ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of financial condition as of December 31, 2022 and 2021 and results of operations for each of the years in the three-year period ended December 31, 2022 should be read in conjunction with our consolidated financial statements and related notes thereto, included in Part II ITEM 8 of this report.
Forward-Looking Statements
The disclosures set forth in this item are qualified by important factors detailed in Part I captioned Forward-Looking Statements and ITEM 1A captioned Risk Factors of this report and other cautionary statements set forth elsewhere in the report.
Critical Accounting Estimates
Critical accounting estimates are those estimates made in accordance with generally accepted accounting principles that involve a significant level of estimation and uncertainty and have had or are reasonably likely to have a material impact on our financial condition and results of operations. We consider accounting estimates to be critical to our financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain, (ii) management could have applied different assumptions during the reported period, and (iii) changes in the accounting estimate are reasonably likely to occur in the future and could have a material impact on our financial statements. Management has determined the following accounting estimates and related policies to be critical.
Allowance for Credit Losses on Loans and Unfunded Commitments
The allowance for credit losses on loans is a valuation account that is deducted from the amortized cost basis at the balance sheet date to present the net amount of loans expected to be collected. The allowance for losses on unfunded loan commitments is based on estimates of probability that these commitments will be drawn upon according to historical utilization experience, expected loss severity and loss rates as determined for pooled funded loans. The allowance for credit losses on unfunded commitments is a liability account included in interest payable and other liabilities. Management estimates these allowances quarterly using relevant available information, from
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internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts. Credit loss experience among the Bank and peer groups provides the basis for the estimation of expected credit losses.
The allowance for credit losses ("ACL") model utilizes a discounted cash flow ("DCF") method to measure the expected credit losses on loans collectively evaluated that are sub-segmented by loan pools with similar credit risk characteristics, which generally correspond to federal regulatory reporting codes. In addition, the DCF method incorporates assumptions for probability of default ("PD"), loss given default ("LGD"), and prepayments and curtailments over the contractual terms of the loans. Under the DCF method, the ACL reflects the difference between the amortized cost basis and the present value of the expected cash flows using the loan's effective rate.
Management considers whether adjustments to the quantitative portion of the ACL are needed for differences in segment-specific risk characteristics or to reflect the extent to which it expects current conditions and reasonable and supportable forecasts of economic conditions to differ from the conditions that existed during the historical period included in the development of PD and LGD.
Our allowance model is particularly sensitive to forecasted and seasonally-adjusted actual California unemployment rates, which decreased to 4.1% at December 31, 2022 from 5.8% at December 31, 2021. The ACL model incorporates a one-year forecast. For periods beyond the forecast horizon the economic factors revert to historical averages on a straight-line basis over a one-year period. We performed a sensitivity analysis as of December 31, 2022 and determined that a 1% change (e.g., 4.5% to 5.5%) in the forecasted quarterly unemployment rates over the next four quarters resulted in a 6% change to our allowance for credit losses on loans. This impact does not consider other assumption changes to either the quantitative factors, such as probability of default, loss given default, loan mix or cash flows, prepayment/curtailment rates, and individually analyzed loans, or qualitative factors as discussed in Note 1 - Summary of Significant Accounting Policies. Additionally, because current economic conditions and forecasts can change, as future events are inherently difficult to predict, the estimated credit losses on loans and unfunded commitments could change significantly.
While we believe we use the best information available to determine the allowance for credit losses, our results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. For information regarding critical estimates related to our allowance for credit losses methodology, the provision for credit losses, and risks to asset quality and lending activity, see ITEM 1A - Risk Factors, the Allowance for Credit Losses section in ITEM 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations,
Income Taxes
We are subject to the income tax laws of the U.S., its states, and the municipalities in which we operate. These tax laws are complex and subject to different interpretations by us and the government taxing authorities. We review our provision for income tax expense monthly and calculate the carrying value of deferred tax assets and liabilities quarterly. In establishing a provision for income tax expense, we make judgments and interpretations about the application of these inherently complex tax laws. In addition, our estimates include making judgements about when future items will affect taxable income. Although management believes that the judgments and estimates used are reasonable, actual results could differ and we may be exposed to losses or gains that could be material. For further information on our tax assets and liabilities, and related provision for income taxes, see Note 1 - Summary of Significant Accounting Policies and Note 11 - Income Taxes in ITEM 8 - Financial Statements and Supplementary Data of this Form 10-K.
Fair Value Measurements
We use fair value measurements to record certain financial instruments and to determine fair value disclosures. Available-for-sale securities and interest rate swap agreements are financial instruments recorded at fair value on a recurring basis. Additionally, we record at fair value other financial assets on a nonrecurring basis such as collateral dependent loans and other real estate owned. These nonrecurring fair value adjustments typically involve write-downs of, or specific reserves against, individual assets. We group our assets and liabilities that are measured at fair value into three levels within the fair value hierarchy, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. The classification of assets and liabilities
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within the hierarchy is based on whether the inputs to the valuation methodology used in the measurement are observable or unobservable. Observable inputs reflect market-driven or market-based information obtained from independent sources, while unobservable inputs reflect our estimates about market data. The degree of management judgment involved in determining the fair value of a financial instrument is dependent upon the availability of quoted market prices or observable market data. For financial instruments that trade actively and have quoted market prices or observable market data, there is minimal subjectivity involved in measuring fair value. When observable market prices and data are not fully available, management judgment is necessary to estimate fair value. In addition, changes in the market conditions may reduce the availability of quoted prices or observable data. Therefore, when market data is not available, we use valuation techniques that require more management judgment to estimate the appropriate fair value measurement. Fair value is discussed further in Note 1 - Summary of Significant Accounting Policies and Note 9 - Fair Value of Assets and Liabilities in ITEM 8 - Financial Statements and Supplementary Data of this Form 10-K.
Business Combinations
Business combinations are accounted for using the acquisition method of accounting where the assets and liabilities of the acquired entities have been recorded at their estimated fair values at the date of acquisition. Goodwill represents the excess of the purchase price over the fair value of net assets acquired. The purchase price allocation process requires significant judgment in the estimation of the fair values of the assets acquired and the liabilities assumed. Management may obtain third-party valuations such as appraisals or discounted cash flow analyses, or we may derive fair values internally using techniques as discussed in Fair Value Measurements above. Management assesses qualifications of third-party valuation specialists, reviews assumptions applied and takes responsibility for the results of fair value estimates. Merger-related expenses include costs directly related to merger activity such as legal and professional fees, system consolidation and conversion costs, and compensation costs associated with employee severance and retention incentives. We account for merger-related costs as expenses in the periods in which the costs are incurred and the services received. Accounting policies and estimates are discussed further in Note 1 - Summary of Significant Accounting Policies and Note 18 - Merger in ITEM 8 - Financial Statements and Supplementary Data of this Form 10-K.
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RESULTS OF OPERATIONS
Financial Highlights
The following are highlights of our financial condition and results of operations. The data was derived from the audited consolidated financial statements of Bank of Marin Bancorp.
At December 31,
(dollars in thousands, except per share data) 2022 2021
Selected financial condition data:
Loans, net of allowance for credit losses on loans 1 $ 2,069,563 $ 2,232,622
Borrowings and other obligations $ 112,439 $ 419
Asset quality ratios:
Allowance for credit losses to total loans 1.10 % 1.02 %
Allowance for credit losses to non-accrual loans 9.45x 2.75x
Non-accrual loans to total loans 0.12 % 0.37 %
Capital ratios:
Tangible common equity to tangible assets 8.21 % 8.76 %
Total capital (to risk-weighted assets) 15.90 % 14.58 %
Tier 1 capital (to risk-weighted assets) 15.02 % 13.70 %
Tier 1 capital (to average assets) 9.60 % 8.85 %
Common equity Tier 1 capital (to risk-weighted assets) 15.02 % 13.70 %
Other data:
Number of branches 31 31
Full-time equivalent employees 313 328
For the Years Ended December 31,
Selected operating data:
Net income per common share:
Performance and other financial ratios:
Tax-equivalent net interest margin 3.11 % 3.17 % 3.55 %
Cash dividend payout ratio on common stock 4 33.45 % 40.52 % 41.07 %
Cash dividends per common share $ 0.98 $ 0.94 $ 0.92
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Executive Summary
Annual earnings were $46.6 million in 2022 compared to $33.2 million in 2021. Diluted earnings were $2.92 per share in 2022, compared to $2.30 per share in 2021.
The following are highlights of operating and financial performance for the year ended December 31, 2022:
•Merger-related and conversion costs reduced net income by $604 thousand, or 4 cents per share in 2022, compared to $4.9 million, or 34 cents per share in 2021. As shown in the reconciliation of GAAP to non-GAAP financial measures on page 28, year-to-date return on average assets of 1.08% and return on average equity of 11.16% excluding these costs would have been 1.10% and 11.31%, respectively, compared to 1.08% and 9.67%, respectively, in 2021.
•Loans decreased by $163.1 million in 2022, or 7%, to $2.093 billion as of December 31, 2022, from $2.256 billion as of December 31, 2021. Loan originations of $240.2 million in 2022 were the second highest on record, while payoffs were uncharacteristically high. Payoffs included both Paycheck Protection Program ("PPP") loans and $258.5 million of non-PPP loans, many of which were outside the Bank's control and resulted from activities such as sales of businesses and properties, cash repayments, and project completions. Shortly after December 31, we originated $45 million in commercial loans that were in process at year-end, $20 million of which was syndicated to a participant bank.
•Credit quality remained strong and improved during 2022, with classified loans decreasing $8.1 million and non-accrual loans representing 0.12% of the total loans as of December 31, 2022, compared to 0.37% as of December 31, 2021. Non-accrual loans dropped by $5.9 million (or 71%) in 2022, substantially due to the payoff of three commercial real estate loans from two borrowers. Subsequent to year-end, an additional $1.2 million in non-accrual loans paid off. In 2022 and 2021, we recorded net reversals of the provision for credit losses on loans of $63 thousand and $1.4 million, respectively. In addition, in 2022 and 2021, we recorded net reversals of the provision for credit losses on unfunded commitments of $318 thousand and $992 thousand, respectively.
•Deposits decreased by $235.2 million to $3.573 billion as of December 31, 2022, compared to $3.809 billion as of December 31, 2021, as the Bank continued to carefully manage deposit costs. The decline was a result of anticipated outflows due to planned business activities by a few large clients and some customers moving into alternative investments. At the end of 2021, the Bank held $347.6 million in cash and cash equivalents, and $173.1 million in off-balance sheet amounts with deposit networks in anticipation of expected and potential unexpected deposit outflows during 2022. There were no balances held with deposit networks at the end of 2022. Despite the decrease, non-interest bearing deposits to total deposits increased slightly to 51.5% as of December 31, 2022, compared to 50.2% as of December 31, 2021. Cost of deposits remained low at 0.06% in 2022, down slightly from 0.07% in 2021.
•Net interest income totaled $127.5 million and $105.0 million in 2022 and 2021, respectively. The $22.5 million increase from the prior year was primarily due to higher balances in the investment securities and commercial real estate loan portfolios, a full year of net interest income from acquired earning assets of American River Bankshares ("AMRB"), compared to five months in 2021, and the early redemption of subordinated debt that generated $1.4 million of interest expense in 2021. The tax-equivalent net interest margin decreased by 6 basis points to 3.11% in 2022, compared to 3.17% in 2021, as the proportion of average investment securities to average total interest-earning assets grew from 26% in 2021 to 44% in 2022 and fee income from PPP loans declined.
•The efficiency ratio was 54.39% in 2022, compared to 63.12% in 2021. As shown in the reconciliation of GAAP to non-GAAP financial measures on page 28, the efficiency ratios excluding merger-related and conversion costs would have been 53.77% and 57.51% in 2022 and 2021, respectively.
•After careful consideration, the Bank decided to close four brick-and-mortar branch locations in March 2023. The acquisition of American River Bankshares resulted in an overlap in the Bank’s branch network in Santa Rosa and Healdsburg, prompting branch consolidations within Northern Sonoma County. In addition, our
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Tiburon and Buckhorn branches in Southern Marin and Amador counties are close to other branches that can serve our customers. These closures fulfill the remaining expense savings anticipated from the acquisition, improve efficiency and optimize our delivery channels while generating savings that will help to fund strategic initiatives going forward. The expected pre-tax savings in 2023 from the branch closures, net of accelerated costs, is approximately $470 thousand, and future annual pre-tax savings are expected to be approximately $1.4 million.
•All capital ratios were above regulatory requirements for a well-capitalized institution. The total risk-based capital ratio for Bancorp was 15.9% at December 31, 2022 and 14.6% at December 31, 2021. Tangible common equity to tangible assets declined to 8.2% at December 31, 2022 from 8.8% at December 31, 2021, primarily due to $71.7 million increase in after-tax unrealized losses on available-for-sale securities associated with interest rate changes since December 31, 2021, partially offset by incremental earnings and the smaller balance sheet in 2022. The total risk-based capital ratio for the Bank was 15.7% at December 31, 2022 and 14.4% at December 31, 2021.
•The Board of Directors declared a cash dividend of $0.25 per share on January 20, 2023. This is the 71stconsecutive quarterly dividend paid by Bank of Marin Bancorp. The cash dividend was paid on February 10, 2023 to shareholders of record at the close of business on February 3, 2023.
