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

The following presents management’s discussion and analysis of our consolidated financial condition at September 30, 2023 and December 31, 2022 and the results of our operations for the three and nine months ended September 30, 2023 and 2022. This discussion should be read in conjunction with our unaudited consolidated financial statements and the notes thereto appearing elsewhere in this report and the audited consolidated financial statements and the notes to consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2022. Results of operations for the three and nine month periods ended September 30, 2023 are not necessarily indicative of the results of operations for the balance of 2023, or for any other periods. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause results to differ materially from management’s expectations.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-Q, as well as other periodic reports filed with the U.S. Securities and Exchange Commission, and written or oral communications made from time to time by or on behalf of FVCBankcorp, Inc. and our subsidiary (the “Company”), may contain statements relating to future events or future results of the Company that are considered “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. These forward-looking statements represent plans, estimates, objectives, goals, guidelines, expectations, intentions, projections and statements of our beliefs concerning future events, business plans, objectives, expected operating results and the assumptions upon which those statements are based. Forward-looking statements include without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements, and are typically identified with words such as “may,” “could,” “should,” “will,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “aim,” “intend,” “plan,” or words or phases of similar meaning. We caution that the forward-looking statements are based largely on our expectations and are subject to a number of known and unknown risks and uncertainties that are subject to change based on factors which are, in many instances, beyond our control. Actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements.

The following factors, among others, could cause our financial performance to differ materially from that expressed in such forward-looking statements:

• general business and economic conditions, including higher inflation and its impacts, nationally or in the markets that the Company serves could adversely affect, among other things, real estate valuations, unemployment levels, the ability of businesses to remain viable, consumer and business confidence and consumer and business spending, which could lead to decreases in demand for loans, deposits, and other financial services that the Company provides and increases in loan delinquencies and defaults;
• the risk of changes in interest rates on levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest sensitive assets and liabilities;
• changes in the Company’s liquidity requirements could be adversely affected by changes in its assets and liabilities;
• changes in the assumptions underlying the establishment of reserves for possible credit losses;
• changes in market conditions, specifically declines in the commercial and residential real estate market, volatility and disruption of the capital and credit markets, and soundness of other financial institutions we do business with;
• risks inherent in making loans such as repayment risks and fluctuating collateral values;
• the Company’s investment securities portfolio is subject to credit risk, market risk, and liquidity risk as well as changes in the estimates used to value the securities in the portfolio;
• the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System (the “Federal Reserve”), inflation, interest rate, market and monetary fluctuations;
• declines in the Company's common stock price or the occurrence of what management would deem to be a triggering event that could, under certain circumstances, cause us to record a noncash impairment charge to earnings in future periods;
• the strength of the United States economy in general and the strength of the local economies in which we conduct operations;
• geopolitical conditions, including acts or threats of terrorism, or actions taken by the United States or other governments in response to acts or threats of terrorism and/or military conflicts, which could impact business and economic conditions in the United States and abroad;
• the occurrence of significant natural disasters, including severe weather conditions, floods, health related issues, and other catastrophic events;
• our management of risks inherent in our real estate loan portfolio, and the risk of a prolonged downturn in the real estate market, which could impair the value of our collateral and our ability to sell collateral upon any foreclosure;
• changes in consumer spending and savings habits;
• technological and social media changes;
• changing bank regulatory conditions, policies or programs, whether arising as new legislation or regulatory initiatives, that could lead to restrictions on activities of banks generally, or our subsidiary bank in particular, more restrictive regulatory capital requirements, increased costs, including deposit insurance premiums, regulation or prohibition of certain income producing activities or changes in the secondary market for loans and other products;
• the impact of changes in financial services policies, laws and regulations, including laws, regulations and policies concerning taxes, banking, securities and insurance, and the application thereof by regulatory bodies;
• the impact of changes in laws, regulations and policies affecting the real estate industry;
• the effect of changes in accounting policies and practices, as may be adopted from time to time by bank regulatory agencies, the U.S. Securities and Exchange Commission, the Public Company Accounting Oversight Board, the Financial Accounting Standards Board or other accounting standards setting bodies;
• the timely development of competitive new products and services and the acceptance of these products and services by new and existing customers;
• the willingness of users to substitute competitors’ products and services for our products and services;
• the effect of acquisitions we may make, including, without limitation, the failure to achieve the expected revenue growth and/or expense savings from such acquisitions;
• changes in the level of our nonperforming assets and charge-offs;
• our involvement, from time to time, in legal proceedings and examination and remedial actions by regulators; and
• potential exposure to fraud, negligence, computer theft and cyber-crime.

The foregoing factors should not be considered exhaustive and should be read together with other cautionary statements that are included in our Annual Report on Form 10-K for the year ended December 31, 2022, including those discussed in the section entitled “Risk Factors”. If one or more of the factors affecting our forward-looking information and statements proves incorrect, then our actual results, performance or achievements could differ materially from those expressed in, or implied by, forward-looking information and statements contained in this Form 10-Q. Therefore, we caution you not to place undue reliance on our forward-looking information and statements. We will not update the forward-looking statements to reflect actual results or changes in the factors affecting the forward-looking statements. New risks and uncertainties may emerge from time to time, and it is not possible for us to predict their occurrence or how they will affect us.

Overview

We are a bank holding company headquartered in Fairfax County, Virginia. Our sole subsidiary, FVCbank (the “Bank”), was formed in November 2007 as a community-oriented, locally-owned and managed commercial bank under the laws of the Commonwealth of Virginia. The Bank offers a wide range of traditional bank loan and deposit products and services to both our commercial and retail customers. Our commercial relationship officers focus on attracting small and medium sized businesses, commercial real estate developers and builders, including government contractors, non-profit organizations, and professionals. Our approach to our market features competitive customized financial services offered to customers and prospects in a personal relationship context by seasoned professionals.

On October 12, 2018, we completed our acquisition of Colombo Bank ("Colombo"), which was headquartered in Rockville, Maryland, and added five banking locations in Washington, D.C., and Montgomery County and the City of Baltimore in Maryland.

On August 31, 2021, we announced that the Bank made an investment in Atlantic Coast Mortgage, LLC (“ACM”) for $20.4 million to obtain a 28.7% ownership interest in ACM. The ownership interest is subject to an earnback option of up to 3.7% over the next three years. In addition, the Bank provides a warehouse lending facility to ACM, which includes a construction-to-permanent financing line, and has developed portfolio mortgage products to diversify our held for investment loan portfolio.

On December 15, 2022, the Company announced that the Board of Directors approved a five-for-four split of the Company's common stock in the form of a 25% stock dividend for shareholders of record on January 9, 2023, payable on January 31, 2023. Earnings per share and all other per share information reflected herein have been adjusted for the five-for-four split of the Company's common stock for comparative purposes.

Net interest income is our primary source of revenue. We define revenue as net interest income plus non-interest income. We manage our balance sheet and interest rate risk exposure to maximize, and concurrently stabilize, net interest income. We do this by monitoring our liquidity position and the spread between the interest rates earned on interest-earning assets and the interest rates paid on interest-bearing liabilities. We attempt to minimize our exposure to interest rate risk, but are unable to eliminate it entirely. In addition to managing interest rate risk, we also analyze our loan portfolio for exposure to credit risk. Loan defaults and foreclosures are inherent risks in the banking industry, and we attempt to limit our exposure to these risks by carefully underwriting and then monitoring our extensions of credit. In addition to net interest income, non-interest income is a complementary source of revenue for us and includes, among other things, service charges on deposits and loans, income from minority membership interest in ACM, merchant services fee income, insurance commission income, income from bank owned life insurance (“BOLI”), and gains and losses on sales of investment securities available-for-sale.

Critical Accounting Policies

General

The accounting principles we apply under U.S. generally accepted accounting principles (“GAAP”) are complex and require management to apply significant judgment to various accounting, reporting and disclosure matters. Management must use assumptions, judgments and estimates when applying these principles where precise measurements are not possible or practical. These policies are critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such judgments, assumptions and estimates may have a significant impact on the consolidated financial statements. Actual results, in fact, could differ from initial estimates.

