requesting and reviewing periodic financial statements from commercial loan customers, and we have a disciplined and formalized review of the existence of collateral and its value. The primary risk element with respect to each residential mortgage loan and consumer loan is the timeliness of scheduled payments. We have a reporting system that monitors past due loans and have adopted policies to pursue creditors’ rights in order to preserve our collateral position.
See Note 1- Significant Accounting Policies in this Quarterly Report on Form 10-Q for further detailed descriptions of our estimation process and methodology related to the allowance. See also Note 3 – Loans and Allowance for Credit Losses in this Quarterly Report on Form 10-Q for further information regarding our loan portfolio and allowance.
The allowance equaled $44.7 million, or 1.10% of total loans, or over 2,000% of nonperforming loans, as of June 30, 2023. As of June 30, 2023, the allowance was comprised of $44.2 million in general reserves relating to performing loans and $0.5 million in specific reserves on other loans, primarily nonperforming loans. Loans with an aggregate carrying value of $0.4 million as of June 30, 2023 had been subject to previous partial charge-offs aggregating $0.3 million over the past several years. As of June 30, 2023, there were no specific reserves allocated to loans that had been subject to a previous partial charge-off.
Although we believe the allowance is adequate to absorb loan losses in our loan portfolio as they arise, there can be no assurance that we will not sustain loan losses in any given period that could be substantial in relation to, or greater than, the size of the allowance.
Securities available for sale increased $6.0 million during the first six months of 2023, totaling $609 million as of June 30, 2023. There were no purchases or maturities of U.S. Government agency bonds during the first six months of 2023. There were no purchases of U.S. Government agency guaranteed mortgage-backed securities during the first six months of 2023; however, we did receive $1.6 million of principal paydowns on U.S. Government agency guaranteed mortgage-backed securities. Purchases of municipal bonds totaled $11.6 million during the first six months of 2023; proceeds from matured municipal bonds totaled $8.6 million. At June 30, 2023, the portfolio was primarily comprised of U.S. Government agency bonds (65%), municipal bonds (30%) and U.S. Government agency guaranteed mortgage-backed securities (5%). All of our securities are currently designated as available for sale, and are therefore stated at fair value. The fair value of securities designated as available for sale at June 30, 2023 totaled $609 million, including a net unrealized loss of $77.9 million. The net unrealized loss equaled $82.7 million as of December 31, 2022. After we considered whether the securities were issued by the federal government or its agencies and whether downgrades by bond rating agencies had occurred, we determined that the unrealized losses were due to changing interest rate environment. We maintain the securities portfolio at levels to provide adequate pledging and secondary liquidity for our daily operations. In addition, the securities portfolio serves a primary interest rate risk management function. We expect any upcoming purchases to generally consist of municipal bonds, with the securities portfolio maintained at about 12% of total assets.
Market values on our U.S. Government agency bonds, mortgage-backed securities issued or guaranteed by U.S. Government agencies and municipal bonds are generally determined on a monthly basis with the assistance of a third-party vendor. Evaluated pricing models that vary by type of security and incorporate available market data are utilized. Standard inputs include issuer and type of security, benchmark yields, reported trades, broker/dealer quotes and issuer spreads. The market value of certain non-rated securities issued by relatively small municipalities generally located within our markets is estimated at carrying value. We believe our valuation methodology provides for a reasonable estimation of market value, and that it is consistent with the requirements of accounting guidelines.
FHLBI stock totaled $21.5 million as of June 30, 2023, compared to $17.7 million as of December 31, 2022. The $3.8 million increase reflects additional stock purchased in association with an increase in outstanding advances during the first six months of 2023. Our investment in FHLBI stock is necessary to engage in their advance and other financing programs. We have regularly received quarterly cash dividends, and we expect a cash dividend will continue to be paid in future quarterly periods.
Interest-earning deposits, primarily consisting of funds deposited at the Federal Reserve Bank of Chicago, are used to manage daily liquidity needs and interest rate risk sensitivity. During the first six months of 2023, the average balance of these funds equaled $48.1 million, or 1.0% of average earning assets, compared to $657 million, or 13.6% of average earning assets, during the first six months of 2022. Typically, we maintain interest-earning deposits at approximately $75 million, or about 2% of average earning assets. The elevated level during the first six months of 2022 primarily reflected increased local deposits stemming from Covid-19-related federal government stimulus payments and reduced business and consumer investing and spending during 2021 and into 2022. The level of interest-earning deposits was on a declining trend throughout 2022 as excess monies were used to fund loan growth and securities purchases, as well as out-of-area deposit and FHLBI advance maturities. We also experienced a decline in local deposits throughout 2022. Interest-earning deposits totaled $34.9 million at year-end 2022.
Interest-earning deposits totaled $139 million as of June 30, 2023, an increase of $104 million from December 31, 2022, and approximately $91 million higher than the average balance during the first six months of 2023. We obtained $111 million in brokered deposits and $90.0 million in FHLBI advances during the second quarter of 2023, combined with $70.0 million in FHLBI advances during the first quarter of 2023, to offset the impact of loan fundings and net deposit withdrawals during the first half of 2023, and to rebuild our on-balance sheet liquidity position.
Net premises and equipment equaled $52.3 million at June 30, 2023, an increase of $0.8 million from December 31, 2022. We recorded a reduction of $1.0 million associated with the planned sale of a former branch facility during the first six months of 2023, comprised of a $0.6 million transfer to foreclosed assets and a write-down of $0.4 million. Depreciation expense totaled $2.9 million during the first six months of 2023, while investments associated with the construction and opening of new facilities and the renovation of existing facilities totaled $4.7 million.