•As recent events in the marketplace unfold, including the closures of Silicon Valley Bank on March 10, 2023 followed by Signature Bank on March 12, 2023, the Bank remains focused on our banking relationships. We believe our deposit franchise is sound, with a focus on core deposits from community-based customers with whom we have strong relationships. Those relationships are centered around the needs of local corporations, business operators and real estate investors, with very little exposure to technology start-up companies and no exposure to digital assets, two areas of risk that strongly influenced the aforementioned closures. On March 13, 2023, we initiated an outreach effort to answer our customers' questions or concerns about the recent events, strengths of the Bank, and other matters such as FDIC insurance coverage. In February 2023, we enhanced our borrowing capacity at the FHLB by pledging certain held-to-maturity securities to the Securities-Backed Credit Program, increasing our total immediate contingent funding sources to approximately $2.0 billion, or 59% of total deposits as of February 28, 2023. The Bank also has the option to add another $267 million to its borrowing capacity through the Federal Reserve’s new Bank Term Funding Program ("BTFP").
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Statement Regarding Use of Non-GAAP Financial Measures
In this Form 10-K, Bancorp's financial results are presented in accordance with GAAP and refer to certain non-GAAP financial measures. Management believes that presentation of operating results using non-GAAP financial measures provides useful supplemental information to investors and facilitates the analysis of Bancorp's operating results and comparison of operating results across reporting periods. Management also uses non-GAAP financial measures to establish budgets and manage Bancorp's business. A reconciliation of the GAAP financial measures to comparable non-GAAP financial measures is presented below.
Reconciliation of GAAP and Non-GAAP Financial Measures
Year ended December 31,
Net income
Merger-related and conversion costs:
Professional services 67 1,976 —
Total merger costs before tax benefits 858 6,458 —
Income tax benefit of merger-related expenses (254) (1,547) —
Total merger-related and conversion costs, net of tax benefits 604 4,911 —
Diluted earnings per share
Diluted earnings per share (GAAP) $ 2.92 $ 2.30 $ 2.22
Merger-related and conversion costs, net of tax benefits 0.04 0.34 —
Comparable diluted earnings per share (non-GAAP) $ 2.96 $ 2.64 $ 2.22
Return on average assets
Return on average assets (GAAP) 1.08 % 0.94 % 1.04 %
Comparable return on average assets (non-GAAP) 1.10 % 1.08 % 1.04 %
Return on average equity
Return on average equity (GAAP) 11.16 % 8.43 % 8.60 %
Comparable return on average equity (non-GAAP) 11.31 % 9.67 % 8.60 %
Efficiency ratio
Merger-related expenses (858) (6,458) —
Comparable efficiency ratio (non-GAAP) 53.77 % 57.51 % 55.56 %
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Net Interest Income
Net interest income is the interest earned on loans, investment securities and other interest-earning assets minus interest expense incurred on deposits and other interest-bearing liabilities. Net interest income is affected by changes in general market interest rates and by changes in the amounts and composition of interest-earning assets and interest-bearing liabilities. Interest rate changes can create fluctuations in net interest income and/or margin due to an imbalance in the timing of repricing or maturity of assets or liabilities. We manage interest rate risk exposure with the goal of optimizing the effect of interest rate volatility on net interest income.
Net interest margin is expressed as net interest income divided by average interest-earning assets. Net interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate incurred on total interest-bearing liabilities. Both of these measures are reported on a taxable-equivalent basis. Net interest margin is the higher of the two because it reflects interest income earned on assets funded with non-interest-bearing sources of funds, which include demand deposits and stockholders’ equity.
The following table compares interest income, average interest-earning assets, interest expense, and average interest-bearing liabilities for the periods presented. The table also presents net interest income, net interest margin and net interest rate spread for the years indicated.
Average Statements of Condition and Analysis of Net Interest Income
Year ended Year ended Year ended
Interest Interest Interest
Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
Assets
Liabilities and Stockholders' Equity
Tax-equivalent net interest rate spread 3.03 % 3.04 % 3.41 %
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Analysis of Changes in Net Interest Income
The following table presents the effects of changes in average balances (volume) or changes in average rates on tax-equivalent net interest income for the years indicated. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates. Rate variances are equal to the increase or decrease in rates multiplied by prior period average balances. Mix variances are attributable to the change in yields or rates multiplied by the change in average balances.
2022 Compared to 2021
Net interest income totaled $127.5 million in 2022, compared to $105.0 million in 2021. The $22.5 million increase from the prior year was primarily due to higher balances in the investment and commercial real estate loan portfolios, which added $18.4 million and $6.1 million, respectively, to net interest income. Additionally, 2022 incorporated a full year of net interest income from acquired earning assets of AMRB, compared to five months in 2021. Average interest-bearing liabilities increased $376.6 million while the average cost dropped nine basis points, largely due to the extinguishment of subordinated debt that generated $1.4 million of interest expense in 2021.
The tax-equivalent net interest margin decreased six basis points to 3.11% in 2022, from 3.17% in 2021, as the proportion of average investment securities to average total interest-earning assets grew from 26% in 2021 to 44% in 2022 and fee income from PPP loans declined.
2021 Compared to 2020
Net interest income totaled $105.0 million and $96.7 million in 2021 and 2020, respectively. The $8.3 million increase in 2021 was primarily due to higher average loan and investment securities balances. In addition, we recognized $8.3 million in SBA PPP fees, net of cost in 2021, compared to $3.8 million in 2020. These increases were partially offset by $1.4 million in interest and accelerated discount accretion on the early redemption of a subordinated debenture in the first quarter of 2021, and lower yields on investment securities.
The tax-equivalent net interest margin decreased 38 basis points to 3.17% in 2021, from 3.55% in 2020 for the reasons already mentioned and as shown in the above table. The SBA PPP loans improved the 2021 net interest margin by 10 basis points, and the early redemption of the subordinated debenture reduced it by 4 basis points.
Market Interest Rates
Market interest rates are, in part, based on the target federal funds interest rate (the interest rate banks charge each other for short-term borrowings) implemented by the Federal Reserve Open Market Committee ("FOMC").
In response to the evolving risks to economic activity caused by the COVID-19 pandemic, the FOMC made two emergency federal funds rate cuts totaling 150 basis points in March 2020. The federal funds rate range remained
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between 0.0% to 0.25% through the beginning of 2022, putting downward pressure on our asset yields and net interest margin. Beginning in March 2022, the FOMC began successive increases to the federal funds rate due to the evolving inflation risks, international political unrest and oil and other supply chain disruptions. As a result of five rate adjustments during 2022, the federal funds target rate range increased to 4.25% to 4.50% at year-end. Subsequently, on February 1, 2023, the FOMC increased the rate by another 25 basis points to a range of 4.50% to 4.75%. As shown in the table above, higher interest rates contributed an additional $5.9 million to net interest income in 2022 compared to 2021. Additional rate increases are anticipated in 2023, as Federal Reserve policymakers continue to monitor inflation and economic developments. See ITEM 7A. Quantitative and Qualitative Disclosure about Market Risk for further information.
Provision for Credit Losses on Loans
We recorded a net $63 thousand reversal of the provision for credit losses on loans in 2022, compared to a $1.4 million reversal of the provision for credit losses in 2021 and $4.6 million provision for credit losses in 2020.
The net reversal of the provision in 2022 was largely due to a $55.4 million decrease in applicable loan balances (excludes the $107.7 million decrease in PPP loans for which there was no allowance) and improvements in the Moody's Analytics' Baseline Forecast of California unemployment rates since December 31, 2021, which decreased the quantitative "modeled" allowance for credit losses. These decreases were partially offset by adjustments to qualitative risk factors to account for the ongoing deterioration in the economic outlook that management believes is not captured in the quantitative portion of the allowance.
The net provision reversal in 2021 was primarily due to continued improvements in Moody's Analytics' Baseline Forecast of California unemployment rates and adjustments to qualitative risk factors due to a decline in the volume of loans downgraded to substandard classification, fewer delinquencies, and the elimination of an allowance related to a commercial real estate loan that had been individually analyzed for potential credit losses in the previous periods and paid off in 2021. These reversals were partially offset by an increase in the allowance for credit losses related to qualitative risk factor adjustments for recent changes in executive leadership and senior lending positions, and integration of AMRB.
The provision for credit losses in 2020 calculated under the incurred loss method (prior to the adoption of the excepted credit loss method on December 31, 2020) was largely due to the uncertainty about the impact of the COVID-19 pandemic on the local and regional economies and our customers at that time. In addition, under the CECL method, we increased our allowance for credit losses by approximately $925 thousand for previously acquired loans (i.e., non-purchased credit deteriorated or "non-PCD" loans); whereas, under previous GAAP (incurred loss method) we did not record an allowance on our unimpaired previously acquired non-PCD loans. The pandemic also negatively affected the financial condition of many of our borrowers, which was partially alleviated by our payment relief program under the 2020 CARES Act and the SBA PPP.
Non-interest Income
The table below details the components of non-interest income.
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2022 Compared to 2021
Non-interest income totaled $10.9 million in 2022, a $773 thousand increase from $10.1 million in 2021. The increase was primarily due to higher fees on deposit balances held in off-balance sheet deposit networks contributing $504 thousand in additional income, $414 thousand more service charges on deposit accounts, $296 thousand higher FHLB dividends, and a combination of smaller increases. Increases were partially offset by a $965 thousand reduction in bank-owned life insurance as the prior year included $1.1 million in benefits collected on insurance policies. Additionally, 2022 incorporated a full year of non-interest income from the AMRB acquisition, compared to five months in 2021.
2021 Compared to 2020
Non-interest income totaled $10.1 million and $8.6 million in 2021 and 2020, respectively. The $1.5 million increase was primarily due to the collection of $1.1 million in benefits on bank-owned life insurance policies and an increase in service charges and interchange fees related to the expanded deposit base. In March 2020, we implemented temporary waivers for all ATM fees, overdraft fees and early withdrawal penalties for time deposits to help ease the financial burden customers began experiencing due to the pandemic. We reinstituted the fees in May 2021. Additionally, Wealth Management and Trust income increased due to the addition of new accounts and favorable market performance in 2021. Increases were partially offset by the $931 thousand reduction in gains on sales of investment securities.
Non-interest Expense
The table below details the components of non-interest expense.
Other non-interest expense:
2022 Compared to 2021
Non-interest expense increased $2.6 million to $75.3 million in 2022 from $72.6 million in 2021. Information technology expenses increased $647 thousand due to investments in software and equipment during 2022. Total occupancy expenses, including depreciation and amortization, increased $626 thousand resulting primarily from merger growth and $212 thousand in accelerated costs related to planned branch closures. Other increases in 2022 included core deposit intangible amortization and FDIC insurance, largely attributable to the 2021 AMRB acquisition, a $345 thousand valuation adjustment in other real estate owned expense, and a $490 thousand increase in employment recruiting costs included in other expense.
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Salaries and employee benefits expense was relatively flat year-over-year. In 2022, increases in staffing and profit sharing expenses, a reduction in deferred loan origination costs, and a combination of smaller items were largely offset by a decrease in supplemental executive retirement plan expense from an adjustment to the discount rate, and a decline in merger-related expenses, as shown in the table on page 28.
Professional services decreased $1.7 million from the prior year, primarily due to higher merger-related costs and additional consulting expenses associated with PPP loan forgiveness application processing in 2021, partially offset by higher audit and accounting fees in 2022. Data processing expenses decreased by $490 thousand primarily due to merger-related expenses in 2021, as shown in the table on page 28, partially offset by an increase in processing costs in 2022 associated with higher volumes for the larger bank.
2021 Compared to 2020
Non-interest expense increased $14.1 million to $72.6 million in 2021 from $58.5 million in 2020. The largest increase of $6.5 million came from merger-related and conversion costs. In addition to $3.0 million in merger costs, salaries and related benefits rose another $4.5 million due to increased numbers of employees, regularly scheduled annual merit and related increases, and lower deferred loan origination costs. Professional services included $817 thousand more in consulting expenses for PPP loan forgiveness application processing, investment advisory services, and legal costs. Data processing increased by an additional $828 thousand primarily due to increases core processing and mobile banking systems charges, and other categories increased due to the larger size of the bank. FDIC insurance increased by $415 thousand due to an increase in our deposit base. Charitable contributions decreased due to supplemental contributions in 2020 related to the pandemic.
Provision for Income Taxes
Income tax provisions reflect accruals for taxes at the applicable rates for federal income tax and California franchise tax based upon reported pre-tax income. Provisions also reflect permanent differences between income for tax and financial reporting purposes (such as earnings on tax exempt loans and municipal securities, BOLI, low-income housing tax credits, and stock-based compensation from the exercise of stock options, disqualifying dispositions of incentive stock options and vesting of restricted stock awards).
The provision for income taxes totaled $16.9 million at an effective tax rate of 26.6% in 2022, compared to $11.7 million at an effective tax rate of 26.0% in 2021 and $10.3 million at an effective tax rate of 25.5% in 2020. The increase in the provision in 2022 compared to 2021 reflected higher pre-tax income. The 60 basis point increase in the effective tax rate in 2022 as compared to 2021 was primarily due to lower BOLI income and the smaller proportion of tax-exempt loan and investment securities interest income to pre-tax income in 2022, partially offset by the non-deductible merger expenses and executive compensation in 2021. The 50 basis point increase in the effective tax rate in 2021 compared to 2020 was due to non-deductible merger expenses and executive compensation, partially offset by higher BOLI income and tax-exempt loan and investment securities interest income.
