ITEM 1A.RISK FACTORS
Our business faces significant risks, including credit, market/liquidity, operational, legal/regulatory and strategic/reputation risks. The factors described below may not be the only risks we face and are not intended to serve as a comprehensive listing or be applicable only to the category of risk under which they are disclosed. The risks described below are generally applicable to more than one of the following categories of risks. Additional risks that we do not yet know of or that we currently think are immaterial may also impair our business operations. If any of the events or circumstances described in the following factors actually occurs, our business, financial condition and/or results of operations could be materially and adversely affected.
Economic Risks
The COVID-19 pandemic has significantly impacted the State of Hawaii and our business. The ultimate impact on our business and financial results will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.
Our operations, like those of other financial institutions that operate in our market, are significantly influenced by economic conditions in Hawaii, including the strength of the real estate market and the tourism industry. The COVID-19 pandemic resulted in an extreme decline in tourism to the state of Hawaii in 2020. In 2021, we experienced a rebound in tourism, but not to the full extent of pre-pandemic levels. Should economic conditions in the state of Hawaii deteriorate again due to actual or perceived increase in COVID-19 risk, including further spread and new variants, it can negatively impact our results of operations, including our net income. In addition, material adverse effects on our business may include all or a combination of valuation impairments on our investments, loans, mortgage servicing rights, deferred tax assets or counter-party risk derivatives.
Furthermore, a prolonged or worsening pandemic could influence the recognition of credit losses in our loan portfolios and increase our allowance for credit losses. Similarly, because of changing economic and market conditions affecting issuers, we may be required to recognize an allowance for credit losses in future periods on the securities we hold as well as reductions in other comprehensive income.
While most of our temporarily closed branches and offices have reopened, there is potential that our business operations may be disrupted if our workforce is unable to work effectively, including because of illness, quarantines, government actions, or other restrictions.
The extent to which the COVID-19 pandemic continues to impact our business, results of operations, and financial condition, as well as our results of operations and our regulatory capital and liquidity ratios, will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities and other third parties in response to the pandemic.
Difficult economic and market conditions in Hawaii would result in significant adverse effects on us because of the geographic concentration of our business.
Unlike larger national or other regional banks that are more geographically diversified, our business and operations are closely tied to the Hawaii market. The Hawaii economy relies on tourism, real estate, government and other service-based industries. Declines in tourism, increases in energy costs, the availability of affordable air transportation, adverse weather and natural disasters, and local budget issues impact consumer and corporate spending. As a result, such events may contribute to the deterioration in Hawaii's general economic condition, which could adversely impact us and our borrowers.
In addition, the high concentration of Hawaii real estate loans in our portfolio, combined with the deterioration in these sectors caused by an economic downturn, previously had and could have in the future a significantly more adverse impact on our operating results than many other banks across the nation. If our borrowers experience financial difficulty, or if property values securing our real estate loans decline, we will incur elevated credit costs due to the composition and concentration of our loan portfolio, which will have an adverse effect on our financial condition and results of operations.
Our real estate loan operations have a considerable effect on our results of operations.
The performance of our real estate loans depends on a number of factors, including the continued strength of the real estate markets in which we operate. As we have previously seen in the Hawaii and U.S. Mainland construction and real estate
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markets, the strength of the real estate market and the results of our operations could be negatively affected by an economic downturn.
In addition, declines in the market for commercial property could cause some of our borrowers to suffer losses on their projects, which would negatively affect our financial condition, results of operations and prospects. Declines in housing prices and the supply of existing houses for sale could cause residential developers who are our borrowers to suffer losses on their projects and encounter difficulty in repaying their loans. We cannot assure you that we will have an adequate allowance for credit losses to cover future losses. If we suffer greater losses than we are projecting, our financial condition and results of operations would be adversely affected.
Our ability to maintain adequate sources of funding and liquidity and required capital levels may be negatively impacted by uncertainty in the economic environment which may, among other things, impact our ability to satisfy our obligations.
Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of investments or loans, and other sources would have a substantial negative effect on our liquidity which could affect or limit our ability to satisfy our obligations and our ability to grow profitability at the same rate. Our access to funding sources in amounts adequate to finance our activities on terms that are acceptable to us could be impaired by factors that affect us specifically, the financial services industry, or the economy in general. Factors that could detrimentally impact our access to liquidity sources include concerns regarding deterioration in our financial condition, increased regulatory actions against us and a decrease in the level of our business activity as a result of a downturn in the markets in which our loans or deposits are concentrated. Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial industry in light of the past turmoil faced by banking organizations and the credit markets. In addition, our financial flexibility could be constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates, including in the current rising interest rate environment.
The management of liquidity risk is critical to the management of our business and our ability to service our customer base. In managing our balance sheet, our primary source of funding is customer deposits. Our ability to continue to attract these deposits and other funding sources is subject to variability based upon a number of factors including volume and volatility in the securities' markets, our financial condition, our credit rating and the relative interest rates that we are prepared to pay for these liabilities. The availability and level of deposits and other funding sources is highly dependent upon the perception of the liquidity and creditworthiness of the financial institution, and perception can change quickly in response to market conditions or circumstances unique to a particular company. Concerns about our past and future financial condition or concerns about our credit exposure to other parties could adversely impact our sources of liquidity, financial position, including regulatory capital ratios, results of operations and our business prospects.
If our level of deposits were to materially decrease, we would need to raise additional funds by increasing the interest that we pay on certificates of deposits or other depository accounts, seek other debt or equity financing or draw upon our available lines of credit. We rely on commercial and retail deposits, and to a lesser extent, advances from the Federal Home Loan Bank of Des Moines ("FHLB") and the Federal Reserve discount window, to fund our operations. Although we have historically been able to replace maturing deposits and advances as necessary, we might not be able to replace such funds in the future if, among other things, our results of operations or financial condition or the results of operations or financial condition of the FHLB or market conditions were to change.
During 2020 and 2021, our level of deposits increased materially, which was largely driven by customer response to the pandemic including market instability and deposits of PPP funds and government assistance. We cannot assure you that the bank will retain these deposits.
Our line of credit with the FHLB serves as a primary outside source of liquidity. The Federal Reserve discount window also serves as an additional outside source of liquidity. Borrowings under this arrangement are through the Federal Reserve's primary facility under the borrower-in-custody program. The duration of borrowings from the Federal Reserve discount window are generally for a very short period, usually overnight. In the event that these outside sources of liquidity become unavailable to us, we will need to seek additional sources of liquidity, including selling assets. We cannot assure you that we will be able to sell assets at a level to allow us to repay borrowings or meet our liquidity needs.
We constantly monitor our activities with respect to liquidity and evaluate closely our utilization of our cash assets; however, there can be no assurance that our liquidity or the cost of funds to us may not be materially and adversely impacted as a result of economic, market, or operational considerations that we may not be able to control.
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The fiscal, monetary and regulatory policies of the federal government and its agencies could have a material adverse effect on our results of operations.
The FRB regulates the supply of money and credit in the U.S. Its policies determine in large part the cost of funds for lending and investing and the return earned on those loans and investments, both of which affect the net interest margin. It also can materially decrease the value of financial assets we hold, such as debt securities.
Our net interest income and net interest margin may be negatively impacted by a prolonged low interest rate environment as it may result in us holding lower yielding loans and securities on our balance sheet, particularly if we are unable to replace the maturing higher yielding assets with similar higher yielding assets. Changes in the slope of the yield curve, which represents the spread between short-term and long-term interest rates, could also reduce our net interest income and net interest margin. Historically, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates. When the yield curve flattens, our net interest income and net interest margin could decrease as our cost of funds increases relative to the yield we can earn on our assets.
In a rising interest rate environment, as we are currently experiencing, there is potential for decreased demand for our loan products, an increase in our cost of funds, and the curtailment of economic recovery.
Changes in FRB policies and our regulatory environment are beyond our control, and we are unable to predict what changes may occur or the manner in which any future changes may affect our business, financial condition and results of operation.
Negative developments in the global and U.S. economies could have an adverse effect on us.
Our business and operations are sensitive to business and economic conditions globally and domestically. Adverse economic and business conditions in the U.S. generally, and in our market areas, in particular, could reduce our growth rate, affect our borrowers' ability to repay their loans and, consequently, adversely affect our financial condition and performance. Other economic conditions that affect our financial performance include short-term and long-term interest rates, the prevailing yield curve, inflation (which we are currently experiencing) and price levels (particularly for real estate), monetary policy, unemployment and the strength of the domestic economy as a whole. Unfavorable market conditions can result in a deterioration in the credit quality of our borrowers and the demand for our products and services, an increase in the number of loan delinquencies, defaults and charge-offs, additional provisions for credit losses, adverse asset values and an overall material adverse effect on the quality of our loan portfolio. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment; natural disasters; or a combination of these or other factors.
Credit Risks
Our Banking-as-a-Service ("BaaS") collaboration agreements may expose us to credit risk.
Our collaboration with Swell Financial, Inc. ("Swell") and Elevate Credit, Inc. (“Elevate”) provides that the bank has entered into an agreement with Swell pursuant to which Swell will market bank consumer checking and consumer line of credit (“LOC”) accounts using the Swell brand and Swell’s digital platform. A subsidiary of Elevate will be providing the underwriting model for the LOC accounts. Another subsidiary of Elevate will cover any losses on the LOC accounts, and in addition will provide cash collateral to the bank to secure payment of such losses. Further, Elevate will be a partial guarantor of losses on the LOC accounts. While the bank believes the Elevate subsidiary’s cash collateral on deposit at the bank will be sufficient to cover any foreseeable losses on the LOC accounts, in the event the cash collateral amount is not adequately maintained or the cash collateral amount is insufficient to cover the losses on the LOC accounts and the Elevate subsidiary does not or cannot otherwise meet its obligations under its agreement with the bank and Elevate does not or cannot meet its obligations under its partial guaranty, the bank may incur losses on the LOC accounts. Losses associated with the LOC accounts (or the portfolios of other third parties with whom we enter into comparable BaaS relationships) in such circumstances could have a material adverse effect on our net income, results of operations and financial condition.
A large percentage of our loans are collateralized by real estate and any deterioration in the real estate market may result in additional losses and adversely affect our financial results.
Our results of operations have been, and in future periods, will continue to be significantly impacted by the economy in Hawaii, and to a lesser extent, other markets we are exposed to including California. Approximately 76% of our loan portfolio as of
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December 31, 2021 was comprised of loans primarily collateralized by real estate, with the significant majority of these loans concentrated in Hawaii.
Deterioration of the economic environment in Hawaii, California or other markets we are exposed to, domestic or foreign, including a decline in the real estate market and single-family home resales or a material external shock, may significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. In the event of a default with respect to any of these loans, amounts received upon sale of the collateral may be insufficient to recover outstanding principal and interest on the loan.
Our allowance for credit loss methodology resulted in a credit to our provision for credit losses but the credit provision may not continue.
In 2021, we recorded a credit to the provision for credit losses. Although other factors of our overall risk profile have improved in recent years and general economic trends and market conditions have stabilized, concerns over the global and U.S. economies still remain. Accordingly, it is possible that the real estate markets we participate in could deteriorate as it did from the latter part of 2007 through 2010. If this occurs, it may result in an increase in loan delinquencies, loan charge-offs, and our allowance for loan and lease losses. Even if economic conditions improve or stay the same, it is possible that we may experience material credit losses and in turn, increases to our allowance for credit losses, due to any number of factors, including but not limited to, the elevated risk still inherent in our existing loan portfolio resulting from our high concentration of loans collateralized by real estate. If that were to occur, we may have to record a provision for loan and lease losses which would have an adverse impact on our net income. Under typical stable portfolio and market conditions, we would generally record a provision for credit losses when there is growth in our loan portfolio.
Our allowance for credit losses may not be sufficient to cover actual credit losses, which could adversely affect our results of operations. Additional credit losses may occur in the future and may occur at a rate greater than we have experienced to date.
As a lender, we are exposed to the risk that our loan customers may not repay their loans according to their terms and that the collateral or guarantees securing these loans may be insufficient to assure repayment. The underwriting and credit monitoring policies and procedures that we have adopted to address this risk may not prevent unexpected losses that could have a material adverse effect on our business, financial condition, results of operations and cash flows. We maintain an allowance for credit losses to provide for loan defaults and non-performance, which also includes increases for new loan growth. While we believe that our allowance for credit losses is appropriate to cover expected losses, we cannot assure you that we will not increase the allowance for credit losses further or that regulators will not require us to increase the allowance for credit losses which could have a material adverse effect on our net income and financial condition.
Management makes various assumptions and judgments about the collectability of our loan portfolio, which are regularly reevaluated and are based in part on:
•current economic conditions and their estimated effects on specific borrowers;
•an evaluation of the existing relationships among loans, potential credit losses and the present level of the allowance for credit losses;
•results of examinations of our loan portfolios by regulatory agencies; and
•management's internal review of the loan portfolio.
In determining the size of the allowance for credit loss, we rely on an analysis of our loan portfolio, our experience and a third-party economic forecast. If our assumptions prove to be incorrect, our current allowance for credit losses may not be sufficient to cover the losses.
In addition, third parties, including our federal and state regulators, periodically evaluate the adequacy of our allowance for credit losses and may communicate with us concerning the methodology or judgments that we have raised in determining the allowance for credit losses. As a result of this input, we may be required to assign different grades to specific credits, increase our provision for credit losses, and/or recognize further loan charge offs which could have a material adverse effect on our net income and financial condition. See Note 1 - Summary of Significant Accounting Policiesto the Consolidated Financial Statements under "Part II, Item 8. Financial Statements and Supplementary Data."
