FS Bancorp, Inc.: Form 10-Q for the period ended Sep 30, 2023

Forward–Looking Statements

This report contains forward-looking statements, which can be identified by the use of words such as “believes,” “expects,” “anticipates,” “estimates,” or similar expressions. Forward-looking statements include, but are not limited to:

• statements of our goals, intentions, and expectations;
• statements regarding our business plans, prospects, growth, and operating strategies;
• statements regarding the quality of our loan and investment portfolios; and
• estimates of our risks and future costs and benefits.

These forward-looking statements are subject to significant risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

• expected revenues, cost savings, synergies and other benefits from our recently completed branch purchase, might not be realized within the expected time frames or at all and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, might be greater than expected;
• potential adverse impacts to economic conditions in the Company’s local market areas, other markets where the Company has lending relationships, or other aspects of the Company’s business operations or financial markets, including, without limitation, as a result of employment levels, labor shortages, the effects of inflation, a potential recession or slowed economic growth;
• changes in the interest rate environment, including the recent increases in the Board of Governors of the Federal Reserve System (“Federal Reserve”) benchmark rate and duration at which such increased interest rate levels are maintained, which could adversely affect our revenues and expenses, the values of our assets and obligations, and the availability and cost of capital and liquidity;
• the impact of continuing high inflation and the current and future monetary policies of the Federal Reserve in response thereto;
• the effects of any federal government shutdown;
• the credit risks of lending activities, including changes in the level and trend of loan delinquencies, write offs, changes in our allowance for credit losses (“ACL”) for loans, and provision for credit losses on loans that may be impacted by deterioration in the housing and commercial real estate markets;
• secondary market conditions and our ability to originate loans for sale and sell loans in the secondary market;
• fluctuations in the demand for loans, the number of unsold homes, land and other properties, and fluctuations in real estate values in our market area;
• staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges;
• the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation;
• changes in the interest rate environment that reduce our interest margins or reduce the fair value of financial instruments;
• increased competitive pressures among financial services companies;
• our ability to execute our plans to grow our residential construction lending, our home lending operations, our warehouse lending, and the geographic expansion of our indirect home improvement lending;
• our ability to attract and retain deposits;
• our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto;
• our ability to control operating costs and expenses;
• our ability to retain key members of our senior management team;
• changes in consumer spending, borrowing, and savings habits;
• our ability to successfully manage our growth;
• the impact of bank failures or adverse developments at other banks and related negative press about the banking industry in general on investor and depositor sentiment;
• legislative or regulatory changes that adversely affect our business including changes in banking, securities and tax law, and in regulatory policies and principles, or the interpretation of regulatory capital or other rules;

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• our ability to pay dividends on our common stock;
• the quality and composition of our securities portfolio and the impact of any adverse changes in the securities markets;
• changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Public Company Accounting Oversight Board or the Financial Accounting Standards Board (“FASB”);
• costs and effects of litigation, including settlements and judgments;
• disruptions, security breaches, or other adverse events, failures, or interruptions in, or attacks on, our information technology systems or on the third-party vendors who perform several of our critical processing functions;
• inability of key third-party vendors to perform their obligations to us;
• the economic impact of climate change, severe weather events, natural disasters, pandemics, epidemics and other public health crises, acts of war or terrorism, and other external events on our business;
• other economic, competitive, governmental, regulatory, and technical factors affecting our operations, pricing, products and services, and
• other risks described elsewhere in this Form 10‑Q and our other reports filed with or furnished to SEC, including our Annual Report on Form 10-K for the year ended December 31, 2022.

Any of the forward-looking statements made in this Form 10‑Q and in other public statements may turn out to be wrong because of inaccurate assumptions we might make, because of the factors illustrated above or because of other factors that we cannot foresee. Forward-looking statements are based upon management’s beliefs and assumptions at the time they are made. The Company undertakes no obligation to update or revise any forward-looking statement included in this report or to update the reasons why actual results could differ from those contained in such statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties and assumptions, the forward-looking statements discussed in this report might not occur and you should not put undue reliance on any forward-looking statements.

Overview

FS Bancorp and its subsidiary bank, 1st Security Bank have been serving the Puget Sound area since 1936. Originally chartered as a credit union, known as Washington’s Credit Union, the credit union served various select employment groups. On April 1, 2004, the credit union converted to a Washington state-chartered mutual savings bank. On July 9, 2012, the Bank converted from mutual to stock ownership and became the wholly owned subsidiary of FS Bancorp.

The Company is relationship-driven, delivering banking and financial services to local families, local and regional businesses and industry niches in suburban communities in the greater Puget Sound area, the Kennewick-Pasco-Richland metropolitan area of Washington, also known as the Tri-Cities, Goldendale, Vancouver, and White Salmon, Washington and Manzanita, Newport, Ontario, Tillamook and Waldport, Oregon. On February 24, 2023, the Company completed its purchase of seven retail bank branches from Columbia State Bank (the “Branch Purchase”) and acquired approximately $425.5 million in deposits and $66.1 million in loans. The seven acquired branches are in the communities of Goldendale, and White Salmon, Washington, and Manzanita, Newport, Ontario, Tillamook, and Waldport, Oregon. The Branch Purchase expanded our Puget Sound-focused retail footprint into southeast Washington and the state of Oregon as well as providing an opportunity to extend our unique brand of community banking into those communities.

The Company also maintains its long-standing indirect consumer lending platform which operates primarily throughout the Western United States and has been expanding its partnership with companies present in other areas of the country as well. The Company emphasizes long-term relationships with families and businesses within the communities served, working with them to meet their financial needs. The Company is also actively involved in community activities and events within these market areas, which further strengthens our relationships within those markets.

The Company focuses on diversifying revenues, expanding lending channels, and growing the banking franchise. Management remains focused on building diversified revenue streams based upon credit, interest rate, and concentration risks. Our business plan remains as follows:

• Growing and diversifying our loan portfolio;
• Maintaining strong asset quality;
• Emphasizing lower cost core deposits to reduce the costs of funding our loan growth;
• Capturing our customers’ full relationship by offering a wide range of products and services by leveraging our well-established involvement in our communities and by selectively emphasizing products and services designed to meet our customers’ banking needs; and
• Expanding the Company’s markets.

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The Company is a diversified lender with a focus on the origination of one-to-four-family loans, commercial real estate mortgage loans, second mortgage or home equity loan products, consumer loans including indirect home improvement (“fixture secured”) loans which also include solar-related home improvement loans, marine lending, and commercial business loans. As part of our expanding lending products, the Company additionally offers residential mortgage and commercial construction warehouse lending consistent with our business plan to further diversify revenues. Historically, consumer loans, in particular, fixture secured loans had represented the largest portion of the Company’s loan portfolio and had traditionally been the mainstay of the Company’s lending strategy. At September 30, 2023, consumer loans represented 26.6% of the Company’s total gross loan portfolio, compared to 24.6% at September 30, 2022. In recent years, the Company has placed more of an emphasis on real estate lending products, such as one-to-four-family loans, commercial real estate loans, including speculative residential construction loans, and commercial business loans, while growing the current size of the consumer loan portfolio.