We file a consolidated return in the U.S. Federal tax jurisdiction and a combined return in the State of California tax jurisdiction. There were no ongoing federal or state income tax examinations at the issuance of this report. At December 31, 2022 and 2021, neither the Bank nor Bancorp had accruals for interest or penalties related to unrecognized tax benefits.
FINANCIAL CONDITION
Investment Securities
We maintain an investment securities portfolio to provide liquidity and to generate earnings on funds that have not been loaned to customers. Management determines the maturities and types of securities to be purchased based on liquidity and interest rate risk position, and the desire to attain a reasonable investment yield balanced with risk exposure. The tables below show the composition of the debt securities portfolio by expected maturity at December 31, 2022 and 2021. Expected maturities differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties. We estimate and update expected maturity dates regularly based on current and historical prepayment speeds. The weighted
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average life of the investment portfolio at December 31, 2022 and 2021 was approximately seven and six years, respectively.
December 31, 2022 Within 1 Year 1-5 Years 5-10 Years After 10 Years Total
Held-to-maturity:
Available-for-sale:
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December 31, 2021 Within 1 Year 1-5 Years 5-10 Years After 10 Years Total
Held-to-maturity:
Available-for-sale:
1 Book value reflects cost, adjusted for accumulated amortization and accretion.
2 Weighted average calculation is based on amortized cost of securities.
3 Yields on tax-exempt municipal bonds are presented on a taxable equivalent basis, using federal tax rate of 21%.
The amortized cost of our investment securities portfolio increased $353.1 thousand or 23.4% during 2022. We purchased $243.5 million in securities in 2022 designated as available-for-sale to provide flexibility for liquidity and interest rate risk management. We also purchased $319.9 million in securities in 2022 designated as held-to-maturity. These purchases were offset by $177.3 million of paydowns, calls and maturities, and $10.7 million of sales during 2022. The weighted average yield on the purchases of securities was 3.22% for the 2022 year and 6.08% for the fourth quarter of 2022. We transferred $357.5 million of available-for-sale securities to held-to-maturity in March 2022. Refer to Note 2, Investment Securities, to the Consolidated Financial Statements in ITEM 8 of this report for further information.
During 2022, we purchased $364.6 million in agency collateralized mortgage obligations ("CMOs"), $60.9 million in agency mortgage-backed securities ("MBSs"), $61.2 million in debentures of government sponsored agencies, $30.0 million in corporate bonds, $29.9 million in SBA-backed securities and $16.8 million in obligations of state and political subdivisions. We consider agency debentures and CMOs issued by U.S. government sponsored entities to have low credit risk as they carry the credit support of the U.S. federal government. The debentures, CMOs and MBS issued by U.S. government sponsored agencies, SBA-backed securities and U.S. Treasury securities made up 86.7% of the portfolio at December 31, 2022, compared to 85.6% at December 31, 2021. See the discussion in the section captioned “Securities May Lose Value due to Credit Quality of the Issuers” in ITEM 1A Risk Factors above.
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At December 31, 2022 and 2021, distribution of our investment in obligations of state and political subdivisions was as follows:
Within California:
Outside California:
Percent of investment portfolio 9.6% 9.3% 11.7% 12.0%
The portion of the portfolio outside the state of California is distributed among twelve states. Of the total investment in obligations of state and political subdivisions, the largest concentrations outside California are in Texas (39.6%), Washington (14.4%), and Wisconsin (8.9%). Our investment in obligations issued by municipal issuers in Texas are either guaranteed by the AAA-rated Texas Permanent School Fund ("PSF") or backed by revenue sources from essential services (such as utilities and transportation).
Investments in states, municipalities and political subdivisions are subject to an initial pre-purchase credit assessment and ongoing monitoring. Key considerations include:
•The soundness of a municipality’s budgetary position and stability of its tax revenues
•Debt profile and level of unfunded liabilities, diversity of revenue sources, taxing authority of the issuer
•Local demographics/economics including unemployment data, largest local taxpayers and employers, income indices and home values
•For revenue bonds, the source and strength of revenue for municipal authorities including obligors' financial condition and reserve levels, annual debt service and debt coverage ratio, and credit enhancement (such as insurer’s strength)
•Credit ratings by major credit rating agencies
Loans
Loans Outstanding by Class and Percent of Total
Real estate
Allowance for credit losses on loans (22,983) (23,023)
Total loans, net of allowance for credit losses $ 2,069,563 $ 2,232,622
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Loans decreased by $163.1 million in 2022, or 7%, to $2.093 billion as of December 31, 2022, from $2.256 billion as of December 31, 2021. Year-over-year changes were largely attributable to a $107.7 million decrease in PPP loans and a decrease in investor-owned commercial real estate loans, partially offset by growth in owner-occupied commercial real estate loans. Loan originations were $240.2 million in 2022 compared to $181.7 million in 2021, an increase of 32%. Non-PPP payoffs were $258.5 million in 2022, compared to $218.1 million in 2021. Much of the payoffs in 2022 were outside the Bank's control and resulted from activities such as sales of businesses and properties, cash repayments, and project completions. The originations and payoffs noted above, combined with utilization on lines of credit and amortization on existing loans, resulted in the net decreases for these periods.
Non-PPP payoffs as a percentage of beginning of the year loan balances were 11.5% in 2022 and 10.4% in 2021. Approximately 90% and 86%, of total loans were secured by real estate as of December 31, 2022 and 2021, respectively. The increase in the percentage secured by real estate from 2021 to 2022 was primarily due to a $107.7 million reduction in unsecured loans guaranteed by the SBA under the PPP, which are included in commercial and industrial loans. For additional information on loan concentration risk, see ITEM 1A, Risk Factors.
The following table summarizes our commercial real estate loan concentrations by the county in which the property was located as of December 31, 2022 and 2021.
Commercial Real Estate Loans Outstanding by County
(dollars in thousands; unaudited) December 31, 2022 December 31, 2021
Commercial real estate loans decreased $34.6 million in 2022, compared to a $315.2 million increase in 2021. The decrease in 2022 was primarily due to cash paydowns as part of ongoing deleveraging, refinancings and asset sales. The increase in 2021 was primarily due to the AMRB acquisition and expanded footprint in Northern California. Of the commercial real estate loans at December 31, 2022, 77% were investor-owned and 23% were owner-occupied. Almost the entire commercial real estate loan portfolio is comprised of term loans for which the primary source of repayment is either the cash flow from leasing activities of the real estate collateral or the operating cash flow of the owner occupant.
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The following table shows an analysis of construction loans by type and county as of December 31, 2022 and 2021.
Construction Loans Outstanding by Type and County
(dollars in thousands; unaudited) December 31, 2022 December 31, 2021
(dollars in thousands; unaudited) December 31, 2022 December 31, 2021
County Amount Percent of Construction Loans Amount Percent of Construction Loans
Construction loans decreased by $5.5 million in 2022, compared to an increase of $46.8 million in 2021. The decrease in 2022 was primarily due to $46.6 million in payoffs and $3.6 million in conversions to commercial real estate financing. These decreases were partially offset by $37.5 million advanced on existing construction loans and $7.2 million in new financing. The increase in 2021 was primarily due to $48.8 million advanced on existing construction loans, $13.2 million in loans assumed in the AMRB acquisition and $7.2 million in new financing. These increases were partially offset by $19.5 million in payoffs and $2.9 million in conversions to commercial real estate financing. Undisbursed construction loan commitments at December 31, 2022 and 2021 were $43.2 million and $77.8 million, respectively.
The following table presents the amortized costs and maturity distribution of our loans by class as of December 31, 2022 based on their contractual maturity dates. Maturities do not include scheduled payments or potential prepayments.
Loan Maturity Distribution
(in thousands; unaudited)
Real estate
1 Commercial and industrial due within 1 year includes SBA PPP loans totaling $3.5 million (net of $99 thousand in unrecognized fees and costs), which are expected to be forgiven by the SBA in 2023.
2 Construction loans that mature after 5 years are structured to convert to permanent financing after the initial construction period.
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The following table shows the mix of variable-rate loans to fixed-rate loans due after one year by class as of December 31, 2022. The large majority of the variable-rate loans are tied to independent indices (such as the Prime Rate or a Treasury Constant Maturity Rate). Most loans with original terms of more than five years have provisions for the fixed rates to reset, or convert to variable rates, after three, five or seven years. These loans are included in variable-rate balances below.
Loan Interest Rate Sensitivity - Due After One Year
(in thousands; unaudited) Fixed Variable Total
Real estate
Allowance for Credit Losses on Loans
The allowance for credit losses on loans is calculated in accordance with ASC 326 based on management's best estimate of current expected credit losses over the loans' contractual terms, adjusted for estimated prepayments where applicable. The contractual terms exclude anticipated extensions, renewals and modifications, except for reasonably expected extensions of certain troubled debt restructure loans. Relevant available information includes historical credit loss experience, current conditions and reasonable and supportable forecasts. While historical credit loss experience provides the basis for the estimation of expected credit losses, adjustments to historical loss information may be made for differences in current portfolio-specific risk characteristics, environmental conditions or other relevant factors. All specifically identifiable and quantifiable losses are charged off against the allowance. The ultimate adequacy of the allowance depends on a variety of complex factors, some of which may be beyond management's control, such as volatility in the real estate market, changes in interest rates and economic and political environments. Based on the current conditions of the loan portfolio and reasonable and supportable forecasts, management believes that the $23.0 million allowance for credit losses at December 31, 2022 was adequate to absorb expected credit losses in our loan portfolio. For additional information on our allowance for credit losses methodology, refer to Notes 1 and 3 to the Consolidated Financial Statements in ITEM 8 of this report.
The allowance for credit losses to loans was 1.10% at December 31, 2022 and 1.02% at December 31, 2021. The allowance for credit losses to loans, excluding SBA PPP loans was 1.10% and 1.07% at year-end 2022 and 2021, respectively (for a discussion of this non-GAAP financial measure, refer to ITEM 7, Financial Highlights section of this report).
The $40 thousand decrease in the allowance for credit losses on loans in 2022 was largely due to a $55.4 million decrease in applicable loan balances (excludes the $107.7 million decrease in PPP loans for which there was no allowance) and improvements in the Moody's Analytics' Baseline Forecast of California unemployment rates since December 31, 2021, which decreased the quantitative "modeled" allowance for credit losses. These decreases were partially offset by adjustments to qualitative risk factors to account for the ongoing deterioration in the economic outlook that management believes is not captured in the quantitative portion of the allowance and $23 thousand in net recoveries. For further information, refer to the Provision for Credit Losses section above, and Notes 1 and 3 to the Consolidated Financial Statements in ITEM 8 of this report.
Due to the high credit quality of our loan portfolio experienced to date, net charge-offs have been minimal for the past several years. Net recoveries totaled $23 thousand in 2022, compared to net recoveries of $93 thousand in 2021 and net charge-offs of $1 thousand in 2020.
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The following table presents the allowance for credit losses on loans by loan class in accordance with the methodology described in Note 1 to the Consolidated Financial Statements in ITEM 8 of this report, as well as the percentage of total loans in each of the same loan classes as of December 31, 2022 and 2021.
Allocation of the Allowance for Credit Losses
Specific allocations 9 — — — — — — — 9
Specific allocations — — — — — — — — —
The table below shows the activity in the allowance for credit losses for each of the three years presented below.
Allowance for Credit Losses Rollforward
Impact of CECL adoption — — 1,604
(Reversal of) provision for credit losses (63) (1,449) 4,594
Initial allowance for PCD loans — 1,505 —
Loans charged-off:
Commercial and industrial (9) — (30)
Installment and other consumer (23) (5) (1)
Total loans charged-off (32) (5) (31)
Loans recovered:
Commercial and industrial 22 14 27
Real estate:
Home equity — 50 —
Net loans (charged-off) recovered 23 93 (1)
Net recoveries (charge-offs) to average loans NM NM NM
NM - Not meaningful.
Net charge-offs and recoveries for the years ended December 31, 2022, 2021 and 2020 were considered insignificant.
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The following shows non-performing loans and loans modified in a TDR as of December 31, 2022 and 2021.
Non-Performing Loans and Troubled Debt Restructurings
(dollars in thousands; unaudited) December 31, 2022 December 31, 2021
Non-accrual loans:
Real estate:
Commercial, owner-occupied $ 1,563 $ 7,269
Commercial, investor-owned — 694
Installment and other consumer 91 —
Accruing TDR loans:1
Commercial and industrial $ 900 $ 1,183
Real estate:
Commercial, owner-occupied — —
Commercial, investor-owned 160 179
Installment and other consumer 457 607
Total non-accrual and accruing TDR loans $ 4,204 $ 10,475
Criticized and classified loans:
Allowance for credit losses to non-accrual loans 9.45x 2.75x
Non-accrual loans to total loans 0.12 % 0.37 %
1 Excludes TDR loans on non-accrual status that are included above.
Non-Accrual and TDR
Non-accrual loans decreased by $5.9 million in 2022, primarily due to the payoff of two owner-occupied commercial real estate loans totaling $7.1 million and paydowns and the upgrade of a $695 thousand loan to accrual status as a result of improved financial condition and performance, partially offset by $2.0 million in loans designated as non-accrual in 2022. Over 96% of the non-accrual loans as of December 31, 2022 were well-secured by either commercial or residential real estate.