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Our commercial, financial and agricultural loan and commercial real estate loan portfolios expose us to risks that may be greater than the risks related to our other loans.
Our loan portfolio includes commercial, financial and agricultural loans and commercial real estate loans, which are secured by commercial real estate, including but not limited to, structures and facilities to support activities designated as multi-family residential properties, industrial, warehouse, general office, retail, health care and religious dwellings. Commercial, financial and agricultural and commercial real estate loans carry more risk as compared to other types of lending, because they typically involve larger loan balances often concentrated with a single borrower or groups of related borrowers.
Accordingly, charge-offs on commercial, financial and agricultural and commercial real estate loans may be larger on a per loan basis than those incurred with our residential or consumer loan portfolios. In addition, these loans expose a lender to greater credit risk than loans secured by residential real estate. The payment experience on commercial real estate loans that are secured by income producing properties are typically dependent on the successful operation of the related real estate property and thus, may subject us to adverse conditions in the real estate market or to the general economy. The collateral securing these loans typically cannot be liquidated as easily as residential real estate. If we foreclose on these loans, our holding period for the collateral typically is longer than residential properties because there are fewer potential purchasers of the collateral.
Unexpected deterioration in the credit quality of our commercial or commercial real estate loan portfolios would require us to increase our provision for credit losses, which would reduce our profitability and could materially adversely affect our business, financial condition, results of operations and prospects.
In addition, federal and state banking regulators may require banks with higher levels of commercial real estate loans to implement more stringent underwriting, internal controls, risk management policies and portfolio stress testing, as well as possibly higher levels of allowances for credit losses and capital levels as a result of commercial real estate lending growth and exposures.
We may incur future losses in connection with certain representations and warranties we have made with respect to mortgages that we have sold in the secondary market.
In connection with the sale of mortgage loans into the secondary market, we make representations and warranties, which, if breached, may require us to repurchase such loans, substitute other loans or indemnify the purchasers of such loans for actual losses incurred in respect to such loans. A substantial decline in residential real estate values in the markets in which we originated such loans could increase the risk of such consequences. While we currently believe our repurchase risk is low, it is possible that requests to repurchase loans could occur in the future and such requests may have a material adverse effect on our financial condition and results of operations.
Interest Rate and Liquidity Risks
Our business is subject to interest rate risk and fluctuations in interest rates may adversely affect our earnings.
The majority of our assets and liabilities are monetary in nature and subject to risk from changes in interest rates. Like most financial institutions, our earnings and profitability depend significantly on our net interest income, which is the difference between interest income on interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings. We expect that we will periodically experience "gaps" in the interest rate sensitivities of our assets and liabilities, meaning that either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. If market interest rates should move contrary to our position, this "gap" will work against us and our earnings may be negatively affected. In light of our current volume and mix of interest-earning assets and interest-bearing liabilities, our net interest margin could be expected to increase modestly during periods of rising interest rates, and to decline slightly during periods of falling interest rates. We are unable to predict or control fluctuations of market interest rates, which are affected by many factors, including the following:
•inflation;
•recession;
•market conditions;
•changes in unemployment;
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•the money supply;
•international disorder and instability in domestic and foreign financial markets; and
•governmental actions.
Our asset/liability management strategy may not be able to control our risk from changes in market interest rates and it may not be able to prevent changes in interest rates from having a material adverse effect on our results of operations and financial condition. From time to time, we may reposition our assets and liabilities to reduce our net interest income volatility. Failure to perform in any of these areas could significantly weaken our competitive position, which could adversely affect our growth and profitability, which, in turn, could have a material adverse effect on our financial condition and results of operations.
If we are unable to effectively manage the composition and risk of our investment securities portfolio, which we expect will continue to comprise a significant portion of our earning assets, our net interest income and net interest margin could be adversely affected.
Our primary sources of interest income include interest on loans, as well as interest earned on investment securities. Interest earned on investment securities represented 11.2% of our interest income in the year ended December 31, 2021, as compared to 12.1% of our interest income in the year ended December 31, 2020. Accordingly, effectively managing our investment securities portfolio to generate interest income while managing the composition and risks (including credit, interest rate and liquidity) associated with that portfolio, including the mix of government agency and non-agency securities, remains important. If we are unable to effectively manage our investment securities portfolio or if the interest income generated by our investment securities portfolio declines, our net interest income and net interest margin could be adversely affected.
We may be adversely impacted by the transition from LIBOR as a reference rate
In 2017, the United Kingdom Financial Conduct Authority ("FCA") announced that after 2021 it would no longer compel banks to submit the rates required to calculate the LIBOR. In March 2021, the FCA and Intercontinental Exchange (ICE) Benchmark Administration (IBA) announced that the publication of the most commonly used U.S. dollar LIBOR settings would be extended through June 30, 2023 and cease publishing other LIBOR settings after December 31, 2021. Subsequently, federal financial institution regulatory agencies in conjunction with state bank and credit union regulators issued a joint statement stressing their expectation that supervised institutions with LIBOR exposure continue to progress toward an orderly transition away from LIBOR. It is not possible to predict whether LIBOR will continue to be viewed as an acceptable market benchmark (until cessation), what rate or rates may become accepted alternatives, (including uncertainties regarding Secured Overnight Financing Rate ("SOFR"), or what the effect of any such changes in views or alternative may be on the markets for LIBOR-indexed financial instruments. We have a cross-functional committee to lead the transition from LIBOR to a planned adoption of reference rates which could include SOFR, Prime Rate or others.
We have loans, derivatives and debt with attributes that are either directly or indirectly dependent on LIBOR. The transition from LIBOR could create considerable costs and additional risk. Since proposed alternative rates are calculated differently, payments under contracts referencing new rates will differ from those referencing LIBOR. The transition may change our market risk profile, and require changes to risk and pricing models, valuation tools, product design and hedging strategies. Although we are unable to assess what the ultimate impact of the transition from LIBOR will be, failure to adequately manage the transition could have a material adverse effect on our business, financial condition, and results of operations.
We rely on the mortgage secondary market for some of our liquidity.
We originate and sell mortgage loans. We rely on Federal National Mortgage Association ("Fannie Mae"), Federal Home Loan Mortgage Corporation ("Freddie Mac") and other purchasers to purchase first mortgage loans in order to reduce our credit risk and interest rate risk and provide funding for additional loans we desire to originate. We cannot provide assurance that these purchasers will not materially limit their purchases from us due to capital constraints or other factors, including, with respect to Fannie Mae and Freddie Mac, a change in the criteria for conforming loans. In addition, various proposals have been made to reform the U.S. residential mortgage finance market, including the role of Fannie Mae and Freddie Mac. The exact effects of any such reforms are not yet known, but may limit our ability to sell conforming loans to Fannie Mae or Freddie Mac. In addition, mortgage lending is highly regulated, and our inability to comply with all federal and state regulations and investor guidelines regarding the origination, underwriting, documentation and servicing of mortgage loans may also impact our ability to continue selling mortgage loans. If we are unable to continue to sell loans in the secondary market, our ability to fund, and thus originate, additional mortgage loans may be adversely affected, which could have a material adverse effect on our business, financial condition or results of operations.
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We are required to act as a source of financial and managerial strength for our bank.
We are required to act as a source of financial and managerial strength to the bank. We may be required to commit additional resources to the bank at times when we may not be in a financial position to provide such resources or when it may not be in our, or our shareholders’ best interests to do so. Providing such support is more likely during times of financial stress for us and the bank, which may make any capital we are required to raise to provide such support more expensive than it might otherwise be. In addition, any capital loans we make to the bank are subordinate in right of payment to depositors and to certain other indebtedness of the bank.
We rely on dividends from our subsidiary for most of our revenue.
Because we are a holding company with no significant operations other than our bank, we depend upon dividends from our bank for a substantial portion of our revenues and our liquidity.
Hawaii law only permits the bank to pay dividends out of retained earnings as defined under Hawaii banking law ("Statutory Retained Earnings"), which differs from GAAP retained earnings. As of December 31, 2021, the bank had Statutory Retained Earnings of $114.0 million. In addition, regulatory authorities could limit the ability of the bank to pay dividends to CPF. The inability to receive dividends from the bank could have a material adverse effect on our financial condition, results of operations and prospects.
Our ability to pay cash dividends to our shareholders is subject to restrictions under federal and Hawaii law, including restrictions imposed by the FRB and covenants set forth in various agreements we are a party to, including covenants set forth in our subordinated debentures and subordinated notes. We cannot provide any assurance that we will continue to pay dividends.
Operational Risks
Our RISE2020 initiative may not be successful.
During the second half of 2019 and throughout 2020, we invested an aggregate of approximately $40 million to upgrade our branch spaces, digital banking platforms and ATM network through an initiative we called RISE2020. RISE2020 was intended to enhance customer experience, drive stronger long-term growth and profitability, improve shareholder returns and lower our efficiency ratio. Our RISE2020 initiative was completed in early 2021, however, the COVID-19 pandemic resulted in some revisions to our original initiatives, plans and timelines. Following the completion, we continue to monitor and further enhance our facilities, platforms and processes that were part of the RISE2020 initiative. While the investments we made in RISE2020 are projected to result in increased revenue and growth, the increases are forecasted to occur over a period of time and are heavily dependent upon our ability to continue to execute on our business and strategic objectives. We cannot provide any assurance that RISE2020 will achieve any of our objectives or will achieve our objectives to the extent we have forecasted. In particular, we may not be able to attract new business from existing customers; new customers may not be attracted to our platform despite the amount of expense we incur; and continued enhancements of RISE2020 initiatives may disrupt our operations. If our RISE2020 initiative is not successful, our overall noninterest expense will have increased without a corresponding increase in revenue and growth which could have a material adverse effect on our business, financial condition or results of operations.
Our agreements with BaaS partners may produce limited revenue and may expose us to liability for compliance violations by BaaS partners.
We recently announced the launch of a new BaaS initiative with the goal of expanding our services in Hawaii and on the U.S. Mainland by collaborating with and investing in fintech companies. In conjunction with that initiative, we intend to collaborate with Elevate Credit, Inc. and Swell Financial, Inc. where the bank will serve as the bank sponsor for a new consumer banking application. We may enter into agreements with other BaaS partners pursuant to which we will provide certain banking services for the BaaS partner customers. Our agreements with our partners will have varying terms and may be terminated by the parties under certain circumstances. If our BaaS partners are not successful in achieving customer acceptance of their programs or terminate the agreements before the end of their respective terms, our revenue under the various agreements may be limited or may cease altogether. In addition, our bank regulators may hold us responsible for the activities of our bank partners with respect to the marketing or administration of their programs, which may result in increased compliance costs for us or potentially compliance violations as a result of BaaS partner activities, any of which could have a material adverse effect on our financial condition or results of operations.
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Our strategy of offering BaaS has been adopted by other institutions with which we compete.
Other online banking operations as well as the online banking programs of other banks have instituted BaaS strategies similar to ours. As a consequence, we anticipate that we will encounter competition in this area currently and in the future. This competition may increase our costs, reduce our revenues or revenue growth or make it difficult for us to compete effectively in obtaining these relationships.
Managing reputational risk is important to attracting and maintaining customers, investors and employees
Threats to our reputation can come from many sources, including adverse sentiment about financial institutions generally, unethical practices, employee mistakes, misconduct or fraud, failure to deliver minimum standards of service or quality, failure of any product or service offered by us to meet our customers’ expectations, compliance deficiencies, government investigations, litigation, and questionable, unlawful or fraudulent activities of our partners, contract counterparties, employees or customers. We have policies and procedures in place to protect our reputation and promote ethical conduct, but these policies and procedures may not be fully effective to address reputational threats in all circumstances. Negative publicity regarding our business, employees, partners, contracting counterparties, employees or customers, with or without merit, may result in the loss of customers, investors and employees, costly litigation, a decline in revenues and increased governmental scrutiny and regulation.
The ongoing design and maintenance of data and related internal controls over financial reporting related to Current Expected Credit Losses ("CECL") will require a significant amount of time and resources which may have a material impact on our results of operations.
CECL has increased the amount of data and assumptions we need to collect and review to determine the appropriate level of the allowance for credit losses. A significant amount of time and resources has been spent and will continue to be spent in order to implement and maintain CECL effectively, including the design and implementation of related adequate internal controls, which may adversely affect our results of operations. If we are unable to maintain effective internal control over financial reporting relating to CECL, our ability to report our financial condition and results of operations accurately and on a timely basis could also be adversely affected.
Consumer protection initiatives related to the foreclosure process could materially affect our ability as a creditor to obtain remedies.
In 2011, Hawaii revised its rules for nonjudicial, or out-of-court, foreclosures. Prior to the revision, most lenders used the nonjudicial foreclosure method to handle foreclosures in Hawaii, as the process was less expensive and quicker than going through the court foreclosure process. After the revised rules went into effect, many lenders ended up forgoing nonjudicial foreclosures entirely and filing all foreclosures in court, which has created a backlog and slowed the judicial foreclosure process. Many lenders continue to exclusively use the judicial foreclosure process, making the foreclosure process very lengthy. Additionally, the joint federal-state settlement with several mortgage servicers over abuse of foreclosure practices creates further uncertainty for us and the mortgage servicing industry in general with respect to implementation of mortgage loan modifications and loss mitigation practices going forward. The manner in which these issues are ultimately resolved could impact our foreclosure procedures, which in turn could adversely affect our business, financial condition or results of operations.
