FSBW US Equity☆

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This discussion and analysis reviews our consolidated financial statements and other relevant statistical data and is intended to enhance your understanding of our financial condition and results of operations. The information in this section has been derived from the Consolidated Financial Statements and footnotes thereto that appear in Item 8. of this Form 10-K. The information contained in this section should be read in conjunction with these Consolidated Financial Statements and footnotes and the business and financial information provided in this Form 10-K.

Overview

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

The Company is relationship-driven, delivering banking and financial services to local families, local and regional businesses and industry niches within distinct Western Washington communities, predominately, the Puget Sound area, and one loan production office located in the Tri-Cities, Washington.

The Company also maintains its long-standing indirect consumer lending platform which operates primarily throughout the West Coast. The Company emphasizes long-term relationships with families and businesses within the communities served, working with them to meet their financial needs. The Company is also actively involved in community activities and events within these market areas, which further strengthens our relationships within those markets.

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

● Growing and diversifying our loan portfolio;

● Maintaining strong asset quality;

● Expanding the Company’s markets.

The Company is a diversified lender with a focus on the origination of one-to-four-family loans, commercial real estate mortgage loans, second mortgage or home equity loan products, consumer loans, including indirect home improvement (“fixture secured”) loans which also include solar-related home improvement loans, marine lending, and commercial business loans. As part of our expanding lending products, the Company experienced growth in residential mortgage and commercial construction warehouse lending consistent with our business plan to further diversify revenues. Historically, consumer loans, in particular, fixture secured loans had represented the largest portion of the Company’s loan portfolio and had traditionally been the mainstay of the Company’s lending strategy. At December 31, 2021, consumer loans represented 24.1% of the Company’s total gross loan portfolio, up slightly from 23.8% at December 31, 2020. In recent years, the Company has placed more of an emphasis on real estate lending products, such as one-to-four-family loans, commercial real estate loans, including speculative residential construction loans, as well as commercial business loans, while maintaining the proportional size of the consumer loan portfolio.

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Fixture secured loans to finance window, gutter, siding replacement, solar panels, pools, and other improvement renovations are a large and regionally expanding segment of the consumer loan portfolio. These fixture secured consumer loans are dependent on the Bank’s contractor/dealer network of 147 active dealers located throughout Washington, Oregon, California, Idaho, Colorado, Arizona, Nevada, and Minnesota with five contractor/dealers responsible for 49.5% of the funded loans dollar volume for the year ended December 31, 2021. The Company funded $247.4 million, or approximately 11,000 loans during the year ended December 31, 2021.

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The following table details fixture secured loan originations by state for the periods indicated:

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​ ​ For the Twelve Months Ended ​ ​ For the Twelve Months Ended ​

State ​ Amount ​ Percent ​ ​ Amount ​ Percent ​

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The Company originates one-to-four-family residential mortgage loans through referrals from real estate agents, financial planners, builders, and from existing customers. Retail banking customers are also an important source of the Company’s loan originations. The Company originated $1.55 billion of one-to-four-family loans which includes loans held for sale, loans held for investment, and fixed seconds in addition to loans brokered to other institutions of $10.0 million through the home lending segment during the year ended December 31, 2021, of which $1.42 billion were sold to investors. Of the loans sold to investors, $1.10 billion were sold to the FNMA, FHLMC, FHLB, and/or GNMA with servicing rights retained for the purpose of further developing these customer relationships. At December 31, 2021, one-to-four-family residential mortgage loans held for investment, which excludes loans held for sale of $125.8 million, totaled $366.4 million, or 20.8%, of the total gross loan portfolio.

For the year ended December 31, 2021, there were more one-to-four-family loans originated to finance home purchases, reflecting increased sales of one-to-four-family homes, and decreased refinance activity, compared to the same period in the prior year as refinances surged due to the lowering of market interest rates in response to COVID-19. Residential construction and development lending, while not as common as other options like one-to-four-family loans, will continue to be an important element in our total loan portfolio, and we will continue to take a disciplined approach by concentrating our efforts on loans to builders and developers in our market areas known to us. These short-term loans typically mature in six to twelve months. In addition, the funding is usually not fully disbursed at origination, thereby reducing our net loans receivable in the short-term.