Non-accrual loans decreased by $857 thousand in 2021, primarily due to $1.0 million in payoffs and paydowns, partially offset by a $114 thousand well-secured investor-owned commercial real estate loan assumed in the AMRB acquisition and one $67 thousand home equity loan placed on non-accrual status in 2021.
Total accruing TDR loans were $1.8 million and $2.1 million as of December 31, 2022 and 2021, respectively. The $327 thousand decrease in 2022 was primarily due to $425 thousand in paydowns, partially offset by one loan totaling $98 thousand that was designated as TDR during 2022.
The $3.0 million decrease in 2021 was primarily due to $4.0 million in paydowns and payoffs, partially offset by two loans totaling $1.0 million that were designated as TDRs during 2021.
For information regarding temporary relief from TDR accounting afforded by the CARES Act, refer to the Executive Summary section above and Note 3 to the Consolidated Financial Statements in ITEM 8, under “Troubled Debt Restructuring."
Criticized and Classified Loans
Loans designated as special mention decreased by $13.1 million in 2022, primarily due to $30.2 million in upgrades to a pass risk rating, $7.7 million in paydowns and payoffs, and $3.6 million in downgrades from special mention to substandard. These decreases were partially offset by $27.8 million in downgrades from pass to special mention and $695 thousand in upgrades from substandard to special mention during 2022. Of the $27.8 million in
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downgrades to special mention, $22.5 million (or 81%) was well-secured by commercial real estate and the remaining $5.3 million commercial loans had strong support.
Loans designated as special mention decreased by $13.6 million in 2021, primarily due to $33.1 million in upgrades to a pass risk rating, $18.9 million in paydowns and payoffs, and two loans that were downgraded from special mention to substandard totaling $5.4 million. These decreases were partially offset by $17.2 million in loans that were downgraded from pass/watch, $13.5 million in loans assumed in the AMRB acquisition, and $13.2 million in loans that were upgraded from substandard to special mention during 2021. Of the $17.2 million in downgrades to special mention, $13.2 million (or 77%) was well-secured by commercial real estate and the remaining $4.0 million in commercial loans had strong support. Loans designated as special mention exhibit potential weakness that deserve close attention.
Loans classified substandard decreased by $8.1 million in 2022, primarily due to $16.1 million in paydowns and payoffs and $871 thousand in upgrades to special mention or pass, partially offset by downgrades totaling $8.8 million. Of the downgraded loans, $4.7 million (or 53%) was secured by commercial real estate and $3.6 million (or 41%) was to commercial borrowers. In addition, of the $16.1 million in paydowns and payoffs, $2.7 million was from loans downgraded in 2022.
Loans classified substandard increased by $13.3 million in 2021, primarily due to downgrades totaling $25.4 million and $2.3 million in substandard loans assumed in the AMRB acquisition. Of the downgraded loans, $24.2 million were secured by commercial real estate. The downgrades were partially offset by $13.2 million in upgrades to special mention and $4.2 million in paydowns and payoffs.
Refer to Note 3 to the Consolidated Financial Statements in ITEM 8 of this report for an allocation of criticized and classified loans by loan class.
Other Assets
BOLI totaled $67.1 million at December 31, 2022, compared to $61.5 million at December 31, 2021. The increase of $5.6 million was primarily due to the purchase of $4.7 million in new policies and an increase in the cash surrender value from net investment earnings.
Interest receivable and other assets totaled $79.8 million and $51.4 million at December 31, 2022 and 2021, respectively. The $28.4 million increase was primarily due to a $30.5 million increase in net deferred tax assets as discussed below.
Net deferred tax assets totaled $43.9 million and $13.3 million at December 31, 2022 and 2021, respectively. Deferred tax assets consist primarily of tax benefits expected to be realized in future periods related to temporary differences such as the allowances for credit losses and unfunded loan commitments, net operating loss carryforwards, and deferred compensation and salary continuation plans. The $30.5 million increase in 2022 was primarily due to a $30.2 million increase in deferred tax assets related to changes in unrealized losses on available-for-sale investment securities, a $466 thousand increase in deferred tax assets related to state franchise tax and a $441 thousand decrease in deferred tax liabilities related to core deposit intangibles. These increases to net deferred tax assets were partially offset by a $430 thousand decrease in deferred tax assets related to the decrease in deferred compensation and salary continuation plans. Management believes deferred tax assets will be realizable due to our consistent record of earnings and the expectation that earnings will continue at a level adequate to realize such benefits. Therefore, no valuation allowance was established as of December 31, 2022 or 2021. For additional information, refer to Note 11 to the Consolidated Financial Statements in ITEM 8 of this report.
We held $16.7 million of FHLB stock recorded at cost in other assets at December 31, 2022 and 2021. The FHLB paid $1.0 million, $760 thousand and $654 thousand in cash dividends in 2022, 2021 and 2020, respectively. For additional information, refer to Note 2 to the Consolidated Financial Statements in ITEM 8 of this report.
Accrued interest on investment securities totaled $6.9 million and $4.8 million at December 31, 2022 and 2021, respectively. The increase was due to purchases of $563.4 million in securities.
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Deposits
Deposits decreased by $235.2 million, to $3.573 billion at December 31, 2022, compared to $3.809 billion at December 31, 2021. Non-interest bearing deposits decreased by $71 million in 2022 and made up 51% of total deposits at year-end. The decline was a result of anticipated outflows due to planned business activities by a few large clients, some customers moving into alternative investments and normal year-end fluctuations. See ITEM 1A, Risk Factors, for a discussion of potential risks associated with concentrations and volatility due to activity of our large deposit customers. Our relationship banking model is the foundation for the strong deposit base and allows us to proactively and strategically address changes in the interest rate environment and technology adoption by our customers. With our low cost of deposits, the Bank is well-positioned to implement deposit retention strategies.
Distribution of Average Deposits
The table below shows the relative composition of our average deposits for 2022 and 2021. For average rates paid on deposits, refer to Average Statements of Condition and Analysis of Net Interest Income table in ITEM 7- Management's Discussion and Analysis of Financial Condition and Results of Operations.
As of December 31,
1 Money market balances include Insured Cash Sweep® ("ICS") in both 2022 and 2021. Demand Deposit Marketplace SM ("DDM") and ICS balances are discussed in Note 6 to the Consolidated Financial Statements in ITEM 8 of this report.
Total estimated uninsured deposits as of December 31, 2022 and December 31, 2021 were $1.584 billion and $1.830 billion, respectively.
Maturities of Uninsured Time Deposits
The following table shows time deposits by account that are in excess of $250,000 by time remaining to maturity at December 31, 2022.
(in thousands; unaudited) Total Uninsured Portion
Over three months through six months 8,241 5,491
Over six months through twelve months 7,206 3,456
Borrowings
As of December 31, 2022 and 2021, respectively, our total borrowing capacity included $711.6 million and $820.5 million in secured lines of credit with FHLB and $58.7 million and $70.8 million with the Federal Reserve Bank of San Francisco (“FRBSF”). We also had $150.0 million in unsecured lines with correspondent banks to cover any short-term borrowing needs at December 31, 2022 and 2021. FHLB overnight borrowings at December 31, 2022 were $112.0 million for a net available balance of $599.6 million. There were no overnight borrowings at December 31, 2021. The FRBSF and other correspondent bank lines were not utilized at December 31, 2022 or 2021.
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In February 2023, we increased our borrowing capacity at the FHLB by pledging certain held-to-maturity securities to the Securities-Backed Credit Program, which increased our total FHLB borrowing capacity to $1.0372 billion as of February 28, 2023 from $711.6 million as of December 31, 2022.
As part of a bank acquisition, we assumed a subordinated debenture due to the NorCal Community Bancorp Trust II with a contractual balance of $4.1 million. On March 15, 2021, we redeemed the $2.8 million subordinated debenture (accreted value), which carried an average interest rate of 5.68% in 2020. For additional information, see Note 7, Borrowings and Other Obligations, in ITEM 8 of this report.
Deferred Compensation Obligations
We maintain a non-qualified, unfunded deferred compensation plan for certain key management personnel. Under this plan, participating employees may defer compensation, which will entitle them to receive certain payments for up to fifteen years commencing upon retirement, death, disability or termination of employment. The participating employee may elect to receive payments over periods not to exceed fifteen years. A similar Deferred Director Fee Plan entitles participating members of the Board of Directors to receive payments as elected by the participant upon separation from service, death, disability or termination of service. At December 31, 2022 and 2021, our aggregate payment obligations under both plans totaled $7.1 million and $7.9 million, respectively.
Our Salary Continuation Plan ("SERP") provides a percentage of salary continuation benefits to a select group of executive management upon retirement at age sixty-five and reduced benefits upon early retirement. At December 31, 2022 and 2021, our liability under the SERP was $4.7 million and $5.3 million, respectively, and is recorded in interest payable and other liabilities in the Consolidated Statements of Condition. The Plan is unfunded and non-qualified for tax purposes and for purposes of Title I of the Employee Retirement Income Security Act of 1974.
Decreases in both the deferred compensation plan and SERP liabilities in 2022 mainly resulted from increases in benefit payments to retired employees. In addition, we increased the discount rate on the SERP payments to reflect market conditions, which reduced the present value of the SERP obligation.
For additional information, see Note 10 to the Consolidated Financial Statements in ITEM 8 of this report.
Capital Adequacy
As discussed in Note 15 to the Consolidated Financial Statements in ITEM 8 of this report, the Bank's capital ratios were above regulatory guidelines to be considered "well capitalized" and Bancorp's ratios exceeded the required minimum ratios for capital adequacy purposes. For further discussion of bank capital requirements, refer to the SUPERVISION AND REGULATION section in ITEM 1 of this report.
The Bank's total risk-based capital ratio increased from 14.4% at December 31, 2021 to 15.7% at December 31, 2022, primarily due to capital creation from net income, partially offset by a $16.2 million dividend to the Holding Company to cover dividends to shareholders and Holding Company operating costs. Bancorp's total risk-based capital ratio was 14.6% at December 31, 2021 and 15.9% at December 31, 2022. Tangible common equity to tangible assets declined to 8.2% at December 31, 2022 from 8.8% at December 31, 2021, primarily due to $71.7 million increase in after-tax unrealized losses on available-for-sale securities associated with interest rate changes since December 31, 2021, partially offset by incremental earnings and the smaller balance sheet in 2022.
Bancorp's share repurchase program and activity are discussed in detail in ITEM 5 and in Note 8 to the Consolidated Financial Statements in ITEM 8 of this report. We expect to maintain strong capital levels and do not expect that we will be required to raise additional capital in 2023. Our anticipated sources of capital in 2023 include future earnings and shares issued under the stock-based compensation program.
Liquidity and Capital Resources
The goal of liquidity management is to provide adequate funds to meet loan demand and to fund operating activities and deposit withdrawals. We accomplish this goal by maintaining an appropriate level of liquid assets and formal lines of credit with the FHLB, FRBSF and correspondent banks that enable us to borrow funds as discussed in Note 7 to the Consolidated Financial Statement in ITEM 8 of this report. Our Asset Liability Management Committee
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("ALCO"), which is comprised of independent Bank directors and the Bank's Chief Executive Officer, is responsible for approving and monitoring our liquidity targets and strategies. ALCO has adopted a contingency funding plan that provides early detection of potential liquidity issues in the market or the Bank and institutes prompt responses that may prevent or alleviate a potential liquidity crisis. Management monitors liquidity daily and regularly adjusts our position based on current and future liquidity needs. We also have relationships with third-party deposit networks and can adjust the placement of our deposits via reciprocal or one-way sales as part of our cash management strategy, as discussed in Note 6 to the Consolidated Financial Statement in ITEM 8 of this report.
We obtain funds from the repayment and maturity of loans, deposit inflows, investment security maturities, sales and paydowns, federal funds purchases, FHLB advances, other borrowings, and cash flow from operations. Our primary uses of funds are the origination of loans, the purchase of investment securities, withdrawals of deposits, maturity of certificates of deposit, repayment of borrowings, and dividends to common stockholders.
The most significant component of our daily liquidity position is customer deposits. The attraction and retention of new deposits depends upon the variety and effectiveness of our customer account products, service and convenience, rates paid to customers, and our financial strength. The cash cycles and unique business activities of some of our large commercial depositors may cause short-term fluctuations in their deposit balances held with us.
Our cash and cash equivalents decreased by $302.2 million to $45.4 million at December 31 2022 from $347.6 million at December 31, 2021. Significant uses of liquidity during 2022 were $563.4 million in investment securities purchased, $235.2 million in withdrawals of deposits, $15.7 million in cash dividends paid on common stock to our shareholders, $4.7 million in purchase of bank owned life insurance policies and $1.2 million in common stock repurchases.
The most significant sources of liquidity during 2022 were proceeds from loans collected net of originations totaling $164.0 million, proceeds from principal paydowns, maturities and sales of investment securities totaled $187.9 million and Federal Home Loan Bank borrowings of $112.0 million. In addition, $55.3 million in net cash was provided by operating activities. Refer to the Consolidated Statement of Cash Flows in this Form 10-K for additional information on our sources and uses of liquidity. Management anticipates that our current liquidity position and core deposit base are adequate to fund our operations.