Total deposits increased $44.0 million during the first six months of 2023, totaling $3.76 billion at June 30, 2023. Local deposits decreased $67.3 million, while out-of-area deposits increased $111 million. The reduction in local deposits largely occurred during the initial months of 2023, reflecting a typical level of customers’ tax and bonus payments and partnership distributions. Local deposits increased $47.5 million during the second quarter of 2023. Wholesale funds, comprised of out-of-area deposits and FHLBI advances, totaled $579 million, or about 13% of total funds, as of June 30, 2023, compared to $308 million, or about 7% of total funds, at December 31, 2022.
Noninterest-bearing deposits decreased $233 million during the first six months of 2023, in large part reflecting the aforementioned customary level of customers’ tax and bonus payments and partnership distributions during the initial months of 2023, but also includes transfers to interest-bearing deposits and withdrawals associated with the sales of businesses. Interest-bearing checking accounts and savings deposits were down $33.9 million and $67.0 million during the first six months of 2023, respectively, primarily reflecting the transfers of funds to higher-paying money market deposit accounts and time deposits. Money market deposit accounts were up $150 million and local time deposits increased $116 million during the first six months of 2023.
Sweep accounts increased $25.1 million during the first six months of 2023, totaling $219 million as of June 30, 2023. The aggregate balance of this funding type is subject to relatively large daily fluctuations given the nature of the customers utilizing this product and the sizable balances maintained by many of the customers. The average balance of sweep accounts equaled $214 million during the first six months of 2023, with a high balance of $263 million and a low balance of $181 million. Our sweep account program entails transferring collected funds from certain business noninterest-bearing checking accounts and savings deposits into overnight interest-bearing repurchase agreements. Such sweep accounts are not deposit accounts and are not afforded federal deposit insurance, and are accounted for as secured borrowings. All of our repurchase agreements are accounted for as secured borrowings.
FHLBI advances increased $160 million during the first six months of 2023, totaling $468 million as of June 30, 2023. Bullet advances aggregating $200 million were obtained during the first six months of 2023, consisting of $160 million to fund loan growth and rebuild on-balance sheet liquidity, and $40.0 million to replace FHLBI bullet advance maturities. Payments on amortizing FHLBI advances totaled $0.4 million during the first six months of 2023. Bullet FHLBI advances are generally obtained to provide funds for loan growth and are used to assist in managing interest rate risk, while amortizing FHLBI advances are generally acquired to match-fund specific longer-term fixed rate commercial loans, with the dollar amount and amortization structure of the underlying advances reflective of the associated commercial loans. FHLBI advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit as of June 30, 2023 totaled $860 million, with remaining availability based on collateral equaling $386 million.
Shareholders’ equity was $479 million at June 30, 2023, compared to $441 million at December 31, 2022. Positively impacting shareholders’ equity during the first six months of 2023 was net income of $41.3 million, which was partially offset by the payment of cash dividends totaling $10.3 million. A $3.8 million after-tax increase in the market value of our available for sale securities portfolio, reflecting a decline in market interest rates, positively impacted shareholders’ equity during the first six months of 2023.
Liquidity
Liquidity is measured by our ability to raise funds through deposits, borrowed funds, and capital, or cash flow from the repayment of loans and securities. These funds are used to fund loans, meet deposit withdrawals, and operate our company. Liquidity is primarily achieved through local and out-of-area deposits and liquid assets such as securities available for sale, matured and called securities, federal funds sold and interest-earning deposits. Asset and liability management is the process of managing our balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity.
To assist in providing needed funds and managing interest rate risk, we periodically obtain monies from wholesale funding sources. Wholesale funds, comprised of out-of-area deposits and advances from the FHLBI, totaled $579 million, or about 13% of combined deposits and borrowed funds, as of June 30, 2023, compared to $308 million, or about 7% of combined deposits and borrowed funds, as of December 31, 2022.
Sweep accounts increased $25.1 million during the first six months of 2023, totaling $219 million as of June 30, 2023. The aggregate balance of this funding type is subject to relatively large daily fluctuations given the nature of the customers utilizing this product and the sizable balances maintained by many of the customers. The average balance of sweep accounts equaled $214 million during the first six months of 2023, with a high balance of $263 million and a low balance of $181 million. Our sweep account program entails transferring collected funds from certain business noninterest-bearing checking accounts and savings deposits into overnight interest-bearing repurchase agreements. Such sweep accounts are not deposit accounts and are not afforded federal deposit insurance, and are accounted for as secured borrowings. All of our repurchase agreements are accounted for as secured borrowings.
Information regarding our repurchase agreements as of June 30, 2023 and during the first six months of 2023 is as follows:
| Outstanding balance at June 30, 2023 | $219,457,000 |
| Weighted average interest rate at June 30, 2023 | 1.52% |
| Maximum daily balance six months ended June 30, 2023 | $262,992,000 |
| Average daily balance for six months ended June 30, 2023 | $213,853,000 |
| Weighted average interest rate for six months ended June 30, 2023 | 1.17% |
FHLBI advances increased $160 million during the first six months of 2023, totaling $468 million as of June 30, 2023. Bullet advances aggregating $200 million were obtained during the first six months of 2023, consisting of $160 million to fund loan growth and rebuild on-balance sheet liquidity, and $40.0 million to replace FHLBI bullet advance maturities. Payments on amortizing FHLBI advances totaled $0.4 million during the first six months of 2023. Bullet FHLBI advances are generally obtained to provide funds for loan growth and are used to assist in managing interest rate risk, while amortizing FHLBI advances are generally acquired to match-fund specific longer-term fixed rate commercial loans, with the dollar amount and amortization structure of the underlying advances reflective of the associated commercial loans. FHLBI advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit as of June 30, 2023 totaled $860 million, with remaining availability based on collateral equaling $386 million.