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

The Company’s earnings are primarily dependent upon net interest income, the difference between interest income and interest expense. Interest income is a function of the balances of loans and investments outstanding during a given period and the yield earned on these loans and investments. Interest expense is a function of the amount of deposits and borrowings outstanding during the same period and interest rates paid on these deposits and borrowings. The continuing low interest rate environment is expected to continue to put downward pressure on loan yields and the yields on other

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floating rate interest earning assets as well, which may adversely affect our net interest income and net interest margin in 2022.

Another significant influence on the Company’s earnings is fee income from mortgage banking activities. The Company’s earnings are also affected by the provision for loan losses, service charges and fees, gains from sales of assets, operating expenses and income taxes. The Company recorded a provision of $500,000 for the year ended December 31, 2021, compared to $13.0 million for the same period one year ago, reflecting improved economic factors at December 31, 2021, the increase in the loan portfolio due to organic growth, and net loan charge-offs. The reduction of the provision for loan losses also reflects improvements in “watch” classified loans that were downgraded due to the COVID-19 pandemic which have shown loan-level improvements at December 31, 2021.

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Summary of Critical Accounting Policies and Estimates

Certain of the Company’s accounting policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances which could affect these judgments include, but are not limited to, changes in interest rates, changes in the performance of the economy, and changes in the financial condition of borrowers. Management believes that its critical accounting policies and estimates include the following:

Allowance for Loan and Lease Losses (“ALLL”). The ALLL is the amount estimated by management as necessary to cover probable losses inherent in the loan portfolio at the balance sheet date. The ALLL is established through the provision for loan losses, which is charged to income. A high degree of judgment is necessary when determining the amount of the ALLL. Among the material estimates required to establish the ALLL are: loss exposure at default; the amount and timing of future cash flows on impacted loans; value of collateral; and determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management reviews the level of the ALLL at least quarterly and establishes the provision for loan losses based upon an evaluation of the portfolio, past loss experience, current economic conditions, and other factors related to the collectability of the loan portfolio. Although the Company believes that the best information available currently is used to establish the ALLL, future adjustments to the ALLL may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation. As the Company adds new products to the loan portfolio and expands the Company’s market area, management intends to enhance and adapt the methodology to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have a significant effect on the calculation of the ALLL in any given period. Management believes that its systematic methodology continues to be appropriate. In June 2016, the Financial Accounting Standards Board issued ASU No. 2016-13, Measurement of Credit Losses on Financial Instruments, referred to as the Current Expected Credit Loss (“CECL”) model, which was early adopted by the Company and effective January 1, 2022. For additional information on CECL see “Note 1 - Basis of Presentation and Summary of Significant Accounting Policies - Recent Accounting Pronouncements” of the Notes to the Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

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Servicing Rights. Servicing assets are recognized as separate assets when rights are acquired through the purchase or through the sale of financial assets. Generally, purchased servicing rights are capitalized at the cost to acquire the rights. For sales of mortgage loans, the value of servicing is capitalized during the month of sale. Fair value is based on market prices for comparable mortgage contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds, and default rates and losses. A significant change in prepayments of the loans in the servicing portfolio could result in significant changes in the valuation adjustments, thus creating potential volatility in the carrying amount of servicing rights. Refer to Note 4, Servicing Rights of the Notes to the Consolidated Financial Statements for further information.

Servicing assets are evaluated quarterly for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights into tranches based on predominant characteristics, such as interest rate, loan type, and investor type. Impairment is recognized through a valuation allowance for an individual tranche, to the extent that fair value is less than the capitalized amount for the tranches. If the Company later determines that all or a

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portion of the impairment no longer exists for a particular tranche, a reduction of the allowance may be recorded as a recovery and an increase to income. Capitalized servicing rights are stated separately on the Consolidated Balance Sheets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets.

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

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

Fair Value.ASC 820, “Fair Value Measurements and Disclosures,” establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction. The objective of a fair value measurement is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions (that is, an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability). For additional details, see “Note 15 - Fair Value Measurement” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K for additional information about the level of pricing transparency associated with financial instruments carried at fair value.

Income Taxes. Income taxes are reflected in the Company’s consolidated financial statements to show the tax effects of the operations and transactions reported in the consolidated financial statements and consist of taxes currently payable plus deferred taxes. ASC 740, “Accounting for Income Taxes,” requires the asset and liability approach for financial accounting and reporting for deferred income taxes. Deferred tax assets and liabilities result from temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities. They are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled and are determined using the assets and liability method of accounting. The deferred income provision represents the difference between net deferred tax asset/liability at the beginning and end of the reported period. In formulating the

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deferred tax asset, the Company is required to estimate income and taxes in the jurisdiction in which the Company operates. This process involves estimating the actual current tax exposure for the reported period together with assessing temporary differences resulting from differing treatment of items, such as depreciation and the provision for loan losses, for tax and financial reporting purposes.