The accounting policies we view as critical are those relating to judgments, assumptions and estimates regarding the determination of the allowance for credit losses - loans & reserve for unfunded commitments, allowance for credit losses - securities, and fair value measurements.

Allowance for Credit Losses - Loans & Unfunded Commitments

We maintain the allowance for credit losses at a level that represents management’s best estimate of expected losses in our loan portfolio. We adopted the provisions of the current expected credit losses ("CECL") accounting standard as of January 1, 2023 in accordance with the required implementation date and recorded the impact of the adoption to retained earnings, net of deferred income taxes, as required by the standard. Prior to the adoption of CECL, we utilized an incurred loss model to derive our best estimate of the allowance for credit losses.

Accounting Standards Codification ("ASC") 326 requires that an estimate of CECL be immediately recognized and reevaluated over the contractual life of the financial asset. The allowance for credit losses ("ACL") is a valuation account that is deducted from the amortized cost basis of loans to present the net amount expected to be collected on the loan portfolio. Loans, or portions thereof, are charged off against the ACL when they are deemed uncollectible. Expected recoveries are recorded to the extent they do not exceed the aggregate of amounts previously and expected to be charged-off.

Reserves on loans that do not share risk characteristics are evaluated on an individual basis. Nonaccrual loans are specifically reviewed for loss potential and when deemed appropriate are assigned a reserve based on an individual evaluation. The remainder of the portfolio, representing all loans not evaluated individually for impairment, is segmented based on call report code and processed through a cash flow valuation model. In particular, loan-level probability of default ("PD") and severity (also referred to as loss given default ("LGD")) is applied to derive a baseline expected loss as of the valuation date. These expected default and severity rates, which are regression-derived and based on peer historical loan-level performance data, are calibrated to incorporate our reasonable and supportable forecast of future losses as well as any necessary qualitative adjustments.

Typically, financial institutions use their historical loss experience and trends in losses for each loan segment which are then adjusted for portfolio trends and economic and environmental factors in determining the allowance for credit losses. Since the Bank’s inception in 2007, we have experienced minimal loss history within our loan portfolio. Due to the fact that limited internal loss history exists to generate statistical significance, we determined it was most prudent to rely on peer data when deriving our best estimate of PD and LGD. As part of our estimation process, we will continue to assess the reasonableness of the data, assumptions, and model methodology utilized to derive our allowance for credit losses.

For each of the modeled loan segments, we generate cash flow projections at the instrument level wherein payment expectations are adjusted for estimated prepayment speeds, PD rates, and LGD rates. The modeling of expected prepayment speeds is based on internal loan-level historical data. For our cash flow model, we utilize national unemployment for reasonable and supportable forecasting of expected default. To further adjust the ACL for expected losses not already within the quantitative component of the calculation, we may consider qualitative factors as prescribed in ASC 326.

Financial instruments include off-balance sheet credit instruments such as commitments to make loans and commercial letters of credit issued to meet customer financing needs. Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for off-balance sheet loan commitments is represented by the contractual amount of those instruments. Such financial instruments are recorded when they are funded. We record a reserve for unfunded commitments on off-balance sheet credit exposures through a charge to provision for credit loss expense in our Consolidated Statement of Income. The reserve for unfunded commitments is estimated by call report code segmentation as of the valuation date under the CECL model using the same methodologies as portfolio loans taking utilization rates into consideration. The reserve for unfunded commitments is reflected as a liability on our Consolidated Balance Sheet.

While our methodology in establishing the ACL attributes portions of a combined reserve to multiple elements, we believe that the combined allowance of credit losses (which is inclusive of the reserve for unfunded commitments) represents the most appropriate coverage metric for loss absorption purposes.

Our methodology utilized in the estimation of the ACL, which is performed at least quarterly, is designed to be dynamic and responsive to changes in our loan portfolio credit quality, composition, and forecasted economic conditions. The review of the reasonableness and appropriateness of the ACL is reviewed by the CECL Committee for approval as of the valuation date. Additionally, information is provided to the Board of Directors on a quarterly basis along with our consolidated financial statements.

Credit losses are an inherent part of our business and, although we believe the methodologies for determining the ACL and the current level of the allowance and reserve on unfunded commitments are appropriate, it is possible that there may be unidentified losses in the portfolio at any particular time that may become evident at a future date pursuant to additional internal analysis or regulatory comment. Additional provisions for such losses, if necessary, would be recorded, and would negatively impact earnings.

Collateral Dependent Financial Assets

Loans that do not share risk characteristics are evaluated on an individual basis. For collateral dependent financial assets where the Company has determined that foreclosure of the collateral is probable, or where the borrower is experiencing financial difficulty and the Company expects repayment of the financial asset to be provided substantially through the sale of the collateral, the ACL is measured based on the difference between the fair value of the collateral and the amortized cost basis of the asset as of the measurement date. When repayment is expected to be from the operation of the collateral, expected credit losses are calculated as the amount by which the amortized cost basis of the financial asset exceeds the net present value ("NPV") from the operation of the collateral. When repayment is expected to be from the sale of the collateral, expected credit losses are calculated as the amount by which the amortized cost basis of the financial asset exceeds the fair value of the underlying collateral less estimated cost to sell. The ACL may be zero if the fair value of the collateral at the measurement date exceeds the amortized cost basis of the financial asset.

Allowance for Credit Losses - Securities

We evaluate our available-for-sale and held-to-maturity debt securities portfolios for expected credit losses as of the valuation date under ASC 326. For available-for-sale debt securities in an unrealized loss position, we first assess whether we intend to sell, or if it is more likely than not that we will be required to sell, the security before recovery of our amortized cost basis. If either criterion is met, the security’s amortized cost basis is written down to fair value through income during the current period. For available-for-sale debt securities that do not meet the aforementioned criteria, we evaluate whether the decline in fair value has resulted from credit losses or other driving factors. If our assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security is 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, an ACL is recorded for the credit loss (which represents the difference between the expected cash flows and amortized cost basis), limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an ACL is recognized in other comprehensive income.

The entire amount of an impairment loss is recognized in earnings only when: (1) we intend to sell the security; or (2) it is more likely than not that we will have to sell the security before recovery of our amortized cost basis; or (3) we do not expect to recover the entire amortized cost basis of the security. In all other situations, only the portion of the impairment loss representing the credit loss must be recognized in earnings, with the remaining portion being recognized in shareholders' equity as comprehensive income, net of deferred taxes.

Changes in the ACL are recorded as a provision for (or reversal of) credit losses. Losses are charged against the ACL when we believe the uncollectibility of an available-for-sale security is confirmed or when either of the criteria regarding intent or requirement to sell is met. Any impairment not recorded through an ACL is recognized in other comprehensive income as a noncredit-related impairment.

As part of our estimation process, we have made a policy election to exclude accrued interest from the amortized cost basis of available-for-sale debt securities and report accrued interest separately in other assets in the Consolidated Balance Sheet. Available-for-sale debt securities are placed on nonaccrual status when we no longer expect to receive all contractual amounts due, which is generally at 90 days past due. Accrued interest receivable is reversed against interest income when a security is placed on nonaccrual status. Accordingly, we do not recognize an ACL against accrued interest receivable. This approach is consistent with our nonaccrual policy implemented for our loan portfolio.

We separately evaluate our held-to-maturity investment securities for any credit losses. If we determine that a security indicates evidence of deteriorated credit quality, the security is individually-evaluated and a discounted cash flow analysis is performed and compared to the amortized cost basis. As of September 30, 2023, we had one security classified as held-to-maturity with an amortized cost basis of $264 thousand with the remainder of the securities portfolio held as available-for-sale.

