Mercantile Bank Corp: Form 10-Q for the period ended Sep 30, 2023

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 September 30, 2023 and December 31, 2022 and the results of operations for the three months and nine months ended September 30, 2023 and September 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 $20.9 million, or $1.30 per diluted share, for the third quarter of 2023, compared with net income of $16.0 million, or $1.01 per diluted share, during the third quarter of 2022. Net income for the first nine months of 2023 totaled $62.2 million, or $3.89 per diluted share, compared to $39.3 million, or $2.48 per diluted share, during the first nine 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 $87.0 million during the first nine 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 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 $246 million during the first nine months of 2023. As a percentage of total commercial loans, commercial and industrial loans and owner occupied commercial real estate (“CRE”) loans combined equaled 57.1% as of September 30, 2023, compared to 58.2% as of December 31, 2022. The new commercial loan pipeline remains strong, and at September 30, 2023, we had $379 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 $99.9 million during the first nine months of 2023, providing for an annualized growth rate of about 19%. With increased residential mortgage loan rates during 2022 and the first nine months 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 nine months of 2023, approximately 49% of our residential mortgage loan production was comprised of longer-term fixed rate loans, compared to nearly 36% in 2022 and approximately 68% 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 September 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 0.14% of total loans as of September 30, 2023. Accruing loans past due 30 to 89 days remain very low, and foreclosed properties totaled less than $0.1 million as of September 30, 2023. Gross loan charge-offs totaled $0.8 million during the first nine months of 2023, while recoveries of prior period loan charge-offs aggregated $0.7 million.

We recorded a provision expense of $5.9 million during the first nine months of 2023, generally reflecting allocations necessitated by net loan growth and adjustments to historical loss information to better represent our expectations for future credit losses. Changes to qualitative factors included a reduction of the historical loss information factor which coincided with adjustments to historical loss information and an allocation considering local economic conditions, particularly the potential impacts of the United Auto Workers strike against the three Detroit-based auto manufacturers. A higher reserve balance for residential mortgage loans stemming from slower principal prepayment rates and the resulting extended average life of the portfolio also impacted provision expense during the first nine months of 2023. Net changes in specific reserve balances reduced the reserve balance $0.9 million, while updated economic forecasts resulted in a $0.1 million reduction during the first nine months 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 nine months of 2023, the average balance of these funds equaled $102 million, or 2.2% of average earning assets, compared to $535 million, or 11.2% of average earning assets, during the first nine 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 nine 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 $201 million as of September 30, 2023, an increase of $167 million from December 31, 2022, and approximately $100 million higher than the average balance during the first nine 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. We experienced deposit growth, net of a large transfer from a sweep account to a deposit account, of approximately $100 million during the third quarter of 2023. We did not obtain any additional brokered deposits or FHLBI advances during the third quarter of 2023.

Total deposits and sweep accounts increased $158 million during the first nine months of 2023, totaling $4.06 billion at September 30, 2023. Local deposits and sweep accounts increased $46.4 million, while out-of-area deposits increased $111 million.

Net interest income increased $6.6 million and $37.3 million during the third quarter and first nine months of 2023, respectively, compared to the respective time periods in 2022. Interest income was $23.0 million and $74.0 million higher during the third quarter and first nine months of 2023, respectively, when compared to the same time periods in 2022, in large part reflecting an increasing rate environment and ongoing loan growth. Interest expense was $16.4 million and $36.7 million higher during the third quarter and first nine months of 2023, respectively, when compared to the respective time periods in 2022, primarily reflecting an increasing interest rate environment.

Noninterest income increased $2.0 million and decreased $0.5 million during the third quarter and first nine months of 2023, respectively, compared to the respective time periods in 2022. Mortgage banking income increased $1.0 million during the respective third quarter periods, while declining $1.2 million during the respective nine month periods, in large part reflecting changes in the volume of refinance activity and residential mortgage loans sold during the various time periods. 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 declined due to increased earnings credit rates on noninterest-bearing checking accounts.