Deferred tax assets and liabilities occur when taxable income is larger or smaller than reported income on the income statements due to accounting valuation methods that differ from tax, as well as tax rate estimates and payments made quarterly and adjusted to actual at the end of the year. Deferred tax assets and liabilities are temporary differences deductible or payable in future periods. The Company had net deferred tax liabilities of $1.2 million and $58,000 at December 31, 2021 and 2020, respectively.

The Company’s accounting policies are discussed in detail in “Note 1 - Basis of Presentation and Summary” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

Our Business and Operating Strategy and Goals

The Company’s primary objective is to operate 1st Security Bank of Washington as a well capitalized, profitable, independent, community-oriented financial institution, serving customers in its primary market area defined generally as the greater Puget Sound market area. The Company’s strategy is to provide innovative products and superior customer service to small businesses, industry and geographic niches, and individuals located in its primary market area. Services are currently provided to communities through the main office and 21 full-service bank branches and are supported with 24/7 access to on-line banking and participation in a worldwide ATM network.

The Company focuses on diversifying revenues, expanding lending channels, and growing the banking franchise. Management remains focused on building diversified revenue streams based upon credit, interest rate, and concentration risks. The Board of Directors seeks to accomplish the Company’s objectives through the adoption of a strategy designed to improve profitability and maintain a strong capital position and high asset quality. This strategy primarily involves:

Growing and diversifying the loan portfolio and revenue streams. The Company is transitioning lending activities from a predominantly consumer-driven model to a more diversified consumer and business model by emphasizing three key lending initiatives: expansion of commercial business lending programs, increasing in-house originations of residential mortgage loans primarily for sale into the secondary market through the mortgage banking program; and commercial real estate lending. Additionally, the Company seeks to diversify the loan portfolio by increasing lending to small businesses in the market area, as well as residential construction lending.

Maintaining strong asset quality. The Company believes that strong asset quality is a key to long-term financial success. The percentage of nonperforming loans to total gross loans were 0.33% and 0.49% at December 31, 2021 and 2020, respectively. The percentage of nonperforming assets to total assets were 0.25% and 0.37% at December 31, 2021 and 2020, respectively. The Company has actively managed the delinquent loans and nonperforming assets by aggressively pursuing the collection of consumer debts and marketing saleable properties upon which were foreclosed or repossessed, work-outs of classified assets and loan charge-offs. In the past several years, the Company also began emphasizing consumer loan originations to borrowers with higher credit scores, generally, credit scores over 720 (although the policy allows us to go lower). Although the Company plans to place more emphasis on certain lending products, such as commercial and multi-family real estate loans, construction and development loans, including speculative residential construction loans, and commercial business loans, while growing the current size of the one-to-four-family residential mortgage loans and the consumer loan portfolios, the Company continues to manage its credit exposures through the use of experienced bankers and an overall conservative approach to lending.

Emphasizing lower cost core deposits to reduce the costs of funding loan growth. The Company offers personal and business checking accounts, NOW accounts and savings and money market accounts, which generally are lower-cost sources of funds than certificates of deposit, and are less sensitive to withdrawal when interest rates fluctuate. In order to build a core deposit base, the Company is pursuing a number of strategies. First, a diligent

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attempt to recruit all commercial loan customers to maintain a deposit relationship with the Company, generally a business checking account relationship to the extent practicable, for the term of their loan. Second, interest rate promotions are provided on savings and checking accounts from time to time to encourage the growth of these types of deposits. Third, by hiring experienced personnel with relationships in the communities we serve.

Capturing customers’ full relationship. The Company offers a wide range of products and services that provide diversification of revenue sources and solidify the relationship with the Bank’s customers. The Company focuses on core retail and business deposits, including savings and checking accounts, that lead to long-term customer retention. As part of the commercial lending process, cross-selling the entire business banking relationship, including deposit relationships and business banking products, such as online cash management, treasury management, wires, direct deposit, payment processing and remote deposit capture. The Company’s mortgage banking program also provides opportunities to cross-sell products to new customers.