Our deposit customers may pursue alternatives to deposits at our bank or seek higher yielding deposits causing us to incur increased funding costs.
Checking and savings account balances and other forms of deposits can decrease when our deposit customers perceive alternative investments, such as the stock market or other non-depository investments, as providing superior expected returns or seek to spread their deposits over several banks to maximize FDIC insurance coverage. Furthermore, technology and other changes have made it more convenient for the bank's customers to transfer funds into alternative investments including products offered by other financial institutions or non-bank service providers. Increases in short-term interest rates could increase transfers of deposits to higher yielding deposits. Efforts and initiatives we undertake to retain and increase deposits, including deposit pricing, can increase our costs. When the bank's customers move money out of bank deposits in favor of alternative investments or into higher yielding deposits, or spread their accounts over several banks, we can lose a relatively inexpensive source of funds, thus increasing our funding costs.
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The occurrence of fraudulent activity, data privacy breaches, failures of our information security controls or cybersecurity-related incidents could have a material adverse effect on our business, financial condition and results of operations.
As a financial institution, we are susceptible to fraudulent activity, information security breaches and cybersecurity-related incidents that may be committed against us, our customers or our business partners (including by our own employees and consultants), which may result in financial losses or increased costs to us or, our customers or our business partners, disclosure or misuse of our information or our client information, misappropriation of assets, privacy breaches against our clients, litigation, or damage to our reputation. Such fraudulent activity may take many forms, including check fraud, electronic fraud, wire fraud, phishing, social engineering and other dishonest acts. Information security breaches and cybersecurity-related incidents may include fraudulent or unauthorized access to systems used by us, our vendors, or our clients, denial or degradation of service attacks, and malware or other cyber-attacks. In recent periods, there continues to be a rise in electronic fraudulent activity, security breaches and cyber-attacks within the financial services industry, especially in the commercial banking sector due to cyber criminals targeting commercial bank accounts. Consistent with industry trends, we have also experienced an increase in attempted electronic fraudulent activity, security breaches and cybersecurity-related incidents in recent periods. Moreover, in recent periods, several large corporations, including financial institutions and retail companies, have suffered major data breaches, in some cases exposing not only confidential and proprietary corporate information, but also sensitive financial and other personal information of their customers and employees and subjecting them to potential fraudulent activity. Some of our clients may have been affected by these breaches, which increase their risks of identity theft, credit card fraud and other fraudulent activity that could involve their accounts with us.
Information pertaining to us and our clients is maintained, and transactions are executed, on the networks and systems of us, our clients and certain of our third-party partners, such as our online banking or reporting systems. The secure maintenance and transmission of confidential information, as well as execution of transactions over these systems, are essential to protect us and our clients against fraud and security breaches and to maintain our clients' confidence. Breaches of information security also may occur, and in infrequent cases have occurred, through intentional or unintentional acts by those having access to our systems or our clients' or counterparties' confidential information, including employees. In addition, increases in criminal activity levels and sophistication, advances in computer capabilities, new discoveries, vulnerabilities in third-party technologies (including browsers and operating systems) or other developments could result in a compromise or breach of the technology, processes and controls that we use to prevent fraudulent transactions and to protect data about us, our clients and underlying transactions, as well as the technology used by our clients to access our systems. Although we have developed, and continue to invest in, systems and processes that are designed to detect and prevent data security breaches and cyber-attacks and periodically test our security, we may fail to anticipate or adequately mitigate breaches of security or experience data privacy breaches that could result in: losses to us or our clients; our loss of business and/or clients; damage to our reputation; the incurrence of additional expenses; disruption to our business; our inability to grow our online services or other businesses; additional regulatory scrutiny or penalties, including resulting violations of law (whether federal or one or more various states); or our exposure to civil litigation and possible financial liability — any of which could have a material adverse effect on our business, financial condition and results of operations.
More generally, publicized information concerning security and cyber-related problems and other data privacy breaches could inhibit the use or growth of digital or web-based applications or solutions as a means of conducting commercial transactions. Such publicity may also cause damage to our reputation as a financial institution. As a result, our business, financial condition and results of operations could be materially adversely affected.
Failure to maintain effective internal control over financial reporting or disclosure controls and procedures could adversely affect our ability to report our financial condition and results of operations accurately and on a timely basis.
A failure to maintain effective internal control over financial reporting or disclosure controls and procedures could adversely affect our ability to report our financial results accurately and on a timely basis, which could result in a loss of investor confidence in our financial reporting or adversely affect our access to sources of liquidity. Furthermore, because of the inherent limitations of any system of internal control over financial reporting, including the possibility of human error, the circumvention or overriding of controls and fraud, even effective internal controls may not prevent or detect all misstatements. Frequent or rapid changes in procedures, methodologies, systems, personnel and technology exacerbate the challenge of developing and maintaining a system of internal controls and can increase the cost and level of effort to develop and maintain such systems.
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Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition.
Periodically the Financial Accounting Standards Board ("FASB") and the SEC change the financial accounting and reporting standards that govern the preparation of our financial statements. As a result of changes to financial accounting or reporting standards, whether promulgated or required by the FASB or other regulators, we could be required to change certain of the assumptions or estimates we have previously used in preparing our financial statements, which could adversely affect our business, financial condition and results of operations. See Note 1 - Summary of Significant Accounting Policies to the Consolidated Financial Statements under "Part II, Item 8. Financial Statements and Supplementary Data."
Financial services companies depend on the accuracy and completeness of information about customers and counterparties.
In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports and other financial information. We may also rely on representations of those customers, counterparties or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports or other financial information could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
We operate in a highly competitive industry and market area.
We face substantial competition in all areas of our operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national, regional and community banks within the various markets we operate. Additionally, various out of state banks conduct business in the market areas in which we currently operate. We also face competition from many other types of financial institutions, including, without limitation, savings banks, credit unions, finance companies, financial service providers, including mortgage providers and brokers, operating via the internet and other technology platforms, brokerage firms, insurance companies, factoring companies and other financial intermediaries.
The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of our competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than we can.
Our ability to compete successfully depends on a number of factors, including, among other things:
•the ability to develop, maintain and build upon long-term customer relationships based on top quality service, high ethical standards and safe, sound assets;
•the ability to expand our market position;
•the scope, relevance and pricing of products and services offered to meet customer needs and demands;
•the rate at which we introduce new products and services relative to our competitors;
•customer satisfaction with our level of service; and
•industry and general economic trends.
Failure to perform in any of these areas could significantly weaken our competitive position, which could adversely affect our growth and profitability, which, in turn, could have a material adverse effect on our financial condition and results of operations.
In addition, the soundness of our financial condition may also affect our competitiveness. Customers may decide not to do business with the bank due to its financial condition.
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We are subject to environmental liability risk associated with our bank branches and any real estate collateral we acquire upon foreclosure.
During the ordinary course of business, we may foreclose on and take title to properties securing certain loans that we have originated or acquired. We also own several of our branch locations. For any real property that we may possess, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage and costs of complying with applicable environmental regulatory requirements. Failure to comply with such requirements can result in penalties. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property's value or limit our ability to use, sell or lease the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our business, financial condition or results of operations.
Our business could be adversely affected by unfavorable actions from rating agencies.
Ratings assigned by ratings agencies to us, our affiliates or our securities may impact the decision of certain customers, in particular, institutions, to do business with us. A rating downgrade or a negative rating could adversely affect our deposits,our ability to access the capital markets on favorable terms and our business relationships.
Risks Related to Legal, Compliance and Regulatory Matters
Governmental regulation and regulatory actions against us may impair our operations or restrict our growth.
As a regulated financial institution, we are subject to significant governmental supervision and regulation. These regulations affect our lending practices, capital structure, investment practices, dividend policy and growth, among other things. Statutes and regulations affecting our business may be changed at any time and the interpretation of these statutes and regulations by examining authorities may also change. In addition, regulations may be adopted which increase expenses associated with running our business and adversely affect our earnings.
There can be no assurance that such statutes and regulations, any changes thereto or to their interpretation will not adversely affect our business. In particular, these statutes and regulations, and any changes thereto, could subject us to additional costs (including legal and compliance costs), limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. In addition to governmental supervision and regulation, we are subject to changes in other federal and state laws, including changes in tax laws, which could materially affect us and the banking industry generally. We are subject to the rules and regulations of the FRB, the FDIC and the DFI, and certain rules and regulations promulgated by the CFPB. In addition, we are subject to the rules and regulation of the NYSE and the SEC and are subject to enforcement actions and other punitive actions by these agencies. If we fail to comply with federal and state regulations, the regulators may limit our activities or growth, impose fines on us or in the case of our bank regulators, ultimately require our bank to cease its operations. Bank regulations can hinder our ability to compete with financial services companies that are not regulated in the same manner or are less regulated. Federal and state bank regulatory agencies regulate many aspects of our operations. These areas include:
•the capital that must be maintained;
•the kinds of activities that can be engaged in;
•the kinds and amounts of investments that can be made;
•the locations of offices;
•insurance of deposits and the premiums that we must pay for this insurance;
•procedures and policies we must adopt;
•conditions and restrictions on our executive compensation; and
•how much cash we must set aside as reserves for deposits.
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In addition, bank regulatory authorities may bring enforcement actions against banks and bank holding companies, including CPF and the bank, for unsafe or unsound practices in the conduct of their businesses or for violations of any law, rule or regulation. Enforcement actions against us, including any condition imposed in writing by the appropriate bank regulatory agency or any written agreement with the authority, could include a federal conservatorship or receivership for the bank, the issuance of additional orders that could be judicially enforced, the imposition of civil monetary penalties, the issuance of directives to enter into a strategic transaction, whether by merger or otherwise, with a third-party, the termination of insurance of deposits, the issuance of removal and prohibition orders against institution-affiliated parties, and the enforcement of such actions through injunctions or restraining orders. In addition, if we were to grow beyond $10 billion in assets, we would be subject to enhanced CFPB examination and our compliance costs would increase.
We face a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statutes and regulations.
The Bank Secrecy Act, the USA PATRIOT Act of 2001, and other laws and regulations require financial institutions, among other duties, to institute and maintain an effective anti-money laundering program and file suspicious activity and currency transaction reports as appropriate. The federal Financial Crimes Enforcement Network is authorized to impose significant civil money penalties for violations of those requirements and has engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice, Drug Enforcement Administration, and Internal Revenue Service. We are also subject to increased scrutiny of compliance with the rules enforced by the Office of Foreign Assets Control and compliance with the Foreign Corrupt Practices Act. If our policies, procedures and systems are deemed deficient, we would be subject to liability, including fines and regulatory actions, which may include restrictions on our ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain aspects of our business plan. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us. Any of these results could materially and adversely affect our business, financial condition and results of operations.
Regulatory capital standards impose enhanced capital adequacy requirements on us.
Increased regulatory capital requirements (and the associated compliance costs), which have been adopted by federal banking regulators, impose additional capital requirements on our business. The administration of existing capital adequacy laws as well as adoption of new laws and regulations relating to capital adequacy, or more expansive or aggressive interpretations of existing laws and regulations, could have a material adverse effect on our business, liquidity, financial condition and results of operations and could substantially restrict our ability to pay dividends, repurchase any of our capital stock, or pay executive bonuses. In addition, increased regulatory capital requirements as well as our financial condition could require us to raise additional capital which would dilute our existing shareholders at the time of such capital issuance.
We are subject to various legal claims and litigation.
From time to time, customers, employees and others whom we do business with, or are regulated by, as well as our shareholders, can make claims and take legal action against us. Regardless of whether these claims and legal actions are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to us, they may result in significant financial liability and/or adversely affect the market perception of us and our products and services, as well as impact customer demand for our products and services. Any financial liability or reputational damage could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations. Even if these claims and legal actions do not result in a financial liability or reputational damage, defending these claims and actions have resulted in, and will continue to result in, increased legal and professional services costs, which adds to our noninterest expense and negatively impacts our operating results.
Risks Related to an Investment in the Company's Securities
The market price of our common stock could decline.
The trading price of our common stock may fluctuate widely as a result of a number of factors, many of which are outside our control. In addition, the stock market is subject to fluctuations in the share prices and trading volumes that affect the market prices of the shares of many companies. These broad market fluctuations could adversely affect the market price of our common stock. Among the factors that could affect our stock price are:
•failure to comply with all of the requirements of any governmental orders or agreements we may become subject to and the possibility of resulting action by the regulators;
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•deterioration of asset quality;
•the incurrence of losses;
•actual or anticipated quarterly fluctuations in our operating results and financial condition;
•changes in revenue or earnings/losses estimates or publication of research reports and recommendations by financial analysts;
•failure to meet analysts' revenue or earnings/losses estimates;
•speculation in the press or investment community;
•strategic actions by us or our competitors, such as mergers, acquisitions, restructurings, changes in products or markets, or public offerings;
•additions or departures of key personnel;
•actions by institutional shareholders;
•fluctuations in the stock price and operating results of our competitors;
•future sales of other equity or debt securities, including our common stock;
•general market conditions and, in particular, developments related to market conditions for the financial services industry;
•proposed or adopted regulatory changes or developments;
•breaches in our security systems and loss of customer data;
•anticipated or pending investigations, proceedings or litigation that involve or affect us; or
•domestic and international economic factors unrelated to our performance.