Fixture secured loans to finance window, gutter, siding replacement, solar panels, spas, and other improvement renovations are a large and regionally expanding segment of the consumer loan portfolio. These fixture-secured consumer loans are dependent on the Bank’s contractor/dealer network of 92 active dealers located throughout Washington, Oregon, California, Idaho, Colorado, Nevada, Arizona, Minnesota, Texas, Utah, Massachusetts, Montana, and most recently, New Hampshire with five contractor/dealers responsible for 65.5% of the dollar volume of funded loans for the three months ended September 30, 2023. Management reviewed dealer concentrations and determined, as of September 30, 2023, any dealer owned by the same corporate entity will now be included under that corporate entity and not as a separate dealer. The Company funded $39.0 million or approximately 1,700 loans during the quarter ended September 30, 2023. The following table details fixture secured loan originations by state for the periods indicated:

(Dollars in thousands)

The Company originates one-to-four-family residential mortgage loans through referrals from real estate agents, financial planners, builders, and from existing customers. Retail banking customers are also an important source of the Company’s loan originations. The Company originated $151.3 million of one-to-four-family loans (which included loans held for sale, loans held for investment and fixed seconds) in addition to $4.4 million of loans brokered to other institutions through the home lending segment during the three months ended September 30, 2023, of which $117.6 million were sold to investors. Of the loans sold to investors, $76.6 million were sold to the FNMA, FHLMC, FHLB, and/or GNMA with servicing rights retained for the purpose of further developing these customer relationships. At September 30, 2023, one-to-four-family residential mortgage loans held for investment, which excludes loans held for sale of $18.6 million, totaled $540.7 million, or 22.5%, of the total gross loan portfolio.

For the three months ended September 30, 2023, one-to-four-family loan originations and refinancing activity decreased as a result of increased market interest rates. Residential construction and development lending, while not as common as other loan origination options like one-to-four-family loans, will continue to be an important element in our total loan portfolio, and we will continue to take a disciplined approach by concentrating our efforts on loans to builders and developers in our market areas known to us. These short-term loans typically mature in six to 18 months. In addition, the funding is usually not fully disbursed at origination, thereby reducing our net loans receivable in the short term.

The Company is significantly affected by prevailing economic conditions, as well as government policies and regulations concerning, among other things, monetary and fiscal affairs. Deposit flows are influenced by several factors, including interest rates paid on time deposits, other investments, account maturities, and the overall level of personal income and savings. Lending activities are influenced by the demand for funds, the number and quality of lenders, and regional economic cycles. Sources of funds for lending activities include primarily deposits, including brokered deposits, borrowings, payments on loans, and income provided from operations.

The Company’s earnings are primarily dependent upon net interest income, the difference between interest income and interest expense. Interest income is a function of the balances of loans and investments outstanding during a given period and the yield earned on these loans and investments. Interest expense is a function of the amount of deposits and borrowings outstanding during the same period and interest rates paid on these deposits and borrowings.

The Company’s earnings are also significantly affected by fee income from mortgage banking activities, the provision for (recovery of) credit losses, service charges and fees, gains from sales of assets, operating expenses and income taxes. Most notable of these factors, the Company recorded a provision for credit losses $548,000 for the three months ended September 30, 2023, compared to $1.7 million for the same period one year ago. The decreased provision in the current period was primarily due to a decrease in net loan growth, particularly in consumer loans.

Critical Accounting Estimates

We prepare our consolidated financial statements in accordance with GAAP. In doing so, we must make estimates and assumptions. Our critical accounting estimates are those estimates that involve a significant level of uncertainty at the time the estimate was made, and changes in the estimate that are reasonably likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. Accordingly, actual results could differ materially from our estimates. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. Management believes that its critical accounting policies include the following:

Allowance for Credit Losses on Held-to-Maturity Securities. Management measures expected credit losses on held-to-maturity securities by individual security. Accrued interest receivable on held-to-maturity debt securities is excluded from the estimate of credit losses. The estimate of expected credit losses considers credit ratings and historical credit loss information that is adjusted for current conditions and reasonable and supportable forecasts.

The held-to-maturity portfolio consists entirely of corporate securities. Securities are generally rated investment grade or higher. Securities are analyzed individually to establish a reserve.

Allowance for Credit Losses on Available-for-Sale Securities. For available-for-sale securities in an unrealized loss position, management first assesses whether it intends to sell, or is more likely than not to be required to sell, the security before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the security’s amortized cost basis is written down to fair value through income. For debt securities available-for-sale that do not meet the aforementioned criteria, the Company evaluates whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency, and adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an ACL is recorded, limited by the amount that the fair value is less than the amortized cost basis.

Changes in the ACL are recorded as a provision for (or reversal of) credit loss expense. Losses are charged against the allowance when management believes the uncollectibility of an available-for-sale security is confirmed or when either of the criteria regarding intent or requirement to sell is met. Accrued interest receivable on available-for-sale debt securities is not included in the estimate of credit losses.

Allowance for Credit Losses on Loans. The ACL for loans is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on the loans. Loans are charged off against the allowance when management believes the uncollectibility of a loan balance is confirmed and recoveries are credited to the allowance when received. In the case of recoveries, amounts may not exceed the aggregate of amounts previously charged off.

Management utilizes relevant available information, from internal and external sources, relating to past events, current conditions, historical loss experience, and reasonable and supportable forecasts. The lookback period in the analysis includes historical data from 2009 to present. Adjustments to historical loss information are made when management determines historical data is not likely reflective of the current portfolio such as limited data sets or lack of default or loss history. Management may selectively apply external market data to subjectively adjust the Company’s own loss history including index or peer data. Accrued interest receivable is excluded from the estimate of credit losses for loans.

Collective Assessment. The ACL for loans is measured on a collective cohort basis when similar risk characteristics exist. Generally, collectively assessed loans are grouped by call report code and then risk-grade grouping. Risk grade is grouped within each call report code by pass, watch, special mention, substandard, and doubtful. Other loan types are separated into their own cohorts due to specific risk characteristics for that pool of loans.

The Company has elected a non-discounted cash flow methodology with probability of default (“PD”) and loss given default (“LGD”) for all call report code cohorts (“cohorts”), except for the indirect and marine portfolios which are evaluated under a vintage methodology. The vintage methodology measures the expected loss calculation for future periods based on historical performance by the origination period of loans with similar life cycles and risk characteristics. Guaranteed portions of loans are measured with zero risk due to cash collateral and full guaranty.

The PD calculation looks at the historical loan portfolio at points in time (each month during the lookback period) to determine the probability that loans in a certain cohort will default over the next 12-month period. A default is defined as a loan that has moved to past due 90 days and greater, nonaccrual status, or experienced a charge-off during the period. In cohorts where the Company’s historical data is insufficient due to a minimal amount of default activity or zero defaults, management uses index PDs comprised of rates derived from the PD experience of other community banks in place of the Company’s historical PDs. Additionally, management reviews all other cohorts to determine if index PDs should be used outside of these criteria.