Expanding the Company’s markets. In addition to deepening relationships with existing customers, the Company intends to expand business to new customers by leveraging the Company’s well-established involvement in the community and by selectively emphasizing products and services designed to meet their banking needs. The Company also intends to pursue expansion in other market areas through selective growth of the home lending network.

Selected Financial Data

The following table sets forth certain information concerning the Company’s consolidated financial position and results of operations at and for the dates indicated and have been derived from the audited consolidated financial statements. The information below is qualified in its entirety by the detailed information included elsewhere herein and in the Company’s Form 10-K for the years ended December 31, 2021 and 2020, and should be read along with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Item 8. Financial Statements and Supplementary Data.”

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​ ​ At December 31,

Selected Financial Condition Data: ​ ​ ​ ​ ​ ​

Securities available-for-sale, at fair value ​ 271,359 ​ 178,018

Securities held-to-maturity ​ ​ 7,500 ​ ​ 7,500

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​ ​ Year Ended December 31,

Selected Operations Data: ​ ​ ​ ​ ​ ​

Total interest and dividend income ​ $ 96,374 ​ $ 88,837

Net interest income after provision for loan losses ​ 86,149 ​ 61,084

Service charges and fee income ​ 4,349 ​ 2,373

Bargain purchase gain ​ ​ — ​ ​ —

Loss on disposed fixed assets ​ ​ — ​ ​ —

Gain on sale of investment securities ​ — ​ 300

Gain on sale of mortgage servicing rights ​ — ​ —

Earnings on cash surrender value of Bank Owned Life Insurance ​ 866 ​ 870

Income before provision for income taxes ​ 47,420 ​ 49,850

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​ ​ At or For the

​ ​ Year Ended December 31,

Selected Financial Ratios and Other Data 2021 2020

Performance ratios: ​ ​ ​ ​ ​ ​ ​

Return on assets (ratio of net income to average total assets) ​ 1.71 % ​ 2.02 %

Return on equity (ratio of net income to average equity) ​ 15.74 ​ 18.74

Yield on average interest-earning assets ​ 4.59 ​ 4.82

Rate paid on average interest-bearing liabilities ​ 0.65 ​ 1.07

Net interest rate spread ​ 3.94 ​ 3.75

Net interest margin(1) ​ 4.13 ​ 4.02

Operating expense to average total assets ​ 3.48 ​ 3.43

Average interest-earning assets to average ​ ​

Margin on loans sold (3) ​ 2.69 ​ 2.48

Asset quality ratios: ​ ​

Non-performing assets to total assets at end of period(4) ​ 0.25 % ​ 0.37 %

Non-performing loans to total gross loans(5) ​ 0.33 ​ 0.49

Allowance for loan losses to non-performing loans(5) ​ 440.24 ​ 337.22

Allowance for loan losses to gross loans receivable ​ 1.46 ​ 1.66

Capital ratios: ​ ​

Equity to total assets at end of period ​ 10.83 % ​ 10.88 %

Average equity to average assets ​ 10.86 ​ 10.80

Other data: ​ ​

Number of full-service offices ​ 21 ​ 21

Full-time equivalent employees ​ 536 ​ 506

Net income per common share: ​ ​

Book values: ​ ​ ​

Book value per common share ​ $ 30.75 (7)​ $ 27.67 (6)​

Share and per share data has been adjusted for all periods to reflect a two-for-one- stock split effective July 14, 2021.

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(1) Net interest income divided by average interest-earning assets.

(3) Cash margins on loans sold net of deferred fees/costs.

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Comparison of Financial Condition at December 31, 2021 and December 31, 2020

Assets. Total assets increased $173.2 million, to $2.29 billion at December 31, 2021, from $2.11 billion at December 31, 2020, primarily due to increases in loans receivable, net of $183.6 million, securities available-for-sale of $93.3 million, servicing rights of $4.4 million, and other assets of $2.5 million, partially offset by decreases in total cash and cash equivalents of $65.1 million, loans held for sale of $40.6 million, Federal Home Loan Bank (“FHLB”) stock of $2.7 million, and certificates of deposit at other financial institutions of $1.7 million. The increase in total assets were primarily funded by deposit growth and net proceeds from the issuance of subordinated notes during the year ended December 31, 2021.