The stock market generally may experience significant volatility. In addition, the trading volume in our common stock may fluctuate more than usual and cause significant price variations to occur. Accordingly, the common stock that you purchase may trade at a price lower than that at which they were purchased. Volatility in the market price of our common stock may prevent individual shareholders from being able to sell their shares when they want or at prices they find attractive.
A significant decline in our stock price could result in substantial losses for shareholders and could lead to costly and disruptive securities litigation.
Anti-takeover provisions in our restated articles of incorporation and bylaws and applicable federal and state law may limit the ability of another party to acquire us or a significant block of common stock, which could cause our stock price to decline.
Various provisions of our restated articles of incorporation and bylaws and certain other actions we have taken could delay or prevent a third-party from acquiring us, even if doing so might be beneficial to our shareholders. These include, among other things, the authorization to issue "blank check" preferred stock by action of the Board of Directors acting alone, thus without obtaining shareholder approval. In addition, applicable provisions of federal and state law require regulatory approval in connection with certain acquisitions of our common stock and super-majority voting provisions in connection with certain transactions. In particular, both federal and state law limit the acquisition of ownership of certain percentage thresholds of our common stock without providing prior notice to the regulatory agencies and obtaining prior regulatory approval or non-objection or being able to rely on an exemption from such acquisition. See the "Supervision and Regulation" section. We are also subject to the provisions of the Hawaii Control Share Acquisitions Act which prohibits the consummation of a “control share acquisition” (with threshold ranges starting at 10% and set at 10% intervals up to a majority) unless approved by our shareholders or otherwise exempt. Unless approved or otherwise exempt, for a period of one year after acquisition, the shares
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acquired by a person in a control share acquisition will be (i) denied voting rights, (ii) be nontransferable, and (iii) be subject to redemption at our option. Collectively, these provisions of our restated articles of incorporation and bylaws and applicable federal and state law may prevent a merger or acquisition that would be attractive to shareholders, limit the ability of another party to acquire a significant block of our common stock, and could limit the price investors would be willing to pay in the future for our common stock.
Our common stock is equity and therefore is subordinate to our subsidiaries' indebtedness and preferred stock.
Our common stock constitutes equity interests and does not constitute indebtedness. As such, common stock will rank junior to all current and future indebtedness and other non-equity claims on us with respect to assets available to satisfy claims against us, including in the event of our liquidation. We may, and the bank and our other subsidiaries may also, incur additional indebtedness from time to time and may increase our aggregate level of outstanding indebtedness. As of December 31, 2021, we had (i) $50.0 million in face amount of trust preferred securities outstanding and accrued and unpaid dividends thereon of $0.1 million and (ii) $55.0 million in principal amount of subordinated notes outstanding and accrued and unpaid interest thereon of $0.4 million. Additionally, holders of common stock are subject to the prior dividend and liquidation rights of any holders of our preferred stock that may be outstanding from time to time. The Board of Directors is authorized to cause us to issue additional classes or series of preferred stock without any action on the part of our stockholders. If we issue preferred shares in the future that have a preference over our common stock with respect to the payment of dividends or upon liquidation, or if we issue preferred shares with voting rights that dilute the voting power of the common stock, then the rights of holders of our common stock or the market price of our common stock could be adversely affected.
There is a limited trading market for our common stock and as a result, you may not be able to resell your shares at or above the price you pay for them at the time you otherwise may desire.
Although our common stock is listed for trading on the NYSE, the volume of trading in our common shares is lower than many other companies listed on the NYSE. A public trading market with depth, liquidity and orderliness depends on the presence in the market of willing buyers and sellers of our common shares at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. As a result, you may not be able to resell your common stock at or above the price you pay or at the time(s) you otherwise may desire.
The soundness of other financial institutions could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. There is no assurance that any such losses would not materially and adversely affect our results of operations.
Our common stock is not insured and you could lose the value of your entire investment.
An investment in our common stock is not a deposit and is not insured against loss by the government or any governmental
agency.
Risks Related to Technology
We continually encounter technological change.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. In addition, there are a limited number of qualified persons in our local marketplace with the knowledge and experience required to effectively maintain our information technology systems and implement our technology initiatives. Failure to successfully attract and retain qualified personnel, or keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
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General Risk Factors
We are dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect our prospects.
Competition for qualified employees and personnel in the banking industry is intense and there is a limited number of qualified persons with knowledge of, and experience in, the regional banking industry, especially in the Hawaii market. The process of recruiting personnel with the combination of skills and attributes required to carry out our strategies is often lengthy. Our success depends to a significant degree upon our ability to attract and retain qualified management, loan origination, finance, administrative, marketing, and technical personnel, and upon the continued contributions of our management and personnel. In particular, our success has been and continues to be highly dependent upon the abilities of key executives, including our Chairman and Chief Executive Officer, our Executive Vice Chair, our President and Chief Operating Officer, our Senior Executive Vice President and Chief Financial Officer, and our other executive officers and certain other employees.
Natural disasters and other external events (including pandemic viruses or disease) could have a material adverse affect on our financial condition and results of operations.
Our branch offices as well as a substantial majority of our loan portfolio is in the state of Hawaii. As a result, natural disasters and other severe weather occurrences such as tsunamis, volcanic eruptions (such as the recent eruption of Mount Kilauea), hurricanes and earthquakes and other adverse external events, including the effects of any pandemic viruses or diseases (such as the current COVID-19 pandemic), could have a significant effect on our ability to conduct our business and adversely affect the tourism and visitor industry in the state of Hawaii. Such events could affect the ability of our borrowers to repay their outstanding loans, impair the value of collateral securing our loans, cause significant property damage, result in loss of revenue, adversely impact our deposit base and/or cause us to incur additional expenses. Accordingly, the occurrence of any such natural disasters, severe weather events, or other occurrences over which we have no control could have a material adverse effect on our business, which, in turn, could adversely affect our financial condition and results of operations.
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ITEM 1B.UNRESOLVED STAFF COMMENTS
None.
ITEM 2.PROPERTIES
We hold title to the land and building in which our Main branch office and headquarters, Hilo branch office, Kailua-Kona branch office, Pearl City branch office, Kaneohe branch office and certain operations offices are located. We also hold title to a portion of the land on which our operations center is located. The remaining portion of the land where our operations center is located is leased, as are all remaining branch and support office facilities. We also own four floors of a commercial office condominium in downtown Honolulu where certain bank training classes are held and residential mortgage sales and operations are located. In 2021, we acquired title to land in Kahului, Maui where the Company intends to build its new branch and regional office.
We occupy or hold leases for approximately 40 other properties including office space for our remaining branches. These leases expire on various dates through 2045 and generally contain renewal options for periods ranging from 5 to 15 years. For additional information relating to lease rental expense and commitments as of December 31, 2021, see Note 19 - Operating Leases to the Consolidated Financial Statements under "Part II, Item 8. Financial Statements and Supplementary Data."
ITEM 3. LEGAL PROCEEDINGS
Certain claims and lawsuits have been filed or are pending against us arising in the ordinary course of business. In the opinion of management, all such matters are of a nature that, if disposed of unfavorably, would not have a material adverse effect on our consolidated results of operations or financial position. See Note 23 - Contingent Liabilities and Other Commitments to the Consolidated Financial Statements under "Part II, Item 8. Financial Statements and Supplementary Data."
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is traded on the NYSE under the ticker symbol "CPF." Set forth below is a line graph comparing the cumulative total stockholder return on the Company's common stock, based on the market price of the common stock and assuming reinvestment of dividends, with the Russell 2000 Index and the Standard and Poor's ("S&P") SmallCap 600 Commercial Bank Index for the five year period commencing December 31, 2016 and ending December 31, 2021. The graph assumes the investment of $100 on December 31, 2016.
Indexed Total Annual Return
(as of December 31, 2021)
December 31,
As of February 5, 2022, there were 3,089 shareholders of record, excluding individuals and institutions for which shares were held in the names of nominees and brokerage firms.
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Dividends
Dividends are payable at the discretion of the Board of Directors and there can be no assurance that the Board of Directors will continue to pay dividends at the same rate, or at all, in the future. Our ability to pay cash dividends to our shareholders is subject to restrictions under federal and Hawaii law, including restrictions imposed by the FRB and covenants set forth in various agreements we are a party to, including covenants set forth in trust preferred securities and subordinated notes.
Under the terms of our trust preferred securities and subordinated notes, our ability to pay dividends with respect to common stock would be restricted if our obligations under our trust preferred securities and subordinated notes were not current. Our obligations on our outstanding trust preferred securities and subordinated notes are current as of December 31, 2021.
Additionally, our ability to pay dividends depends on our ability to obtain dividends from our bank. As a Hawaii state-chartered bank, the bank may only pay dividends to the extent it has retained earnings as defined under Hawaii banking law ("Statutory Retained Earnings"), which differs from GAAP retained earnings. As of December 31, 2021, the bank had Statutory Retained Earnings of $114.0 million. In addition, the bank's regulators could impose limitations or conditions on the bank's ability to pay dividends to the Company.
See "Part I, Item 1. Business — Supervision and Regulation — Regulatory Actions" for a discussion on regulatory restrictions.
Issuer Purchases of Equity Securities
In March 2020, the Company decided to suspend its share repurchase program due to the economic uncertainty in the wake of the COVID-19 pandemic. On January 26, 2021, the Company's Board of Directors approved a new share repurchase authorization of up to $25 million of its common stock (the "2021 Repurchase Plan"). The Company resumed repurchases during the second quarter of 2021. During the second and third quarters of 2021, the Company repurchased 391,300 shares of common stock at a cost of $10.2 million. During the fourth quarter of 2021, we repurchased 305,594 shares of common stock at a cost of $8.4 million. A total of $6.3 million remained available for repurchase under the 2021 Repurchase Plan at December 31, 2021. In January 2021, we announced a new $30 million repurchase program which replaces the 2021 Repurchase Plan.
Issuer Purchases of Equity Securities
Information relating to compensation plans under which equity securities of the Registrant are authorized for issuance is set forth under "Part III, Item 12—Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters."
ITEM 6.RESERVED
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ITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Introduction
We are a bank holding company that, through our banking subsidiary, Central Pacific Bank, offers full service commercial banking in the state of Hawaii.
We strive to provide exceptional customer service and products that meet our customers' needs. Our products and services consist primarily of the following:
•Loans: Our loans consist of commercial, financial and agricultural, commercial mortgage, and construction loans to small and medium-sized companies, business professionals, and real estate investors and developers, as well as residential mortgage, home equity and consumer loans to local homeowners and individuals. Our lending activities contribute to a key component of our revenues reported in interest income.
•Deposits: We offer a full range of deposit products and services including checking, savings and time deposits, cash management, and digital banking services. We also maintain a broad branch and ATM network in the state of Hawaii. The interest paid on such deposits has a significant impact on our interest expense, an important factor in determining our earnings. In addition, fees and service charges on deposit accounts contribute to our revenues.
Additionally, we offer wealth management products and services, such as non-deposit investment products, annuities, insurance, investment management, asset custody and general consultation and planning services.
Executive Overview
In 2021, we believe we delivered strong financial performance for the Company despite the pandemic environment.
•We recorded net income of $79.9 million, or $2.83 per diluted common share in 2021, compared to $37.3 million, or $1.32 per diluted common share in 2020.
•We recorded return on average assets ("ROA") and return on average shareholders' equity ("ROE") ratios of 1.13% and 14.38%, respectively, in 2021, compared to ROA and ROE ratios of 0.58% and 6.85%, respectively, in 2020.
•Asset quality remains strong as our nonperforming assets totaled $5.9 million, or 0.08% of total assets at December 31, 2021, compared to $6.2 million, or 0.09% of total assets at December 31, 2020.
•We realized strong core loan growth of $462.6 million, or 10.2% (excluding Small Business Administration ("SBA") Paycheck Protection Program ("PPP") loans), or total loan growth of $137.5 million, or 2.8% (including PPP loans), as well as strong core deposit growth of $1.02 billion, or 19.9% in 2021.
•Our capital position and consistent profitability allowed us to increase our regular cash dividends paid from $0.92 per share in 2020 to $0.96 per share in 2021. In addition, we repurchased 696,894 shares of common stock under our share repurchase program for $18.7 million, or an average of $26.79 per share.
RISE2020
Commencing in the second quarter of 2019, the Company launched RISE2020, a multifaceted initiative intended to enhance customer experience, drive stronger long-term growth and profitability, improve shareholder returns and lower our efficiency ratio. RISE2020 included initiatives in the following key areas of opportunity: Digital Banking, Revenue Enhancements, Branch Transformation and Operational Excellence. RISE2020 was intended to provide Central Pacific Bank with premier products and services in several strategic areas.
During 2019, the outsourcing of the Company's residential mortgage loan servicing, the launch of its new website under the cpb.bank domain name and the implementation of its end-to-end commercial loan origination system was completed. During the first quarter of 2020, the Company opened its concept branch, providing its customers a glimpse into the future of Central Pacific Bank. After significant development, the Company's new online and mobile banking platforms for its retail customers launched in August 2020. The rollout of newly upgraded ATMs was completed in the fourth quarter of 2020. Despite several
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challenges resulting from the impact of the COVID-19 pandemic, the Company completed its RISE2020 initiative culminating with the grand opening of the fully renovated Central Pacific Plaza headquarters building and flagship main branch, and the launch of a new brand design in early January 2021. Following the completion, we continue to monitor and further enhance our facilities, platforms and processes that were part of the RISE2020 initiative.