Fair Value Measurements

We determine the fair values of financial instruments based on the fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value. Our investment securities available-for-sale are recorded at fair value using reliable and unbiased evaluations by an industry-wide valuation service. This service uses evaluated pricing models that vary based on asset class and include available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs. Depending on the availability of observable inputs and prices, different valuation models could produce materially different fair value estimates. The values presented may not represent future fair values and may not be realizable.

LIBOR and Other Benchmark Rates

We previously had certain loans, interest rate swap agreements, investment securities, and debt obligations with interest rates indexed to the London Interbank Offered Rate ("LIBOR"). The administrator of LIBOR announced that the most commonly used U.S. dollar LIBOR settings would cease to be published or cease to be representative after June 30, 2023. Central banks and regulators around the world have commissioned working groups to find suitable replacements for LIBOR and to implement financial benchmark reforms more generally. There continues to be uncertainty regarding the use of alternative reference rates ("ARRs"), which may cause disruptions in a variety of markets, as well as adversely impact our business, operations and financial results.

The Adjustable Interest Rate (LIBOR) Act, enacted in March 2022, provides a statutory framework to replace LIBOR with a benchmark rate based on Secured Overnight Funding Rate for contracts governed by U.S. law that have no or ineffective fallbacks. Although governmental authorities have endeavored to facilitate an orderly discontinuation of LIBOR, no assurance can be provided that this aim will be achieved or that the use, level, and volatility of LIBOR or other interest rates, or the value of LIBOR-based securities will not be adversely affected.

To facilitate an orderly transition from interbank offered rates and other benchmark rates to ARRs, we established an enterprise-wide initiative led by senior management. The objective of this initiative was to identify, assess and monitor risks associated with the expected discontinuation or unavailability of benchmarks, including LIBOR, achieve operational readiness and engage impacted clients in connection with the transition to ARRs. As of September 30, 2023, we no longer have any financial instruments that are indexed to LIBOR.

Results of Operations— Three and Nine Months Ended September 30, 2023 and 2022

Overview

We recorded net income of $4.0 million, or $0.22 diluted earnings per share, for the three months ended September 30, 2023, compared to net income of $7.0 million, or $0.38 per diluted earnings per share, for the three months ended September 30, 2022, a decrease of $3.0 million, or 43%. Net interest income decreased $4.2 million, or 24%, to $13.3 million for the three months ended September 30, 2023, compared to $17.5 million for the same period of 2022. A release of reserves for credit losses of $729 thousand was recorded for the three months ended September 30, 2023, compared to a provision for credit losses of $365 thousand for the same period of 2022. Noninterest income was $225 thousand and $575 thousand for the three months ended September 30, 2023 and 2022, respectively. Noninterest expense was $9.0 million for the three months ended September 30, 2023, compared to $8.6 million for the three months ended September 30, 2022, an increase of $449 thousand, or 5%.

The annualized return on average assets for the three months ended September 30, 2023 and 2022 was 0.70% and 1.32%, respectively. The annualized return on average equity for the three months ended September 30, 2023 and 2022 was 7.57% and 13.87%, respectively.

For the nine months ended September 30, 2023, we recorded net income of $8.9 million, or $0.49 diluted earnings per share, compared to net income of $20.1 million, or $1.09 diluted earnings per share for the nine months ended September 30, 2022. Net income for the nine months ended September 30, 2023 was impacted by an after-tax loss totaling $3.6 million from the February sale of available-for-sale investment securities. Additionally, net income for the nine months ended September 30, 2023 included our portion of losses from our membership interest in ACM, which was $1.4 million, net of tax, compared to income of $754 thousand, net of tax, for the nine months ended September 30, 2022. Net interest income for the nine months ended September 30, 2023 was $41.7 million, compared to $49.4 million for the same period in 2022, a decrease of $7.6 million, or 15%. Provision for credit losses for the nine months ended September 30, 2023 was $132 thousand, compared to $1.9 million for the same period of 2022. Non-interest income was recorded as a loss of $3.5 million compared to income of $2.8 million for the nine months ended September 30, 2023 and 2022, respectively. Noninterest expense was $27.3 million and $25.3 million for the nine months ended September 30, 2023 and 2022, respectively, an increase of $2.0 million, or 8%.

Commercial bank operating earnings, which exclude the losses on the above-noted securities sales, and 2022 merger-related expenses, all net of tax, for the three months ended September 30, 2023 and September 30, 2022 were $4.0 million and $7.0 million, respectively, a decrease of $3.0 million. For the nine months ended September 30, 2023 and September 30, 2022, commercial bank operating earnings were $12.5 million and $20.2 million, respectively. Diluted commercial bank operating earnings per share for the three months ended September 30, 2023 and September 30, 2022 was $0.23 and $0.40 respectively. For the nine months ended September 30, 2023 and 2022, diluted commercial bank operating earnings per share was $0.69 and $1.09, respectively. We consider commercial bank operating earnings a useful financial measure of our operating performance. Commercial bank operating earnings is determined by methods other than in accordance with GAAP. A reconciliation of non-GAAP financial measures to their most comparable financial measure in accordance with GAAP can be found in the tables below.

Reconciliation of Net Income (GAAP) to Commercial Bank Operating Earnings (Non-GAAP)

(Dollars in thousands, except per share data)

47

Net Interest Income/Margin

Net interest income is our primary source of revenue, representing the difference between interest and fees earned on interest-earning assets and the interest paid on deposits and other interest-bearing liabilities. The following table presents average balance information, interest income, interest expense and the corresponding average yields earned and rates paid for the three months ended September 30, 2023 and 2022.

Average Balances and Interest Rates on Interest-Earning Assets and Interest-Bearing Liabilities

For the Three Months Ended September 30, 2023 and 2022

(Dollars in thousands)

49

(1) Nonaccrual loans are included in average balances and do not have a material effect on the average yield. Interest income on nonaccruing loans was not material for the periods presented. Net loan fees and late charges included in interest income on loans totaled $612 thousand and $917 thousand for the three months ended September 30, 2023 and 2022, respectively.

(2) The average yields for investment securities are reported on a fully taxable equivalent basis at an effective rate of 22% for September 30, 2023 and 21% for September 30, 2022.

The level of net interest income is affected primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates.

The following table shows the effect that these factors had on the interest earned from our interest-earning assets and interest incurred on our interest-bearing liabilities for the three months ended September 30, 2023.

Rate and Volume Analysis

For the Three Months Ended September 30, 2023 and 2022

(Dollars in thousands)

(1) Nonaccrual loans are included in average balances and do not have a material effect on the average yield. Interest income on nonaccruing loans was not material for the periods presented.

(2) The average yields for investment securities are reported on a fully taxable equivalent basis at an effective rate of 22% for September 30, 2023 and 21% for September 30, 2022.

Net interest income totaled $13.3 million, a decrease of $4.2 million, or 24%, for three months ended September 30, 2023, compared to September 30, 2022. The decrease in net interest income is primarily due to an increase in funding costs, which have increased precipitously as a result of Federal Reserve monetary policy, coupled with the need to meet intense competition from market area banks, brokerages, other financial institutions and the U.S. Treasury.

Average earning assets increased $157.2 million to $2.21 billion during the third quarter of 2023 as compared to $2.06 billion for the same period of 2022, primarily related to average growth in our loan portfolio of $201.3 million for the third quarter of 2023 as compared to the same period of 2022. This growth was offset by a decrease in average investment securities of $68.0 million for the quarter ended September 30, 2023 as compared to the year ago quarter for

2022, a result of the securities sale executed during the first quarter of 2023 and the decrease in the market value of the securities portfolio during the past year.

Interest income for the three months ended September 30, 2023 increased $6.3 million to $27.4 million from $21.1 million for the three months ended September 30, 2022. Loan interest income during the third quarter of 2023 increased $5.9 million as compared to the year ago quarter due to both loan growth and an increase in yields earned on the portfolio. Income from investment securities decreased $264 thousand for the three months ended September 30, 2023 compared to the same period of 2022, primarily as a result of a decrease in volume due to the securities sale. This decrease was offset by an increase of $705 thousand in interest income from deposits at other financial institutions for the third quarter of 2023 compared to the third quarter of 2022, which was primarily due to the increase in rates earned on those funds.