We also have the ability to borrow up to an aggregate $70.0 million on a daily basis through correspondent banks using established unsecured federal funds purchased lines of credit. We accessed one of the lines of credit during the first six months of 2023, with an average balance of $4.8 million. In contrast, our interest-earning deposit balance with the Federal Reserve Bank of Chicago averaged $42.1 million during the first six months of 2023. We also have a line of credit through the Discount Window of the Federal Reserve Bank of Chicago. Using certain municipal bonds as collateral, we could have borrowed up to $26.7 million as of June 30, 2023. We did not utilize this line of credit during the first six months of 2023 or at any time during the previous 14 fiscal years, and do not plan to access this line of credit in future periods.
The following table reflects, as of June 30, 2023, significant fixed and determinable contractual obligations to third parties by payment date, excluding accrued interest:
| One Year or Less | One to Three Years | Three to Five Years | Over Five Years | Total | |
|---|---|---|---|---|---|
| Deposits without a stated maturity | $3,154,550,000 | $0 | $0 | $0 | $3,154,550,000 |
| Time deposits | 432,582,000 | 106,508,000 | 63,149,000 | 0 | 602,239,000 |
| Short-term borrowings | 219,457,000 | 0 | 0 | 0 | 219,457,000 |
| Federal Home Loan Bank advances | 90,826,000 | 171,762,000 | 181,917,000 | 23,405,000 | 467,910,000 |
| Subordinated debentures | 0 | 0 | 0 | 49,301,000 | 49,301,000 |
| Subordinated notes | 0 | 0 | 0 | 88,800,000 | 88,800,000 |
| Other borrowed money | 0 | 0 | 0 | 1,090,000 | 1,090,000 |
| Property leases | 1,174,000 | 1,279,000 | 820,000 | 1,472,000 | 4,745,000 |
In addition to normal loan funding and deposit flow, we must maintain liquidity to meet the demands of certain unfunded loan commitments and standby letters of credit. As of June 30, 2023, we had a total of $2.15 billion in unfunded loan commitments and $24.1 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $1.80 billion were commitments available as lines of credit to be drawn at any time as customers’ cash needs vary, and $351 million were for loan commitments generally expected to be accepted and closed and become funded within the next 12 to 18 months. We regularly monitor fluctuations in loan balances and commitment levels, and include such data in our overall liquidity management.
While we have observed the well-publicized liquidity problems at certain financial institutions during the first six months of 2023, we do not believe that we are subject to the same circumstances that apparently caused those crises. We monitor our liquidity position and funding strategies on an ongoing basis, but recognize that unexpected events, changes in economic or market conditions, a reduction in earnings performance, declining capital levels or situations beyond our control could cause liquidity challenges. We have developed contingency funding plans that provide a framework for meeting liquidity disruptions.
Capital Resources
Shareholders’ equity was $479 million at June 30, 2023, compared to $441 million at December 31, 2022. Positively impacting shareholders’ equity during the first six months of 2023 was net income of $41.3 million, which was partially offset by the payment of cash dividends totaling $10.3 million. A $3.8 million after-tax increase in the market value of our available for sale securities portfolio, reflecting a decline in market interest rates, positively impacted shareholders’ equity during the first six months of 2023.
We and our bank are subject to regulatory capital requirements administered by state and federal banking agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. Under the final BASEL III capital rules that became effective on January 1, 2015, there is a requirement for a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets which is in addition to the other minimum risk-based capital standards in the rule. Institutions that do not meet this required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in cash dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital buffer requirement was phased in over three years beginning in 2016. The capital buffer requirement raised the minimum required common equity Tier 1 capital ratio to 7.0%, the Tier 1 capital ratio to 8.5% and the total capital ratio to 10.5% on a fully phased-in basis on January 1, 2019. We believe that, as of June 30, 2023, our bank met all capital adequacy requirements under the BASEL III capital rules on a fully phased-in basis.
As of June 30, 2023, our bank’s total risk-based capital ratio was 13.7%, unchanged from December 31, 2022. Our bank’s total regulatory capital increased $36.1 million during the first six months of 2023, in large part reflecting net income totaling $46.5 million, which was partially offset by cash dividends paid to us aggregating $13.0 million. Our bank’s total risk-based capital ratio was also impacted by a $251 million increase in total risk-weighted assets, primarily resulting from net growth in commercial and residential mortgage loans. As of June 30, 2023, our bank’s total regulatory capital equaled $655 million, or $177 million in excess of the 10.0% minimum that is among the requirements to be categorized as “well capitalized.” Our and our bank’s capital ratios as of June 30, 2023 and December 31, 2022 are disclosed in Note 12 of the Notes to Consolidated Financial Statements.
Results of Operations
We recorded net income of $20.4 million, or $1.27 per basic and diluted share, for the second quarter of 2023, compared with net income of $11.7 million, or $0.74 per basic and diluted share, for the second quarter of 2022. We recorded net income of $41.3 million, or $2.58 per basic and diluted share, for the first six months of 2023, compared with net income of $23.2 million, or $1.47 per basic and diluted share, for the first six months of 2022. Diluted earnings per share increased $0.53, or 71.6%, during the second quarter of 2023, and $1.11, or 75.5%, during the first six months of 2023 compared with the respective prior-year periods.