The LGD calculation looks at actual losses (net charge-offs) experienced over the entire lookback period for each cohort of loans. The aggregate loss amount is divided by the exposure at default to determine an LGD rate. All defaults (non-accrual, charge-off, or greater than 90 days past due) occurring during the lookback period are included in the denominator, whether a loss occurred or not and exposure at default is determined by the loan balance immediately preceding the default event (i.e., nonaccrual or charge-off). Due to limited charge-off history, management uses index LGDs comprised of rates derived from the LGD experience of other community banks in place of the Company’s historical LGDs.

The Company utilizes reasonable and supportable forecasts of future economic conditions when estimating the ACL for loans. The calculation includes a 12-month PD forecast based on the Company’s regression model comparing peer nonperforming loan ratios to the national unemployment rate. After the forecast period, PD rates revert on a straight-line basis back to long-term historical average rates over a 12-month period. Due to limited default history, management uses index PDs comprised of rates derived from the PD experience of other community banks in place of the Company’s historical PDs.

The Company recognizes that all significant factors that affect the collectability of the loan portfolio must be considered to determine the estimated credit losses as of the evaluation date. Furthermore, the methodology, in and of itself and even when selectively adjusted by comparison to market and peer data, does not provide a sufficient basis to determine the estimated credit losses. The Company adjusts the modeled historical losses by qualitative and environmental adjustments to incorporate all significant risks to form a sufficient basis to estimate the credit losses.

Individual Assessment. Loans classified as nonaccrual, are reviewed quarterly for potential individual assessment. Any loan classified as a nonaccrual that is not determined to need individual assessment is evaluated collectively within its respective cohort.

Where the primary and/or expected source of repayment of a specific loan is believed to be the future liquidation of available collateral, impairment will generally be measured based upon expected future collateral proceeds, net of disposition expenses including sales commissions as well as other costs potentially necessary to sell the asset(s) (i.e., past due taxes, liens, etc.). Estimates of future collateral proceeds will be based upon available appraisals, reference to recent valuations of comparable properties, use of consultants or other professionals with relevant market and/or property-specific knowledge, and any other sources of information believed appropriate by management under the specific circumstances. When appraisals are ordered to support the impairment analysis of an impaired loan, the appraisal is reviewed by the Company’s internal appraisal reviewer.

Where the primary and/or expected source of repayment of a specific loan is believed to be the receipt of principal and interest payments from the borrower and/or the refinancing of the loan by another creditor, impairment will generally be measured based upon the present value of expected proceeds discounted at the contractual interest rate. Expected refinancing proceeds may be estimated from review of term sheets received by the borrower from other creditors and/or from the Company’s knowledge of terms generally available from other banks.

Determining the Contractual Term. Expected credit losses are estimated over the contractual term of the loans, adjusted for expected prepayments when appropriate. The contractual term excludes expected extensions, renewals and modifications. Prepayment assumptions will be determined by analysis of historical behavior by loan cohort.

Allowance for Credit Losses on Unfunded Commitments. The Company estimates expected credit losses over the contractual period in which the Company is exposed to credit risk via a contractual obligation to extend credit unless that obligation is unconditionally cancellable by the Company. The ACL for unfunded commitments is adjusted through a provision for credit loss expense. The estimate includes consideration of the likelihood that funding will occur and an estimate of expected credit losses on commitments expected to be funded over its estimated life. The estimate utilizes the same factors and assumptions as the ACL for loans and is applied at the same collective cohort level.

Mortgage Servicing Rights. Servicing assets are recognized as separate assets when rights are acquired through the purchase or through the sale of financial assets. Generally, purchased servicing rights are capitalized at the cost to acquire the rights. For sales of mortgage loans, the value of MSR is capitalized during the month of sale. Fair value is based on market prices for comparable mortgage contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds, and default rates and losses.

Servicing assets are evaluated quarterly for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant characteristics, such as interest rate, loan type, and investor type. Impairment is recognized through a valuation allowance for an individual tranche, to the extent that fair value is less than the capitalized amount for the tranches. If the Company later determines that all or a portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as a recovery and an increase to income. Capitalized servicing rights are stated separately on the Consolidated Balance Sheets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets.

Derivatives and Hedging Activity. ASC 815, “Derivatives and Hedging,” requires that derivatives of the Company be recorded in the consolidated financial statements at fair value. Management considers its accounting policy for derivatives to be a critical accounting policy because these instruments have certain interest rate risk characteristics that change in value based upon changes in the capital markets. Fair values for derivative assets and liabilities are measured on a recurring basis. The Company’s primary use of derivative instruments is related to the mortgage banking activities in the form of commitments to extend credit, commitments to sell loans, TBA mortgage-backed securities trades and option contracts to mitigate the risk of the commitments to extend credit. Estimates of the percentage of commitments to extend credit on loans to be held for sale that may not fund are based upon historical data and current market trends. The fair value adjustments of the derivatives are recorded on the Consolidated Statements of Income with offsets to other assets or other liabilities on the Consolidated Balance Sheets.

Derivative instruments not related to mortgage banking activities primarily relate to interest rate swap agreements accounted for as cash flow hedges and fair value hedges. To qualify for hedge accounting, derivatives must be highly effective at reducing the risk associated with the exposure being hedged and must be designated as a hedge at the inception of the derivative contract. If derivative instruments are designated as fair value hedges, and such hedges are highly effective, both the change in the fair value of the hedge and the hedged item are included in current earnings. If derivative instruments are designated as cash flow hedges, fair value adjustments related to the effective portion are recorded in other comprehensive income and are reclassified to earnings when the hedged transaction is reflected in earnings. If derivative instruments are designated as cash flow hedges, fair value adjustments related to the effective portion are recorded in other comprehensive income and are reclassified to earnings when the hedged transaction is reflected in earnings. Ineffective portions of cash flow hedges are reflected in earnings as they occur. Actual cash receipts and/or payments and related accruals on derivatives related to hedges are recorded as adjustments to the interest income or interest expense associated with the hedged item. During the life of the hedge, the Company formally assesses whether derivatives designated as hedging instruments continue to be highly effective in offsetting changes in the fair value or cash flows of hedged items. If it is determined that a hedge has ceased to be highly effective, the Company will discontinue hedge accounting prospectively. At such time, previous adjustments to the carrying value of the hedged item are reversed into current earnings and the derivative instrument is reclassified to a trading position recorded at fair value. For derivatives not designated as hedges, changes in fair value are recognized in earnings, in noninterest income.

Fair Value. ASC 820, “Fair Value Measurements and Disclosures,” establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by several factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction. The objective of a fair value measurement is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions (that is, an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability). For additional details, see “Note 11 – Fair Value Measurements” of the Notes to Consolidated Financial Statements included in Part I. Item 1 of this report.

Business Combinations and Goodwill. Pursuant to applicable accounting guidance, we recognize assets acquired, including identified intangible assets, and the liabilities assumed in acquisitions at their fair values as of the acquisition date, with the related transaction costs expensed in the period incurred. Determining the fair value of assets acquired and liabilities assumed often involves estimates based on internal or third-party valuations which include appraisals, discounted cash flow analysis, or other valuation techniques that may include estimates of attrition, inflation, asset growth rates, discount rates, credit risk, multiples of earnings, or other relevant factors. The determination of fair value may require us to make point-in-time estimates about discount rates, future expected cash flows, market conditions, and other future events that can be volatile in nature and challenging to assess. While we use the best estimates and assumptions to accurately value assets acquired and liabilities assumed at the acquisition date, the estimates are inherently uncertain and subject to refinement.