Banking-as-a-Service ("BaaS") Initiative
In January 2022, the Company announced the launch of a new BaaS initiative with the goal of expanding the Company both in and beyond Hawaii by investing in or collaborating with leading fintech companies. The BaaS initiative is being developed based on the successful product development and launch strategies used in the Company's new Shaka digital product. Shaka, Hawaii’s first all-digital checking account, was launched with a VIP waitlist campaign and a large social media influencer campaign. As of February 18, 2022, over 3,500 Shaka accounts have been opened since the product launch on November 8, 2021.
Beginning in the first quarter of 2022, the Company will continue its BaaS initiatives with an equity investment in Swell Financial, Inc. ("Swell"), a new fintech company. Swell plans to launch a consumer banking app that combines checking, credit and more into one integrated account, and Central Pacific Bank will serve as the bank sponsor. There will also be a collaboration between the Company, Swell and Elevate Credit, Inc. (NYSE:ELVT), a leading provider of digital lending solutions. Swell is scheduled to launch its first product in mid-2022, which is all-digital and available for consumers across most of the U.S. Mainland.
Basis of Presentation
Management's discussion and analysis of financial condition and results of operations should be read in conjunction with the accompanying consolidated financial statements under "Part II, Item 8. Financial Statements and Supplementary Data."
COVID-19 Pandemic
The ongoing novel coronavirus disease ("COVID-19") pandemic caused significant disruption in the local, national and global economies and financial markets in 2020. While the economy now appears to be on a track for recovery and most COVID-19 related restrictions have been lifted, continuation and worsening of COVID-19 could cause reductions in business activity and financial transactions, labor shortages, supply chain interruptions and overall economic and financial market instability.
In response to the anticipated economic effects of COVID-19, the Board of Governors of the Federal Reserve System (the "FRB") has taken a number of actions that have significantly affected the financial markets in the United States, including actions intended to result in substantial decreases in market interest rates. While interest rates have remained low, inflation has significantly increased. We expect future increases in interest rates to moderate inflation which in effect may adversely impact the Company's loan origination and sales and pressure funding costs. Changes in market interest rates, which we do not control or have little to no influence over, affect our net interest income, margins and profitability. Therefore, we control the composition of our financial assets and liabilities with asset repricing options and maintain models that monitor those positions and sensitivity of our interest rate risk to best mitigate the adverse effects of the changing interest rate environment.
Our operations, like those of other financial institutions that operate in our market, are significantly influenced by economic conditions in Hawaii, including the strength of the real estate market and the tourism industry. Hawaii's economy which was significantly impacted by COVID-19, appears to be on track for recovery. Most of the government imposed restrictions have been loosened, and the tourism industry has started to rebound. While like the rest of the nation, the state of Hawaii experienced a rise in COVID-19 cases related to the Delta and Omicron variants, the recent cases have been less severe. Large scale shutdowns like those that occurred in 2020 are unlikely as the majority of the population is now vaccinated and it is anticipated that we will shift from a pandemic to an endemic as society learns to live with the virus. As of February 2, 2022 the Centers for Disease Control and Prevention reported there were 224,257 cumulative cases (7-day moving average of 1,463 new infections and 10.3% positivity rate) and 1,204 COVID-19-related deaths in Hawaii. As of February 2, 2022, 75.0% of Hawaii's population has been fully vaccinated.
The state of Hawaii has successfully run its ‘Safe Travels’ program since July 2021, which allows travelers who were fully vaccinated in the United States or its territories to enter Hawaii on domestic flights without pretravel testing/quarantine starting the 15th day after the completion of their vaccination. Visitor arrivals greatly increased in the summer of 2021 with the daily average exceeding 30,000 per day in July 2021, or approximately 90% of pre-pandemic levels. However, in August 2021, similar to many other states, Hawaii experienced a spike in COVID-19 cases due to the Delta variant. To mitigate further spread and due to concerns over hospital capacity, Governor Ige asked that only essential travel to Hawaii occur which resulted in a decline to approximately 20,000 per day in September 2021. Governor Ige welcomed back vaccinated visitors in November
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2021. Travel picked up during the holidays in December 2021 and visitors averaged approximately 27,000 per day. In January 2022, visitors were approximately 23,000 per day. In response to the Omicron variant, certain foreign travel restrictions have been imposed which will delay the return of international visitors, and the full impacts in Hawaii remain uncertain.
Hawaii's unemployment rate decreased to 5.7% during the month of December 2021 and is significantly down from its peak of 21.9% in April and May of 2020.
Financial position and results of operations
Through guidance from regulatory agencies, the Company prudently worked with its borrowers impacted by COVID-19 to defer payments, interest, and fees. Loans on active payment forbearance or deferrals granted to borrowers impacted by the COVID-19 pandemic peaked at $605 million in May 2020. Since then nearly all borrowers who received payment forbearance or deferral have resumed payments. As of December 31, 2021, $0.4 million, or 0.01% of the total loan portfolio, remained on payment deferral.
During the third quarter of 2020, the Company recorded a reserve on the accrued interest receivable for loans on active forbearance or deferral totaling $0.2 million. Due to the significant decline in loans on active forbearance or deferral, the Company reversed the $0.2 million reserve during the second quarter of 2021 and no longer has a reserve on accrued interest receivable as of December 31, 2021.
To support our customers during the onset of the pandemic, the Company temporarily waived non-CPB ATM fees and early withdrawal fees on our time deposits and granted temporary increases on debit card and mobile deposit transaction limits throughout the second quarter of 2020. Beginning July 1, 2020, we reinstated these fees that were waived throughout the previous quarter, but the temporary increases on debit card and mobile deposit transaction limits remain in place.
Liquidity and capital
Through our past experience during the Great Recession in the late 2000s, we believe we have developed robust liquidity and capital stress tests and comprehensive liquidity and capital contingency plans. We further believe our liquidity and capital positions are strong. The Company maintains access to multiple sources of liquidity and wholesale funding markets have remained open. During 2020 and 2021, we experienced a significant inflow of deposits due to government stimulus and general market uncertainty; however, this may not continue.
To further strengthen its capital position, the Company issued $55.0 million in subordinated debt in October 2020 which is classified as tier 2 capital for regulatory purposes, and down-streamed $46.8 million of the net proceeds from our offering to the bank, which qualifies as tier 1 capital for regulatory purchases for the bank.
In March 2020, we decided to suspend our share repurchase program in light of the pandemic. In January 2021, our Board of Directors approved a new authorization to repurchase up to $25 million in common stock. In 2021, the Company repurchased 696,894 shares of common stock under our share repurchase program for $18.7 million, or an average of $26.79 per share.
During the second and third quarters of 2021, the Company repurchased 391,300 shares of common stock for $10.2 million and recorded $6.5 million against common stock and $3.7 million against retained earnings. During the fourth quarter of 2021, the Company elected to apply the total cost of all shares repurchased in 2021 and going forward as a reduction to common stock. This resulted in a $3.7 million reclassification adjustment to increase retained earnings and a corresponding $3.7 million decrease in common stock during the fourth quarter of 2021 related to the repurchases completed in the second and third quarters of 2021. This reclassification adjustment did not impact net income, our consolidated statements of income, comprehensive income and cash flows, or any of the Company's financial ratios.
Asset valuation
COVID-19 has not affected the Company’s ability to account timely for the assets on its balance sheet. The Company has also not made significant changes in the methodology used to determine the fair value of assets measured in accordance with GAAP, except for updating certain valuation assumptions to account for pandemic-related circumstances such as widening credit spreads.
The Company has a significant real estate loan portfolio. Thus far, Hawaii real estate market continues to be extremely strong and real estate collateral values have remained relatively stable, but we cannot be assured this will continue.
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Processes, controls and business continuity plan
The Company's Business Continuity Plan includes a Pandemic Preparedness Plan which it successfully activated in early March 2020. The Company’s remote workforce plan has been rolled out with an overall smooth transition. The Company already had Virtual Private Network ("VPN") technology capability, and during the first quarter of 2020, expanded VPN access to over 70% of its employees. In addition to VPN, the Company believes it is well-setup with the latest technologies that enable our operations to continue efficiently. The Company is using collaboration tools and several other cloud-based software programs. For its customers, during the third quarter of 2020 the Company launched its premier digital banking platform which is one of the key initiatives and milestones in its RISE2020 initiative.
The Company deployed a remote workforce plan at the onset of the pandemic in 2020 and has been able to continue operations without disruption as well as maintain its systems and internal controls in light of the measures the Company has taken to prevent the spread of COVID-19. The Company is developing a gradual, phased-in return-to-office plan that includes a portion of the workforce continuing with flexible, remote work schedules. In September 2021, the Company implemented required weekly COVID testing for the small portion of its workforce that remained unvaccinated. Over 95% of the Company’s employees are fully vaccinated as of December 31, 2021.
Lending operations and accommodations to borrowers
To support its customers during the onset of the pandemic in 2020, the Company moved quickly to put in place a number of COVID-19 relief programs for its consumer and business customers affected by the pandemic. For its customers, the Company offered an employment disruption loan as well as consumer, commercial, commercial mortgage, and residential mortgage payment deferral programs. In addition, we waived non-CPB ATM fees and early withdrawal fees on our time deposits throughout the second quarter of 2020 and increased spending cap limits on debit cards and mobile deposit limits to $10,000 daily. Beginning July 1, 2020, the previously waived fees were reinstated but the increased spending cap limits will remain in place temporarily.
The bank is a SBA approved lender and actively participated in assisting customers with loan applications for the SBA’s Paycheck Protection Program, or PPP, which was part of the CARES Act. PPP loans have a two or five-year term and earn interest at 1%. The SBA pays the originating bank a processing fee ranging from 1% to 5%, based on the size of the loan, which the Company is recognizing over the life of the loan. The Company saw tremendous interest in the PPP. With the significant increase in volume of PPP loan requests, the Company redeployed staff to handle and assist with loan processing. Additionally, the Company brought on some outside resources to assist with the PPP.
The SBA began accepting submissions for the initial round of PPP loans on April 3, 2020. In April 2020, the Paycheck Protection Program and Health Care Enhancement Act added an additional round of funding for the PPP. In June 2020, the Paycheck Protection Program Flexibility Act of 2020 was enacted, which among other things, gave borrowers additional time and flexibility to use PPP loan proceeds. Through the end of the second round in August 2020, the Company funded over 7,200 PPP loans totaling $558.9 million and received gross processing fees of $21.2 million.
In December 2020, the Consolidated Appropriations Act, 2021 was passed which among other things, included a third round of funding and a new simplified forgiveness procedure for PPP loans of $150,000 or less. During 2021, the Company funded over 4,600 loans totaling $320.9 million in the third round, which ended on May 31, 2021, and received additional gross processing fees of $18.4 million.
The Company has developed a PPP forgiveness portal and, with assistance from a third party vendor, has assisted its customers with applying for forgiveness from the SBA. We have received forgiveness payments and repayments from borrowers totaling $784.9 million as of December 31, 2021. A total outstanding balance of $94.9 million and net deferred fees of $3.5 million remain as of December 31, 2021. Although the Company believes that the majority of the remaining loans will ultimately be forgiven by the SBA in accordance with the terms of the program, there could be risks and liabilities by the Company that cannot be determined at this time.
The Company had previously become aware of two PPP loans that it originated for $10.0 million and $3.0 million, in which they were under investigation for borrower fraud and/or misrepresentations. The $10.0 million PPP loan was fully repaid for all principal and interest outstanding by the SBA in the third quarter of 2021 under their 100% guarantee. The $3.0 million loan was partially forgiven by the SBA, and the remaining principal balance on the loan totaled $0.3 million at December 31, 2021.
The Company provided initial three-month principal and interest payment forbearance for our residential mortgage customers, and three-month principal and interest payment deferrals for our consumer customers. Both residential mortgage and consumer customers were granted extensions to their forbearance or deferral, if needed. The Company was deferring either the full loan
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payment or the principal component of the loan payment for generally three to six months for its commercial real estate and commercial and industrial loan customers on a case-by-case basis depending on need. Nearly all of loans that were granted forbearance or deferral have returned to payment. As of December 31, 2021, the Company had loan payment forbearance or deferrals on outstanding balances of $0.4 million, or 0.01% of total loans.
In accordance with the revised interagency guidance issued in April 2020 and Section 4013 of the CARES Act, banks are provided an option to elect to not account for certain loan modifications related to COVID-19 as TDRs as long as the borrowers were not more than 30 days past due as of February 29, 2020 (time of modification program implementation) and December 31, 2019, respectively. As of December 31, 2021, there were no loans with modifications that did not meet the criteria under Section 4013 of CARES Act or the "Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus (Revised)".
During the third quarter of 2020, the Company recorded a reserve on the accrued interest receivable of loans on active forbearance or deferral totaling $0.2 million, with the offset recorded to provision for credit losses. This reserve balance was reversed during the second quarter of 2021 due to the significant decline in loans on active forbearance or deferral. The Company no longer has a reserve on accrued interest receivable as of December 31, 2021.
Credit
In March 2020, the Company reviewed its entire commercial loan portfolio and actively reached out to its customers to determine the initial impact, if any, of COVID-19 on their businesses. The review continued throughout the remainder of 2020. The Company proactively worked with many of its customers in providing loan payment deferrals as well as assisted in the application and approval of PPP loans.