Total average interest-bearing deposits increased $300.3 million to $1.61 billion for the three months ended September 30, 2023 compared to $1.31 billion for the three months ended September 30, 2022. Average noninterest-bearing deposits decreased $80.9 million to $425.8 million for the three months ended September 30, 2023 compared to $506.7 million for the same period in 2022. Average wholesale deposits increased $324.7 million to $366.7 million for the three months ended September 30, 2023 compared to $42.0 million for the same period in 2022. Average other borrowed funds, which include federal funds purchased, FHLB advances, and our subordinated notes, decreased $72.8 million to $9.1 million at September 30, 2023 compared to $81.9 million at September 30, 2022

Interest expense for the three months ended September 30, 2023 increased $10.5 million to $14.1 million from $3.6 million for the three months ended September 30, 2022. Deposit interest expense for the third quarter of 2023 increased $10.9 million compared to the year ago quarter primarily as a result of increased rates, which contributed $10.0 million to the increase.

Our net interest margin, on a tax equivalent basis, for the three months ended September 30, 2023 and 2022 was 2.39% and 3.38%, respectively. The decrease in our net interest margin was primarily a result of the increase in the cost of our interest-bearing liabilities during 2023 compared to 2022, a result of the rising rate environment. The yield on interest-earning assets increased 85 basis points to 4.95% for the three months ended September 30, 2023, compared to 4.10% for the same period of 2022. The average yield of the loan portfolio for the three month periods ended September 30, 2023 and 2022 was 5.40% and 4.64%, respectively, an increase of 76 basis points. The cost of interest-bearing deposits increased 252 basis points to 3.40% for the three months ended September 30, 2023, compared to 0.88% for the same period of 2022, which was primarily attributable to the repricing of our interest-bearing deposits due to higher interest rates. Cost of deposits (which includes noninterest-bearing deposits) was 2.36% for the three months ended September 30, 2023 compared to 0.64% for the same three month period of 2022. Cost of other borrowed funds increased 141 basis points to 4.04% for the three months ended September 30, 2023 compared to 2.63% for the three months ended September 30, 2022.

Average balances of nonperforming loans, which consist of nonaccrual loans, are included in the net interest margin calculation and did not have a material impact on our net interest margin in 2023 and 2022.

Net interest income, on a tax equivalent basis, is a non-GAAP financial measure that we believe provides a more accurate picture of the interest margin for comparative purposes. To derive our net interest margin on a tax equivalent basis, net interest income is adjusted to reflect tax-exempt income on an equivalent before tax basis with a corresponding increase in income tax expense. For purposes of this calculation, we use our statutory tax rates for the periods presented. This measure ensures comparability of net interest income arising from taxable and tax-exempt sources.

The following table provides a reconciliation of our GAAP net interest income to our tax equivalent net interest income.

Supplemental Financial Data and Reconciliations to GAAP Financial Measures

(Dollars in thousands)

The following table presents average balance information, interest income, interest expense and the corresponding average yields earned and rates paid for the nine months ended September 30, 2023 and 2022.

Average Balance Sheets and Interest Rates on Interest-Earning Assets and Interest-Bearing Liabilities

For the Nine Months Ended September 30, 2023 and 2022

(Dollars in thousands)

54

(1) Nonaccrual loans are included in average balances and do not have a material effect on the average yield. Interest income on nonaccruing loans was not material for the periods presented. Net loan fees and late charges included in interest income on loans totaled $1.5 million and $2.5 million for the nine months ended September 30, 2023 and 2022, respectively.

(2) The average yields for investment securities are reported on a fully taxable equivalent basis at an effective rate of 22% for September 30, 2023 and 21% for September 30, 2022.

The level of net interest income is affected primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates.

The following table shows the effect that these factors had on the interest earned from our interest-earning assets and interest incurred on our interest-bearing liabilities for the nine months ended September 30, 2023 and 2022.

Rate and Volume Analysis

For the Nine Months Ended September 30, 2023 and 2022

(Dollars in thousands)

(1) Nonaccrual loans are included in average balances and do not have a material effect on the average yield. Interest income on nonaccruing loans was not material for the periods presented.

(2) The average yields for investment securities are reported on a fully taxable equivalent basis at an effective rate of 22% for September 30, 2023 and 21% for September 30, 2022

Net interest income totaled $13.3 million, a decrease of $4.2 million, or 24%, for three months ended September 30, 2023, compared to September 30, 2022. Net interest income for the nine months ended September 30, 2023 and September 30, 2022, was $41.7 million and $49.4 million, respectively, a decrease of $7.6 million, or 15%. The decrease in net interest income is again primarily due to an increase in funding costs, which have increased significantly over the last 15 months.

Average earning assets increased $194.6 million to $2.30 billion during the nine months ended September 30, 2023 as compared to $2.10 billion for the same period of 2022, primarily related to average growth in our loan portfolio of $281.0 million for the nine months of 2023 as compared to the same period of 2022. This growth was offset by a decrease in average investment securities of $55.7 million for the year-to-date period ended September 30, 2023 as compared to the same year ago period for 2022, a result of the securities sale executed during the first quarter of 2023 and the decrease in the market value of the securities portfolio during the past year. The average balance for deposits at other financial institutions also decreased $34.5 million for the nine months ended September 30, 2023 compared to the same period of 2022, as excess liquidity was used to fund loan originations.

Interest income for the nine months ended September 30, 2023 increased $22.6 million to $80.0 million from $57.3 million for the nine months ended September 30, 2022. Loan interest income during the first nine months of 2023 increased $21.4 million as compared to the year ago nine month period as a result of both loan growth and an increase in yields earned on the portfolio. Income from investment securities decreased $416 thousand for the nine months ended September 30, 2023 compared to the same period of 2022, primarily as a result of a decrease in volume due to the securities sale. This decrease was offset by an increase of $1.6 million in interest income from deposits at other financial institutions for the first nine months of 2023 compared to the same period of 2022, which was primarily due to the increase in rates earned on those funds.

Total average interest-bearing deposits increased $215.5 million to $1.51 billion for the nine months ended September 30, 2023 compared to $1.29 billion for the nine months ended September 30, 2022. Average noninterest-bearing deposits decreased $80.9 million to $433.3 million for the nine months ended September 30, 2023 compared to $514.2 million for the same period of 2022. Average wholesale deposits increased $294.9 million to $332.2 million for the nine months ended September 30, 2023 compared to $37.3 million for the same period in 2022. Average other borrowed funds, which include federal funds purchased and FHLB advances, increased $53.4 million to $98.4 million at September 30, 2023 compared to $45.0 million at September 30, 2022.

Interest expense for the nine months ended September 30, 2023 increased $30.3 million to $38.2 million from $8.0 million for the nine months ended September 30, 2022. Deposit interest expense for the year-to-date period of 2023 increased $28.0 million compared to the year ago nine month period primarily as a result of increased rates, which contributed $27.8 million to the increase.

Our net interest margin, on a tax equivalent basis, for the nine months ended September 30, 2023 and 2022 was 2.53% and 3.27%, respectively. The decrease in our net interest margin was primarily a result of the increase in the cost of our interest-bearing liabilities during 2023 compared to 2022, a result of the rising rate environment. The yield on interest-earning assets increased 87 basis points to 4.83% for the nine months ended September 30, 2023, compared to 3.79% for the same period of 2022. The average yield of the loan portfolio for the nine month periods ended September 30, 2023 and 2022 was 5.29% and 4.42%, respectively, an increase of 87 basis points. The cost of interest-bearing deposits increased 239 basis points to 3.07% for the nine months ended September 30, 2023, compared to 0.68% for the same period of 2022, which was primarily attributable to the repricing of our interest-bearing deposits due to higher interest rates. Cost of deposits (which includes noninterest-bearing deposits) was 2.09% for the nine months ended September 30, 2023 compared to 0.49% for the same nine month period of 2022. Cost of other borrowed funds increased 216 basis points to 3.89% for the nine months ended September 30, 2023 compared to 1.73% for the nine months ended September 30, 2022.