The higher levels of net income during the second quarter and first six months of 2023 compared to the respective prior-year periods resulted from increased net interest income, which more than offset higher overhead costs and credit loss provisions, as well as lower noninterest income. The increases in net interest income during the 2023 periods mainly resulted from significantly improved net interest margins and loan growth. The higher levels of overhead costs during the 2023 periods primarily reflected increases in compensation costs, credit reserves for unfunded loan commitments, interest rate swap credit reserves and associated collateral interest costs, and Federal Deposit Insurance Corporation (“FDIC”) deposit insurance premiums. The credit loss provisions recorded during the current-year periods mainly reflected allocations commanded by net loan growth and adjustments to historical loss factors to better represent our expectations for future credit losses. Continuing strong loan quality measures, including low levels of loan charge-offs, during the 2023 and 2022 periods largely mitigated additional reserves associated with these factors. Excluding the impact of a bank owned life insurance claim recorded during the second quarter of 2022, noninterest income increased $0.4 million, or 6.0%, during the second quarter of 2023 compared with the prior-year second quarter. The higher level of noninterest income mainly stemmed from increased interest rate swap income, credit and debit card income, and payroll servicing fees, which more than offset decreased service charges on accounts and mortgage banking income. The lower level of noninterest income during the first six months of 2023 primarily reflected decreases in mortgage banking income and service charges on accounts, which more than offset increases in credit and debit card income and payroll servicing fees.
Interest income during the second quarter of 2023 was $65.9 million, an increase of $26.4 million, or 66.7%, from the $39.5 million earned during the second quarter of 2022. The increase mainly resulted from a higher yield on average earning assets. The yield on average earning assets was 5.61% during the second quarter of 2023, up from 3.32% during the respective 2022 period. The higher yield primarily resulted from an increased yield on loans, reflecting the rising interest rate environment. The yield on loans was 6.19% during the second quarter of 2023, up from 3.97% during the prior-year second quarter mainly due to higher interest rates on variable-rate commercial loans stemming from the Federal Open Market Committee (“FOMC”) significantly raising the targeted federal funds rate in an effort to curb elevated inflation levels. The FOMC increased the targeted federal funds rate by 475 basis points during the period of May 2022 through May 2023. During the period of March 2022 through June 2023, variable-rate commercial loans represented approximately 64% of total commercial loans on an average basis. A change in earning asset mix, comprised of a decrease in lower-yielding interest-earning deposits and an increase in higher-yielding loans as a percentage of earning assets, along with increased yields on securities and interest-earning deposits, reflecting the rising interest rate environment, also contributed to the higher yield on average earning assets. On average, lower-yielding interest-earning deposits represented 1.4% of earning assets during the second quarter of 2023, down from 11.1% during the respective 2022 period, while higher-yielding loans represented 85.2% of earning assets during the current-year second quarter, up from 76.0% during the second quarter of 2022.
A significant volume of excess on-balance sheet liquidity, which initially surfaced in the second quarter of 2020 in large part due to government stimulus programs related to the Covid-19 environment, negatively impacted the yield on average earning assets by 28 basis points during the second quarter of 2022. The excess funds, consisting almost entirely of low-yielding deposits with the Federal Reserve Bank of Chicago, were mainly a product of local deposit growth and the Paycheck Protection Program.
Average earning assets equaled $4.72 billion during the second quarter of 2023, down $62.6 million, or 1.3%, from the level of $4.78 billion during the second quarter of 2022; average loans and average securities were up $384 million and $18.9 million, respectively, while average interest-earning deposits were down $466 million.
Interest income during the first six months of 2023 was $126 million, an increase of $51.0 million, or 67.6%, from the $75.4 million earned during the first six months of 2022. The increase primarily resulted from a higher yield on average earning assets. The yield on average earning assets was 5.48% during the first six months of 2023, up from 3.16% during the respective 2022 period. The higher yield mainly resulted from an increased yield on loans, reflecting the rising interest rate environment. The yield on loans was 6.05% during the first six months of 2023, up from 3.92% during the first six months of 2022 primarily due to higher interest rates on variable-rate commercial loans stemming from FOMC rate hikes. A change in earning asset mix, comprised of a decrease in lower-yielding interest-earning deposits and an increase in higher-yielding loans as a percentage of earning assets, along with increased yields on securities and interest-earning deposits, depicting the rising interest rate environment, also contributed to the higher yield on average earning assets. On average, lower-yielding interest-earning deposits represented 1.0% of earning assets during the first six months of 2023, down from 13.6% during the respective 2022 period, while higher-yielding loans represented 85.4% of earning assets during the first six months of 2023, up from 73.7% during the first six months of 2022. The significant volume of excess on-balance sheet liquidity negatively impacted the yield on average earning assets by 37 basis points during the first six months of 2022.
Average earning assets equaled $4.65 billion during the first six months of 2023, down $178 million, or 3.7%, from the level of $4.83 billion during the first six months of 2022; average interest-earning deposits declined $609 million, average loans increased $414 million, and average securities were up $16.6 million.
Interest expense during the second quarter of 2023 was $18.4 million, an increase of $13.2 million, or 252%, from the $5.2 million expensed during the second quarter of 2022. The increase is mainly attributable to a higher average weighted cost of interest-bearing liabilities, which rose from 0.72% during the second quarter of 2022 to 2.37% during the current-year second quarter primarily due to increased costs of deposits and borrowings. Reflecting the rising interest rate environment, the cost of interest-bearing, non-time deposits increased from 0.24% during the second quarter of 2022 to 1.85% during the second quarter of 2023, while the cost of time deposits increased from 0.83% to 3.27% during the respective periods. The higher cost of interest-bearing, non-time deposits primarily resulted from increased rates paid on money market accounts. The cost of borrowed funds increased from 1.90% during the second quarter of 2022 to 2.90% during the second quarter of 2023 mainly due to higher costs of sweep accounts, FHLBI advances, and subordinated debentures. The cost of sweep accounts increased from 0.10% during the second quarter of 2022 to 1.45% during the second quarter of 2023, while the cost of FHLBI advances increased from 2.02% to 2.68% during the respective periods, reflecting the rising interest rate environment. The cost of subordinated debentures was 9.57% during the second quarter of 2023, up from 4.63% during the respective 2022 period due to increases in the 90-Day Libor Rate.