The volume of loan payment deferrals granted peaked in May 2020 at approximately $605 million in total loan balances, and has since declined to $0.4 million, or 0.01% of total loans, at December 31, 2021. Most borrowers have resumed payments with the total count on active deferral dropping from a peak of 467 at May 31, 2020 to 36 at December 31, 2021. The Company is providing alternative payment plans on a limited basis following the end of the payment deferral period. Our consumer loan payment deferrals totaled $0.4 million at December 31, 2021, compared to $2.3 million at December 31, 2020. There were no residential mortgage loans on active payment forbearance at December 31, 2021, compared to $70.4 million at December 31, 2020. There were no commercial, commercial real estate and construction loan portfolio loans on active payment deferral at December 31, 2021, compared to $47.5 million at December 31, 2020.
Criticized loans at December 31, 2021 decreased by $116.3 million from the previous year to $76.0 million, or 1.5% of the total loan portfolio excluding PPP loans. Special mention loans decreased by $110.8 million to $31.7 million, or 0.6% of the total loan portfolio excluding PPP loans. Classified loans decreased by $5.5 million to $44.3 million, or 0.9% of the total loan portfolio excluding PPP loans.
The Company believes that the residential, home equity and commercial real estate and construction loan portfolios are lower risk. These loans comprise of $3.86 billion or 77.0% of our total loan portfolio, net of PPP loans. Overall, the Company's loan portfolio remains well diversified.
Business Environment
The majority of our operations are concentrated in the state of Hawaii. As a result, our performance is significantly influenced by strength of the real estate markets, the tourism industry and economic environment in Hawaii. Macroeconomic conditions also influence our performance. A favorable business environment is generally characterized by expanding gross state product, low unemployment and rising personal income; while an unfavorable business environment is characterized by the reverse.
Following the solid performances of our leading economic indicators in 2019, Hawaii's economy was greatly impacted by the COVID-19 pandemic in 2020. Hawaii's visitor industry continued to be impacted by the COVID-19 pandemic in 2021, however the state is making progress towards economic recovery as travel restrictions have started to loosen. Starting July 2021, passengers arriving from out-of-state could bypass the State’s mandatory 10-day self-quarantine if they were fully vaccinated in the United States or with a valid negative COVID-19 NAAT test result from a Trusted Testing Partner prior to their departure through the Safe Travels program.
According to preliminary year-end statistics from the Hawaii Tourism Authority ("HTA"), approximately 6.8 million total visitors arrived in the state in the year ended December 31, 2021. This was an increase approximately 150.3% from the 2.7 million visitor arrivals in the year ended December 31, 2020, but a decline of approximately 34.7% from the pre-pandemic and record year in 2019. The HTA also reported that total spending by visitors was $13.0 billion in the year ended December 31,
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2021 (total spending statistics for 2020 were not available), which declined by approximately 26.6% from the pre-pandemic and record year in 2019. According to a recent report by The Economic Research Organization at the University of Hawaii ("UHERO"), total visitor arrivals is expected to increase to approximately 8.3 million in 2022 and visitor spending is expected to increase to approximately $16.5 billion in 2022.
The Department of Labor and Industrial Relations reported that Hawaii's seasonally adjusted annual unemployment rate 5.7% in the month of December 2021, The unemployment rate of 5.7% in December 2021 continues to decline from the high of 21.9% in the months of April and May 2020, but remains above the national seasonally adjusted unemployment rate of 3.9%. UHERO projects Hawaii's seasonally adjusted annual unemployment rate to be around 5.4% in 2022.
Hawaii's economy is measured by the growth of real personal income and real gross state product. The State of Hawaii's Department of Business, Economic Development and Tourism ("DBEDT") is expected to report real personal income grew by approximately 0.1% and real gross state product grew by approximately 3.9% for 2021. DBEDT projects real personal income to decline by 3.2% and real gross state product to increase by 3.0% for 2022.
Real estate lending is a primary focus for us, including residential mortgage and commercial mortgage loans. As a result, we are dependent on the strength of Hawaii's real estate market. 2021 was a record year for the Oahu real estate market. According to the Honolulu Board of Realtors, the median resale price for a single-family on Oahu exceeded $1 million during the months of August to December 2021. For the year ended December 31, 2021, the median price for a single-family home on Oahu was $990,000, representing an increase of 19.3% from the median resale price of $830,000 for the year ended December 31, 2020. The median resale price for condominiums on Oahu was $475,000 for the year ended December 31, 2021, representing an increase of 9.2% from the median resale price of $435,000 for the year ended December 31, 2020. Oahu unit sales volume increased by 17.9% for single-family homes, and increased by 53.1% for condominiums in 2021 from 2020.
As we have seen in the past, our operating results are significantly impacted by the economy in Hawaii and the composition of our loan portfolio. Loan demand, deposit growth, provision for credit losses, asset quality, noninterest income and noninterest expense are all affected by changes in economic conditions. If the residential and commercial real estate markets we have exposure to deteriorate our results of operations would be negatively impacted. See the "Overview of Results of Operations—Concentrations of Credit Risk" section for a further discussion on how a deteriorating real estate market, combined with the elevated concentration risk within our portfolio, could have a significant negative impact on our asset quality and credit losses.
In an attempt to help the overall economy, the FRB has kept interest rates low through its targeted Fed Funds rate. On March 3, 2020, the Federal Reserve reduced the Federal Funds range by 50 basis points to 1.00% to 1.25%. On March 15, 2020, the Federal Reserve further reduced the Federal Funds range by 100 basis points to 0% to 0.25% and announced a $700 billion quantitative easing program in response to the expected economic downturn caused by COVID-19. During the remainder of 2020 and all of 2021, the Federal Reserve elected to hold the Federal Funds rate at 0% to 0.25%. Officials expect rates to increase beginning in 2022 due to increased inflation risks.
Changes in monetary policy, including changes in interest rates, could influence, among other things, (i) the amount of interest we receive on loans and securities, (ii) the amount of interest we pay on deposits and borrowings, (iii) our ability to originate loans and obtain deposits, and (iv) the fair value of our assets and liabilities.
Critical Accounting Policies and Use of Estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP") requires that management make a number of judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, income and expense in the financial statements and the related disclosures made. Various elements of our accounting policies, by their nature, involve the application of highly sensitive and judgmental estimates and assumptions. Some of these policies and estimates relate to matters that are highly complex and contain substantial inherent uncertainties. Actual amounts and values as of the balance sheet dates may be materially different than the amounts and values reported due to the inherent uncertainty in the estimation process. Also, future amounts and values could differ materially from those estimates due to changes in values and circumstances after the balance sheet date.
Accounting estimates are deemed critical when a different estimate could have reasonably been used or where changes in the estimate are reasonably likely to occur from period to period and would materially impact our consolidated financial statements as of or for the periods presented. Management has discussed the development and selection of the critical accounting policy and estimates noted below with the Audit Committee of the Board of Directors, and the Audit Committee has reviewed the accompanying disclosures.
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The Company identified a significant accounting policy which involves a higher degree of judgment and complexity in making certain estimates and assumptions that affect amounts reported in our consolidated financial statements. At December 31, 2021, the significant accounting policy which we believed to be the most critical in preparing our consolidated financial statements is the determination of the allowance for credit losses. This is further described in Note 1 - Summary of Significant Accounting Policies in the accompanying notes to the consolidated financial statements in this report.
On January 1, 2020, the Company adopted Accounting Standards Update ("ASU") 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments,” which created material changes to the Company’s existing critical accounting policy that existed at December 31, 2019. Effective January 1, 2020 through December 31, 2021, the significant accounting policy which we believe to be the most critical in preparing our consolidated financial statements is the determination of the allowance for credit losses on loans.
Allowance for Credit Losses on Loans
Management considers the policies related to the allowance for credit losses ("ACL") on loans as the most critical to the financial statement presentation. The total ACL on loans includes activity related to allowances calculated in accordance with Accounting Standards Codification (“ASC”) 326, "Financial Instruments – Credit Losses". The ACL is established through provisioning of current expected credit losses as a charge to current earnings. Loan losses are charged off against the allowance when management believes the uncollectibility of a loan balance is confirmed while allowance is credited if subsequent recoveries are made. The amount maintained in the ACL reflects management’s continuing evaluation of the estimated credit losses expected to be recognized over the life of the loans in our loan portfolio at the balance sheet date. Allowance for credit losses is measured on a collective basis when similar risk characteristics exist. We stratify the loan portfolio into homogeneous groups of loans that possess similar loss potential characteristics and calculate the net amount expected to be collected over the life of the loans to estimate the expected credit losses in the loan portfolio. The Company’s methodologies for estimating the ACL consider available relevant information about the collectability of cash flows, including information about past events, current conditions, and reasonable and supportable forecasts. Refer to Note 1 - Summary of Significant Accounting Policies in the accompanying notes to the consolidated financial statements in this report for further discussion of the risk factors considered by management in establishing the ACL.
Overview of Results of Operations
2021 vs. 2020 Comparison
In 2021, we recognized net income of $79.9 million, or fully diluted earnings per common share ("EPS") of $2.83, compared to net income of $37.3 million, or EPS of $1.32, in 2020. Our ROA and ROE for 2021 was 1.13% and 14.38%, respectively, compared to 0.58% and 6.85%, respectively, in 2020.
We recorded a credit to the provision for credit losses of $14.6 million in 2021, compared to a debit to the provision of $42.1 million in 2020. The credit to the provision for credit losses was driven by the improved economic forecast assumptions used in our credit reserve modeling, improvements in the loan portfolio and lower net charge-offs in 2021.
Net interest income increased by $13.4 million from 2020 to 2021, primarily driven by higher net interest income and fees on PPP loans, combined with lower deposit and borrowing costs due to the historically low interest rate environment, partially offset by lower yields earned on the loans and investment securities portfolios.
Other operating income decreased by $2.1 million from 2020 to 2021. The decrease in other operating income was primarily due to lower mortgage banking income, partially offset by higher ATM fees included in other service charges and fees. See Table 3 - Components of Other Operating Income for more information.
Other operating expense increased by $11.3 million from 2020 to 2021. The increase was primarily due to higher salaries and employee benefits, higher legal and professional services, higher advertising expense, and higher directors' deferred compensation plan expense. The higher salaries and employee benefits in 2021 is primarily attributable to strategic hirings for the Company's RISE2020 and BaaS initiatives, higher incentive compensation due to stronger Company performance,and non-recurring severance costs. See Table 4 - Components of Other Operating Expense for more information.
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2020 vs. 2019 Comparison
In 2020, we recognized net income of $37.3 million, or EPS of $1.32, compared to net income of $58.3 million, or EPS of $2.03, in 2019. Our ROA and ROE for 2020 was 0.58% and 6.85%, respectively, compared to 0.99% and 11.36%, respectively, in 2019.
We recorded a provision for credit losses of $42.1 million in 2020, compared to a credit of $6.3 million in 2019. The higher provision for credit losses was driven by the economic forecast which captured the effect of the COVID-19 pandemic and led to the decline in net income, EPS, ROA and ROE in 2020 compared to 2019.
Net interest income increased by $13.6 million from 2019 to 2020, primarily driven by lower deposit and borrowing costs due to the historically low interest rate environment due to the pandemic environment, combined with net interest income and fees on PPP loans, partially offset by lower yields earned on the loans and investment securities portfolios.
Other operating income increased by $3.4 million from 2019 to 2020. The increase in other operating income was primarily due to higher mortgage banking income, partially offset by lower service charges on deposit accounts. In addition, the Company recorded a gain of $2.6 million during the first quarter of 2019 from the conversion of MasterCard Class B common stock received during their initial public offering to Class A common stock and immediate sale of the converted shares. See Table 3 - Components of Other Operating Income for more information.
Other operating expense increased by $10.1 million from 2019 to 2020. The increase in other operating expense was primarily due to higher salaries and employee benefits, higher computer software expenses, higher legal and professional expenses, branch consolidation costs, and higher advertising expense, partially offset by lower director deferred compensation plan expense and lower entertainment and promotions expense. See Table 4 - Components of Other Operating Expense for more information.
Net Interest Income
The following table sets forth information concerning average interest-earning assets and interest-bearing liabilities and the yields and rates thereon. Net interest income, when expressed as a percentage of average interest-earning assets, is referred to as "net interest margin." Interest income, which includes loan fees and resultant yield information, is expressed on a taxable-equivalent basis using a federal statutory tax rate of 21%. Table 2 presents an analysis of changes in components of net interest income between years. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to: (i) changes in volume and (ii) changes in rates. The change in volume is calculated as change in average balance, multiplied by prior period average yield/rate. The change in rate is calculated as change in average yield/rate, multiplied by current period volume. The change in interest income not solely due to change in volume or change in rate has been allocated proportionately to change in volume and change in average yield/rate.
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Table 1. Average Balances, Interest Income and Expense, Yields, and Rates (Taxable-Equivalent)
Assets
Interest-earning assets:
Investment securities, excluding valuation allowance:
Liabilities and Equity
Interest-bearing liabilities:
Non-controlling interest 25 2 —
(1) At amortized cost.
(2) Includes nonaccrual loans.