Total immediate contingent funding sources, including unrestricted cash, unencumbered available-for-sale securities and total borrowing capacity was $1.7 billion, or 49% of total deposits as of December 31, 2022. In February 2023, we enhanced our borrowing capacity at the FHLB by pledging certain held-to-maturity securities to the Securities-Backed Credit Program, increasing the Bank's total immediate contingent funding sources to approximately $2.0 billion, or 59% of deposits as of February 28, 2023. In addition, under the Federal Reserve’s new BTFP facility, the the Bank has the option to add approximately $267 million to its borrowing capacity.
Undrawn credit commitments, as discussed in Note 16 to the Consolidated Financial Statements in ITEM 8 of this report, totaled $566.9 million at December 31, 2022. We expect to fund these commitments to the extent utilized primarily through the repayment of existing loans, deposit growth and liquid assets. Over the next twelve months, $87.0 million of time deposits will mature. We expect to replace these funds with new deposits. Our emphasis on local deposits, combined with our liquid investment portfolio, provides a very stable funding base.
Since Bancorp is a holding company and does not conduct regular banking operations, its primary sources of liquidity are dividends from the Bank. Under the California Financial Code, payment of a dividend from the Bank to Bancorp without advance regulatory approval is restricted to the lesser of the Bank’s retained earnings or the amount of the Bank’s net profits from the previous three fiscal years less the amount of dividends paid during that period. The primary uses of funds for Bancorp are shareholder dividends, ordinary operating expenses and stock repurchases. Bancorp held $4.5 million of cash at December 31, 2022. Management anticipates that there will be sufficient earnings at the Bank to provide dividends to Bancorp to meet its funding requirements for the foreseeable future.
ITEM 7A. Quantitative and Qualitative Disclosures about Market Risk
Market risk is defined as the risk of loss arising from an adverse change in the market value (or prices) of financial instruments. A significant component of market risk is interest rate risk, which is inherent in our lending, investment,
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borrowing, and deposit gathering activities. The Bank manages interest rate sensitivity to minimize the exposure of our net interest margin, earnings, and capital to changes in interest rates. Interest rate changes can create fluctuations in the net interest margin due to an imbalance in the timing of repricing or maturity of assets or liabilities. Interest rate changes can also affect the market value of our financial instruments, such as available-for-sale securities and the related unrealized gains or losses, which affects our equity value.
To mitigate interest rate risk, the structure of our assets and liabilities is managed with the objective of correlating the effects of interest rate changes on loans and investments with those of deposits and borrowings. The asset liability management policy sets limits on the acceptable amount of change to net interest income and economic value of equity in different interest rate environments.
From time to time, we enter into interest rate swap contracts to mitigate the changes in the fair value of specified long-term fixed-rate loans and firm commitments to enter into long-term fixed-rate loans caused by changes in interest rates. Refer to Note 14 to the Consolidated Financial Statements in ITEM 8 of this report.
ALCO and the Board of Directors review our exposure to interest rate risk at least quarterly. We use simulation models to measure interest rate risk and to evaluate strategies to improve profitability. A simplified static statement of condition is prepared on a quarterly basis as a starting point, using instrument level data of our actual loans, investments, borrowings and deposits as inputs. If potential changes to net equity value and net interest income resulting from hypothetical interest rate changes are not within the limits established by the Board of Directors, management may adjust the asset and liability mix to bring the risk position within approved limits or take other actions. At December 31, 2022, interest rate risk was within policy guidelines established by ALCO and the Board. One set of interest rates modeled and evaluated against flat interest rates and a static balance sheet is a series of immediate parallel shifts in the yield curve. Our most recent analysis of our interest rate sensitivity is provided in the following table as an example rather than an expectation of likely interest rate movements.
Effect of Interest Rate Change on Net Interest Income (NII)
Interest rate sensitivity is a function of the repricing characteristics of our assets and liabilities. The Bank runs a combination of scenarios and sensitivities in its attempt to capture the range of interest rate risk including the simulations mentioned above. As with any simulation model or other method of measuring interest rate risk, limitations are inherent in the process and dependent on assumptions. For example, if we choose to pay interest on certain business deposits that are currently non-interest bearing, causing those deposits to become rate sensitive in the future, we would become less asset sensitive than the model currently indicates. Additionally, assets and liabilities may react differently to changes in market interest rates in terms of both timing and responsiveness to market rate movements. Important deposit modeling assumptions include the speed of deposit run-off and the amount by which interest-bearing deposit rates increase or decrease when market interest rates change, otherwise known as the deposit beta. We applied an average deposit beta of 35% to rates paid on non-maturity interest-bearing deposits in rising rate scenarios, reflected in the table above. The actual rates and timing of prepayments on loans and investment securities could vary significantly from the assumptions applied in the various scenarios. Lastly, uneven changes in different tenors of U.S. Treasury rates that result in changes to the shape of the yield curve could produce different results from those presented in the table. Accordingly, the results presented should not be relied upon as indicative of actual results in the event of changing market interest rates.
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
To the Shareholders and the Board of Directors
Bank of Marin Bancorp
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated statements of condition of Bank of Marin Bancorp and Subsidiary (the “Company”) as of December 31, 2022 and 2021, the related consolidated statements of comprehensive (loss) income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2022, and the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2022, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2022 and 2021, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2022, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2022, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO.
Basis for Opinions
The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
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Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Allowance for Credit Losses for Loans
As discussed in Notes 1 and 3 to the consolidated financial statements, the allowance for credit losses for loans at December 31, 2022, was $23 million on a total loan portfolio of $2.1 billion. The allowance for credit losses provides an estimate of lifetime expected losses in the loan portfolio. The measurement of expected credit losses is based on relevant available information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts that affect the collectability of the financial assets.
We identified the allowance for credit losses for loans as a critical audit matter. The principal considerations for our determination of the allowance for credit losses for loans as a critical audit matter are subjectivity of the estimation and application of forecasted economic conditions and qualitative internal and external risk factors used in the calculation of the allowance for credit losses for loans. The economic forecast component of the allowance for credit losses for loans is used to compare the conditions that existed during the historical period to current conditions and future expectations. The qualitative internal and external risk factors are used to adjust for differences in segment-specific risk characteristics or conditions that differ from those that existed during the historical period for which the probability of default and loss given default factors were developed. Auditing management’s judgements regarding forecasted economic conditions and qualitative internal and external risk factors applied to the allowance for credit losses for loans involved a high degree of subjectivity.
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The primary procedures we performed to address this critical audit matter included:
•Testing the design, implementation, and operating effectiveness of controls related to management’s calculation of the allowance for credit losses for loans, including controls over qualitative internal and external risk factors and the forecasted economic conditions utilized.
•Testing the appropriateness of the methodology used in the calculation of the allowance for credit losses for loans, as well as testing completeness and accuracy of the data used in the calculation, application of the forecasted economic conditions, and qualitative internal and external risk factors determined by management and used in the calculation, and verifying calculations in the allowance for credit losses for loans.
•Obtaining management’s analysis and supporting documentation related to the forecasted economic conditions, and testing whether the forecasts used in the calculation of the allowance for credit losses for loans are reasonable and supportable based on the analysis provided by management.
•Obtaining management’s analysis of internal and external qualitative factors, and evaluating the reasonableness of the assumptions used in determining the qualitative factor adjustments.
/s/ Moss Adams LLP
Portland, Oregon
March 15, 2023
We have served as the Company’s auditor since 2004.
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March 15, 2023
Management's Report on Internal Control over Financial Reporting
Management of Bank of Marin Bancorp and subsidiary, (the "Company") is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles ("GAAP"). The Company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company's assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures are being made only in accordance with authorizations of management and board of directors; and (3) provide reasonable assurance regarding prevention, or timely detection and correction of unauthorized acquisition, use, or disposition of the Company's assets that could have a material effect on the financial statements.
Management conducted an assessment of the effectiveness of internal control over financial reporting as of December 31, 2022, utilizing the framework established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management has concluded that the Company maintained effective internal control over financial reporting as of December 31, 2022.
The Company's independent registered public accounting firm, Moss Adams LLP, has issued an attestation report on our internal control over financial reporting, which appears on the previous page.
/s/ Timothy D. Myers
Timothy D. Myers, President and Chief Executive Officer
/s/ Tani Girton
Tani Girton, EVP and Chief Financial Officer
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BANK OF MARIN BANCORPCONSOLIDATED STATEMENTS OF CONDITION
(in thousands, except share data) 2022 2021
Assets
Cash, cash equivalents and restricted cash $ 45,424 $ 347,641
Investment securities:
Allowance for credit losses on loans (22,983) (23,023)
Bank premises and equipment, net 8,134 7,558
Other real estate owned 455 800
Liabilities and Stockholders' Equity
Liabilities
Deposits:
Interest bearing:
Interest payable and other liabilities 22,946 29,443
Commitments and contingent liabilities (Note 12)
Stockholders' Equity
Preferred stock, no par value, Authorized - 5,000,000 shares, none issued — —
Accumulated other comprehensive loss, net of tax (73,746) (2,024)
The accompanying notes are an integral part of these consolidated financial statements.
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BANK OF MARIN BANCORPCONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME
Interest income
Interest on federal funds sold and due from banks 1,407 399 461
Interest expense
Interest on interest-bearing transaction accounts 421 172 186
Interest on savings accounts 125 94 68
Interest on borrowings and other obligations 91 9 4
Interest on subordinated debenture — 1,361 158
(Reversal of) provision for credit losses on loans (63) (1,449) 4,594
Non-interest income
Earnings on bank-owned life insurance, net 1,229 2,194 973
Dividends on Federal Home Loan Bank stock 1,056 760 654
(Losses) gains on sale of investment securities, net (63) (16) 915
Non-interest expense
Federal Deposit Insurance Corporation insurance 1,179 889 474
Other real estate owned 359 5 —
Net income per common share:
Weighted average common shares:
Comprehensive (loss) income:
Other comprehensive (loss) income:
The accompanying notes are an integral part of these consolidated financial statements.
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BANK OF MARIN BANCORPCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Shares Amount
Other comprehensive income, net of tax — — — 8,098 8,098
Stock issued under employee stock purchase plan 2,392 72 — — 72
Stock issued under employee stock ownership plan 39,900 1,289 — — 1,289
Restricted stock granted 29,100 — — — —
Restricted stock forfeited / cancelled (14,314) — — — —
Stock-based compensation - stock options — 319 — — 319
Stock-based compensation - restricted stock — 884 — — 884
Cash dividends paid on common stock ($0.92 per share) — — (12,506) — (12,506)
Stock purchased by directors under director stock plan 1,146 43 — — 43
Stock issued in payment of director fees 5,723 217 — — 217
Stock issued under employee stock purchase plan 2,648 90 — — 90
Stock issued under employee stock ownership plan 36,075 1,330 — — 1,330
Restricted stock granted 30,742 — — — —
Restricted stock forfeited / cancelled (3,848) — — — —
Stock-based compensation - stock options — 491 — — 491
Stock-based compensation - restricted stock — 481 — — 481
Cash dividends paid on common stock ($0.94 per share) — — (13,107) — (13,107)
Stock purchased by directors under director stock plan 1,034 34 — — 34
Stock issued in payment of director fees 6,443 217 — — 217
Stock issued under employee stock purchase plan 2,025 62 — — 62
Stock issued under employee stock ownership plan 38,000 1,233 — — 1,233
Restricted stock granted 46,672 — — — —
Restricted stock forfeited / cancelled (13,692) — — — —
Stock-based compensation - stock options — 251 — — 251
Stock-based compensation - restricted stock — 712 — — 712
Cash dividends paid on common stock ($0.98 per share) — — (15,673) — (15,673)
Stock purchased by directors under director stock plan 515 16 — — 16
Stock issued in payment of director fees 10,145 355 — — 355
Stock repurchased, including commissions (23,275) (877) — — (877)
1 Refer to Note 1, Summary of Accounting Policies, for information on the adoption of ASU 2016-13 in 2020.
The accompanying notes are an integral part of these consolidated financial statements.
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BANK OF MARIN BANCORP CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash Flows from Operating Activities:
(Reversal of) provision for credit losses on loans (63) (1,449) 4,594
Noncash contribution expense to employee stock ownership plan 1,233 1,330 1,289
Noncash director compensation expense 355 217 217
Accretion of discount on subordinated debenture — 1,347 69
Net change in deferred loan origination costs/fees (2,716) (3,155) 5,040
Write-down of other real estate owned 345 — —
Losses (gains) on sale of investment securities, net 63 16 (915)
Earnings on bank-owned life insurance policies (1,229) (2,194) (973)
Net changes in interest receivable and other assets 2,228 5,554 (5,135)
Net changes in interest payable and other liabilities (4,708) 2,276 (547)
Cash Flows from Investing Activities:
Purchase of held-to-maturity securities (319,937) (305,329) —
Proceeds from sale of available-for-sale securities 10,664 6,632 33,756
Purchase of bank-owned life insurance policies (4,714) (1,943) (941)
Cash receipts from bank-owned life insurance policies 350 2,478 —
Purchase of premises and equipment (2,266) (1,044) (981)
Cash and cash equivalents acquired from American River Bankshares — 140,577 —
Purchase of Federal Home Loan Bank stock — — (176)
Cash paid for low income housing tax credit investment (30) (398) (1,355)
Cash Flows from Financing Activities:
Federal Home Loan Bank borrowings (repayment) 112,000 (13,885) —
Repayment of finance lease obligations (131) (86) (172)
Repayment of subordinated debenture including execution costs — (4,126) —
Proceeds from stock options exercised 821 463 1,304
Restricted stock surrendered for tax withholdings upon vesting (40) (166) (73)
Supplemental disclosure of cash flow information:
Supplemental disclosure of noncash investing and financing activities:
Repurchase of stock not yet settled $ — $ 373 $ 413
Fair value of liabilities assumed $ — $ 816,558 $ —
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1: Summary of Significant Accounting Policies
Nature of Operations - Bank of Marin Bancorp ("Bancorp"), headquartered in Novato, California, conducts business primarily through its wholly-owned subsidiary, Bank of Marin (the "Bank"), a California state-chartered commercial bank that provides a wide range of financial services through 31 retail branches and 8 commercial banking offices across 10 counties, including Alameda, Amador, Contra Costa, Marin, Napa, Placer, Sacramento, San Francisco, San Mateo and Sonoma. Our customer base is made up of business, not-for-profit and personal banking relationships from the communities within our Northern California footprint.