Noninterest expense increased $2.1 million and $5.9 million during the third quarter and first nine months of 2023, respectively, compared to the respective time periods in 2022. The increased costs primarily resulted from higher compensation and benefit costs, increased Federal Deposit Insurance Corporation ("FDIC") insurance assessments reflecting the industry-wide adjustments effective January 1, 2023, and higher interest rate swap cash collateral holding costs.

Financial Condition

Our total assets increased $378 million during the first nine months of 2023, and totaled $5.25 billion as of September 30, 2023. Total loans were up $188 million, and interest-earning deposits increased $167 million. Total deposits increased $188 million, and FHLBI advances were up $150 million.

Commercial loans increased $87.0 million during the first nine 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 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 $246 million during the first nine months of 2023. Multi-family and residential rental property loans grew $41.8 million, owner-occupied CRE loans were up $31.9 million, non-owner occupied CRE loans increased $21.2 million, and vacant land, land development and residential construction loans were up $11.0 million, while commercial and industrial loans decreased $18.9 million. As a percentage of total commercial loans, commercial and industrial loans and owner occupied CRE loans combined equaled 57.1% as of September 30, 2023, compared to 58.2% as of December 31, 2022. Commercial loans totaled $3.22 billion, or 78.4% of total loans, as of September 30, 2023, compared to $3.13 billion, or 80.0% of total loans, as of December 31, 2022.

As of September 30, 2023, we had $379 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 $288 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 40% during the first nine months of 2023, which was at the lower end of our historical range of 40% to 45%.

Residential mortgage loans, excluding home equity lines of credit, increased $99.9 million during the first nine months of 2023, providing for an annualized growth rate of about 19%. With increased residential mortgage loan rates during 2022 and the first nine months of 2023, we 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 nine months of 2023, approximately 49% of our residential mortgage loan production was comprised of longer-term fixed rate loans, compared to nearly 36% in 2022 and approximately 68% 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 September 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 $0.7 million and other consumer-related loans increased $1.6 million during the first nine months of 2023, and at September 30, 2023 totaled $36.7 million and $31.4 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:

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 $5.9 million, or 0.1% of total loans, as of September 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 $5.9 million (0.1% of total assets) as of September 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

OTHER REAL ESTATE OWNED & REPOSSESSED ASSETS

58

The following tables provide a reconciliation of nonperforming assets:

NONPERFORMING LOANS RECONCILIATION

OTHER REAL ESTATE OWNED & REPOSSESSED ASSETS RECONCILIATION

Loan charge-offs totaled $0.2 million during the third quarter of 2023, and aggregated $0.8 million during the first nine months of 2023, while recoveries of prior period loan charge-offs equaled $0.2 million and $0.7 million during the respective time periods. Net loan charge-offs, as a percentage of average total loans, equaled an annualized 0.01% during both the third quarter and first nine months of 2023 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 $48.0 million, or 1.17% of total loans and over eight times the level of nonperforming loans, as of September 30, 2023. As of September 30, 2023, the allowance was comprised of $46.4 million in general reserves relating to performing loans and $1.6 million in specific reserves on other loans, primarily nonperforming loans. Loans with an aggregate carrying value of $0.4 million as of September 30, 2023 had been subject to previous partial charge-offs aggregating $0.3 million over the past several years. As of September 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 decreased $10.6 million during the first nine months of 2023, totaling $592 million as of September 30, 2023. There were no purchases of U.S. Government agency bonds during the first nine months of 2023. Proceeds from a matured U.S. Government agency bond totaling $2.0 million were received during the first nine months of 2023. There were no purchases of U.S. Government agency guaranteed mortgage-backed securities during the first nine months of 2023; however, we received $2.3 million of principal paydowns on U.S. Government agency guaranteed mortgage-backed securities. Purchases of municipal bonds totaled $13.0 million during the first nine months of 2023; proceeds from matured municipal bonds totaled $8.6 million. At September 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 September 30, 2023 totaled $592 million, including a net unrealized loss of $93.2 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 September 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 nine 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 nine months of 2023, the average balance of these funds equaled $102 million, or 2.2% of average earning assets, compared to $535 million, or 11.2% of average earning assets, during the first nine 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 nine 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 $201 million as of September 30, 2023, an increase of $167 million from December 31, 2022, and approximately $100 million higher than the average balance during the first nine 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. We experienced deposit growth, net of a large transfer from a sweep account to a deposit account, of approximately $100 million during the third quarter of 2023. We did not obtain any additional brokered deposits or FHLBI advances during the third quarter of 2023.