A change in funding mix, consisting of increases in higher-costing time deposits and borrowings as a percentage of interest-bearing liabilities, also contributed to the higher cost of interest-bearing liabilities during the second quarter of 2023. Average interest-bearing liabilities totaled $3.11 billion during the current-year second quarter, compared to $2.91 billion during the second quarter of 2022, representing an increase of $198 million, or 6.8%.
Interest expense during the first six months of 2023 was $30.5 million, an increase of $20.3 million, or 198%, from the $10.2 million expensed during the first six months of 2022. The increase is attributable to a higher average weighted cost of interest-bearing liabilities, which rose from 0.69% during the first six months of 2022 to 2.06% during the first six months of 2023 primarily due to increased costs of deposits and borrowings. Reflecting the rising interest rate environment, the cost of interest-bearing, non-time deposits increased from 0.22% during the first six months of 2022 to 1.56% during the first six months of 2023, while the cost of time deposits increased from 0.86% to 2.84% during the respective periods. The higher cost of interest-bearing, non-time deposits primarily resulted from increased rates paid on money market accounts. The cost of borrowed funds increased from 1.86% during the first six months of 2022 to 2.73% during the first six months of 2023 mainly due to higher costs of subordinated debentures, sweep accounts, and FHLBI advances. The cost of subordinated debentures was 9.31% during the first six months of 2023, up from 4.22% during the respective 2022 period due to increases in the 90-Day Libor Rate. The cost of sweep accounts increased from 0.10% during the first six months of 2022 to 1.17% during the first six months of 2023, while the cost of FHLBI advances increased from 2.01% to 2.44% during the respective periods, reflecting the rising interest rate environment.
A change in funding mix, consisting of increases in higher-costing time deposits and borrowings as a percentage of interest-bearing liabilities, also contributed to the higher cost of interest-bearing liabilities during the first six months of 2023. Average interest-bearing liabilities totaled $2.98 billion during the first six months of 2023, down slightly from $2.99 billion during the respective 2022 period.
Net interest income during the second quarter of 2023 was $47.6 million, an increase of $13.3 million, or 38.5%, from the $34.3 million earned during the respective 2022 period. The increase primarily resulted from a significantly improved net interest margin. The net interest margin increased from 2.88% in the second quarter of 2022 to 4.05% in the current-year second quarter due to a higher yield on average earning assets, which more than offset an increase in the cost of funds. The increased yield primarily stemmed from a higher yield on commercial loans. The cost of funds equaled 1.56% in the second quarter of 2023, up from 0.44% in the second quarter of 2022 primarily due to higher costs of deposits and borrowed funds, reflecting the impact of the rising interest rate environment, and a change in funding mix, consisting of a decrease in lower-cost non-time deposits and increases in higher-cost time deposits and borrowings as a percentage of interest-bearing liabilities. The significant level of excess on-balance sheet liquidity negatively impacted the net interest margin by 23 basis points during the second quarter of 2022.
Net interest income during the first six months of 2023 was $95.9 million, an increase of $30.7 million, or 47.1%, from the $65.2 million earned during the first six months of 2022. The increase mainly resulted from a substantially improved net interest margin. The net interest margin increased from 2.73% in the first six months of 2022 to 4.16% in the respective 2023 period due to a higher yield on average earning assets, which more than offset an increase in the cost of funds. The increased yield on average earning assets primarily resulted from a higher yield on commercial loans. The cost of funds equaled 1.32% during the first six months of 2023, up from 0.43% during the respective prior-year period mainly due to higher costs of deposits and borrowed funds, reflecting the impact of the increasing interest rate environment, and a change in funding mix, consisting of a decrease in lower-cost non-time deposits and increases in higher-cost time deposits and borrowings as a percentage of interest-bearing liabilities. The significant level of excess on-balance sheet liquidity negatively impacted the net interest margin by 32 basis points during the first six months of 2022.
The following tables set forth certain information relating to our consolidated average interest-earning assets and interest-bearing liabilities and reflect the average yield on assets and average cost of liabilities for the second quarters and first six months of 2023 and 2022. Such yields and costs are derived by dividing income or expense by the average daily balance of assets or liabilities, respectively, for the period presented. Tax-exempt securities interest income and yield for the second quarters and first six months of 2023 and 2022 have been computed on a tax equivalent basis using a marginal tax rate of 21.0%. Securities interest income was increased by $60,000 in the second quarter of both 2023 and 2022 and $120,000 in the first six months of both 2023 and 2022 for this non-GAAP, but industry standard, adjustment. These adjustments equated to increases in our net interest margin of less than one basis point for each of the 2023 and 2022 periods.