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Loans receivable, net, increased $183.6 million, to $1.73 billion at December 31, 2021, from $1.54 billion at December 31, 2020. Total real estate loans increased $167.6 million, including increases in one-to-four-family portfolio loans of $55.3 million, multi-family loans of $47.1 million, commercial real estate loans of $42.3 million, and construction and development loans of $25.5 million, partially offset by a decrease in home equity loans of $2.5 million. Undisbursed construction and development loan commitments increased $38.6 million, or 26.9%, to $182.3 million at December 31, 2021, as compared to $143.7 million at December 31, 2020. Consumer loans increased $48.6 million, primarily due to increases of $54.3 million in indirect home improvement loans, partially offset by a decrease of $5.1 million in marine loans. Commercial business loans decreased $31.5 million, due to a decrease in warehouse lending of $15.8 million reflecting the recent increase in residential mortgage interest rates and reduced refinance activity and commercial and industrial loans decreasing $15.7 million, including a net decrease in PPP loans of $37.9 million. The focused increase in commercial and industrial loans is tied to the Bank’s investment in our business lending platform, including employees to service business lending customers and cash management teams to support business deposits.

Loans held for sale, consisting of one-to-four-family loans, decreased by $40.6 million, or 24.4%, to $125.8 million at December 31, 2021, compared to $166.4 million at December 31, 2020. Purchase activity was driven by a strong housing market in the Pacific Northwest while slightly higher market rates in 2021 reduced refinance activity. The Company continues to invest in its home lending operations and strategically adds production staff in the markets we serve.

One-to-four-family loan originations for the year ended December 31, 2021, included $1.35 billion of loans originated for sale, $190.2 million of portfolio loans including first and second liens, and $10.0 million of loans brokered to other institutions.

Originations of one-to-four-family loans to purchase and to refinance a home for the periods indicated were as follows:

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​ ​ For the Year Ended ​ ​ ​ For the Year Ended ​ ​ ​ Year ​ Year

​ ​ December 31, 2021 ​ ​ ​ December 31, 2020 ​ ​ ​ over Year ​ over Year

​ Amount Percent Amount Percent ​ ​ $ Change % Change

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During the year ended December 31, 2021, the Company sold $1.42 billion of one-to-four-family loans, compared to sales of $1.64 billion one year ago. In addition, the cash margin on loans sold, net of deferred fees and capitalized expenses, increased to 2.69% for the year ended December 31, 2021, compared to 2.48% for the year ended December 31, 2020. Margin reported is based on actual loans sold into the secondary market and the related value of capitalized servicing, partially offset by recognized deferred loans fees and capitalized expenses. The gross cash margins on loans sold, were 3.97% and 4.25% for the year ended December 31, 2021 and 2020, respectively. Gross cash margins on loans sold is defined as the margin on loans sold without the impact of deferred loan fees and costs.

The ALLL was $25.6 million, or 1.46% of gross loans receivable, excluding loans held for sale at December 31, 2021, compared to $26.2 million, or 1.66% of gross loans receivable, excluding loans held for sale, at December 31, 2020. Substandard loans increased to $18.1 million at December 31, 2021, compared to $17.6 million at December 31, 2020. This increase in substandard loans was primarily due to increases of $5.7 million in commercial and industrial loans, partially offset by a $4.7 million decrease in one-to-four-family. Nonperforming loans, consisting solely of nonaccruing loans 90-days or more past due, decreased to $5.8 million at December 31, 2021, from $7.8 million at December 31, 2020. At December 31, 2021, nonperforming loans consisted of $4.4 million in commercial business loans, $551,000 of indirect home improvement loans, $480,000 in one-to-four-family loans, and $301,000 of home equity loans. The ratio of nonperforming loans to total gross loans was 0.33% at December 31, 2021, compared to 0.49% at December 31, 2020. There were no OREO properties at December 31, 2021, and one OREO property totaling $90,000 at December 31, 2020. As of December 31, 2021, the amount of loans remaining under interest-only payment/relief agreements due to COVID-19 included commercial real estate loans of $6.9 million and commercial business loans of $2.1 million. These loans were classified as current and accruing interest, with the exception of $1.2 million in commercial business loans which were classified as nonaccrual, yet current on contractual payments. These modifications were not classified as troubled debt restructurings pursuant to guidance in effect at the time of modification. At December 31, 2021 the Company had no

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TDRs. See “Item 1. Business - Lending Activities - Asset Quality” of this Form 10-K for additional information regarding the Company’s nonperforming loans.

In accordance with acquisition accounting, the ALLL does not include the recorded discount on loans acquired in the Anchor Acquisition of $751,000 and $1.5 million on $84.3 million and $132.6 million of gross loans at December 31, 2021 and December 31, 2020, respectively.