The primary identifiable intangible asset we typically record in connection with a whole bank or bank branch acquisition is the value of the core deposit intangibles which represents the estimated value of the long-term deposit relationships acquired in the transaction. Determining the amount of identifiable intangible assets and their average lives involves multiple assumptions and estimates and is typically determined by performing a discounted cash flow analysis, which involves a combination of any or all the following assumptions: customer attrition/runoff, alternative funding costs, deposit servicing costs, and discount rates. The core deposit intangibles are amortized over the estimated useful lives of the deposit accounts based on a method that we believe reasonably approximates the anticipated benefit stream from this intangible. The estimated useful lives are periodically reviewed for reasonableness and have generally been estimated to have a life ranging from seven to ten years, with an accelerated rate of amortization. We review identifiable intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Our policy is that an impairment loss is recognized, equal to the difference between the asset’s carrying amount and its fair value, if the sum of the expected undiscounted future cash flows is less than the carrying amount of the asset. Estimating future cash flows involves the use of multiple estimates and assumptions, such as those listed above.

The ACL for purchase credit deteriorated (“PCD”) assets is recognized within business combination accounting with no initial impact to net income. Changes in estimates of expected credit losses on PCD loans after acquisition are recognized as provision expense (or reversal of provision expense) in subsequent periods as they arise. The ACL for non-PCD assets is recognized as provision expense in the same reporting period as the business combination. Estimated loan losses for acquired loans are determined using methodologies and applying estimates and assumptions that were described previously in the Allowance for Credit Losses on Loans section.

Non-PCD loans acquired are generally estimated at fair value using a discounted cash flow approach with assumptions of discount rate, remaining life, prepayments, probability of default, and loss given default. The actual cash flows on these loans could differ materially from the fair value estimates. The amount we record as the fair values for the loans is generally less than the contractual unpaid principal balance due from the borrowers, with the difference being referred to as the “discount” on the acquired loans. Discounts on acquired non-PCD loans are accreted to interest income over their estimated remaining lives, which may include prepayment estimates in certain circumstances.

Similarly, premiums or discounts on acquired debt are accreted or amortized to interest expense over their remaining lives. Actual accretion or amortization of premiums and discounts from a business acquisition may differ materially from our estimates impacting our operating results.

Goodwill arising from business combinations represents the excess of the purchase price over the sum of the estimated fair values of the tangible and identifiable intangible assets acquired less the estimated fair value of the liabilities assumed. Goodwill has an indefinite useful life and is evaluated for impairment annually or more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. We believe that the accounting for goodwill also involves a higher degree of judgment than most other significant accounting policies. ASC 350–10 establishes standards for an impairment assessment of goodwill.

At each reporting date between annual goodwill impairment tests, we consider potential indicators of impairment. Generally, absent potential impairment indicators, we perform an annual assessment of whether the events and circumstances resulted in it being more likely than not that the fair value of any reporting unit was less than its carrying value. Impairment indicators considered include the condition of the economy and banking industry; government intervention and regulatory updates; the impact of recent events to financial performance and cost factors of the reporting unit; performance of the Company's stock, and other relevant events.

Income Taxes. Income taxes are reflected in the Company’s consolidated financial statements to show the tax effects of the operations and transactions reported in the consolidated financial statements and consist of taxes currently payable plus deferred taxes. ASC 740, “Accounting for Income Taxes,” requires the asset and liability approach for financial accounting and reporting for deferred income taxes. Deferred tax assets and liabilities result from temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities. They are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled and are determined using the assets and liability method of accounting. The deferred income tax provision represents the difference between net deferred tax asset/liability at the beginning and end of the reported period. In formulating the deferred tax asset, the Company is required to estimate income and taxes in the jurisdiction in which the Company operates. This process involves estimating the actual current tax exposure for the reported period together with assessing temporary differences resulting from differing treatment of items, such as depreciation and the provision for credit losses, for tax and financial reporting purposes.

Deferred tax assets and liabilities occur when taxable income is larger or smaller than reported income on the income statements due to accounting valuation methods that differ from tax, as well as tax rate estimates and payments made quarterly and adjusted to actual at the end of the year. Deferred tax assets and liabilities are temporary differences deductible or payable in future periods. The Company had net deferred tax assets of $7.4 million and $6.7 million, at September 30, 2023 and December 31, 2022, respectively.

Comparison of Financial Condition at September 30, 2023 and December 31, 2022

Assets. Total assets increased $287.2 million to $2.92 billion at September 30, 2023, from $2.63 billion at December 31, 2022, primarily due to an increase in loans receivable, net of $184.7 million, approximately $60.1 million of which was acquired in the Branch Purchase, as well as increases in total cash and cash equivalents of $39.2 million, securities available-for-sale of $22.7 million, CDI, net of $15.0 million, certificates of deposit (“CDs”) at other financial institutions of $12.9 million, other assets of $9.3 million, premises and equipment of $5.8 million, accrued interest receivable of $2.8 million, and goodwill of $1.3 million. These increases were partially offset by decreases in FHLB stock of $6.9 million and loans held for sale of $1.5 million.

Loans receivable, net increased $184.7 million to $2.38 billion at September 30, 2023, from $2.19 billion at December 31, 2022, which included approximately $60.1 million in loans acquired in the Branch Purchase. Total real estate loans increased $84.7 million, including increases in one-to-four-family loans of $71.2 million, commercial real estate loans of $30.6 million, multi-family loans of $23.9 million, and home equity loans of $11.7 million, partially offset by a decrease in construction and development loans of $52.7 million. Undisbursed construction and development loan commitments decreased $40.5 million, to $161.2 million at September 30, 2023, as compared to $201.7 million at December 31, 2022. Consumer loans increased $70.5 million primarily due to an increase of $66.7 million in indirect home improvement loans and $3.3 million in marine loans. Commercial business loans increased $32.0 million as a result of an increase in commercial and industrial lending of $39.7 million, partially offset by a decrease in warehouse lending of $7.7 million.

Loans held for sale, consisting of one-to-four-family loans, decreased by $1.5 million to $18.6 million at September 30, 2023, from $20.1 million at December 31, 2022. The Company continues to invest in its home lending operations and strategically add production staff in the markets we serve.

One-to-four-family loan originations for the nine months ended September 30, 2023, included $292.3 million of loans originated for sale, $117.3 million of portfolio loans including first and second liens, and $12.3 million of loans brokered to other institutions.

Originations of one-to-four-family loans for the periods indicated were as follows:

(Dollars in thousands)

During the nine months ended September 30, 2023, the Company sold $320.9 million of one-to-four-family loans compared to sales of $639.0 million for the same period one year ago. Gross margin on home loan sales increased to 3.07% for the nine months ended September 30, 2023, compared to 2.85% for the nine months ended September 30, 2022. Gross margin is defined as the margin on loans sold (cash sales) without the impact of deferred costs.

The ACL for loans was $30.5 million or 1.27% of gross loans receivable (excluding loans held for sale), at September 30, 2023, compared to $28.0 million or 1.26% of gross loans receivable (excluding loans held for sale), at December 31, 2022. The increase was primarily due to an increase in loans and increased reserves on individually evaluated nonaccrual loans.