Provision Expense and Allowance for Credit Losses

Our policy is to maintain the allowance for credit losses at a level that represents our best estimate of expected losses in the loan portfolio as of the valuation date. Both the amount of the provision and the level of the allowance for credit losses are impacted by many factors, including general and industry-specific economic conditions, actual and expected credit losses, historical trends and specific conditions of individual borrowers. We adopted CECL as of January 1, 2023 in accordance with the required implementation date and recorded the impact of the adoption to retained earnings, net of deferred income taxes, as required by the standard. Note that prior to the adoption of CECL, we utilized an incurred loss model to derive our best estimate of the allowance for loan losses.

As a result of the adoption of CECL, reserves for credit losses increased $3.7 million and consisted of increases to the allowance for credit losses on loans as well as an increase in reserves for unfunded commitments (referred to as combined ACL herein). For the third quarter and first nine months of 2023, subsequent to the aforementioned adoption, the Company released $729 thousand of its allowance for credit losses and recorded a provision for credit losses of $132 thousand, respectively, compared to a provision of $365 thousand for the three months ended September 30, 2022 and a provision of $1.9 million for the nine months ended September 30, 2022. The Company continues to lend to well-established and relationship-driven borrowers and has a proven track record of low historical credit losses.

We continue to maintain our disciplined credit guidelines during the current rising rate environment. We proactively monitor the impact of rising interest rates on our adjustable loans as the industry navigates through this economic cycle of increased inflation and higher interest rates. Credit quality metrics remained strong for the third quarter of 2023 with reserves on the individually evaluated portfolio decreasing to $72 thousand as of September 30, 2023, down from $86 thousand at December 31, 2022, and down from $164 thousand at September 30, 2022, a result of valuation adjustments. We recorded net recoveries of $7 thousand during the third quarter of 2023 and net charge-offs of $9 thousand for same period of 2022. For the nine months ended September 30, 2023 and 2022, we recorded net charge-offs of $326 thousand and $416 thousand, respectively.

See “Asset Quality” below for additional information on the credit quality of the loan portfolio. The allowance for credit losses at September 30, 2023 was $18.8 million compared to $16.0 million at December 31, 2022. Our allowance for credit losses on loans as a percent of total loans, net of deferred fees and costs, was 1.06% at September 30, 2023, compared to 0.87% at December 31, 2022.

Noninterest Income

The following table provides detail for non-interest income for the three and nine months ended September 30, 2023 and 2022.

Non-Interest Income

For the Three and Nine Months Ended September 30, 2023 and 2022

(Dollars in thousands)

Noninterest income includes service charges on deposits and loans, loan swap fee income, income from our membership interest in ACM and other investments, income from our BOLI policies, and other fee income, and continues to supplement our operating results. Non-interest income for the three months ended September 30, 2023 was $225 thousand compared to $575 thousand for the three month ended September 30, 2022. For the nine months ended September 30, 2023, we recorded noninterest income as a loss of $3.5 million compared to income of $2.8 million for same period in 2022.

Fee income from loans was $107 thousand for the three months ended September 30, 2023, compared to $32 thousand for the three months ended September 30, 2022, an increase of $75 thousand, primarily due to an increase in back-to-back loan swap fee income. Service charges on deposit accounts and other fee income totaled $284 thousand for the three months ended September 30, 2023, compared to $241 thousand for the same period in 2022. Loss from our minority membership interest in ACM was $650 thousand for the three months ended September 30, 2023 compared to $160 thousand for the same period of 2022. Income from BOLI increased $21 thousand to $373 thousand for the three months ended September 30, 2023, compared to $352 thousand for the same period of 2022.

Non-interest income for the nine months ended September 30, 2023 was a loss of $3.5 million compared to income of $2.8 million for same period in 2022. The decrease in non-interest income is primarily attributable to a loss on the sale of available-for-sale securities of $4.6 million resulting from the balance sheet repositioning completed in the first quarter of 2023. Additionally, we recorded a loss of $1.4 million related to the Bank's minority investment in ACM during the first nine months of 2023. Fee income from loans was $352 thousand for the nine months ended September 30, 2023, compared to $159 thousand for the nine months ended September 30, 2022, an increase of $193 thousand, primarily due to an increase in loan extension fees and back-to-back loan swap fee income. Service charges on deposit accounts and other fee income totaled $731 thousand for the nine months ended September 30, 2023, compared to $706 thousand for the same period in 2022. Income from BOLI increased $223 thousand to $1.1 million for the nine months ended September 30, 2023, compared to $844 thousand for the same period of 2022.

Non-interest Expense

The following table reflects the components of non-interest expense for the three and nine months ended September 30, 2023 and 2022.

Non-Interest Expense

(Dollars in thousands)

Non-interest expense includes, among other things, salaries and benefits, occupancy and equipment costs, professional fees, data processing, insurance and miscellaneous expenses. Non-interest expense was $9.0 million and $8.6 million for the three month periods ended September 30, 2023 and 2022, respectively. Salaries and benefits expense was $5.3 million and $5.2 million for the third quarters of 2023 and 2022 respectively, an increase of $65 thousand, or 1.2%, which was primarily related to a decrease in salaries deferred related to loan origination activity totaling $211 thousand. Internet banking and software expense increased $228 thousand compared to the quarter ended September 30, 2022, primarily as a result of enhanced customer software solutions. Federal Deposit Insurance Corporate ("FDIC") insurance premium expense increased $276 thousand for the three months ended September 30, 2023 compared to the same period of 2022, a result of the FDIC increasing the assessment rate to replenish its deposit insurance fund. Marketing expenses increased $74 thousand to $167 thousand for the three months ended September 30, 2023 compared to the same period of 2022, related to lower cost deposit gathering and branding efforts. Lastly, loan related expenses decreased $431 thousand during the quarter ended September 30, 2023 compared to the same period of 2022, as we received a recovery of legal expenses associated with a previous watchlist credit.

Non-interest expense was $27.3 million and $25.3 million for the nine months ended September 30, 2023 and 2022, respectively, an increase of $2.0 million. Salaries and benefits expense was $15.4 million and $15.1 million for the nine months ended September 30, 2023 and 2022 respectively, an increase of $280 thousand, or 1.9%. During the first quarter of 2023, we had staffing changes that are expected to result in annualized savings of approximately $1.0 million. Internet banking and software expense increased $573 thousand compared to the nine months ended September 30, 2022, primarily as a result of enhanced customer software solutions. FDIC insurance premium expense increased $453 thousand for the nine months ended September 30, 2023 compared to the same period of 2022, a result of the FDIC increasing the assessment rate to replenish its deposit insurance fund. Marketing expenses increased $257 thousand to $527 thousand for the nine months ended September 30, 2023 compared to the same period of 2022, related to higher deposit gathering and branding efforts.

Income Taxes

We recorded a provision for income taxes of $1.2 million for the three months ended September 30, 2023, compared to $2.1 million for the same period in 2022. The effective tax rate for each of the three months ended September 30, 2023 and 2022 was 22.4% and 20.0%, respectively. For the nine months ended September 30, 2023 and 2022, provision for income taxes was $1.9 million and $5.0 million, respectively. The effective tax rate for the nine months ended September 30, 2023 was 17.9% and for the comparable nine month period of 2022 was 19.8%. The effective tax rates for these year-to-date periods are less than the Company's combined federal and state statutory rate of 22.5% primarily because of discrete tax benefits recorded as a result of exercised nonqualified stock options during the aforementioned periods.