MERCANTILE BANK CORPORATION
(dollars in thousands)
| ASSETS | Quarters ended June 30, 2 0 2 3 Average Balance | Interest | Average Rate | 2 0 2 2 Average Balance | Interest | Average Rate |
|---|---|---|---|---|---|---|
| Loans | $4,017,690 | $62,006 | 6.19% | $3,633,587 | $36,003 | 3.97% |
| Investment securities | 634,607 | 3,171 | 2.00 | 615,733 | 2,589 | 1.68 |
| Interest-earning deposits | 64,958 | 801 | 4.88 | 530,571 | 1,018 | 0.76 |
| Total interest - earning assets | 4,717,255 | 65,978 | 5.61 | 4,779,891 | 39,610 | 3.32 |
| Allowance for credit losses | (44,025) | (35,681) | ||||
| Other assets | 315,244 | 333,248 | ||||
| Total assets | $4,988,474 | $5,077,458 | ||||
| LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||
| Interest-bearing deposits | $2,278,877 | $12,379 | 2.18% | $2,201,797 | $1,873 | 0.34% |
| Short-term borrowings | 237,270 | 914 | 1.55 | 193,735 | 49 | 0.10 |
| Federal Home Loan Bank advances | 450,767 | 3,051 | 2.68 | 373,911 | 1,911 | 2.02 |
| Other borrowings | 139,068 | 2,023 | 5.75 | 138,127 | 1,391 | 4.04 |
| Total interest-bearing liabilities | 3,105,982 | 18,367 | 2.37 | 2,907,570 | 5,224 | 0.72 |
| Noninterest-bearing deposits | 1,361,901 | 1,706,349 | ||||
| Other liabilities | 46,608 | 34,666 | ||||
| Shareholders’ equity | 473,983 | 428,873 | ||||
| Total liabilities and shareholders’ equity | $4,988,474 | $5,077,458 | ||||
| Net interest income | $47,611 | $34,386 | ||||
| Net interest rate spread | 3.24% | 2.60% | ||||
| Net interest spread on average assets | 3.82% | 2.72% | ||||
| Net interest margin on earning assets | 4.05% | 2.88% |
68
MERCANTILE BANK CORPORATION
(dollars in thousands)
| ASSETS | Six months ended June 30, 2 0 2 3 Average Balance | Interest | Average Rate | 2 0 2 2 Average Balance | Interest | Average Rate |
|---|---|---|---|---|---|---|
| Loans | $3,973,255 | $119,159 | 6.05% | $3,559,461 | $69,254 | 3.92% |
| Investment securities | 631,137 | 6,238 | 1.98 | 614,532 | 4,914 | 1.60 |
| Interest-earning deposits | 48,113 | 1,125 | 4.65 | 656,682 | 1,384 | 0.42 |
| Total interest - earning assets | 4,652,505 | 126,522 | 5.48 | 4,830,675 | 75,552 | 3.16 |
| Allowance for credit losses | (43,553) | (35,486) | ||||
| Other assets | 313,590 | 327,569 | ||||
| Total assets | $4,922,542 | $5,122,758 | ||||
| LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||
| Interest-bearing deposits | $2,231,902 | $20,286 | 1.83% | $2,282,667 | $3,698 | 0.33% |
| Short-term borrowings | 218,678 | 1,373 | 1.27 | 196,328 | 99 | 0.10 |
| Federal Home Loan Bank advances | 394,708 | 4,845 | 2.44 | 373,290 | 3,774 | 2.01 |
| Other borrowings | 138,944 | 3,963 | 5.67 | 137,004 | 2,650 | 3.90 |
| Total interest-bearing liabilities | 2,984,232 | 30,467 | 2.06 | 2,989,289 | 10,221 | 0.69 |
| Noninterest-bearing deposits | 1,426,331 | 1,666,125 | ||||
| Other liabilities | 48,169 | 28,034 | ||||
| Shareholders’ equity | 463,810 | 439,310 | ||||
| Total liabilities and shareholders’ equity | $4,922,542 | $5,122,758 | ||||
| Net interest income | $96,055 | $65,331 | ||||
| Net interest rate spread | 3.42% | 2.47% | ||||
| Net interest spread on average assets | 3.93% | 2.57% | ||||
| Net interest margin on earning assets | 4.16% | 2.73% |
Provisions for credit losses of $2.0 million and $0.5 million were recorded during the second quarters of 2023 and 2022, respectively. A provision for credit losses of $2.6 million was recorded during the first six months of 2023, compared with a provision of $0.6 million during the first six months of 2022. The provision expense recorded during the 2023 periods mainly reflected allocations necessitated by net loan growth and adjustments to historical loss factors to better represent our expectations for future credit losses. The provision expense recorded during the prior-year periods primarily reflected allocations required by net loan growth, increased specific reserves for certain problem commercial loan relationships, and a higher reserve for residential mortgage loans stemming from slower principal prepayment rates and the associated extended average life of the portfolio. Ongoing strong loan quality metrics, including low levels of loan charge-offs, during the 2023 and 2022 periods largely mitigated additional reserves associated with the previously mentioned factors.
Noninterest income during the second quarter of 2023 was $7.6 million, compared to $7.7 million during the respective 2022 period, while noninterest income during the first six months of 2023 was $14.6 million, compared to $17.0 million during the first six months of 2022. Noninterest income during the second quarter and first six months of 2022 included a $0.5 million bank owned life insurance claim. Excluding the impact of this transaction, noninterest income increased $0.4 million, or 6.0%, during the second quarter of 2023 compared with the prior-year second quarter, and decreased $1.9 million, or 11.5%, during the first six months of 2023 compared with the first six months of 2022. The higher level of noninterest income during the second quarter of 2023 primarily stemmed from increased interest rate swap income, credit and debit card income, and payroll servicing fees, which more than offset decreased service charges on accounts and mortgage banking income. Growth in credit and debit card income and payroll servicing fees during the first six months of 2023 was outweighed by lower levels of mortgage banking income and service charges on accounts, resulting in a decline in noninterest income compared to the respective prior-year period. The declines in service charges on accounts reflected increased earnings credit rates in response to the increasing interest rate environment, while the reductions in mortgage banking income reflected higher residential mortgage loan rates stemming from the rising interest rate environment, resulting in significantly lower levels of refinance activity.