Loans classified as substandard decreased $1.0 million to $19.2 million at September 30, 2023, compared to $20.2 million at December 31, 2022. The decrease was primarily due to a decrease of $1.8 million in commercial real estate loans, partially offset by increases of $600,000 in indirect home improvement loans and $200,000 in one-to-four-family loans. Nonperforming loans, consisting solely of nonaccrual loans, decreased $3.1 million to $5.6 million at September 30, 2023, from $8.7 million at December 31, 2022. The ratio of nonperforming loans to total gross loans was 0.23% at September 30, 2023, compared to 0.39% at December 31, 2022. There was one OREO property in the amount of $570,000 (a closed branch in Centralia, Washington) at both September 30, 2023 and December 31, 2022.

Liabilities. Total liabilities increased $268.2 million to $2.67 billion at September 30, 2023, from $2.40 billion at December 31, 2022, primarily due to increases of $326.7 million in deposits, $5.3 million in other liabilities and $795,000 in operating lease liability, offset by a decrease of $64.6 million in borrowings.

Total deposits increased $326.7 million to $2.45 billion at September 30, 2023, from $2.13 billion at December 31, 2022, due to the Branch Purchase in which we acquired approximately $424.9 million in deposits. CDs increased $287.2 million to $1.02 billion at September 30, 2023, from $729.8 million at December 31, 2022. Transactional accounts (noninterest-bearing checking, interest-bearing checking and escrow accounts) increased $200.3 million to $889.6 million at September 30, 2023, from $689.3 million at December 31, 2022, due to increases of $105.7 million in noninterest-bearing checking, $84.3 million in interest-bearing checking and $10.3 in escrow accounts related to mortgages serviced. Money market and savings accounts decreased $160.8 million to $547.9 million at September 30, 2023, from $708.6 million at December 31, 2022 as depositors shifted funds to higher yielding CDs and other investment alternatives.

Deposits are summarized as follows at the dates indicated:

(Dollars in thousands)

(1) Includes $50.1 million and $2.3 million of brokered deposits at September 30, 2023 and December 31, 2022, respectively.

(2) Includes $51,000 and $59.7 million of brokered deposits at September 30, 2023 and December 31, 2022, respectively.

(3) Includes $323.3 million and $332.0 million of brokered CDs at September 30, 2023 and December 31, 2022, respectively.

(4) CDs that meet or exceed the FDIC insurance limit.

(5) Noninterest-bearing checking.

The Bank had uninsured deposits of approximately $591.6 million or 24.1% of total deposits, at September 30, 2023, compared to approximately $560.0 million or 26.3% of total deposits at December 31, 2022. The uninsured amounts are estimates based on the methodologies and assumptions used for the Bank’s regulatory reporting requirements.

At September 30, 2023, borrowings totaled $121.9 million and were comprised of advances from the Federal Reserve Bank’s Term Funding Program of $90.0 million, overnight funding of $28.0 million, and advances from the and FHLB fixed-rate advances of $3.9 million. Borrowings decreased $64.6 million to $121.9 million at September 30, 2023, from $186.5 million of FHLB advances at December 31, 2022. The decrease was partially attributable to a shift in funding mix to brokered CDs.

Stockholders’ Equity. Total stockholders’ equity increased $19.0 million to $250.7 million at September 30, 2023, from $231.7 million at December 31, 2022. The increase in stockholders’ equity at September 30, 2023, compared to December 31, 2022, was primarily due to net income of $26.3 million, partially offset by dividends paid of $5.8 million. In addition, stockholders’ equity was positively impacted by unrealized gains on fair value and cash flow hedges of $3.6 million, net of tax, and unrealized net losses in securities available-for-sale of $7.3 million, net of tax, reflecting changes in market interest rates during the period, resulting in a $3.8 million decrease in accumulated other comprehensive income. Book value per common share was $32.58 at September 30, 2023, compared to $30.42 at December 31, 2022.

We calculated book value per share at September 30, 2023, based on 7,693,951 common shares, which was the difference between the 7,796,095 reported common shares and 102,144 unvested restricted stock shares outstanding as of that date. We calculated book value per share at December 31, 2022, based on 7,617,655 common shares, which was the difference between the 7,736,185 reported common shares and 118,530 unvested restricted stock shares outstanding as of that date.

Comparison of Results of Operations for the Three Months Ended September 30, 2023 and 2022

General. Net income was $9.0 million for the three months ended September 30, 2023, and $8.5 million for the three months ended September 30, 2022. The increase in net income for the three months ended September 30, 2023, was primarily due to a $3.1 million or 11.3% increase in net interest income, a $1.2 million or 68.1% decrease in the provision for credit losses, and an $801,000 or 19.2% increase in noninterest income, partially offset by a $4.2 million or 22.0% increase in noninterest expense and a $335,000 or 15.3% increase in provision for income taxes.

Average Balances, Interest and Average Yields/Cost

The following table sets forth for the periods indicated, information regarding average balances of assets and liabilities, as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities, resultant yields, interest rate spread, net interest margin (otherwise known as net yield on interest-earning assets), and the ratio of average interest-earning assets to average interest-bearing liabilities. Also presented is the weighted average yield on interest-earning assets, rates paid on interest-bearing liabilities and the resultant spread at for the periods presented. Average balances are daily average balances. Nonaccrual loans have been included in the table as loans carrying a zero yield. The yields on tax-exempt municipal bonds have not been computed on a tax equivalent basis.

(Dollars in thousands)

(1) The average loans receivable, net balances include nonaccrual loans.

(2) Includes net deferred fee recognition of $1.4 million and $2.0 million for the three months ended September 30, 2023 and 2022, respectively.

(3) Shown at amortized cost.

58

Net Interest Income. Net interest income increased $3.1 million to $30.6 million for the three months ended September 30, 2023, from $27.5 million for the three months ended September 30, 2022, as a result of an increase in interest income on loans, taxable AFS investment securities and interest-bearing deposits at other financial institutions, partially offset by an increase in interest expense. Total interest income increased $12.0 million for the three months ended September 30, 2023, compared to the same period in 2022, primarily due to an increase of $10.3 million in interest income on loans receivable, including fees, primarily due to new loans being originated at higher rates and variable-rate loans repricing higher following recent increases in market interest rates. In addition, interest income on taxable AFS investment securities and interest-bearing deposits at other financial institutions increased $1.1 million and $620,000, respectively, during the three months ended September 30, 2023, compared to the same period in 2022, primarily due to recent increases in market interest rates. Total interest expense increased $8.9 million for the three months ended September 30, 2023, primarily as a result of higher market interest rates, higher utilization of borrowings and a shift in deposit mix from transactional accounts to higher cost CDs.

Net interest margin (“NIM”) decreased 20 basis points to 4.34% for the three months ended September 30, 2023, from 4.54% for the same quarter in the prior year. The decrease in NIM reflects the rise of average balances of higher costing CDs and borrowings which reduced the impact of new loan originations at higher interest rates and variable rate interest-earning assets repricing higher following recent increases in market interest rates.