Net premises and equipment equaled $52.2 million at September 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 nine months of 2023, comprised of a $0.6 million transfer to foreclosed assets and a write-down of $0.4 million; this facility was sold during the third quarter of 2023 for $0.6 million. Depreciation expense totaled $4.4 million during the first nine months of 2023, while investments associated with the construction and opening of new facilities and the renovation of existing facilities totaled $6.2 million.

Total deposits increased $188 million during the first nine months of 2023, totaling $3.90 billion at September 30, 2023. Local deposits increased $76.6 million, while out-of-area deposits increased $111 million. We experienced a reduction in local deposits during the first part of 2023, reflecting a typical level of customers’ tax and bonus payments and partnership distributions. Local deposits increased $144 million during the third quarter of 2023. Wholesale funds, comprised of out-of-area deposits and FHLBI advances, totaled $569 million, or about 13% of total funds, as of September 30, 2023, compared to $308 million, or about 7% of total funds, at December 31, 2022.

Noninterest-bearing deposits decreased $295 million during the first nine months of 2023, in large part reflecting the aforementioned customary level of customers’ tax and bonus payments and partnership distributions during the first part of 2023, but also includes transfers to interest-bearing deposits and withdrawals associated with the sales of businesses. Interest-bearing checking accounts increased $95.8 million, including the aforementioned transfer from the sweep account product, during the first nine months of 2023. Savings deposits were down $94.7 million during the first nine months of 2023, primarily reflecting the transfers of funds to higher-paying money market deposit accounts and time deposits. Money market deposit accounts were up $200 million, in large part reflecting growth in deposits from existing and new municipal depositors, as well as from transfers from no- and low-cost deposit products. Local time deposits increased $171 million during the first nine months of 2023.

Sweep accounts decreased $30.3 million during the first nine months of 2023, totaling $164 million as of September 30, 2023. The decline includes the aforementioned transfer to the interest-bearing checking account product. 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 $212 million during the first nine months of 2023, with a high balance of $269 million and a low balance of $164 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 $150 million during the first nine months of 2023, totaling $458 million as of September 30, 2023. Bullet advances aggregating $200 million were obtained during the first nine 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 nine 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 September 30, 2023 totaled $888 million, with remaining availability based on collateral equaling $424 million.

Shareholders’ equity was $483 million at September 30, 2023, compared to $441 million at December 31, 2022. Negatively impacting shareholders’ equity during the first nine months of 2023 was net income of $62.2 million, which was partially offset by the payment of cash dividends totaling $15.7 million. An $8.2 million after-tax decrease in the market value of our available for sale securities portfolio, reflecting an increase in market interest rates, negatively impacted shareholders’ equity during the first nine 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 $569 million, or about 13% of combined deposits and borrowed funds, as of September 30, 2023, compared to $308 million, or about 7% of combined deposits and borrowed funds, as of December 31, 2022.

Sweep accounts decreased $30.3 million during the first nine months of 2023, totaling $164 million as of September 30, 2023. The decline includes the aforementioned transfer to the interest-bearing checking account product. 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 $212 million during the first nine months of 2023, with a high balance of $269 million and a low balance of $164 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 September 30, 2023 and during the first nine months of 2023 is as follows:

FHLBI advances increased $150 million during the first nine months of 2023, totaling $458 million as of September 30, 2023. Bullet advances aggregating $200 million were obtained during the first nine 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 nine 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 September 30, 2023 totaled $888 million, with remaining availability based on collateral equaling $424 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 nine months of 2023, with an average balance of $3.2 million. In contrast, our interest-earning deposit balance with the Federal Reserve Bank of Chicago averaged $95.0 million during the first nine 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 $25.4 million as of September 30, 2023. We did not utilize this line of credit during the first nine 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 September 30, 2023, significant fixed and determinable contractual obligations to third parties by payment date, excluding accrued interest:

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 September 30, 2023, we had a total of $1.78 billion in unfunded loan commitments and $19.4 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $1.49 billion were commitments available as lines of credit to be drawn at any time as customers’ cash needs vary, and $288 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 nine 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 $483 million at September 30, 2023, compared to $441 million at December 31, 2022. Positively impacting shareholders’ equity during the first nine months of 2023 was net income of $62.2 million, which was partially offset by the payment of cash dividends totaling $15.7 million. An $8.2 million after-tax decrease in the market value of our available for sale securities portfolio, reflecting an increase in market interest rates, negatively impacted shareholders’ equity during the first nine 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 September 30, 2023, our bank met all capital adequacy requirements under the BASEL III capital rules on a fully phased-in basis.

As of September 30, 2023, our bank’s total risk-based capital ratio was 13.8%, compared to 13.7% as of December 31, 2022. Our bank’s total regulatory capital increased $57.2 million during the first nine months of 2023, in large part reflecting net income totaling $70.0 million, which was partially offset by cash dividends paid to us aggregating $19.5 million. Our bank’s total risk-based capital ratio was also impacted by a $378 million increase in total risk-weighted assets, primarily resulting from net growth in commercial and residential mortgage loans. As of September 30, 2023, our bank’s total regulatory capital equaled $676 million, or $185 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 September 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 $20.9 million, or $1.30 per basic and diluted share, for the third quarter of 2023, compared with net income of $16.0 million, or $1.01 per basic and diluted share, for the third quarter of 2022. We recorded net income of $62.2 million, or $3.89 per basic and diluted share, for the first nine months of 2023, compared with net income of $39.3 million, or $2.48 per basic and diluted share, for the first nine months of 2022. Diluted earnings per share increased $0.29, or 28.7%, during the third quarter of 2023, and $1.41, or 56.9%, during the first nine months of 2023 compared with the respective prior-year periods.

The higher levels of net income during the third quarter and first nine months of 2023 compared to the respective prior-year periods primarily resulted from increased net interest income, which more than offset higher overhead costs and credit loss provisions. 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 collateral holding costs, and FDIC deposit insurance premiums. The provision expense recorded during the current-year third quarter mainly reflected the establishment of a specific reserve for a distressed commercial loan relationship, a qualitative factor assessment for local economic conditions, allocations necessitated by net loan growth, and a higher reserve for residential mortgage loans stemming from slower principal prepayment rates and the resulting extended average life of the portfolio. The provision expense recorded during the first nine months of 2023 generally reflected allocations necessitated by net loan growth, adjustments to historical loss information to better represent our expectations for future credit losses, and the previously mentioned higher reserve for residential mortgage loans. The provision expense recorded during the 2022 periods primarily reflected allocations necessitated by net loan growth, increased specific reserves for certain problem commercial loan relationships, a higher reserve for residential mortgage loans, and a decline in forecasted economic conditions. 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 gain on sale of other real estate owned, noninterest income increased $1.6 million, or nearly 22%, during the third quarter of 2023 compared with the prior-year third quarter. The higher level of noninterest income mainly stemmed from increased mortgage banking income, interest rate swap income, bank owned life insurance income, credit and debit card income, and payroll servicing fees, which more than offset decreased service charges on accounts. Noninterest income during the first nine months of 2023 declined in comparison to the first nine months of 2022 as higher levels of credit and debit card income, interest rate swap income, and payroll servicing fees were more than offset by lower levels of mortgage banking income and service charges on accounts.