Noninterest expense totaled $27.8 million during the second quarter of 2023, compared to $26.9 million during the prior-year second quarter. Noninterest expense totaled $56.4 million during the first six months of 2023, compared to $52.7 million during the first six months of 2022. The increases in noninterest expense mainly resulted from larger compensation costs, including salary increases and higher bonus and commercial lender incentive accruals, which outweighed reductions in residential mortgage lender commissions and incentives. The higher levels of salary expense primarily stemmed from annual merit pay increases and market adjustments, as well as lower residential mortgage loan deferred salary costs. The reduced residential mortgage lender commissions and incentives mainly resulted from decreased loan production. The increases in overhead costs also resulted from the recording of increased credit reserves for unfunded loan commitments and higher levels of FDIC deposit insurance premiums, reflecting a higher industry-wide assessment rate, interest rate swap credit reserves and associated collateral interest costs, and health insurance accruals. Overhead costs during the first six months of 2023 included a $0.4 million write-down of a former branch facility in the first quarter of the year, while overhead costs during the second quarter and first six months of 2022 included a $0.4 million expense associated with the sale of a branch facility.
During the second quarter of 2023, we recorded income before federal income tax of $25.4 million and a federal income tax expense of $5.0 million. During the second quarter of 2022, we recorded income before federal income tax of $14.6 million and a federal income tax expense of $2.9 million. During the first six months of 2023, we recorded income before federal income tax of $51.5 million and a federal income tax expense of $10.2 million. During the first six months of 2022, we recorded income before federal income tax of $28.9 million and a federal income tax expense of $5.7 million. The increase in federal income tax expense in both 2023 periods resulted from higher levels of income before federal income tax. Our effective tax rate was 19.8% during the second quarter and first six months of 2023 and the respective 2022 periods.
Market risk
As filed, 7,824 characters, with its headings, lists and tables. Extracted from the main document; charts and exhibits are in the original on sec.gov.
Our primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. All of our transactions are denominated in U.S. dollars with no specific foreign exchange exposure. We have only limited agricultural-related loan assets and therefore have no significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates is assumed to be insignificant. Interest rate risk is the exposure of our financial condition to adverse movements in interest rates. We derive our income primarily from the excess of interest collected on our interest-earning assets over the interest paid on our interest-bearing liabilities. The rates of interest we earn on our assets and owe on our liabilities generally are established contractually for a period of time. Since market interest rates change over time, we are exposed to lower profitability if we cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to our earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to our safety and soundness.
Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. Our interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems and internal control procedures are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, we assess the existing and potential future effects of changes in interest rates on our financial condition, including capital adequacy, earnings, liquidity and asset quality.
We use two interest rate risk measurement techniques. The first, which is commonly referred to as GAP analysis, measures the difference between the dollar amounts of interest sensitive assets and liabilities that will be refinanced or repriced during a given time period. A significant repricing gap could result in a negative impact to our net interest margin during periods of changing market interest rates.
The following table depicts our GAP position as of June 30, 2023:
| Assets: | Within Three Months | Three to Twelve Months | One to Five Years | After Five Years | Total |
|---|---|---|---|---|---|
| Commercial loans | $2,075,911,000 | $101,646,000 | $888,657,000 | $179,209,000 | $3,245,423,000 |
| Residential real estate loans | 56,645,000 | 19,615,000 | 208,513,000 | 509,009,000 | 793,782,000 |
| Consumer loans | 2,279,000 | 511,000 | 8,936,000 | 912,000 | 12,638,000 |
| Securities (1) | 23,997,000 | 31,668,000 | 243,153,000 | 331,667,000 | 630,485,000 |
| Interest-earning deposits | 134,661,000 | 1,252,000 | 2,750,000 | 0 | 138,663,000 |
| Allowance for credit losses | 0 | 0 | 0 | 0 | (44,721,000) |
| Other assets | 0 | 0 | 0 | 0 | 361,317,000 |
| Total assets | 2,293,493,000 | 154,692,000 | 1,352,009,000 | 1,020,797,000 | $5,137,587,000 |
| Liabilities: | |||||
| Interest-bearing checking | 541,168,000 | 0 | 0 | 0 | 541,168,000 |
| Savings deposits | 314,606,000 | 0 | 0 | 0 | 314,606,000 |
| Money market accounts | 927,143,000 | 0 | 0 | 0 | 927,143,000 |
| Time deposits under $100,000 | 26,241,000 | 83,253,000 | 34,558,000 | 0 | 144,052,000 |
| Time deposits $100,000 & over | 80,036,000 | 243,052,000 | 135,099,000 | 0 | 458,187,000 |
| Short-term borrowings | 219,457,000 | 0 | 0 | 0 | 219,457,000 |
| Federal Home Loan Bank advances | 10,000,000 | 80,826,000 | 353,679,000 | 23,405,000 | 467,910,000 |
| Other borrowed money | 50,391,000 | 0 | 88,800,000 | 0 | 139,191,000 |
| Noninterest-bearing checking | 0 | 0 | 0 | 0 | 1,371,633,000 |
| Other liabilities | 0 | 0 | 0 | 0 | 75,538,000 |
| Total liabilities | 2,169,042,000 | 407,131,000 | 612,136,000 | 23,405,000 | 4,658,885,000 |
| Shareholders' equity | 0 | 0 | 0 | 0 | 478,702,000 |
| Total liabilities & shareholders' equity | 2,169,042,000 | 407,131,000 | 612,136,000 | 23,405,000 | $5,137,587,000 |
| Net asset (liability) GAP | $124,451,000 | $(252,439,000) | $739,873,000 | $997,392,000 | |
| Cumulative GAP | $124,451,000 | $(127,988,000) | $611,885,000 | $1,609,277,000 | |
| Percent of cumulative GAP to total assets | 2.4% | (2.5%) | 11.9% | 31.3% |
(1) Mortgage-backed securities are categorized by average life calculations based upon prepayment trends as of June 30, 2023.