Interest Income. Interest income for the three months ended September 30, 2023, increased $12.0 million to $43.3 million, from $31.3 million for the three months ended September 30, 2022. The increase during the period was primarily attributable to the $393.3 million increase in the average balance of total interest-earning assets and a 97-basis point increase in the average yield on total interest-earning assets.

The following table compares average interest-earning asset balances, associated yields, and resulting changes in interest income for the three months ended September 30, 2023 and 2022:

(Dollars in thousands)

(1) The average loans receivable, net balances include nonaccrual loans.

(2) Shown at amortized cost.

Interest Expense. Interest expense increased $8.9 million to $12.6 million for the three months ended September 30, 2023, from $3.8 million for the same prior year quarter, primarily due to an increase of interest expense on deposits of $7.9 million and on borrowings of $993,000. The average cost of funds for total interest-bearing liabilities increased 168 basis points to 2.60% for the three months ended September 30, 2023, from 0.92% for the three months ended September 30, 2022. The increase in interest expense was predominantly due to an increase in cost for deposits and borrowings as well as an increase in the average balances of CDs and borrowings. The average cost of total interest-bearing deposits increased 167 basis points to 2.38%, for the three months ended September 30, 2023, compared to 0.71%, for the three months ended September 30, 2022. The average cost of funds, including noninterest-bearing checking, increased 124 basis points to 1.92% for the three months ended September 30, 2023, from 0.68% for the three months ended September 30, 2022.

The following table details average balances of interest-bearing liabilities, associated rates, and resulting change in interest expense for the three months ended September 30, 2023 and 2022:

(Dollars in thousands)

59

Provision for Credit Losses. For the three months ended September 30, 2023, the provision for credit losses was $548,000, consisting of a $684,000 provision for credit losses on loans and a $14,000 provision for credit losses on securities held-to-maturity, partially offset by a $149,000 reversal of the allowance for credit losses on unfunded loan commitments, compared to $1.7 million provision for credit losses for the three months ended September 30, 2022, consisting of a $2.0 million provision for credit losses on loans, offset by a $305,000 reversal of credit losses on unfunded loan commitments. The provision for credit losses on loans reflects the increase in total loans receivable and net charge-offs for the three months ended September 30, 2023, while the reversal of the allowance for credit losses on unfunded loan commitments for the three months ended September 30, 2023, was a result of a decrease in total unfunded commitments during current quarter.

During the three months ended September 30, 2023, net loan charge-offs totaled $533,000, compared to $563,000 during the three months ended September 30, 2022. The decrease was primarily due to decreases in net charge-offs of $388,000 in deposit overdrafts and $35,000 in marine loans, partially offset by net increases of $387,000 in indirect home improvement loans and $3,000 in other loans. A further decline in national and local economic conditions, as a result the effects of inflation, a potential recession or slowed economic growth, among other economic factors, could result in a material increase in the ACL for loans and may adversely affect the Company’s financial condition and result of operations.

Noninterest Income. Noninterest income increased $801,000 to $5.0 million for the three months ended September 30, 2023, from $4.2 million for the three months ended September 30, 2022. The increase reflects a $555,000 increase in service charges and fee income, primarily as a result of a $588,000 increase in deposit fees, including interchange income, and an increase of $473,000 in gain on sale of loans, partially offset by a $239,000 decrease other noninterest income. As of September 30, 2023, the servicing rights were being amortized over an approximate six-year period. Gross margin on home loan sales increased to 3.08% for the three months ended September 30, 2023, from 2.85% for the three months ended September 30, 2022.

Noninterest Expense. Noninterest expense increased $4.2 million to $23.6 million for the three months ended September 30, 2023, from $19.3 million for the three months ended September 30, 2022. The increase was primarily the result a $2.1 million increase in salaries and benefits, largely due to an increase in the number of FTEs as a result of the Branch Acquisition. Other increases included $829,000 in amortization of CDI, $597,000 in operations expense, $293,000 in data processing, $244,000 in occupancy expense, and $232,000 in marketing and advertising, offset by a decrease of $182,000 in loan costs.

The efficiency ratio, which is calculated by dividing noninterest expense by total net interest income and noninterest income, worsened to 66.22% for the three months ended September 30, 2023, compared to 60.99% for the three months ended September 30, 2022, primarily due to the increase in noninterest expenses, much of which was related to the Branch Acquisition.

Provision for Income Taxes. For the three months ended September 30, 2023, the Company recorded a provision for income taxes of $2.5 million as compared to $2.2 million for the three months ended September 30, 2022. The increase in the income taxes provision was primarily due to an $830,000 increase in pre-tax income during the three months ended September 30, 2023, as compared to the same quarter last year. The effective corporate income tax rates for the three months ended September 30, 2023 and 2022 were 22.0% and 20.6%, respectively. The increase in the effective corporate income tax rate was attributable to a decrease in nontaxable income between periods.

Comparison of Results of Operations for the Nine Months Ended September 30, 2023 and 2022

General. Net income was $26.3 million for the nine months ended September 30, 2023, and $22.0 million for the nine months ended September 30, 2022. The increase in net income for the nine months ended September 30, 2023 compared to the same period in 2022, was primarily due to a $17.9 million, or 23.8%, increase in net interest income and a $1.3 million, or 27.2%, decrease in the provision for credit losses, partially offset by a $14.0 million, or 24.4%, increase in noninterest expense and a $1.5 million, or 28.1%, increase in provision for income taxes.

Average Balances, Interest and Average Yields/Cost

The following table sets forth for the periods indicated, information regarding average balances of assets and liabilities, as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities, resultant yields, interest rate spread, net interest margin (otherwise known as net yield on interest-earning assets), and the ratio of average interest-earning assets to average interest-bearing liabilities. Also presented is the weighted average yield on interest-earning assets, rates paid on interest-bearing liabilities and the resultant spread at for the periods presented. Average balances are daily average balances. Nonaccrual loans have been included in the table as loans carrying a zero yield. The yields on tax-exempt municipal bonds have not been computed on a tax equivalent basis.

(Dollars in thousands)

(1) The average loans receivable, net balances include nonaccrual loans.

(2) Includes net deferred fee recognition of $4.7 million and $6.2 million for the nine months ended September 30, 2023 and 2022, respectively.

(3) Shown at amortized cost.

Net Interest Income. Net interest income increased $17.9 million to $92.8 million for the nine months ended September 30, 2023, from $75.0 million for the nine months ended September 30, 2022. This increase was primarily the result of an increase in loans and variable rate loans repricing higher and, to a lesser extent, increases in interest income from taxable AFS investment securities and interest-bearing deposits at other financial institutions, partially offset by an increase in interest expense.

Total interest income increased $39.9 million for the nine months ended September 30, 2023, compared to the same period in 2022, primarily due to an increase of $36.2 million in interest income on loans receivable, including fees, primarily due to new loans being originated at higher rates and variable-rate loans repricing higher following recent increases in market interest rates. In addition, interest income on taxable AFS investment securities and interest-bearing deposits at other financial institutions increased $1.8 million and $1.8 million, respectively, during the three months ended September 30, 2023 compared to the same period in 2022, primarily due to recent increases in market interest rates. Total interest expense increased $22.0 million for the nine months ended September 30, 2023, compared to the same period in 2022, primarily as a result of higher interest rates, higher utilization of borrowings and a shift in deposit mix from transactional accounts to higher cost CDs.