Discussion and Analysis of Financial Condition

Overview

Total assets were $2.31 billion at September 30, 2023 and December 31, 2022, respectively. Investment securities were $216.4 million at September 30, 2023, a decrease of $61.9 million, from $278.3 million at December 31, 2022, primarily as a result of the aforementioned sale of available-for-sale investment securities that occurred during the first quarter of 2023. Total deposits increased $257.9 million, or 9%, to $2.00 billion at September 30, 2023 compared to $1.83 billion at December 31, 2022. At September 30, 2023 and December 31, 2022, we had federal funds purchased totaling $0.0 and $30.0 million, respectively. The Bank had FHLB advances of $50.0 million and $235.0 million at September 30, 2023 and December 31, 2022, respectively. Subordinated debt, net of unamortized issuance costs, totaled $19.6 million at each of September 30, 2023 and December 31, 2022.

Loans Receivable, Net

Loans receivable, net of deferred fees, were $1.85 billion at September 30, 2023 and $1.84 billion at December 31, 2022, an increase of $9.1 million, or 0.3%. During the third quarter of 2023, new commercial loan originations totaled $18.4 million with a weighted average rate of 8.01% and repayments of loans and lines of credit totaled $26.0 million with a weighted average rate of 7.58%.

Commercial real estate loans totaled $1.10 billion at September 30, 2023 and December 31, 2022, respectively. As of September 30, 2023, commercial real estate loans represented 59% of the Company's total gross loans receivable. Owner-occupied commercial real estate loans were $212.8 million at September 30, 2023 compared to $206.8 million at December 31, 2022. Nonowner-occupied commercial real estate loans were $884.9 million at September 30, 2023 compared to $893.2 million at December 31, 2022. Commercial construction loans totaled $154.6 million at September 30, 2023, an increase of $6.7 million, or 5%, from $147.9 million at December 31, 2022, and comprised 8% of total gross loans receivable. Of the $154.6 million in construction loans at September 30, 2023, $31.5 million are collateralized by land and only $2.7 million are lot acquisition and development loans (which have a higher degree of credit risk than the remaining portion of the construction portfolio). Our regulatory commercial real estate concentration (which includes nonowner-occupied real estate and construction loans) was 390% of our total risk based capital at September 30, 2023.

The following table presents the composition of our loans receivable portfolio at September 30, 2023 and December 31, 2022.

Loans Receivable

At September 30, 2023 and December 31, 2022

(Dollars in thousands)

Asset Quality

Nonperforming loans, defined as nonaccrual loans and loans contractually past due 90 days or more as to principal or interest and still accruing, were $1.5 million and $4.5 million at September 30, 2023 and December 31, 2022, respectively, a decrease of $3.0 million, or 66%. Loans that we have classified as nonperforming are a result of customer specific deterioration, mostly financial in nature, that are not a result of economic, industry, or environmental causes that we might see as a pattern for possible future losses within our loan portfolio. For each of our criticized assets, we conduct an impairment analysis to determine the level of additional or specific reserves required for any portion of the loan that may result in a loss. As a result of the analysis completed, we had specific reserves totaling $72 thousand and $86 thousand at September 30, 2023 and December 31, 2022, respectively. Our ratio of nonperforming loans to total assets was 0.07% and 0.19% at September 30, 2023 and December 31, 2022, respectively. We had no other real estate owned and there were $8.3 million in loan modifications for borrowers who were experiencing financial difficulty during the nine months ended September 30, 2023.

We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as current financial information, historical payment experience, collateral adequacy, credit documentation, and current economic trends, among other factors. We analyze loans individually by classifying the loans as to credit risk. This analysis includes larger, non-homogeneous loans such as commercial real estate and commercial and industrial loans. This analysis is performed on an ongoing basis as new information is obtained. At September 30, 2023, we had $811 thousand in loans identified as special mention, a decrease from $10.4 million from December 31, 2022. Special mention rated loans are loans that have a potential weakness that deserves our close attention; however, the borrower continues to pay in accordance with their contract. The decrease from December 31, 2022 was primarily related to two relationships comprising of three loans paying off totaling $9.6 million. Loans rated as special mention do not have a specific reserve and are considered well-secured.

At September 30, 2023, we had $2.2 million in loans identified as substandard, a decrease of $1.9 million from December 31, 2022. Substandard rated loans are loans that are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. For each of these substandard loans, a liquidation analysis is completed. The decrease from December 31, 2022 was primarily related to two relationships comprising of three loans paying off totaling $2.7 million offset by two relationships comprising of two loans being downgraded totaling $1.2 million. At September 30, 2023, individual reserves on loans totaling $72 thousand has been allocated within the allowance for credit losses to supplement any shortfall of collateral.

We recorded annualized net charge-offs (recoveries) to average loans receivable of 0.02% for the nine months ended September 30, 2023, compared to 0.04% for the nine months ended September 30, 2022. The following tables provide additional information on our asset quality for the periods presented.

Nonperforming Assets

At September 30, 2023 and December 31, 2022

(Dollars in thousands)

We are closely and proactively monitoring the effects of recent market activity. Our commercial real estate loan portfolio totaled $1.10 billion, or 59% of total, at September 30, 2023 and $1.10 billion, or 58% of total loans, at December 31, 2022. The commercial real estate portfolio, including construction loans, is diversified by asset type and geographic concentration. We manage this portion of the portfolio in a disciplined manner, and have comprehensive policies to monitor, measure and mitigate our loan concentrations within this portfolio segment, including rigorous credit approval, monitoring and administrative practices. Included in commercial real estate are loans secured by office buildings totaling $95.7 million, or 5% of total loans, and retail shopping centers totaling $267.3 million, or 14% of total loans, at September 30, 2023. Multi-family commercial properties totaled $179.0 million, or 10% of total loans, at September 30, 2023. The following table provides further stratification of these asset classes as of September 30, 2023 (dollars in thousands).

The loans shown in the above table exhibit strong credit quality, reflecting no delinquencies and no classified loans at September 30, 2023. During our assessment of the allowance for credit losses on loans, we addressed the credit risks associated with these portfolio segments and believe that as a result of our conservative underwriting discipline at loan origination, we have appropriately reserved for expected credit concerns in the event of a downturn in economic activity.

At September 30, 2023 and December 31, 2022, there were no performing loans considered potential problem loans. Potential problem loans are defined as loans that are not included in the 90 days or more past due, nonaccrual or restructured categories, but for which known information about possible credit problems causes us to be uncertain as to the ability of the borrowers to comply with the present loan repayment terms which may in the future result in disclosure in the past due, nonaccrual or restructured loan categories. We take a conservative approach with respect to risk rating loans in our portfolio. Based upon the status as a potential problem loan, these loans receive heightened scrutiny and ongoing intensive risk management. Additionally, our allowance for credit losses on loans estimation methodology adjusts expected losses to calibrate the likelihood of a default event to occur through the use of risk ratings.

Unexpected changes in economic growth could adversely affect our loan portfolio, including causing increases in delinquencies and default rates, which would adversely impact our charge-offs, allowance for credit losses, and provision for credit losses. Deterioration in real estate values, employment data and household incomes may also result in higher credit losses for us. Also, in the ordinary course of business, we may be subject to a concentration of credit risk to a particular industry, counterparty, borrower or issuer. A deterioration in the financial condition or prospects of a particular industry or a failure or downgrade of, or default by, any particular entity or group of entities could negatively impact our business, perhaps materially, and the systems by which we set limits and monitor the level of our credit exposure to individual entities and industries, may not function as we have anticipated.

See “Critical Accounting Policies” above for more information on our allowance for credit losses methodology.

The following tables present additional information pertaining to the activity in and allocation of the allowance for credit losses on loans by loan type and the percentage of the loan type to the total loan portfolio. The allocation of the allowance for credit losses on loans to a category of loans is not necessarily indicative of future losses or charge-offs, and does not restrict the use of the allowance to any specific category of loans.