Basis of Presentation - The consolidated financial statements include the accounts of Bancorp, a bank holding company, and its wholly-owned bank subsidiary, Bank of Marin, a California state-chartered commercial bank. References to “we,” “our,” “us” mean Bancorp and the Bank that are consolidated for financial reporting purposes. Our accounting and reporting policies conform to U.S. generally accepted accounting principles ("GAAP"), general practice, and regulatory guidance within the banking industry. A summary of our significant policies follows. All material intercompany transactions have been eliminated. We monitor financial performance and evaluate the revenue streams of the various products, services, locations, and operations on a company-wide basis. Accordingly, all of the community banking and wealth management and trust services are considered by management to be aggregated into one reportable operating segment, community banking. We evaluated subsequent events through the date of filing with the Securities and Exchange Commission (“SEC”) and determined there were no subsequent events that required additional recognition or disclosure.
Accounting Changes and Reclassifications - Certain items in prior financial statements have been reclassified to conform to the current presentation, including the reclassification of the provision for credit losses on unfunded commitments in the second quarter of 2021 from non-interest expense to a separate line item under the provision for credit losses on loans in the consolidated statements of comprehensive (loss) income.In addition, on December 31, 2020, we adopted Accounting Standards Update (“ASU”) 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments and all applicable amendments as subsequently updated for certain clarifications, targeted relief and codification improvements. Accounting Standards Codification (“ASC”) Topic 326 (“ASC 326”) replaced the incurred loss method for measuring credit losses with a current expected credit loss ("CECL") method for financial assets recorded at amortized cost (i.e., loans originated by us and held-to-maturity investment securities). The previous incurred loss method included a general allowance on loans for known and inherent losses within the portfolio, which reflected adjusted historical loss rates and a specific allowance component for impaired loans. The CECL method requires the measurement of all expected credit losses for financial assets measured at amortized cost and certain off-balance-sheet credit exposures to consider credit losses expected to be incurred over the life of the financial asset based on past events, current conditions, and reasonable and supportable forecasts. ASC 326 also requires enhanced disclosures related to the significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards. In addition, ASC 326 include certain changes to the accounting for available-for-sale investment securities including the requirement to recognize an allowance when management intends to sell or believes that it is more likely than not they will be required to sell the security before recovery of its amortized cost.
ASC 326 was effective January 1, 2020. However, in accordance with the accounting relief provisions of the Coronavirus Aid, Relief and Economic Security ("CARES") Act passed in March 2020, we postponed the adoption of the CECL standard to the earlier of the end of the national emergency or December 31, 2020. Therefore, we adopted this standard using the modified retrospective method for all financial assets measured at amortized cost, and off-balance-sheet credit exposures, effective October 1, 2020 (the beginning of the first reporting period in which the standard was effective due to the postponement of CECL) through a cumulative adjustment to retained earnings. Results for reporting periods beginning after September 30, 2020 have been presented under the new standard while prior period amounts continue to be reported in accordance with previously applicable GAAP. Upon adoption, we recorded a cumulative adjustment to retained earnings, net of taxes, based on economic forecasts and other assumptions as of January 1, 2020. That adjustment resulted in an increase to our allowance for credit losses of $1.6 million and an increase to the allowance for unfunded loan commitments of $122 thousand. In addition, we recognized the remaining difference between the allowance for credit losses calculated under the CECL model as of December 31, 2020 and the allowance for credit losses calculated under the incurred loss model as of September 30, 2020 as a reversal of the provision for credit losses and a provision for credit losses on unfunded loan commitments, as shown in the tables below.
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The following tables show the impact to our financial statement line items due to adoption of ASC 326 as of and during the quarter ended December 31, 2020.
Impact to allowance for credit losses on loans:
Allowance for credit losses on loans $ 748
Retained earnings (cumulative transition adjustment) $ (1,604) $ 474 $ (1,130)
Impact to allowance for credit losses on unfunded loan commitments:
Allowance for credit losses on unfunded commitments $ 1,082
Retained earnings (cumulative transition adjustment) $ (122) $ 36 $ (86)
The following table shows the impact on the allowance for credit losses due to the transition from the incurred loss method to the CECL method by loan class.
Allowance for credits losses on loans:
Real estate:
Installment and other consumer loans 406 (125) 281
Allowance for credit losses on unfunded commitments $ 1,697 $ 122 $ 1,819
The Bank did not record an allowance for credit losses on available-for-sale or held-to-maturity investment securities upon the adoption of CECL as the investment portfolio consisted primarily of debt securities backed by the U.S. government and high credit quality obligations of state and political subdivisions. Refer to Note 2, Investment Securities, for more information.
In the second quarter of 2021, we reclassified the provision for credit losses on unfunded commitments from non-interest expense to a separate line item under the provision for credit losses on loans in the consolidated statements of comprehensive (loss) income.
Use of Estimates -The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant accounting estimates reflected in the consolidated financial statements include the allowance for credit losses, income taxes, and fair value measurements (including fair values of acquired assets and assumed liabilities at acquisition dates) as discussed in the Notes herein.
Cash, Cash Equivalents and Restricted Cash - include cash, due from banks, federal funds sold and other short-term investments with maturities of less than three months at the time of purchase.Restricted cash includes balances not immediately available for business operations such as Federal Reserve Bank of San Francisco reserve requirements and cash pledged for interest rate swap contracts and local agency deposits.
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Investment Securities - are classified as "held-to-maturity," "trading securities" or "available-for-sale." Investments classified as held-to-maturity are those that we have the ability and intent to hold until maturity and are reported at cost, adjusted for the amortization or accretion of premiums or discounts. Investments held for resale in anticipation of short-term market movements are classified as trading securities and are reported at fair value, with unrealized gains and losses included in earnings. Investments that are neither held-to-maturity nor trading are classified as available-for-sale and are reported at fair value. Unrealized gains and losses for available-for-sale securities, net of related taxes, are reported as a separate component of comprehensive (loss) income and included in stockholders' equity until realized. For discussion of our methodology in determining fair value, see Note 9, Fair Value of Assets and Liabilities.
Purchase premiums and discounts on investment securities are amortized or accreted over the life of the related security as an adjustment to yield using the effective interest method. For certain callable debt securities purchased at a premium, we amortize the premium to the earliest call date.
Dividend and interest income are recognized when earned. Realized gains and losses on the sale of securities are included in non-interest income. The specific identification method is used to calculate realized gains and losses on sales of securities.
Securities transferred from the available-for-sale category to the held-to-maturity category are recorded at fair value at the date of transfer. Unrealized holding gains or losses on the dates of the transfer of securities from available-for-sale to held-to-maturity are included in the balance of accumulated other comprehensive (loss) income, net of tax, in the consolidated balance sheets. These unrealized holding gains or losses on the dates of transfer are amortized over the remaining life of the securities as yield adjustments in a manner consistent with the amortization or accretion of the original purchase premium or discount on the associated security.
Allowance for Credit Losses on Investment Securities - The allowance for credit losses on held-to-maturity securities is a contra-asset valuation account determined in accordance with ASC 326, which is deducted from the securities' amortized cost basis at the balance sheet date as a result of management's assessment of the net amount expected to be collected. The allowance is measured on a pooled basis for securities with similar risk characteristics using historical credit loss information, adjusted for current conditions and reasonable and supportable forecasts. Securities that are determined to be uncollectible are written off against the allowance.
For available-for-sale securities in an unrealized loss position ("impaired security"), we assess whether 1) we intend to sell the security, or, 2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis. Under either of these conditions, the security's amortized cost is written down to fair value through a charge to previously recognized allowances or earnings, as applicable. For impaired securities that do not meet these conditions, we assess whether the decline in fair value was due to credit loss or other factors. This assessment considers, among other things: 1) the extent to which the fair value is less than amortized cost, 2) the financial condition and near-term prospects of the issuer, 3) any changes to the rating of the security by a rating agency, and 4) our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair value. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss component. Any impairment due to non-credit-related factors that has not been recorded through an allowance for credit losses is recognized in other comprehensive (loss) income. The discount rate used in determining the present value of the expected cash flows is based on the effective interest rate implicit in the security at the date of purchase.
Accrued interest receivable is excluded from the amortized costs and fair values of both held-to-maturity and available-for-sale securities and included in interest receivable and other assets on the consolidated statements of condition. Investment securities are placed on non-accrual status when principal or interest is contractually past due more than ninety days, or management does not expect full payment of principal and interest. We do not record an allowance for credit losses for accrued interest on investment securities, as the amounts are written-off when the investment is placed on non-accrual status. There were no non-accrual investment securities in any of the years presented in the consolidated financial statements.
Originated Loans - are reported at amortized cost, which is the principal amount outstanding net of deferred fees (costs), purchase premiums (discounts) and net charge-offs (recoveries). Amortized cost excludes accrued interest,
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which is reflected in interest receivable and other assets in the consolidated statements of condition. We do not measure an allowance for credit losses on accrued interest receivable balances because these balances are written off in a timely manner as a reduction to interest income when loans are placed on non-accrual status as discussed below. Interest income is accrued daily using the simple interest method. Fees collected upon loan origination and certain direct costs of originating loans are deferred and recognized over the contractual lives of the related loans as yield adjustments using the interest method or straight-line method, as applicable. Upon prepayment or other disposition of the underlying loans before their contractual maturities, any associated unearned fees or unamortized costs are recognized.
Acquired Loans - ASC 326 modified the accounting for purchased loans and requires that an allowance for credit losses be established at the date of acquisition. However, for purchased financial assets with a more-than-insignificant amount of credit deterioration since origination (“PCD assets”) that are measured at amortized cost, the initial allowance for credit losses is added to the purchase price rather than reported as a provision for credit losses. Subsequent changes in the allowance for credit losses on PCD assets are recognized through the provision for credit losses.
Past-Due and Non-Accrual Loan Policy - A loan is considered past due when a payment has not been received by the contractual due date. Loans are placed on non-accrual status when management believes that there is substantial doubt as to the collection of principal or interest, generally when they become contractually past due by 90 days or more with respect to principal or interest, except for loans that are well-secured and in the process of collection. When loans are placed on non-accrual status, any accrued but uncollected interest is reversed from current-period interest income and the amortization of deferred loan origination fees and costs is suspended. Interest payments received on nonaccrual loans are either applied against principal or reported as interest income, according to management’s judgment as to the ultimate collectability of principal. We may return non-accrual loans to accrual status when one of the following occurs:
•The borrower has resumed paying the full amount of the principal and interest and we are satisfied with the borrower's financial position. In order to meet this test, we must have received repayment of all past due principal and interest, unless the amounts contractually due are reasonably assured of repayment within a reasonable period of time, and there has been a sustained period of repayment performance (generally, six consecutive monthly payments), according to the original contractual terms or modified terms for loans whose contractual terms have been restructured in a manner which grants a concession to a borrower experiencing financial difficulties (“troubled debt restructuring”).
•The loan has become well secured and is in the process of collection.
Loan Charge-Off Policy - For all loan types excluding overdraft accounts, we generally make a charge-off determination at or before 90 days past due. A collateral-dependent loan is partially charged down to the fair value of collateral securing it if: (1) it is deemed uncollectable, or (2) it has been classified as a loss by either our internal loan review process or external examiners. A non-collateral-dependent loan is partially charged down to its net realizable value under the same circumstances. Overdraft accounts are generally charged off when they exceed 60 days past due.
Troubled Debt Restructured Loans - Our loan portfolio includes certain loans modified in a troubled debt restructuring (“TDR”), where we have granted economic concessions to borrowers experiencing financial difficulties. These concessions typically result from our loss mitigation activities and may include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. TDRs on non-accrual status at the time of restructure may be returned to accruing status after management considers the borrower’s sustained repayment performance for a reasonable period, generally six months, and obtains reasonable assurance of repayment and performance. Additionally, we may remove a loan from TDR designation if it meets all of the following conditions:
•The loan is subsequently refinanced or restructured at current market interest rates and the new terms are consistent with the treatment of creditworthy borrowers under regular underwriting standards;
•The borrower is no longer considered to be in financial difficulty;
•Performance on the loan is reasonably assured; and
•Existing loan did not have any forgiveness of principal or interest.