Interest income during the third quarter of 2023 was $71.1 million, an increase of $23.0 million, or 47.8%, from the $48.1 million earned during the third quarter of 2022. The increase mainly resulted from a higher yield on average earning assets. The yield on average earning assets was 5.78% during the third quarter of 2023, up from 4.04% 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 6.37% during the third quarter of 2023, up from 4.56% during the prior-year third 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 375 basis points during the period of July 2022 through July 2023, during which time average variable-rate commercial loans represented approximately 65% of average total commercial loans. Increased yields on securities and interest earning deposits, reflecting the rising interest rate environment, along with a change in earning asset mix, comprised of an increase in higher-yielding loans as a percentage of earning assets, also contributed to the higher yield on average earning assets. Average loans represented 82.9% of average earning assets during the third quarter of 2023, up from 80.7% during the third quarter of 2022.

A higher level of earning assets also contributed to the increase in interest income during the third quarter of 2023. Average earning assets equaled $4.89 billion during the third quarter of 2023, up $163 million, or 3.4%, from the level of $4.73 billion during the prior-year third quarter; average loans and average securities were up $240 million and $8.7 million, respectively, while average interest-earning deposits were down $86.0 million.

Interest income during the first nine months of 2023 was $198 million, an increase of $74.0 million, or 59.9%, from the $124 million earned during the first nine months of 2022. The increase primarily resulted from a higher yield on average earning assets and loan growth. The yield on average earning assets was 5.59% during the first nine months of 2023, up from 3.45% 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 6.16% during the first nine months of 2023, up from 4.15% during the first nine months of 2022 primarily due to higher interest rates on variable-rate commercial loans stemming from FOMC rate hikes, which totaled 525 basis points during the period of March 2022 through July 2023. A change in earning asset mix, comprised of an increase in higher-yielding loans as a percentage of earning assets, along with increased yields on interest earning deposits and securities, depicting the rising interest rate environment, also contributed to the higher yield on average earning assets. On an average basis, higher-yielding loans represented 84.5% of earning assets during the first nine months of 2023, up from 76.0% during the first nine months of 2022.

Average earning assets equaled $4.73 billion during the first nine months of 2023, down $63.3 million, or 1.3%, from the level of $4.80 billion during the first nine months of 2022; average interest-earning deposits declined $432 million, average loans increased $355 million, and average securities were up $13.9 million.

Interest expense during the third quarter of 2023 was $22.2 million, an increase of $16.4 million, or 286%, from the $5.8 million expensed during the third quarter of 2022. The increase is mainly attributable to a higher average weighted cost of interest-bearing liabilities, which rose from 0.81% during the third quarter of 2022 to 2.69% during the current-year third 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 0.30% during the third quarter of 2022 to 2.17% during the third quarter of 2023, while the cost of time deposits increased from 0.98% to 3.85% 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 1.99% during the third quarter of 2022 to 2.98% during the third quarter of 2023 mainly due to higher costs of FHLBI advances, sweep accounts, and subordinated debentures. The cost of FHLBI advances increased from 1.98% during the third quarter of 2022 to 2.78% during the third quarter of 2023, while the cost of sweep accounts increased from 0.10% to 1.33% during the respective periods, reflecting the rising interest rate environment. The cost of subordinated debentures was 9.92% during the third quarter of 2023, up from 6.57% during the respective 2022 period due to increases in the 90-Day Libor Rate.

A change in funding mix, largely consisting of an increase in higher-costing time deposits as a percentage of interest-bearing liabilities, also contributed to the higher cost of interest-bearing liabilities during the third quarter of 2023. Average interest-bearing liabilities totaled $3.27 billion during the current-year third quarter, compared to $2.83 billion during the third quarter of 2022, representing an increase of $440 million, or 15.5%.

Interest expense during the first nine months of 2023 was $52.7 million, an increase of $36.7 million, or 230%, from the $16.0 million expensed during the first nine months of 2022. The increase is primarily attributable to a higher average weighted cost of interest-bearing liabilities, which rose from 0.73% during the first nine months of 2022 to 2.28% during the first nine months of 2023 mainly 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 first nine months of 2022 to 1.77% during the first nine months of 2023, while the cost of time deposits increased from 0.90% to 3.25% 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 first nine months of 2022 to 2.82% during first nine months 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 first nine months of 2022 to 1.22% during the first nine months of 2023, while the cost of FHLBI advances increased from 2.00% to 2.57% during the respective periods, reflecting the rising interest rate environment. The cost of subordinated debentures was 9.51% during the first nine months of 2023, up from 5.01% 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 first nine months of 2023. Average interest-bearing liabilities totaled $3.08 billion during the first nine months of 2023, up $145 million, or 4.9%, from $2.94 billion during the respective 2022 period.