NIM increased 17 basis points to 4.56% for the nine months ended September 30, 2023, from 4.39% for the same period in the prior year. The increase in NIM reflects new loan originations at higher interest rates and variable rate interest-earning assets repricing higher following recent increases in market interest rates. The benefit of the higher rates and increase in interest earning assets was partially offset by rising deposit and borrowing costs. Increases in average balances of higher costing CDs and borrowings placed additional pressure on NIM.

Interest Income. Interest income for the nine months ended September 30, 2023, increased $39.9 million to $122.7 million, from $82.9 million for the nine months ended September 30, 2022. The increase during the period was primarily attributable to a $439.5 million increase in the average balance of total interest-earning assets and a 117-basis point increase in the average yield on total interest-earning assets.

The following table compares average interest-earning asset balances, associated yields, and resulting changes in interest income for the nine months ended September 30, 2023 and 2022:

(Dollars in thousands)

(1) The average loans receivable, net balances include nonaccrual loans.

(2) Shown at amortized cost.

Interest Expense. Interest expense increased $22.0 million to $29.9 million for the nine months ended September 30, 2023, from $7.9 million for the same period in the prior year, primarily due to an increase of interest expense on deposits of $19.3 million, primarily higher costing CDs, and on borrowings of $2.7 million. The average cost of funds for total interest-bearing liabilities increased 145 basis points to 2.15% for the nine months ended September 30, 2023, from 0.70% for the nine months ended September 30, 2022. The increase in interest expense was predominantly due to the increase in market rate for deposits, a shift in deposits to higher costing CDs, and an increase in the average balance of borrowings. The average cost of total interest-bearing deposits increased 142 basis points to 1.94%, for the nine months ended September 30, 2023, compared to 0.52%, for the nine months ended September 30, 2022. The average cost of funds, including noninterest-bearing checking, increased 108 basis points to 1.58% for the nine months ended September 30, 2023, from 0.50% for the nine months ended September 30, 2022.

The following table details average balances of interest-bearing liabilities, associated rates and resulting changes in interest expense for the nine months ended September 30, 2023 and 2022:

(Dollars in thousands)

62

Provision for Credit Losses. For the nine months ended September 30, 2023, the provision for credit losses was $3.4 million, consisting of a $4.1 million provision for credit losses on loans partially offset by a $745,000 reversal of the allowance for credit losses on unfunded loan commitments, compared to a $4.6 million provision for credit losses for the nine months ended September 30, 2022, consisting of a $4.5 million provision for credit losses on loans and a $180,000 provision for credit losses on unfunded loan commitments. The provision for credit losses on loans reflects the increase in total loans receivable, increased net charge-offs, and increased reserves on individually evaluated nonaccrual loans. The reversal of the allowance for credit losses on unfunded loan commitments for the nine months ended September 30, 2023, was a result of a decrease in total unfunded commitments during current period.

During the nine months ended September 30, 2023, net loan charge-offs totaled $1.6 million, compared to $843,000 during the nine months ended September 30, 2022. The increase was primarily due to increases in net charge-offs of $972,000 in indirect home improvement loans, $164,000 in marine loans, $10,000 in home equity loans, and $2,000 in other loans, offset by a net decrease of $400,000 in deposit overdrafts charge-offs. Management attributes the increase in net charge-offs primarily to volatile economic conditions. A further decline in national and local economic conditions, as a result the effects of inflation, a potential recession or slowed economic growth, among other economic factors, could result in a material increase in the ACL for loans and may adversely affect the Company’s financial condition and result of operations.

Noninterest Income. Noninterest income increased $622,000 to $15.0 million for the nine months ended September 30, 2023, from $14.4 million for the nine months ended September 30, 2022. The increase reflects a $2.2 million increase in service charges and fee income, primarily as a result of a $1.5 million increase in deposit fees, including interchange income, and a $871,000 increase in servicing fee income from non-portfolio serviced loans, net of mortgage servicing rights amortization, and a $391,000 increase in other noninterest income, partially offset by decreases of $2.0 million in gain on sale of loans due primarily to a reduction in origination and sales volume of loans held for sale. Gross margin on home loan sales increased to 3.07% for the nine months ended September 30, 2023, from 2.85% for the nine months ended September 30, 2022.

Noninterest Expense. Noninterest expense increased $14.0 million to $71.3 million for the nine months ended September 30, 2023, from $57.3 million for the nine months ended September 30, 2022. The increase was primarily a result of a $5.8 million increase in salaries and benefits largely due to an increase in the number of FTEs as a result of the Branch Acquisition. Other increases included $2.1 million in operations, $2.0 million in amortization of core deposit intangible, $1.6 million in acquisition costs, $928,000 in FDIC insurance due to asset growth and an increase in assessment rates, $845,000 in occupancy expense, $729,000 in data processing, and $420,000 in marketing and advertising, offset by a decrease of $386,000 in professional and board fees.

The efficiency ratio weakened to 66.10% for the nine months ended September 30, 2023, compared to 64.14% for the nine months ended September 30, 2022, primarily representing the increase in noninterest expense due to the Branch Acquisition.

Provision for Income Taxes. For the nine months ended September 30, 2023, the Company recorded a provision for income taxes of $6.9 million as compared to $5.4 million for the nine months ended September 30, 2022. The increase in the income tax provision was primarily due to a $5.8 million increase in pre-tax income during the nine months ended September 30, 2023, as compared to the same period last year. The effective corporate income tax rates for the nine months ended September 30, 2023 and 2022 were 20.8% and 19.7%, respectively. The increase in the effective corporate income tax rate was attributable to a decrease in nontaxable income between periods.

Liquidity

Management maintains a liquidity position that it believes will adequately provide funding for loan demand and deposit runoff that may occur in the normal course of business. The Company relies on several different sources to meet potential liquidity demands. The primary sources are increases in deposit accounts, FHLB advances, purchases of federal funds, sale of securities available-for-sale, cash flows from loan payments, sales of one-to-four-family loans held for sale, and maturing securities. While the maturities and the scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.

The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund its operations. The Bank generally maintains sufficient cash and short-term investments to meet short-term liquidity needs. At September 30, 2023, the Bank’s total borrowing capacity was $672.0 million with the FHLB of Des Moines, with unused borrowing capacity of $667.7 million. The FHLB borrowing limit is based on certain categories of loans, primarily real estate loans that qualify as collateral for FHLB advances. At September 30, 2023, the Bank held approximately $1.03 billion in loans that qualify as collateral for FHLB advances.

In addition to the availability of liquidity from the FHLB of Des Moines, the Bank maintains a short-term borrowing line with the FRB with a limit of $222.3 million and a combined credit limit of $101.0 million in written federal funds lines of credit through correspondent banking relationships at September 30, 2023. The FRB borrowing limit is based on certain categories of loans, primarily consumer loans that qualify as collateral for FRB line of credit. At September 30, 2023, the Bank held approximately $629.3 million in loans that qualify as collateral for the FRB line of credit. Additionally, securities with a carrying value of $73.7 million were pledged primarily to provide contingent liquidity through the Bank Term Funding Program at the Federal Reserve Bank at September 30, 2023, with a current limit of $90.0 million and no unused borrowing capacity. Subject to market conditions, we expect to utilize these borrowing facilities from time to time in the future to fund loan originations and deposit withdrawals, to satisfy other financial commitments, repay maturing debt and to take advantage of investment opportunities to the extent feasible.