Allowance for Credit Losses on Loans

(Dollars in thousands)

64

Allocation of the Allowance for Credit Losses on Loans

At September 30, 2023 and December 31, 2022

(Dollars in thousands)

* Percentage of loan type to the total loan portfolio.

Investment Securities

Our investment securities portfolio is used as a source of income and liquidity. The investment portfolio consists of investment securities available-for-sale and investment securities held-to-maturity. Investment securities available-for-sale are those securities that we intend to hold for an indefinite period of time, but not necessarily until maturity. These securities are carried at fair value and may be sold as part of an asset/liability strategy, liquidity management or regulatory capital management. Investment securities held-to-maturity for each of September 30, 2023 and December 31, 2022 totaled $264 thousand, and are those securities that we have the intent and ability to hold to maturity and are carried at amortized cost. The fair value of our investment securities available-for-sale was $216.1 million at September 30, 2023, a decrease of $61.9 million, or 22%, from $278.1 million at December 31, 2022, primarily as a result of the $40.3 million of available-for-sale securities sold in February 2023, principal paydowns of $17.1 million, and an increase in the portfolio's unrealized losses of $4.4 million.

As of September 30, 2023 and December 31, 2022, the majority of the investment securities portfolio consisted of securities rated AAA by a leading rating agency. Investment securities which carry a AAA rating are judged to be of the best quality and carry the smallest degree of investment risk. All of our mortgage-backed securities are guaranteed by either the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, or the Government National Mortgage Association. The effective duration of the investment securities portfolio continues to be slightly over five years, which is within the industry average. Investment securities that were pledged to secure public deposits totaled $121.4 million and $108.7 million at September 30, 2023 and December 31, 2022, respectively.

In accordance with ASC 326, we complete periodic assessments on at least a quarterly basis to determine if credit deterioration exists within our investment securities portfolio and if an allowance for credit losses would be required as of a valuation date. For additional details related to management's assessment process, see the “Critical Accounting Policies” section above. As a result of the assessment performed as of September 30, 2023, the investment securities with unrealized losses are a result of pricing changes due to recent rising interest rate conditions in the current market environment and not as a result of credit deterioration. Contractual cash flows for agency-backed portfolios are guaranteed and funded by the U.S. government. Municipal securities have third party protective elements and there are no negative indications that the contractual cash flows will not be received when due. We do not intend to sell nor do we believe we will be required to sell any of our investment securities portfolio prior to the recovery of the amortized cost as of the valuation date. As such, no impairment was recognized in our investment securities portfolio as of September 30, 2023.

We hold restricted investments in equities of the Federal Reserve Bank of Richmond ("FRB") and FHLB. At September 30, 2023, we owned $3.6 million in FRB stock and $4.0 million in FHLB stock. At December 31, 2022, we owned $4.4 million in FRB stock and $11.1 million in FHLB stock.

The following table presents the weighted average yields of our investment portfolio for each of the maturity ranges at September 30, 2023 and December 31, 2022.

Investment Securities by Stated Yields

At September 30, 2023 and December 31, 2022

Deposits and Other Borrowed Funds

The following table sets forth the average balances of deposits and the percentage of each category to total average deposits for the nine months ended September 30, 2023 and 2022.

Average Deposits Balance

For the Nine Months Ended September 30, 2023 and 2022

(Dollars in thousands)

Total deposits increased $165.8 million, or 9.1%, to $2.00 billion at September 30, 2023 from $1.83 billion at December 31, 2022. Noninterest-bearing deposits were $433.0 million at September 30, 2023, or 22% of total deposits. At September 30, 2023, core deposits, which exclude wholesale deposits, increased $131.3 million from December 31, 2022, or 8%. Time deposits (which exclude wholesale deposits) increased $121.3 million, or 47%, to $381.8 million at September 30, 2023 from December 31, 2022, and were 22% of core deposits, representing new and existing customer deposits as customers were looking to fix interest rates on their deposit balances.

Wholesale deposits were $282.5 million at September 30, 2023 compared to $248.0 million at December 31, 2022, an increase of $34.5 million, or 14%. Wholesale deposits were used to pay off FHLB advances at maturity freeing up collateral for future use as needed. Wholesale deposits are partially fixed at a weighted average rate of 3.62% as we have executed $250.0 million in pay-fixed/receive-floating interest rate swaps to reduce funding costs. In addition, we are a member of the IntraFi Network (“IntraFi”), which gives us the ability to offer Certificates of Deposit Account Registry Service (“CDARS”) and Insured Cash Sweep (“ICS”) products to our customers who seek to maximize FDIC insurance protection. When a customer places a large deposit with us for IntraFi, funds are placed into certificates of deposit or other deposit products with other banks in the CDARS and ICS networks in increments of less than $250 thousand so that principal and interest are eligible for FDIC insurance protection. These deposits are part of our core deposit base. At September 30, 2023 and December 31, 2022, we had $312.4 million and $117.6 million, respectively, in either CDARS reciprocal or ICS reciprocal products.

As of September 30, 2023, the estimated amount of total uninsured deposits (excluding collateralized deposits) was $635.1 million, or 31.8% of total deposits. The estimate of uninsured deposits generally represents the portion of deposit accounts that exceed the FDIC insurance limit of $250,000 and is calculated based on the same methodologies and assumptions used for purposes of the Bank's regulatory reporting requirements.

The following table reports maturities of the estimated amount of uninsured certificates of deposit at September 30, 2023.

Certificates of Deposit Greater than $250,000

At September 30, 2023

(Dollars in thousands)

67

Other borrowed funds, which include federal funds purchased, FHLB advances, and our subordinated notes, were $69.6 million at September 30, 2023 compared to $284.6 million at December 31, 2022. Subordinated debt was $19.6 million at both September 30, 2023 and December 31, 2022. At September 30, 2023 and December 31, 2022, federal funds purchased was $0 and $30.0 million, respectively. For September 30, 2023 and December 31, 2022, FHLB advances totaled $50.0 million and $235.0 million, respectively.

Total wholesale funding (which includes wholesale deposits and FHLB advances) decreased $80.8 million, or 20%, during the third quarter of 2023 to $332.5 million at September 30, 2023 from $513.0 million at December 31, 2022.

Capital Resources

Capital adequacy is an important measure of financial stability and performance. Our objectives are to maintain a level of capitalization that is sufficient to sustain asset growth and promote depositor and investor confidence.

Regulatory agencies measure capital adequacy utilizing a formula that takes into account the individual risk profile of the financial institution. The minimum capital requirements for the Bank are: (i) a common equity Tier 1 (“CET1”), capital ratio of 4.5%; (ii) a Tier 1 to risk-based assets capital ratio of 6%; (iii) a total risk based capital ratio of 8%; and (iv) a Tier 1 leverage ratio of 4%. Additionally, a capital conservation buffer requirement of 2.5% of risk-weighted assets is designed to absorb losses during periods of economic stress and is applicable to the Bank’s CET1 capital, Tier 1 capital and total capital ratios. Including the conservation buffer, we currently consider the Bank’s minimum capital ratios to be as follows: 7.00% for CET1; 8.50% for Tier 1 capital; and 10.50% for Total capital. Banking institutions with a ratio of common equity Tier 1 to risk-weighted assets above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases, and compensation.

On January 1, 2020, the federal banking agencies adopted a “Community Bank Leverage Ratio” ("CBLR"), which is calculated by dividing tangible equity capital by average consolidated total assets. If a “qualified community bank,” generally a depository institution or depository institution holding company with consolidated assets of less than $10.00 billion, opts into the CBLR framework and has a leverage ratio that exceeds the CBLR threshold, which was initially set at 9%, then such bank will be considered to have met all generally applicable leverage and risk based capital requirements under Basel III, the capital ratio requirements for “well capitalized” status under Section 38 of the Federal Deposit Insurance Act, and any other leverage or capital requirements to which it is subject. A bank or holding company may be excluded from qualifying community bank status based on its risk profile, including consideration of its off-balance sheet exposures; trading assets and liabilities; total notional derivatives exposures; and such other facts as the appropriate federal banking agencies determine to be appropriate. At January 1, 2020, we qualified and adopted this simplified capital structure. Effective September 30, 2022, we opted out of the CBLR framework. A banking organization that opts out of the CBLR framework can subsequently opt back into the CBLR framework if it meets the criteria listed above. We believe that the Bank met all capital adequacy requirements to which it was subject as of September 30, 2023 and December 31, 2022.