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Table 2. Analysis of Changes in Net Interest Income (Taxable-Equivalent)
Increase (Decrease)Due to Change In: Increase (Decrease)Due to Change In:
(Dollars in thousands) Volume Rate NetChange Volume Rate NetChange
Interest-earning assets
Investment securities, excluding valuation allowance:
Interest-bearing liabilities
The banking and financial services industry in the state of Hawaii generally, and particularly in our target market areas, is highly competitive. Net interest income is our primary source of earnings and is derived primarily from the difference between the interest we earn on loans and investments versus the interest we pay on deposits and borrowings. Net interest income (expressed on a taxable-equivalent basis) totaled $211.6 million in 2021, which increased by $13.3 million, or 6.7%, from $198.3 million in 2020, which increased by $13.4 million, or 7.3%, from net interest income of $184.9 million recognized in 2019. The increase in net interest income for 2021 was primarily the result of higher net interest income and fees on PPP loans, combined with lower deposit and borrowing costs due to the historically low interest rate environment during the pandemic environment, partially offset by lower yields earned on the loans and investment securities portfolios. In 2021, the Company recognized net interest income and fees on PPP loans of $26.4 million, compared to $12.2 million in 2020.
Average yields earned on our interest-earning assets declined by 24 bp in the year ended December 31, 2021, from the year ended December 31, 2020. The decline in average yields earned on interest-earning assets in 2021 was primarily attributable to the 51 bp decrease in average yields earned on investment securities and the 1 bp decrease in average yields earned on loans. Excluding net interest income and fee on PPP loans, the normalized average yield on loans in 2021 was 3.58%, compared to the normalized average yield on loans in 2020 of 3.87%
Average rates paid on our interest-bearing liabilities in the year ended December 31, 2021 declined by 18 bp from the year ended December 31, 2020. The decline in average rates paid on our interest-bearing liabilities in 2021 was primarily attributable to the 58 bp decrease in average rates paid on our time deposits over $250,000, the 41 bp decrease in average rates paid on our time deposits up to $250,000, the 7 bp decrease in average rates paid on our savings and money market deposits and the 50 bp decrease in average rates paid on our FHLB advances and other short-term borrowings..
In the third quarter of 2021, $104.4 million in available-for-sale securities were sold as part of an investment portfolio rebalancing strategy due to faster than expected prepayments. We received $104.5 million in gross proceeds and reinvested the
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proceeds in $98.8 million in higher yield investment securities with an average yield of 1.55% and a weighted average life of 6.1 years. The investment securities sold had an average yield of 1.13% and a weighted average life of 2.6 years. Gross realized gains and losses on the sale of the investment securities were $1.1 million and $1.0 million, respectively. The specific identification method was used as the basis for determining the cost of all securities sold.
In the second quarter of 2021, $175.0 million in available-for-sale were sold as part of an investment portfolio rebalancing strategy due to faster than expected prepayments. We received $175.0 million in gross proceeds and reinvested the proceeds in $186.1 million in higher yield investment securities with an average yield of 1.70% and a weighted average life of 6.9 years. The investment securities sold had an average yield of -0.11% and a weighted average life of 1.6 years. Gross realized losses and gains on the sale of the investment securities were $2.2 million and $2.2 million, respectively. The specific identification method was used as the basis for determining the cost of all securities sold.
In the fourth quarter of 2020, $89.9 million in available-for-sale securities were sold as part of an investment portfolio rebalancing strategy due to the large downward shift in interest rates and the change in expected prepayments. We received $90.1 million in gross proceeds and reinvested the proceeds in $105.1 million in higher yield, longer duration investment securities with an average yield of 1.27% and a weighted-average life of 4.6 years. The investment securities sold had an average yield of 0.28% and a weighted-average life of 1.2 years. Gross realized losses and gains on the sale of the investment securities were $0.3 million and $0.5 million, respectively. The specific identification method was used as the basis for determining the cost of all securities sold.
In the third quarter of 2020, $90.4 million in available-for-sale non-agency commercial mortgage-backed securities with retail mall exposure were sold to mitigate credit risk during the pandemic. The investment securities sold had an average yield of 3.44% and a weighted-average life of 14.03 years. Gross realized gains and losses on the sale of the investment securities were $0.2 million and $0.6 million, respectively. The specific identification method was used as the basis for determining the cost of all securities sold.
Interest Income
Our primary sources of interest income include interest on loans, which represented 88.4%, 87.4%, and 84.1% of taxable-equivalent interest income in 2021, 2020 and 2019, respectively, as well as interest earned on investment securities, which represented 11.4%, 12.4% and 15.4% of taxable-equivalent interest income, respectively. Interest income expressed on a taxable-equivalent basis of $219.3 million in 2021 increased by $6.2 million, or 2.9%, from the $213.1 million earned in 2020, which decreased by $4.1 million, or 1.9%, from the $217.2 million earned in 2019.
The increase in interest income in 2021 from 2020 was primarily due to higher net interest income and fees on PPP loans of $14.2 million due to higher forgiveness and payoffs, combined with the $238.4 million increase in average investment securities which contributed to an increase of $5.4 million in current year interest income. These increases were partially offset by a decline in average yields earned on the investment securities portfolio of 51 bp, which contributed to decline in current year interest income of $6.8 million. In addition, the normalized average yield on core loans (or total loans excluding PPP loans) declined by 29 bp.
The decrease in interest income in 2020 from 2019 was primarily due to the decline in average yields earned on the loans and investment securities portfolios of 48 bp and 34 bp, respectively, which contributed to decreases in 2020 interest income of $23.2 million and $3.8 million, respectively, from 2019. The $117.7 million decline in average investment securities also contributed to a decrease of $3.2 million in 2020 interest income from 2019. These decreases were partially offset by a $613.9 million increase in average loans, which contributed to an increase of $26.6 million in 2020 interest income from 2019. The increase in average loans was largely attributable to a $358.3 million average PPP loan portfolio, which contributed to an increase of $12.2 million in 2020 net interest income and an average yield of 3.41%.
Interest Expense
In 2021, interest expense was $7.7 million which represented a decrease of $7.0 million, or 47.6%, compared to interest expense of $14.7 million in 2020, which was a decrease of $17.6 million, or 54.4%, compared to $32.3 million in 2019.
In 2021, the decreases in the average rates paid on savings and money market deposits of 7 bp, time deposits up to $250,000 of 41 bp, and time deposits of over $250,000 of 58 bp, contributed to the decrease in interest expense in 2021 from 2020of $1.5 million, $0.9 million, and $3.2 million, respectively. In addition, the decrease in average time deposits over $250,000 and the decrease in average FHLB advances and other short-term borrowings contributed to the decrease in current year interest expense of $1.2 million and $0.7 million, respectively.
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In 2020, the decreases in the average rates paid on savings and money market deposits of 20 bp, time deposits of over $250,000 of 117 bp, FHLB advances and other short-term borrowings of 151 bp, and long-term debt of 94 bp, contributed to the decrease in interest expense in 2021 from 2020of $3.6 million, $8.2 million, $1.4 million, and $1.1 million, respectively. In addition, the decreases in average time deposits of $250,000 and over and FHLB advances and other short-term borrowings contributed to the decrease in 2020 interest expense of $1.2 million and $0.7 million, respectively.
Net Interest Margin
Our net interest margin was 3.18%, 3.30% and 3.35% in 2021, 2020 and 2019, respectively. The decrease in our net interest margin in 2021 from 2020 was primarily due to lower yields on our interest-earning assets due to the historically low interest rate environment we are currently operating in due to the pandemic environment. Average yields earned on interest-earning assets declined by 24 bp, led by declines in average yields earned on investment securities of 51 bp. Excluding net interest income and fees on PPP loans, our normalized average yield on loans declined by 29 bp. These decreases were partially offset by a 18 bp decrease in average rates paid on interest-bearing liabilities.
The decrease in our net interest margin in 2020 from 2019 was primarily due to lower yields on our interest-earning assets. Average yields earned on interest-earning assets declined by 40 bp, led by declines in average yields earned on loans and investment securities of 48 bp and 34 bp, respectively. These decreases were partially offset by a 47 bp decrease in average rates paid on interest-bearing liabilities.
During 2021, the Federal Reserve maintained its Federal Funds range at 0% to 0.25%. Federal Reserve officials have stated they expect to raise interest rates beginning in 2022 due to inflation concerns.
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Other Operating Income
The following table sets forth components of other operating income and the total as a percentage of average assets for the periods indicated.
Table 3. Components of Other Operating Income
Dollar Change Percent Change
Mortgage banking income:
Other:
Gain on sale of MasterCard stock — — 2,555 — (2,555) N.M. (100.0) *
* Not meaningful ("N.M.")
Total other operating income of $43.1 million in 2021 decreased by $2.1 million, or 4.7%, from the $45.2 million earned in 2020, which increased by $3.4 million, or 8.1%, from the $41.8 million earned in 2019.
The decrease in other operating income in 2021 from 2020 was primarily due to lower mortgage banking income of $6.0 million and lower bank-owned life insurance of $0.3 million, partially offset by higher other service charges and fees of $3.5 million. The lower mortgage banking income was primarily attributable to fewer loans sold as more loans were placed in our residential mortgage loan portfolio in 2021 compared to 2020, combined with thinner gain on sale margins. The Company's Home Loans division had another impressive year with $1.18 billion in loan originations in 2021, down just slightly from the record $1.20 billion in loan originations in 2020. The lower amortization of mortgage servicing rights (included in mortgage banking income) was primarily attributable to the increase in market interest rates. These decreases were partially offset by higher other service charges and fees, primarily attributable to higher ATM and debit card fees. During the second quarter of 2020, certain service charges were suspended to support our customers through the pandemic. In addition, there were less transactional activity due to the pandemic resulting in lower service charges on deposit accounts and other service charges and fees during 2020.
The increase in other operating income in 2020 from 2019 was primarily due to higher mortgage banking income of $7.0 million and higher bank-owned life insurance of $0.7 million. The higher mortgage banking income was attributable to a
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Company record $1.20 billion in loan originations by the Company's Home Loan division in 2020. The higher amortization of mortgage servicing rights (included in mortgage banking income) was primarily attributable to the decline in market interest rates. The higher income from bank-owned life insurance was primarily attributable to volatility in the equity markets. These increases were partially offset by lower service charges on deposit accounts of $2.2 million and a one-time gain of $2.6 million from the conversion of MasterCard Class B common stock received during their initial public offering to Class A common stock and immediate sale of the converted shares in the first quarter of 2019.
Other Operating Expense
The following table sets forth components of other operating expense and the total as a percentage of average assets for the periods indicated.
Table 4. Components of Other Operating Expense
Dollar Change Percent Change
Other:
* Not meaningful ("N.M.")
Total other operating expense of $163.0 million in 2021 increased by $11.3 million, or 7.5%, from total operating expense of $151.7 million in 2020, which increased by $10.1 million, or 7.2%, compared to 2019.
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The increase in total other operating expense in 2021, compared to 2020, was primarily due to higher salaries and employee benefits of $6.4 million, higher net occupancy expense of $1.0 million, higher legal and professional services of $1.4 million, higher advertising expense of $1.7 million, and higher directors' deferred compensation plan expenses of $2.2 million. The increase in salaries and employee benefits is primarily due to strategic hiring for our RISE2020 and BaaS initiatives, higher incentive compensation due to improved Company performance and nonrecurring severance payments. The higher advertising expense is primarily due to the Company's new branding along with marketing expenses for our new Shaka product. Fluctuations in the directors' deferred compensation expense are primarily due to volatility in the equity markets. These increases were partially offset by several nonrecurring expenses in late 2020 which included: $1.6 million in branch consolidation costs related to the consolidation of three in-store branches and one traditional branch in 2020 compared to $0.4 million in branch consolidation costs related to the consolidation of one traditional branch in 2021, $0.8 million in settlements of legal proceedings, a $0.7 million FHLB advance prepayment fee, and $0.6 million in losses on disposal of fixed assets in 2020, compared to $0.1 million in losses in 2021.
The increase in total other operating expense in 2020, compared to 2019, was primarily due to a higher salaries and employee benefits of $3.0 million, higher computer software expense of $1.9 million, higher legal and professional services of $1.7 million, higher advertising expense of $1.1 million, and higher FDIC insurance assessment of $1.0 million. The increase in the FDIC insurance assessment is primarily due to the increase in deposits, combined with the Small Bank Assessment Credits which were used up during the second quarter of 2020. In addition, the Company recognized several nonrecurring expenses in late 2020 totaling $5.9 million which included: $2.0 million in employee incentives and other benefits, $1.6 million in branch consolidation costs related to the closure of three in-store branches and one traditional branch in 2020, $0.8 million in settlements of legal proceedings, a $0.7 million FHLB advance prepayment fee, $0.6 million in losses on disposal of fixed assets and $0.5 million in other nonrecurring expenses (included in other). These increases were partially offset by lower directors' deferred compensation expense of $1.5 million and lower entertainment and promotions expense of $1.3 million.
A key measure of operating efficiency tracked by management is the efficiency ratio, which is calculated by dividing total other operating expenses by total pre-provision revenue (net interest income plus other operating income). Management believes that the efficiency ratio provides useful supplemental information that is important to a proper understanding of the company's core business results by investors. Our efficiency ratio should not be viewed as a substitute for results determined in accordance with GAAP, nor is it necessarily comparable to the efficiency ratio presented by other companies. Our efficiency ratio increased to 64.16% in 2021, compared to 62.47% in 2020 and 62.69% in 2019. The increase in our efficiency ratio in 2021 was primarily driven by the aforementioned increases in other operating expenses, partially offset by increases in net interest income.
In 2021, the provision for off-balance sheet credit exposures was reclassified from other operating expense and is now included in the provision for credit losses in the consolidated statements of income. The efficiency ratio in prior periods has been adjusted retrospectively to reflect this change.