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Section 4013 of the 2020 CARES Act, subsequently amended by section 541 of the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act of 2020 ("Economic Aid Act"), provided optional, temporary relief from evaluating loans that may have been considered TDRs under GAAP. This relief applies to loan modifications executed between March 1, 2020 and the earlier of 60 days after the national emergency is terminated or January 1, 2022. The Bank elected to apply these temporary accounting provisions to payment relief loans beginning in March 2020. Accordingly, modifications that met certain criteria of the CARES Act were not categorized as troubled debt restructurings during 2021 and 2020. There were no loans remaining under this payment relief program as of December 31, 2022.
Collateral Dependent Loans - A loan is collateral dependent when the borrower is experiencing financial difficulty and repayment is expected to be provided substantially through the sale or operation of the collateral. For collateral dependent loans, including those for which management determines foreclosure is probable, each loan is individually evaluated and the allowance for credit losses is based on the fair value of the collateral, adjusted for estimated selling costs when repayment is expected from the sale of the collateral, less the loan's amortized cost. In determining the fair value, management considers such information as the appraised value of the collateral, observed and potential future changes in collateral value, and historical loss experience for loans that were secured by similar collateral. Generally, with problem credits that are collateral dependent, we obtain appraisals of the collateral at least annually. We may obtain appraisals more frequently if we believe the collateral value is subject to market volatility, if a specific event has affected the collateral, or if we believe foreclosure is imminent.
Allowance for Credit Losses on Loans ("ACL") - is a valuation account that is deducted from the amortized cost basis at the balance sheet date to present the net amount of loans expected to be collected. Amortized cost does not include accrued interest, which management elected to exclude from the estimate of expected credit losses (refer to the Past-Due and Non-Accrual Loan Policy section above). Management estimates the allowance quarterly using relevant available information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts. Credit loss experience provides the basis for the estimation of expected credit losses.
The ACL model utilizes a discounted cash flow ("DCF") method to measure the expected credit losses on loans collectively evaluated that are sub-segmented by loan pools with similar credit risk characteristics, which are generally comprised of federal regulatory reporting codes (i.e., Call codes). Pooled segments include the following:
•Loans secured by real estate:
- 1-4 family residential construction loans
- Other construction loans and all land development and other land loans
- Secured by farmland (including residential and other improvements)
- Revolving, open-end loans secured by 1-4 family residential properties and extended under lines
of credit
- Closed-end loans secured by 1-4 family residential properties, secured by first liens
- Closed-end loans secured by 1-4 family residential properties, secured by junior liens
- Secured by multifamily (5 or more) residential properties
- Commercial real estate loans secured by owner-occupied non-farm nonresidential properties
- Commercial real estate loans secured by other non-farm nonresidential properties
•Loans to finance agricultural production and other loans to farmers
•Commercial and industrial loans
•Loans to individuals for household, family and other personal expenditures (i.e., consumer loans)
•Municipal entities
•Non-profit organizations
•Other loans (overdraft credit lines)
The DCF method incorporates assumptions for probability of default ("PD"), loss given default ("LGD"), and prepayments and curtailments over the contractual terms of the loans. Under the DCF method, the ACL reflects the difference between the amortized cost basis and the present value of the expected cash flows using the loan's effective rate. We elected to report the change in present values from one reporting period to the next due to the passage of time and changes in the estimate of future expected cash flows through the provision for credit losses, rather than though interest income.
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In determining the PD for each pooled segment, the Bank utilized regression analyses to identify certain economic drivers that were considered highly correlated to historical Bank or peer loan default experience. As a result, management chose the California unemployment rate as the primary economic forecast driver for all segments, except for municipal loans. In addition, the annual percentage change in the California gross domestic product was used in the commercial and industrial loan segment. For municipal loans, the ACL model utilized a constant default rate obtained from a nationally recognized default rate study, which is updated annually. A third party provides LGD estimates for each segment based on a banking industry Frye-Jacobs Risk Index approach. The ACL model incorporates a one-year reasonable and supportable forecast of economic factors, updated quarterly, which is based on Moody's Analytics' Baseline Forecast. For periods beyond the forecast horizon, the economic factors revert to historical averages on a straight-line basis over a one-year period.
Expected credit losses are estimated over the contractual term of the loans, adjusted for expected prepayments and curtailments, when appropriate. The pooled loans' contractual loan terms exclude extensions, renewals, and modifications unless one or more of the following applies: 1) management has a reasonable expectation at the reporting date that a troubled debt restructuring will be executed with an individual borrower, 2) the extension or renewal options are included in the original or modified contract, or 3) an existing troubled debt restructuring is within six months of maturity.
Loans that do not share the same risk characteristics as pooled loans are evaluated individually for credit loss and generally include all non-accrual loans, collateral dependent loans, and certain troubled debt restructured loans and loans graded substandard or worse as determined by management.
Management considers whether adjustments to the quantitative portion of the ACL are needed for differences in segment-specific risk characteristics or to reflect the extent to which it expects current conditions and reasonable and supportable forecasts of economic conditions to differ from the conditions that existed during the historical period included in the development of PD and LGD. Qualitative internal and external risk factors include, but are not limited to, the following:
•Changes in the nature and volume of the loan portfolio
•Changes in the volume and severity of past due loans, the volume of non-accruals loans, and the volume and severity of adversely classified or graded loans
•The existence and effect of individual loan and loan segment concentrations
•Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere
•Changes in the experience, ability, and depth of lending management and other relevant staff
•Changes in the quality of our systematic loan review processes
•Changes in economic and business conditions, and developments that affect the collectability of the portfolio
•Changes in the value of underlying collateral, where applicable
•The effect of other external factors such as legal and regulatory requirements on the level of estimated credit losses in the portfolio
•The effect of acquisitions of other loan portfolios on our infrastructure, including risk associated with entering new geographic areas as a result of such acquisitions
•The presence of specialized lending segments in the portfolio
There were no material changes to the ACL methodology during 2022. However, changes in assumptions that influenced management's current estimate of the expected credit losses were primarily related to a decrease in applicable loan portfolio balances and improvements in the Moody's Analytics' Baseline Forecast of California unemployment rates since December 31, 2021, which decreased the quantitative "modeled" allowance for credit losses. These decreases were partially offset by adjustments to the qualitative economic risk factor to account for the ongoing deterioration in the economic outlook that management believes is not captured in the quantitative portion of the allowance. While we believe we use the best information available to determine the allowance for credit losses, our results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. Our ACL model is sensitive to changes in unemployment rate forecasts and certain other assumptions that could result in material fluctuations in the allowance for credit losses and adversely affect our financial condition and results of operations.
For further information regarding the allowance for loan losses, see Note 3, Loans and Allowance for Loan Losses.
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Allowance for Credit Losses on Unfunded Loan Commitments - We make commitments to extend credit to meet the financing needs of our customers in the form of loans or standby letters of credit. We are exposed to credit losses over a loan's contractual period in the event that a decline in credit quality of the borrower leads to nonperformance. We record an allowance for losses on unfunded loan commitments at the balance sheet date based on estimates of probability that these commitments will be drawn upon according to historical utilization experience of different types of commitments and expected loss severity and loss rates determined for pooled funded loans. The allowance for credit losses on unfunded commitments is a liability account included in interest payable and other liabilities on the consolidated statements of condition. Adjustments to the allowance for unfunded commitments are included in non-interest expense as a provision for (or reversal of) the allowance for unfunded commitments.
Transfers of Financial Assets - We have entered into certain loan participation agreements with other organizations. We account for these transfers of financial assets as sales when control over the transferred financial assets has been surrendered. Control over transferred assets is deemed to be surrendered when 1) the assets and liabilities have been isolated from us, 2) the transferee has the right to pledge or exchange the assets (or beneficial interests) it received, free of conditions that constrain it from taking advantage of that right, beyond a trivial benefit and 3) we do not maintain effective control over the transferred financial assets or third-party beneficial interests related to those transferred assets. Transfers of a portion of a loan must meet the criteria of a participating interest. If it does not meet the criteria of a participating interest, the transfer must be accounted for as a secured borrowing. In order to meet the criteria for a participating interest, all cash flows from the loan must be divided proportionately, the rights of each loan holder must have the same priority, and the loan holders must have no recourse to the transferor other than standard representations and warranties and no loan holder has the right to pledge or exchange the entire loan. We recognized no gains or losses on the sale of these participation interests in 2022, 2021 and 2020.
Premises and Equipment - Land is carried at cost and not depreciated. Bank-owned buildings, leasehold improvements, furniture, fixtures, software and equipment and are stated at cost, less accumulated depreciation, and depreciated/amortized on a straight-line basis. Furniture and fixtures are depreciated over eight years and equipment is generally depreciated over three to twenty years. Bank-owned buildings are depreciated over twenty-five to thirty years. Leasehold improvements are amortized over the lesser of their estimated useful lives or the terms of the leases. When assets are sold or otherwise disposed of, the cost and related accumulated depreciation or amortization are removed from the accounts and any resulting gain or loss is recognized in income for the period. The cost of maintenance and repairs is charged to expense as incurred.
Leases - We lease certain premises under long-term non-cancelable operating leases, most of which include escalation clauses and one or more options to extend the lease term, and some of which contain lease termination clauses. Only those renewal and termination options that management determines are reasonably certain of exercising are included in the calculation of the lease liability. In addition, we lease certain equipment under finance leases. The equipment finance lease terms do not contain renewal options, bargain purchase options or residual value guarantees. We did not have any significant short-term leases during the reported periods.
Lease right-of-use assets represent the right to use the underlying asset while lease liabilities represent the present value of future lease obligations. We elected not to separate non-lease components from lease components and to exclude short-term leases (i.e., lease term of 12 months or less at the commencement date) from right-of-use assets and lease liabilities for all lease classifications. When calculating the lease liability, because most lease contracts do not contain an implicit interest rate, we discount lease payments over a lease's expected term based on the collateralized Federal Home Loan Bank borrowing rate that was commensurate with lease terms and minimum payments at the lease commencement date. Right-of-use assets for operating leases are amortized over the lease term by amounts that represent the difference between periodic straight-line lease expense and periodic interest accretion on the related liability to make lease payments, whereas finance leases are amortized on a straight-line basis over the term of the lease. Expense recognition for operating leases is recorded on a straight-line basis while expense recognition for finance leases represents the sum of periodic amortization of the associated right-of-use asset and the interest accretion on the lease liability. Refer to Note 12, Commitments and Contingencies, for further information.
Business Combinations - Business combinations are accounted for under the acquisition method of accounting in accordance with ASC 805, Business Combinations. A business is defined as a set of activities and assets that is
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both self-sustaining and managed to provide a return to investors and generally has three elements: inputs, processes and outputs. Under the acquisition method, the acquiring entity in a business combination recognizes the acquired assets and assumed liabilities at their estimated fair values as of the date of acquisition. Any excess of the purchase price over the fair value of net assets and other identifiable intangible assets acquired is recorded as goodwill. To the extent the fair value of net assets acquired, including other identifiable assets, exceed the purchase price, a bargain purchase gain is recognized. Assets acquired and liabilities assumed from a business combination are recognized at fair value. Results of operations of an acquired business are included in the consolidated statements of operations from the date of acquisition. Business acquisition-related costs, including conversion and restructuring charges, are expensed as incurred. If substantially all of an acquisition is made up of one asset or several similar assets, or without a substantive process that together contributes to the ability to create outputs, the acquisition is accounted for as an asset acquisition and acquisition costs will be capitalized as part of the assets acquired, rather than expensed in a business combinations.
Goodwill and Other Intangible Assets - Goodwill is determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill that arises from a business combination is periodically evaluated for impairment at the reporting unit level, at least annually. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Core deposit intangible ("CDI") represents the estimated future benefit of deposits related to an acquisition and is booked separately from the related deposits and evaluated periodically for impairment. The CDI asset is amortized on an accelerated method over its estimated life of ten years.At December 31, 2022, the future estimated amortization expense for the CDI arising from our past acquisitions is as follows:
We make a qualitative assessment of whether it is more likely than not that the fair value of a reporting unit where goodwill is assigned is less than its carrying amount. If we conclude that it is more likely than not that the fair value is more than its carrying amount, no impairment is recorded. Goodwill is tested for impairment on an interim basis if circumstances change or an event occurs between annual tests that would more likely than not reduce the fair value of the reporting unit below its carrying amount. The qualitative assessment includes adverse events or circumstances identified that could negatively affect the reporting units’ fair value as well as positive and mitigating events. Such indicators may include, among others, significant changes in legal factors or in the general business climate, significant changes in our stock price and market capitalization, unanticipated competition, and an action or assessment by a regulator. If the fair value of a reporting unit is less than its carrying amount, an impairment charge for the amount by which the carrying amount exceeds the reporting unit's fair value is recognized. The loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. We recorded no impairment adjustments to either the CDI or goodwill in 2022, 2021 and 2020.
Other Real Estate Owned ("OREO") - OREO is comprised of property acquired through a business combination, foreclosure, in substance repossession or acceptance of deeds-in-lieu of foreclosure when the related loan receivable is de-recognized. OREO is recorded at fair value of the collateral less estimated costs to sell, establishing a new cost basis, and subsequently accounted for at the lower of cost or fair value less estimated costs to sell. Any shortfall of collateral value from the recorded investment of the related loan is recognized as loss at the time of foreclosure and is charged against the allowance for loan losses. Fair value of collateral is generally based on an independent appraisal of the property. Revenues and expenses associated with OREO, and subsequent adjustments to the fair value of the property and to the estimated costs of disposal, are realized and reported as a component of non-interest income and expense when incurred. We recorded a $345 thousand valuation adjustment to OREO in 2022.