Shareholders’ equity at September 30, 2023 was $211.2 million, an increase of $8.9 million, or 4%, compared to $202.4 million at December 31, 2022. During the first quarter of 2023, retained earnings decreased $2.8 million primarily as a result of the adoption of CECL on January 1, 2023.

Total shareholders’ equity to total assets for September 30, 2023 and December 31, 2022 was 9.2% and 8.6%, respectively. Tangible book value per share (a non-GAAP financial measure which is defined in the table below) at September 30, 2023 and December 31, 2022 was $11.44 and $11.14, respectively.

As noted above, regulatory capital levels for the Bank meet those established for “well capitalized” institutions. While we are currently considered “well capitalized,” we may from time to time find it necessary to access the capital markets to meet our growth objectives or capitalize on specific business opportunities.

As the Company is a bank holding company with less than $3.00 billion in assets, and which does not (i) conduct significant off balance sheet activities, (ii) engage in significant non-banking activities, or (iii) have a material amount of securities registered under the Securities Exchange Act of 1934 (the “Exchange Act”), it is not currently subject to risk-based capital requirements adopted by the Federal Reserve, pursuant to the small bank holding company policy statement. The Federal Reserve has not historically deemed a bank holding company ineligible for application of the small bank holding company policy statement solely because its common stock is registered under the Exchange Act. There can be no assurance that the Federal Reserve will continue this practice.

The following tables show the minimum capital requirements and the Bank's capital position at September 30, 2023 and December 31, 2022.

Bank Capital Components

At September 30, 2023 and December 31, 2022

(Dollars in thousands)

Tangible Book Value

At September 30, 2023 and December 31, 2022

(Dollars in thousands, except per share data)

Liquidity

Liquidity in the banking industry is defined as the ability to meet the demand for funds of both depositors and borrowers. We must be able to meet these needs by obtaining funding from depositors or other lenders or by converting non-cash items into cash. The objective of our liquidity management program is to ensure that we always have sufficient resources to meet the demands of our depositors and borrowers. Stable core deposits and a strong capital position provide the base for our liquidity position. We believe we have demonstrated our ability to attract deposits because of our convenient branch locations, personal service, technology and pricing. As of September 30, 2023, estimated uninsured deposits (excluding collateralized deposits) for the Bank improved to 31.8% of total deposits from 39.7% at December 31, 2022.

In addition to deposits, we have access to the various wholesale funding markets. These markets include the brokered certificate of deposit market and the federal funds market. We are a member of the IntraFi Network, which allows banking customers to access FDIC insurance protection on deposits through our Bank which exceed FDIC insurance limits. As part of our membership with the IntraFi Network, we have one-way authority for both their CDARs and ICS products which provides the Bank the ability to access additional wholesale funding as needed. We also maintain secured lines of credit with the FRB and the FHLB for which we can borrow up to the allowable amount for the collateral pledged. Having diverse funding alternatives reduces our reliance on any one source for funding.

Cash flow from amortizing assets or maturing assets also provides funding to meet the needs of depositors and borrowers.

We have established a formal liquidity contingency plan which establishes a liquidity management team and provides guidelines for liquidity management. For our liquidity management program, we first determine our current liquidity position and then forecast liquidity based on anticipated changes in the balance sheet. In this forecast, we expect to maintain a liquidity cushion. We also stress test our liquidity position under several different stress scenarios, from moderate to severe. Guidelines for the forecasted liquidity cushion and for liquidity cushions for each stress scenario have been established. We believe that we have sufficient resources to meet our liquidity needs.

Our primary and secondary sources of liquidity remain strong. Liquid assets, which include cash and due from banks, federal funds sold and investment securities available for sale, totaled $313.1 million at September 30, 2023, or 14% of total assets, a decrease from $359.6 million, or 15%, at December 31, 2022. As of September 30, 2023 and December 31, 2022, $121.4 million and $108.7 million, respectively, in investment securities available for sale were pledged as collateral for municipal deposits. We held investments that are classified as held-to-maturity in the amount of $264 thousand at September 30, 2023. To maintain ready access to the Bank’s secured lines of credit, the Bank has pledged a portion of its commercial real estate and residential real estate loan portfolios to the FHLB and FRB. Additional borrowing capacity at the FHLB at September 30, 2023 was approximately $481.6 million. Borrowing capacity with the FRB was approximately $135.9 million at September 30, 2023. We have the ability to access the Federal Reserve's new Bank Term Funding Program ("BTFP"), but have not accessed this facility during the first half of 2023. These facilities are subject to the FHLB and the FRB approving disbursement to us. We also have unsecured federal funds purchased lines of $185.0 million available to us, of which none were used at September 30, 2023. We anticipate maintaining liquidity at a level sufficient to protect depositors, provide for reasonable growth and fully comply with all regulatory requirements. As of September 30, 2023, our liquidity position was significantly in excess of its estimated uninsured deposits at 134%.

Liquidity is essential to our business. Our liquidity could be impaired by an inability to access the capital markets or by unforeseen outflows of cash, including deposits. This situation may arise due to circumstances that we may be unable to control, such as general market disruption, negative views about the financial services industry generally, or an operational problem that affects a third party or us. Our ability to borrow from other financial institutions on favorable terms or at all could be adversely affected by disruptions in the capital markets or other events. While we believe we have a healthy liquidity position and do not anticipate the loss of deposits of any of the significant deposit customers, any of the factors discussed above could materially impact our liquidity position in the future.

Financial Instruments with Off-Balance-Sheet Risk and Credit Risk

We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet.

The Bank’s maximum exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. We evaluate each customer’s credit worthiness on a case-by-case basis and require collateral to support financial instruments when deemed necessary. The amount of collateral obtained upon extension of credit is based on our evaluation of the counterparty. Collateral held varies but may include deposits held by us, marketable securities, accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates up to one year or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. These instruments represent obligations to extend credit or guarantee borrowings and are not recorded on the consolidated statements of financial condition. The rates and terms of these instruments are competitive with others in the market in which we do business.

Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. Those lines of credit may not be drawn upon to the total extent to which we have committed.

Standby letters of credit are conditional commitments we issued to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. We hold certificates of deposit, deposit accounts, and real estate as collateral supporting those commitments for which collateral is deemed necessary.

With the exception of these off-balance sheet arrangements, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, results of operations, changes in financial condition, revenue, expenses, capital expenditures, or capital resources, that is material to our business.

At September 30, 2023 and December 31, 2022, unused commitments to fund loans and lines of credit totaled $217.4 million and $235.6 million, respectively. Commercial and standby letters of credit totaled $6.2 million for the quarters ended September 30, 2023 and December 31, 2022.

The Company maintains disclosure controls and procedures (as defined in Rule 13a - 15(e) under the Exchange Act). As of the end of the period covered by this report, an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures was carried out under the supervision and with the participation of the Company’s management, including its chief executive officer and chief financial officer. Based on and as of the date of such evaluation, these officers concluded that the Company’s disclosure controls and procedures were effective.

The Company also maintains a system of internal accounting controls that is designed to provide assurance that assets are safeguarded and that transactions are executed in accordance with management’s authorization and are properly recorded. This system is continually reviewed and is augmented by written policies and procedures, the careful selection and training of qualified personnel, and an internal audit program to monitor its effectiveness. There were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that materially affected, or are likely to materially affect, our internal control over financial reporting.

There have been no material changes in the risk factors from those disclosed in our Annual Report on Form 10-K for the year ended December 31, 2022.