Net interest income during the third quarter of 2023 was $49.0 million, an increase of $6.6 million, or 15.5%, from the $42.4 million earned during the respective 2022 period. The increase primarily resulted from a significantly improved net interest margin and growth in the loan portfolio. The net interest margin was 3.98% in the third quarter of 2023 up from 3.56% in the prior-year third quarter due to a higher yield on average earning assets, which more than offset an increase in the cost of funds. The increased yield, mainly stemmed from a higher yield on commercial loans. The cost of funds equaled 1.80% in the third quarter of 2023, up from 0.48% in the third 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 noninterest-bearing and lower-cost deposits and an increase in higher-cost money market accounts and time deposits, reflecting deposit migration and new deposit relationships.

Net interest income during the first nine months of 2023 was $145 million, an increase of $37.3 million, or 34.7%, from the $108 million earned during the first nine months of 2022. The increase mainly resulted from a substantially improved net interest margin and loan growth. The net interest margin increased from 3.00% in the first nine months of 2022 to 4.10% 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 1.49% during the first nine months of 2023, up from 0.45% 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 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 third quarters and first nine 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 third quarters and first nine 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 third quarter of both 2023 and 2022 and $180,000 in the first nine 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)

67

MERCANTILE BANK CORPORATION

(dollars in thousands)

Provisions for credit losses of $3.3 million and $2.9 million were recorded during the third quarters of 2023 and 2022, respectively. A provision for credit losses of $5.9 million was recorded during the first nine months of 2023, compared with a provision of $3.5 million during the first nine months of 2022. The provision expense recorded during the current year third quarter mainly reflected the establishment of a specific reserve for a distressed commercial loan relationship, a qualitative factor assessment for local economic conditions reflecting the potential impacts of the United Auto Workers strike against the three Detroit-based auto manufacturers, allocations necessitated by net loan growth, and a higher reserve for residential mortgage loans resulting from slower principal prepayment rates and the related extended average life of the portfolio. The provision expense recorded during the first nine months of 2023 generally reflected allocations necessitated by net loan growth and adjustments to historical loss information to better represent our expectations for future credit losses. Changes to qualitative factors during the first nine months of 2023 included a reduction of the historical loss information factor that coincided with adjustments to historical loss information and an allocation considering local economic conditions, particularly the potential impacts of the aforementioned United Auto Workers strike. An increased reserve balance for residential mortgage loans stemming from slower principal prepayment rates and the resulting extended average life of the portfolio also impacted provision expense during the first nine months of 2023. Net changes in specific reserve balances reduced the reserve balance $0.9 million, while updated economic forecasts resulted in a $0.1 million reduction to the reserve during the first nine months of 2023. The provision expense recorded during the third quarter of 2022 mainly reflected allocations necessitated by commercial loan and residential mortgage loan growth, increased specific reserves for certain distressed commercial loan relationships, and a decline in forecasted economic conditions. The provision expense recorded during the first nine months of 2022 primarily resulted from these factors, along with a higher reserve for residential mortgage loans stemming from slower principal prepayment rates and the associated extended average life of the portfolio. Sustained strength in 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 third quarter of 2023 was $9.2 million, compared to $7.3 million during the respective 2022 period. Noninterest income during the third quarter of 2023 included a $0.4 million gain on sale of other real estate owned. Excluding the impact of this transaction, noninterest income increased $1.6 million, or approximately 22%, during the third quarter of 2023 compared with the prior-year third quarter. The higher level of noninterest income mainly stemmed from increased mortgage banking income, interest rate swap income, bank owned life insurance income, credit and debit card income, and payroll servicing fees, which more than offset decreased service charges on accounts. The increase in mortgage banking income largely reflected a higher loan sold percentage, which increased from approximately 36% in the third quarter of 2022 to approximately 64% in the third quarter of 2023. The growth in interest rate swap income, credit and debit card income, and payroll servicing fees primarily resulted from the successful marketing of products and services to existing and new customers. The decline in service charges on accounts reflected increased earnings credit rates in response to the increasing interest rate environment.