The second interest rate risk measurement we use is commonly referred to as net interest income simulation analysis. We believe that this methodology provides a more accurate measurement of interest rate risk than the GAP analysis, and therefore, it serves as our primary interest rate risk measurement technique. The simulation model assesses the direction and magnitude of variations in net interest income resulting from potential changes in market interest rates.
Key assumptions in the model include prepayment speeds on various loan and investment assets; cash flows and maturities of interest sensitive assets and liabilities; and changes in market conditions impacting loan and deposit volume and pricing. These assumptions are inherently uncertain, subject to fluctuation and revision in a dynamic environment; therefore, the model cannot precisely estimate net interest income or exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions and our strategies, among other factors.
We conducted multiple simulations as of June 30, 2023, in which it was assumed that changes in market interest rates occurred ranging from up 300 basis points to down 300 basis points in equal quarterly instalments over the next twelve months. The following table reflects the suggested dollar and percentage changes in net interest income over the next twelve months in comparison to the $199 million in net interest income projected using our balance sheet amounts and anticipated replacement rates as of June 30, 2023. The resulting estimates are generally within our policy parameters established to manage and monitor interest rate risk.
| Interest Rate Scenario | Dollar Change In Net Interest Income | Percent Change In Net Interest Income |
|---|---|---|
| Interest rates down 300 basis points | $(19,900,000) | (10.0%) |
| Interest rates down 200 basis points | (15,500,000) | (7.8) |
| Interest rates down 100 basis points | (6,700,000) | (3.4) |
| Interest rates up 100 basis points | 6,500,000 | 3.3 |
| Interest rates up 200 basis points | 13,600,000 | 6.8 |
| Interest rates up 300 basis points | 20,800,000 | 10.4 |
The resulting estimates have been significantly impacted by the current interest rate and economic environments, as adjustments have been made to critical model inputs with regards to traditional interest rate relationships. This is especially important as it relates to floating rate commercial loans, which comprise a sizable portion of our balance sheet.
In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including: the growth, composition and absolute levels of loans, deposits, and other earning assets and interest-bearing liabilities; level of nonperforming assets; economic and competitive conditions; potential changes in lending, investing, and deposit gathering strategies; client preferences; and other factors.
Controls and procedures
As filed, 718 characters, with its headings, lists and tables. Extracted from the main document; charts and exhibits are in the original on sec.gov.
As of June 30, 2023, an evaluation was performed under the supervision of and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of June 30, 2023.
There have been no changes in our internal control over financial reporting during the quarter ended June 30, 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Risk factors
As filed, 159 characters, with its headings, lists and tables. Extracted from the main document; charts and exhibits are in the original on sec.gov.
There have been no material changes in our risk factors from those previously disclosed in our annual report on Form 10-K for the year ended December 31, 2022.
Figures reported in this filing
Standardized line items from the XBRL in this filing, for the period ended 2023-06-30. Comparative periods it repeats are left out.
| Line item | Period | Value | XBRL concept |
|---|---|---|---|
| Interest expense | 3 months2023-04-01 to 2023-06-30 | $18.4m | us-gaap:InterestExpense |
| Interest expense | 6 months2023-01-01 to 2023-06-30 | $30.5m | us-gaap:InterestExpense |
| Income tax | 3 months2023-04-01 to 2023-06-30 | $5.0m | us-gaap:IncomeTaxExpenseBenefit |
| Income tax | 6 months2023-01-01 to 2023-06-30 | $10.2m | us-gaap:IncomeTaxExpenseBenefit |
| Net income | 3 months2023-04-01 to 2023-06-30 | $20.4m | us-gaap:NetIncomeLoss |
| Net income | 6 months2023-01-01 to 2023-06-30 | $41.3m | us-gaap:NetIncomeLoss |
| Diluted EPS | 3 months2023-04-01 to 2023-06-30 | $1.27 | us-gaap:EarningsPerShareDiluted |
| Diluted EPS | 6 months2023-01-01 to 2023-06-30 | $2.58 | us-gaap:EarningsPerShareDiluted |
| Basic EPS | 3 months2023-04-01 to 2023-06-30 | $1.27 | us-gaap:EarningsPerShareBasic |
| Basic EPS | 6 months2023-01-01 to 2023-06-30 | $2.58 | us-gaap:EarningsPerShareBasic |
| Diluted shares (weighted) | 3 months2023-04-01 to 2023-06-30 | 16,003,372 shares | us-gaap:WeightedAverageNumberOfDilutedSharesOutstanding |
| Diluted shares (weighted) | 6 months2023-01-01 to 2023-06-30 | 15,999,775 shares | us-gaap:WeightedAverageNumberOfDilutedSharesOutstanding |
| Operating cash flow | 6 months2023-01-01 to 2023-06-30 | $37.5m | us-gaap:NetCashProvidedByUsedInOperatingActivities |
| Dividends paid | 6 months2023-01-01 to 2023-06-30 | $10.3m | us-gaap:PaymentsOfDividendsCommonStock |
| Total assets | At period end2023-06-30 | $5.14bn | us-gaap:Assets |
| Total liabilities | At period end2023-06-30 | $4.66bn | us-gaap:Liabilities |
| Shareholders' equity | At period end2023-06-30 | $478.7m | us-gaap:StockholdersEquity |
Source: SEC EDGAR, the filing index for accession 0001437749-23-022086. Last ingested by Listed: Oct 31, 2026, 03:06 ET. Listed shows no prices and gives no investment advice.