The Bank’s Asset and Liability Management Policy permits management to utilize brokered deposits up to 20% of deposits or $492.7 million at September 30, 2023. Total brokered deposits at September 30, 2023 were $373.5 million. Management utilizes brokered deposits to mitigate interest rate risk and to enhance liquidity when appropriate.

Liquidity management is both a daily and long-term function of the Company’s management. Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds. On a longer-term basis, a strategy is maintained of investing in various lending products and investment securities, including U.S. Government obligations and U.S. agency securities. The Company uses sources of funds primarily to meet ongoing commitments, pay maturing deposits, fund withdrawals, and to fund loan commitments. At September 30, 2023, outstanding loan commitments, including unused lines of credit totaled $548.5 million. The Company purchased $46.9 million in securities during the nine months ended September 30, 2023. Securities purchased during the nine months ended September 30, 2022 totaled $24.0 million. Securities repayments, maturities and sales in those periods were $13.5 million and $17.8 million, respectively.

The Bank’s liquidity is also affected by the volume of loans sold and loan principal payments. During the nine months ended September 30, 2023 and 2022, the Bank sold $320.9 million and $663.8 million in loans and loan participation interests, respectively.

The Bank’s liquidity has been positively impacted by increases in deposit levels. Total deposits increased $326.7 million during the nine months ended September 30, 2023 primarily driven by the Branch Purchase with assumed deposits remaining of $301.2 million and growth in CDs. CDs scheduled to mature in three months or less at September 30, 2023, totaled $338.8 million. It is management’s policy to offer deposit rates that are competitive with other local financial institutions. Based on this strategy, management believes that a majority of maturing relationship deposits will remain with the Bank. Excess liquidity from the Branch Purchase was used to repay borrowings.

For the remainder of 2023, we project that fixed commitments will include $483,000 of operating lease payments. No FHLB advances are scheduled to mature for the remainder of 2023. For information regarding our operating leases, see “Note 7 – Leases” of the Notes to Consolidated Financial Statements included in this report.

As a separate legal entity from the Bank, FS Bancorp, Inc. must provide for its own liquidity. In addition to its own operating expenses (many of which are paid to the Bank), FS Bancorp is responsible for paying for any stock repurchases, dividends declared to its stockholders, interest and principal on outstanding debt, and other general corporate expenses. Sources of capital and liquidity for FS Bancorp include distributions from the Bank and the issuance of debt or equity securities, although there are regulatory restrictions on the ability of the Bank to make distributions.

Dividends and other capital distributions from the Bank are subject to regulatory notice and certain restrictions. The unrestricted cash of FS Bancorp held at the Bank on an unconsolidated basis totaled $8.7 million at September 30, 2023. The Company currently expects to continue the current practice of paying quarterly cash dividends on common stock subject to the Board of Directors' discretion to modify or terminate this practice at any time and for any reason without prior notice. Our current quarterly common stock dividend rate is $0.25 per share, which we believe is a dividend rate per share which enables us to balance our multiple objectives of managing and investing in the Bank, and returning a substantial portion of our cash to our shareholders. Assuming continued payment during 2023 at this rate of $0.25 per share, our total dividends paid each quarter would be approximately $1.9 million based on the number of the current outstanding shares as of September 30, 2023.

Under FS Bancorp’s current stock repurchase program, approximately $4.7 million remained available for future repurchases as of September 30, 2023. See “Unregistered Sales of Equity Securities, Use of Proceeds, and Issuer Purchases of Equity Securities” in Item 2, Part II of this Form 10-Q for additional information relating to stock repurchases.

At September 30, 2023, FS Bancorp, on an unconsolidated basis, had $8.7 million in unrestricted cash to meet liquidity needs.

Capital Resources

The Bank is subject to minimum capital requirements imposed by the FDIC. Based on its capital levels at September 30, 2023, the Bank exceeded these requirements as of that date. Consistent with our goals to operate a sound and profitable organization, our policy is for the Bank to maintain a well-capitalized status under the capital categories of the FDIC. Based on capital levels at September 30, 2023, the Bank was considered to be well capitalized. At September 30, 2023, the Bank exceeded all regulatory capital requirements with Tier 1 leverage-based capital, Tier 1 risk-based capital, total risk-based capital, and common equity Tier 1 capital ratios of 10.3%, 11.8%, 13.1%, and 11.8%, respectively.

As a bank holding company registered with the Federal Reserve, the Company is subject to the capital adequacy requirements of the Federal Reserve. Bank holding companies with less than $3.0 billion in assets are generally not subject to compliance with the Federal Reserve’s capital regulations, which are generally the same as the capital regulations applicable to the Bank. The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to the holding company’s subsidiary bank and the Federal Reserve expects the holding company’s subsidiary bank to be well capitalized under the prompt corrective action regulations. If FS Bancorp were subject to regulatory capital guidelines for bank holding companies with $3.0 billion or more in assets at September 30, 2023, FS Bancorp would have exceeded all regulatory capital requirements. For informational purposes, the regulatory capital ratios calculated for FS Bancorp at September 30, 2023 were 8.9% for Tier 1 leverage-based capital, 10.2% for Tier 1 risk-based capital, 13.4% for total risk-based capital, and 10.2% for CET 1 capital ratio. For additional information regarding regulatory capital compliance, see the discussion included in “Note 14 – Regulatory Capital” to the Notes to Consolidated Financial Statements included in Part I. Item 1 of this report.

There have been no material changes in the market risk disclosures contained in FS Bancorp’s Annual Report on Form 10-K for the fiscal year ended December 31, 2022.

(a) Evaluation of Disclosure Controls and Procedures

An evaluation of the disclosure controls and procedures as defined in Rule 13a‑15(e) of the Exchange Act was carried out as of September 30, 2023 under the supervision and with the participation of the Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”) and several other members of the Company’s senior management. In designing and evaluating the Company’s disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

The Company’s CEO and CFO concluded that based on their evaluation at September 30, 2023, the Company’s disclosure controls and procedures were effective in ensuring that information we are required to disclose in the reports we file or submit under the Exchange Act is (1) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and (2) accumulated and communicated to FS Bancorp management, including its CEO and CFO, as appropriate to allow timely decisions regarding required disclosure, specified in the SEC’s rules and forms.

(b) Changes in Internal Controls

There were no significant changes in the Company’s internal control over financial reporting that occurred during the three months ended September 30, 2023, that have materially affected or are reasonably likely to materially affect our internal control over financial reporting. The Company does not expect that its disclosure controls and procedures and internal control over financial reporting will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls may be circumvented by the individual acts of some persons, by collusion of two or more people, or by override of the control. The design of any control procedure is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.

There have been no material changes in the Risk Factors previously disclosed in FS Bancorp’s Annual Report on Form 10-K for the fiscal year ended December 31, 2022.