Noninterest income during the first nine months of 2023 was $23.8 million, compared to $24.3 million during the first nine months of 2022. The lower level of noninterest income mainly reflected decreased mortgage banking income and service charges on accounts, which more than offset growth in credit and debit card income, interest rate swap income, and payroll servicing fees. The reduction in mortgage banking income primarily stemmed from lower production, the impact of which was partially offset by a higher loan sold percentage, which increased from approximately 36% during the first nine months of 2022 to nearly 49% during the first nine months of 2023. The decrease in service charges on accounts reflected the aforementioned increase in earnings credit rates. Noninterest income during the first nine months of 2023 included a $0.4 million gain on the sale of other real estate owned, while noninterest income during the first nine months of 2022 included a $0.5 million bank owned life insurance claim.

Noninterest expense totaled $28.9 million during the third quarter of 2023, compared to $26.8 million during the prior-year third quarter. The increase in noninterest expense primarily stemmed from larger salary and benefit costs, which outweighed decreased residential mortgage lender commissions and incentives and a lower bonus accrual. The increase in salary and benefit costs mainly resulted from annual merit pay increases, market adjustments, and higher health insurance accruals, as well as lower residential mortgage loan deferred salary costs. The decreased residential mortgage lender commissions and incentives primarily stemmed from reduced loan production. The increase in overhead costs during the third quarter of 2023 also resulted from higher levels of FDIC deposit insurance premiums, reflecting an increased industry-wide assessment rate, contributions to The Mercantile Bank Foundation, and interest rate swap collateral holding costs.

Noninterest expense during the first nine months of 2023 was $85.3 million, compared to $79.5 million during the first nine months of 2022. The increase in noninterest expense mainly resulted from larger salary and benefit costs, including salary increases and a higher bonus accrual, which outweighed reductions in residential mortgage lender commissions and incentives. The higher level of salary and benefit costs primarily stemmed from annual merit pay increases, market adjustments, and increased health insurance accruals, along with lower residential mortgage loan deferred salary costs. The reduced residential mortgage lender commissions and incentives mainly resulted from decreased loan production. The increase in overhead costs also resulted from the recording of increased credit reserves for unfunded loan commitments and higher levels of FDIC deposit insurance premiums and interest rate swap collateral holding costs. Overhead costs during the first nine months of 2023 included a $0.4 million write-down of a former branch facility that was recorded in the first quarter of the year, while overhead costs during the first nine months of 2022 included a $0.4 million expense associated with the sale of a branch facility that occurred in the second quarter of the year.

During the third quarter of 2023, we recorded income before federal income tax of $26.0 million and a federal income tax expense of $5.1 million. During the third quarter of 2022, we recorded income before federal income tax of $20.0 million and a federal income tax expense of $3.9 million. During the first nine months of 2023, we recorded income before federal income tax of $77.5 million and a federal income tax expense of $15.3 million. During the first nine months of 2022, we recorded income before federal income tax of $48.9 million and a federal income tax expense of $9.7 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 19.7% during the third quarter and first nine months of 2023 and the respective 2022 periods.

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 September 30, 2023:

(1) Mortgage-backed securities are categorized by average life calculations based upon prepayment trends as of September 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 September 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 $200 million in net interest income projected using our balance sheet amounts and anticipated replacement rates as of September 30, 2023. The resulting estimates are generally within our policy parameters established to manage and monitor interest rate risk.

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.

As of September 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 September 30, 2023.

There have been no changes in our internal control over financial reporting during the quarter ended September 30, 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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.