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The following table sets forth a reconciliation to our efficiency ratio for each of the dates indicated and the impact of the reclassification of the provision for credit losses in the consolidated statements of income:
Table 5. Reconciliation of Efficiency Ratio
As Reclassified:
Unadjusted:
Impact of Change:
Total operating expenses $ — $ (2,994) $ (29)
Net interest income — — —
Total other operating income — — —
Total revenue $ — $ — $ —
Efficiency ratio — % (1.24) % (0.01) %
Income Taxes
In 2021, the Company recorded income tax expense of $25.8 million, compared to $11.8 million in 2020, and $19.6 million in 2019. Our effective tax rate was 24.4% in 2021 compared to 24.0% in 2020 and 25.2% in 2019.
The increase in income tax expense and the effective tax rate in 2021 from 2020 was primarily attributable to higher pre-tax income, combined with lower tax-exempt income, decreasing the impact of net favorable permanent differences, primarily due to a credit to the provision for credit losses.
The decrease in income tax expense and the effective tax rate in 2020 from 2019 was primarily attributable to lower pre-tax income, increasing the impact of net favorable permanent differences, primarily due to a higher provision for credit losses.
As of December 31, 2021, the valuation allowance on our net deferred tax assets ("DTA") totaled $3.4 million, of which $3.2 million related to our DTA from net apportioned net operating loss ("NOL") carryforwards for California state income tax purposes as we do not expect to generate sufficient income in California to utilize the DTA. The remaining $0.2 million relates to a valuation allowance on the Hawaii capital loss carryforward balance that we do not expect to be able to utilize. Net of this valuation allowance, the Company's net DTA totaled $25.8 million as of December 31, 2021, compared to a net DTA of $26.4 million as of December 31, 2020, and is included in other assets on our consolidated balance sheets.
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Financial Condition
Total assets of $7.42 billion at December 31, 2021 increased by $824.5 million, or 12.5%, from the $6.59 billion at December 31, 2020, and total liabilities of $6.86 billion at December 31, 2021 increased by $813.0 million, or 13.4%, from the $6.05 billion at December 31, 2020. The increase in total assets and total liabilities in 2021 was primarily due to our strong loan and deposit growth.
Loan Portfolio
Our lending activities are focused on commercial, financial and agricultural loans, commercial mortgages, and construction loans to small and medium-sized companies, business professionals, and real estate investors and developers, as well as residential mortgages, home equity and consumer loans to local home-buyers and individuals. Our strategy for generating commercial loans has traditionally relied upon teams of commercial real estate and commercial banking officers organized by geographical and industry lines who are responsible for client prospecting and business development.
To manage credit risk (i.e., the ability of borrowers to repay their loan obligations), management analyzes the borrower's financial condition, repayment source, collateral and other factors that could impact credit quality, such as national and local economic conditions and industry conditions related to respective borrowers. The general underwriting guidelines require analysis and documentation to include among other things, overall credit worthiness of borrower, guarantor support, use of funds, loan term, minimum equity, loan-to-value standards, repayment terms, sources of repayment, covenants, pricing, collateral, insurance, and documentation standards. All loan requests considered by us should be for a clearly defined legitimate purpose with a determinable primary source, as well as alternate sources of repayment. All loans should be supported by appropriate documentation including, current financial statements, credit reports, collateral information, asset verification, tax returns, title reports, and appraisals (where appropriate).
We score consumer and small business loans using underwriting matrices ("Scorecards") developed based on the results of an analysis from a reputable national credit scoring company commissioned by our bank. The Scorecards use the attributes that were determined to most highly correlate with probability of repayment. Those attributes include, but are not limited to the following: (i) credit score, (ii) credit limit amount, and (iii) debt-to-income ratio.
Loans totaled $5.10 billion at December 31, 2021, which increased by $137.5 million, or 2.8%, from the $4.96 billion at December 31, 2020, which increased by $514.6 million, or 11.6%, from the $4.45 billion held at December 31, 2019. Core loans, or total loans excluding PPP loans, increased by $462.6 million, or 10.2%, in 2021. The increase in our loan portfolio in 2021 was largely due to strong residential mortgage demand from new and existing customers. The increase in total loans included net increases in the following loan portfolios: residential mortgage of $185.8 million, or 11.0%, consumer of $144.5 million, or 30.1%, home equity of $86.0 million, or 15.6%, and commercial mortgage of $63.9 million, or 5.5%. These increases were partially offset by net decreases in the following loan portfolios: PPP of $325.0 million, other commercial, financial, and agricultural of $15.0 million, or 2.7%, and construction of $2.5 million, or 2.0%. In 2021, we did not foreclose on any loans. In addition, we recorded loan charge-offs of $6.1 million.
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The following table sets forth information regarding outstanding loans, net of deferred (fees) costs, by category as of the dates indicated.
Table 6. Loans by Categories
December 31,
Commercial, financial and agricultural:
Real estate:
The following table sets forth the geographic distribution of our loan portfolio, net of deferred (fees) costs, and related ACL as of the dates indicated.
Table 7. Geographic Distribution
(Dollars in thousands) Hawaii U.S. Mainland Total Hawaii U.S. Mainland Total
Commercial, financial and agricultural:
Real estate:
Commercial, Financial and Agricultural - Small Business Administration Payroll Protection Program
The bank is a SBA approved lender and actively participated in assisting customers with loan applications for the SBA’s Paycheck Protection Program, or PPP, which was part of the CARES Act. PPP loans have a two or five-year term and earn interest at 1%. The SBA pays the originating bank a processing fee ranging from 1% to 5%, based on the size of the loan, which the Company is recognizing over the life of the loan. The Company saw tremendous interest in the PPP. The SBA began accepting submissions for the initial round of PPP loans on April 3, 2020. In April 2020, the Paycheck Protection Program and Health Care Enhancement Act added an additional round of funding for the PPP. In June 2020, the Paycheck Protection Program Flexibility Act of 2020 was enacted, which among other things, gave borrowers additional time and flexibility to use PPP loan proceeds. Through the end of the second round in August 2020, the Company funded over 7,200 PPP loans totaling $558.9 million and received gross processing fees of $21.2 million. In December 2020, the Consolidated Appropriations Act, 2021 was passed which among other things, included a third round of funding and a new simplified forgiveness procedure for PPP loans of $150,000 or less. During 2021, the Company funded over 4,600 loans totaling $320.9 million in the third round,
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which ended on May 31, 2021, and received additional gross processing fees of $18.4 million. The Company developed a PPP forgiveness portal and with assistance from a third party vendor has assisted its customers with applying for forgiveness from the SBA. We have received forgiveness payments and repayments from borrowers totaling over $784.9 million as of December 31, 2021. A total outstanding balance of $94.9 million and net deferred fees of $3.5 million remain as of December 31, 2021.
Commercial, Financial and Agricultural - Other
Loans in this category consist primarily of term loans and lines of credit to small and middle-market businesses and professionals. The borrower's business is typically regarded as the principal source of repayment, although our underwriting policy and practice generally requires additional sources of collateral, including real estate and other business assets, as well as personal guarantees where possible to mitigate risk. Risk of credit losses could be greater in this loan category relative to secured loans where a greater percentage of the loan amount is usually covered by collateral. Nonetheless, any collateral or personal guarantees obtained on commercial loans can mitigate the increased risk and help to reduce credit losses.
Our historical approach to commercial lending involves teams of lending and cash management personnel who focus on relationship development including loans, deposits and other bank services to new and existing commercial clients.
In 2021, our commercial, financial, and agricultural loan portfolio, excluding PPP loans, decreased by $15.0 million. The decrease in 2021 was attributable to runoff in the U.S. Mainland and Hawaii portfolios of $10.7 million and $4.3 million, respectively.Our commercial, financial, and agricultural loan portfolio, excluding PPP loans, decreased by $25.2 million in 2020.
Real Estate—Construction
Construction loans include both residential and commercial development projects. Each construction project is evaluated for economic viability. Construction loans pose higher credit risks than typical secured loans. In addition to the financial strength of the borrower, construction loans have the added element of completion risk, which is the risk that the project will not be completed on time and within budget, resulting in additional costs that could affect the economic viability of the project and market risk at the time construction is complete.
In 2021, our construction loan portfolio decreased by $2.5 million. Our construction loan portfolio increased by $29.6 million in 2020. These fluctuations are driven by the start and completion of construction projects and are consistent with a normal construction cycle.
Interest Reserves
Our policies require interest reserves for construction loans, including loans to build commercial buildings, residential developments (both large tract projects and individual houses), and multi-family projects.
The outstanding principal balance of loans with interest reserves was $51.3 million at December 31, 2021, compared to $59.0 million in the prior year, while remaining interest reserves was $5.2 million, or 10.1% of the outstanding principal balance of loans with interest reserves at December 31, 2021, compared to $5.3 million, or 8.9% of the outstanding principal balance of loans with interest reserves at December 31, 2020.
Interest reserves allow the Company to advance funds to borrowers to make scheduled payments during the construction period. These advances typically are capitalized and added to the borrower's outstanding loan balance, although we have the right to demand payment under certain circumstances. Our policy is to determine if interest reserve amounts are appropriately included in each project's construction budget and are adequate to cover the expected duration of the construction period.
The amount, terms, and conditions of the interest reserve are established when a loan is originated, although we generally have the option to demand payment if the credit profile of the borrower changes. We evaluate the viability and appropriateness of the construction project based on the project's complexity and feasibility, the timeline, as well as the creditworthiness of the borrowers, sponsors and/or guarantors, and the value of the collateral.
In the event that unfavorable circumstances alter the original project schedule (e.g., cost overruns, project delays, etc.), our policy is to evaluate whether or not it is appropriate to maintain interest capitalization or demand payment of interest in cash and we will work with the borrower to explore various restructuring options, which may include obtaining additional equity and/or requiring additional collateral. We may also require borrowers to directly pay scheduled interest payments.
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Our process for determining that construction projects are moving as planned are detailed in our lending policies and guidelines. Prior to approving a loan, the Company and borrower generally agree on a construction budget, a proforma monthly disbursement schedule, and sales/leaseback assumptions. As each project progresses, the projections are measured against actual disbursements and sales/lease results to determine if the project is on schedule and performing as planned.
The specific monitoring requirements for each loan vary depending on the size and complexity of the project and the experience and financial strength of the borrower, sponsor and/or guarantor. At a minimum, to ensure that loan proceeds are properly disbursed and to assess whether it is appropriate to capitalize interest or demand cash payment of interest, our monitoring process generally includes:
•Physical inspection of the project to ensure work has progressed to the stage for which payment is being requested;
•Verification that the work completed is in conformance with plans and specifications and items for which disbursement is requested are within budget; and
•Determination that there continues to be satisfactory project progress.
In certain rare circumstances, we may decide to extend, renew, and/or restructure the terms of a construction loan. Reasons for the restructure can range from cost overruns to project delays and the restructuring can result in additional funds being advanced or an extension of the maturity date of the loan. Prior to the loan being restructured, our policy is to perform a detailed analysis to ensure that the economics of the project remain feasible and that the risks to the Company are within acceptable lending guidelines.
Real Estate—Mortgage
The following table sets forth information with respect to the composition of the Real Estate—Mortgage loan portfolio as of the dates indicated.
Table 8. Mortgage Loan Portfolio Composition
December 31,
(Dollars in thousands) Amount Percent Amount Percent
Residential:
Residential
Residential mortgage loans include fixed-rate and adjustable-rate loans primarily secured by single-family owner-occupied primary residences in Hawaii. Maximum loan-to-value ratios of 80% are typically required for fixed-rate and adjustable-rate loans secured by single-family owner-occupied residences, although higher levels are permitted with accompanying mortgage insurance. First mortgage loans secured by residential properties generally carry a moderate level of credit risk. With an average loan size of approximately $0.5 million, marketable collateral and a stable Hawaii residential real estate market, credit losses on residential mortgage loans have been minimal during the past several years. However, economic conditions including unemployment levels, future changes in interest rates and other market factors can impact the marketability and value of collateral and thus the level of credit risk inherent in the portfolio.
Closed-end residential mortgage loan balances as of December 31, 2021 totaled $1.88 billion, increasing by $185.8 million, or 11.0%, from the $1.69 billion held at year-end 2020, which increased by $90.4 million, or 5.7%, from the $1.60 billion held at year-end 2019. The increase in closed-end residential mortgage loan balances in 2021 was primarily due to increased demand from both new and existing customers.
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Residential mortgage loans held for sale at December 31, 2021 totaled $3.5 million, a decrease of $13.2 million, or 78.8%, from the December 31, 2020 balance of $16.7 million, which increased by $7.6 million, or 83.7%, from the December 31, 2019 balance of $9.1 million. We did not securitize any residential mortgage loans in 2021, 2020 and 2019.
Home Equity
Home equity lines of credit ("HELOCs"), which typically carry floating or fixed interest rates, are underwritten according to policy and guidelines reviewed and approved by the Board of Directors. All HELOCs originated since early 2011 have a ten-year draw period followed by a 20-year repayment period during which the principal balance will be fully amortized. HELOCs are underwritten using a qualifying payment which assumes the line is fully drawn and is amortizing as if it was in the repayment period. Underwriting criteria include a minimum FICO score, maximum debt-to-income ratio ("DTI"), and maximum combined loan-to-value ratio ("CLTV"). HELOCs are monitored based on default, delinquency, end of draw period, and maturity.