Bank Owned Life Insurance ("BOLI") - The Bank owns life insurance policies on certain key current and former officers. BOLI is recorded in interest receivable and other assets on the consolidated statements of condition at the amount that can be realized under the insurance contract at period-end, which is the cash surrender value adjusted for other charges or amounts due that are probable at settlement.
Federal Home Loan Bank of San Francisco ("FHLB") Stock - The Bank is a member of the FHLB. Members are required to own a certain amount of stock based on the level of borrowings and other factors. As of December 31,
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2022 and 2021 our investment in FHLB stock was carried at cost, as there was no impairment or changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. We periodically evaluate FHLB stock for impairment based on ultimate recovery of par value. FHLB stock is included as part of interest receivable and other assets on the consolidated statements of condition. Both cash and stock dividends are reported as non-interest income.
Investments in Low Income Housing Tax Credit Funds - We have invested in limited partnerships that were formed to develop and operate affordable housing projects for low or moderate-income tenants throughout California. Our ownership percentage in each limited partnership ranges from 1.0% to 3.5%. We account for the investments in qualified affordable housing tax credit funds using the proportional amortization method, where the initial cost of the investment is amortized in proportion to the tax credits and other tax benefits received. Low income housing tax credits and other tax benefits received, net of the amortization of the investment is recognized as part of income tax benefit. Each of the partnerships must meet the regulatory minimum requirements for affordable housing for a minimum 15-year compliance period to fully utilize the tax credits. If the partnerships cease to qualify during the compliance period, the credit may be denied for any period in which the project is not in compliance and a portion of the credit previously taken is subject to recapture with interest. We record an impairment charge if the value of the future tax credits and other tax benefits is less than the carrying value of the investments.
Employee Stock Ownership Plan (“ESOP”) - We recognize compensation cost for ESOP contributions when funds become committed for the purchase of Bancorp's common shares into the ESOP in the year in which the employees render service entitling them to the contribution. If we contribute stock, the compensation cost is the fair value of the shares when they are committed to be released (i.e., when the number of shares becomes known and formally approved). In 2022, 2021 and 2020, Bancorp only made stock contributions to the ESOP.
Income Taxes - Income taxes reported in the consolidated financial statements are computed based on an asset and liability approach. We recognize the amount of taxes payable or refundable for the current year and we record deferred tax assets and liabilities for future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases using enacted tax rates in effect for the year in which the temporary differences are expected to reverse. We record net deferred tax assets to the extent it is more likely than not that they will be realized. In evaluating our ability to recover the deferred tax assets and the need to establish a valuation allowance against the deferred tax assets, management considers all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies. In projecting future taxable income, management develops assumptions including the amount of future state and federal pretax operating income, the reversal of temporary differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates being used to manage the underlying business. Bancorp files consolidated federal and combined state income tax returns.
We recognize the financial statement effect of a tax position when it is more likely than not, based on the technical merits and all available evidence, that the position will be sustained upon examination, including the resolution through protests, appeals or litigation processes. For tax positions that meet the more likely than not threshold, we measure and record the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement with the taxing authority. The remainder of the benefits associated with tax positions taken is recorded as unrecognized tax benefits, along with any related interest and penalties. Interest and penalties related to unrecognized tax benefits are recorded in tax expense.
In deciding whether or not our tax positions taken meet the more likely than not recognition threshold, we must make judgments and interpretations about the application of inherently complex state and federal tax laws. To the extent tax authorities disagree with tax positions taken by us, our effective tax rates could be materially affected in the period of settlement with the taxing authorities. Revision of our estimate of accrued income taxes also may result from our own income tax planning, which may affect effective tax rates and results of operations for any reporting period.
We present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss ("NOL") carryforward, or similar tax loss or tax credit carryforward, rather than as a liability, when (1) the uncertain tax
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position would reduce the NOL or other carryforward under the tax law of the applicable jurisdiction and (2) we intend to and are able to use the deferred tax asset for that purpose. Otherwise, the unrecognized tax benefit is presented as a liability instead of being netted with deferred tax assets.
Earnings per share (“EPS”)- are based upon the weighted average number of common shares outstanding during each year. The following table shows: 1) weighted average basic shares, 2) potentially dilutive weighted average common shares related to stock options and unvested restricted stock awards, and 3) weighted average diluted shares. Basic EPS are calculated by dividing net income by the weighted average number of common shares outstanding during each annual period, excluding unvested restricted stock awards. Diluted EPS are calculated using the weighted average number of potentially dilutive common shares. The number of potentially dilutive common shares included in year-to-date diluted EPS is a year-to-date weighted average of potentially dilutive common shares included in each quarterly diluted EPS computation. In computing diluted EPS, we exclude anti-dilutive shares such as options whose exercise prices exceed the current common stock price, as they would not reduce EPS under the treasury method. We have two forms of outstanding common stock: common stock and unvested restricted stock awards. Holders of unvested restricted stock awards receive non-forfeitable dividends at the same rate as common shareholders and they both share equally in undistributed earnings. Under the two-class method, the difference in EPS is nominal for these participating securities.
Potentially dilutive common shares related to:
Unvested restricted stock awards 17 20 23
Share-Based Compensation - All share-based payments, including stock options and restricted stock, are recognized as stock-based compensation expense in the consolidated statements of comprehensive (loss) income based on the grant-date fair value of the award with a corresponding increase in common stock. The grant-date fair value of the award is amortized on a straight-line basis over the requisite service period, which is generally the vesting period. The stock-based compensation expense excludes stock grants to directors as compensation for their services, which are recognized as director expenses separately based on the grant-date value of the stock. We account for forfeitures as they occur. See Note 8, Stockholders' Equity and Stock Option Plans, for further discussion.
We determine the fair value of stock options at the grant date using a Black-Scholes pricing model that takes into account the stock price at the grant date, exercise price, expected life of the option, volatility of the underlying stock, expected dividend yield and risk-free interest rate over the expected life of the option. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The risk-free rate for periods within the expected life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. Expected volatility is based on the historical volatility of the common stock over the most recent period that is generally commensurate with the expected life of the options. The Black-Scholes option valuation model requires the input of highly subjective assumptions, including the expected life of the stock-based award and stock price volatility. The assumptions used represent management's best estimates based on historical information, but these estimates involve inherent uncertainties and the application of management's judgment. As a result, if other assumptions had been used, the recorded stock-based compensation expense could have been materially different from that recorded in the consolidated financial statements. The fair value of restricted stock is based on the stock price on the grant date.
We record excess tax benefits resulting from the exercise of non-qualified stock options, the disqualifying disposition of incentive stock options and vesting of restricted stock awards as tax benefits in the consolidated statements of comprehensive (loss) income with a corresponding decrease to current taxes payable. In addition, we reflect excess tax benefits as an operating activity in the consolidated statements of cash flows.
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Cash paid for tax withholdings when shares are surrendered in a cashless stock option exchange is classified as a financing activity in the consolidated statements of cash flows.
Derivative Financial Instruments and Hedging Activities - Fair Value Hedges - All of our interest rate swap contracts are designated and qualified as fair value hedges. The terms of our interest rate swap contracts are closely aligned to the terms of the designated fixed-rate loans. The hedging relationships are tested for effectiveness on a quarterly basis using a qualitative approach. The qualitative analysis includes verification that there are no changes to the derivative's or hedged item's key terms and conditions and no adverse developments regarding risk of counterparty default, and validation that we continue to have fair value hedge designation. The interest rate swaps are carried on the consolidated statements of condition at their fair value in other assets (when the fair value is positive) or in other liabilities (when the fair value is negative). The changes in the fair value of the interest rate swaps are recorded in interest income. The unrealized gains or losses due to changes in fair value of the hedged fixed-rate loans due to changes in benchmark interest rates are recorded as an adjustment to the hedged loans and offset in interest income. For derivative instruments executed with the same counterparty under a master netting arrangement, we do not offset fair value amounts of interest rate swaps in liability positions with the ones in asset positions.
From time to time, we make firm commitments to enter into long-term fixed-rate loans with borrowers backed by yield maintenance agreements and simultaneously enter into forward interest rate swap agreements with correspondent banks to mitigate the change in fair value of the yield maintenance agreement. Prior to loan funding, yield maintenance agreements with net settlement features that meet the definition of a derivative are considered as non-designated hedges and are carried on the consolidated statements of condition at their fair value in other assets (when the fair value is positive) or in other liabilities (when the fair value is negative). The offsetting changes in the fair value of the forward swap and the yield maintenance agreement are recorded in interest income. When the fixed-rate loans are originated, the forward swaps are designated to offset the change in fair value in the loans. Subsequent to the point of the swap designations, the fair value of the related yield maintenance agreements at the designation date that was recorded in other assets is amortized using the effective yield method over the life of the respective designated loans.
The net effect of the change in fair value of interest rate swaps, the amortization of the yield maintenance agreement and the change in the fair value of the hedged loans due to changes in benchmark interest rates result in an insignificant amount recognized in interest income. For further detail, see Note 14, Derivative Financial Instruments and Hedging Activities.
Revenue Recognition - We utilize the following five-step model for non-financial instrument related revenue that is in scope for ASC 606, Revenue from Contracts with Customers: 1) identify the contract, 2) identify the performance obligations in the contract, 3) determine the transaction price, 4) allocate the transaction price to the performance obligations in the contract, and, 5) recognize revenue when (or as) the entity satisfies the performance obligation. Our main revenue streams in scope for ASC 606 include:
•Wealth Management and Trust Services ("WMTS") fees - WMTS services include, but are not limited to: customized investment advisory and management; administrative services such as bill pay and tax reporting; trust administration, estate settlement, custody and fiduciary services. Performance obligations for investment advisory and management services are generally satisfied over time. Revenue is recognized monthly according to a tiered fee schedule based on the client's month-end market value of assets under our management. WMTS does not earn revenue based on performance or incentives. Costs associated with WMTS revenue-generating activities, such as payments to sub-advisors, are recorded separately as part of professional service expenses when incurred.
•Deposit account service charges - Service charges on deposit accounts consist of monthly maintenance fees, business account analysis fees, business online banking fees, check order charges, and other deposit account-related fees. Performance obligations for monthly maintenance fees and account analysis fees are satisfied, and the related revenue recognized, when we complete our performance obligation each month. Performance obligations related to transaction-based services (such as check orders) are satisfied, and the related revenue recognized, at a point in time typically when the transaction is completed, except for
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business accounts subject to analysis where the transaction-based fees are part of the monthly account analysis fees.
•Debit card interchange fees - We issue debit cards to our consumer and small business customers that allow them to purchase goods and services from merchants in person, online, or via mobile devices using funds held in their demand deposit accounts held with us. Debit cards issued to our customers are part of global electronic payment networks (such as Visa) who pass a portion of the merchant interchange fees to debit card-issuing member banks like us when our customers make purchases through their networks. Performance obligations for debit card services are satisfied and revenue is recognized daily as the payment networks process transactions. Because we act in an agent capacity, we recognize network costs on a net basis with interchange fees in non-interest income.
Advertising Costs - are expensed as incurred. For the years ended December 31, 2022, 2021, and 2020, advertising costs totaled $1.1 million, $908 thousand, and $769 thousand, respectively.
Comprehensive (Loss) Income - includes net income, changes in the unrealized gains or losses on available-for-sale investment securities, and amortization of net unrealized gains or losses on securities transferred from available-for-sale to held-to-maturity, net of related taxes, reported on the consolidated statements of comprehensive (loss) income and as components of stockholders' equity.
Fair Value Measurements - We use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. We base our fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e., exit price notion) reflecting factors such as a liquidity premium. Securities available-for-sale and derivatives are recorded at fair value on a recurring basis. Our equity investments that do not have readily determinable fair values are recorded at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. FHLB stock and Visa Inc. Class B common stock are carried at cost as of December 31, 2022 and 2021, as there was no impairment or changes resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. Additionally, from time to time, we may be required to record certain assets and liabilities at fair value on a non-recurring basis, such as purchased loans and acquired deposits recorded at acquisition date, certain impaired loans, other real estate owned and securities held-to-maturity that are other-than-temporarily impaired. These non-recurring fair value adjustments typically involve write-downs of individual assets due to application of lower-of-cost or market accounting.
When we develop our fair value measurement process, we maximize the use of observable inputs. Whenever there is no readily available market data, we use our best estimates and assumptions in determining fair value, but these estimates involve inherent uncertainties and the application of management's judgment. As a result, if other assumptions had been used, our recorded earnings or disclosures could have been materially different from those reflected in these consolidated financial statements.
Other Recently Adopted Accounting Standards
Other than the early adoption of a portion of ASU No. 2022-02, Financial Instruments - Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures, as discussed below, we did not adopt any new or amended accounting standards in 2022.
Accounting Standards Not Yet Effective
In March 2020, the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848). The amendments in this ASU are elective and provide optional guidance for a limited period of time to ease the potential burden of accounting for, or recognizing the effects of reference rate reform. The amendments in this ASU provide optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued because of reference rate reform. The amendments in this ASU may be elected through December 31, 2024 (as amended by ASU No. 2022-06 discussed below). An entity may elect the amendments in this update at an interim period with adoption methods varying based on transaction type. We have not elected to apply amendments at this time and will assess the applicability of
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