Liabilities. Total liabilities increased $155.7 million to $2.04 billion at December 31, 2021, from $1.88 billion at December 31, 2020, primarily due to increases of $241.7 million in deposits and $40.0 million in subordinated notes, partially offset by a decrease of $123.3 million in borrowings and $2.9 million in other liabilities.

Total deposits increased $241.7 million to $1.92 billion at December 31, 2021, from $1.67 billion at December 31, 2020. The increase in deposits was primarily driven by organic growth in customer relationships, proceeds from PPP loans and government stimulus checks deposited directly into customer accounts, and reduced withdrawals from deposit accounts due to a change in spending habits as a result of COVID-19. Transactional accounts (noninterest-bearing checking, interest-bearing checking, and escrow accounts) increased $219.6 million to $808.8 million at December 31, 2021, from $589.1 million at December 31, 2020, primarily due to a $94.7 million increase in noninterest-bearing checking, and a $123.0 million increase in interest-bearing checking. Money market and savings accounts increased $163.9 million, or 28.1%, to $746.3 million at December 31, 2021, from $582.4 million at December 31, 2020. Time deposits decreased $141.9 million to $360.7 million at December 31, 2021, from $502.5 million at December 31, 2020. Nonretail CDs which include brokered CDs, online CDs, and public funds decreased $82.4 million to $114.2 million, at December 31, 2021, compared to $196.6 million at December 31, 2020, primarily due to an $88.9 million decrease in brokered CDs. The reduction in non-retail CDs is directly tied to the Company replacing these non-retail CDs with brokered interest-bearing checking deposits of $90.0 million. The bulk of our wholesale funding activity has been tied to liability interest rate swap arrangements of $90.0 million that are funded with 90-day liabilities, as discussed below. Escrow accounts related to mortgages serviced increased $2.0 million to $16.4 million at December 31, 2021, reflecting an increase in the servicing portfolio.

Deposits are summarized as follows at the years indicated:

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​ December 31, December 31,

Escrow accounts related to mortgages serviced ​ 16,389 ​ 14,432

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(5) Time deposits that meet or exceed the FDIC insurance limit.

As a result, primarily due to the COVID-19 pandemic and the resulting availability of PPP loan funds and stimulus funds made available during the first half of 2021, the table above reflects year over year increases as well as changes in the

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composition of deposits, reflecting customers transferring funds from CDs to more liquid interest-bearing accounts, such as money market and interest-bearing checking.

Borrowings comprised of FHLB advances, decreased $123.3 million to $42.5 million at December 31, 2021, from $165.8 million at December 31, 2020, primarily related to the repayment of $63.3 million of Paycheck Protection Program Liquidity Facility (“PPPLF”) borrowings, due in part to SBA forgiveness of the underlying PPP loans and the maturity of $60.0 million of FHLB advances utilizing funds attributable to deposit growth.

During the year ended December 31, 2021, the Company repaid $10.0 million in subordinated notes with an interest rate fixed at 6.5% and issued $50.0 million in aggregate principal amount of its 3.75% fixed-to-floating rate subordinated notes in a private placement transaction announced on February 10, 2021, at an offering price equal to 100% of the aggregate principal amount of the Notes, of which $50.0 million have been exchanged for subordinated notes registered under the Securities Act of 1933. Net proceeds, after placement agent fees and offering expenses, was approximately $49.3 million. The subordinated notes qualify as Tier 2 capital for regulatory capital purposes. For additional information related to our subordinated notes see Note 9, Debt of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10 K.

Management entered into two liability interest rate swap arrangements designated as cash flow hedges in the first quarter of 2020 and one liability interest rate swap arrangement in the third quarter of 2020 to lock the expense costs associated with $90.0 million in brokered deposits. The average cost of these $90 million in notional pay fixed interest rate swap agreements was 73 basis points for which the Bank pays a fixed rate of 73 basis points to the interest rate swap counterparty, compared to the quarterly reset of three-month LIBOR that will adjust quarterly. Management will continue to implement processes to match balance sheet funding duration and minimize interest rate risk and costs.

Stockholders’ Equity. Total stockholders’ equity increased $17.5 million, to $247.5 million at December 31, 2021, from $230.0 million at December 31, 2020. The increase in stockholders’ equity during the year ended December 31, 2021, was primarily due to net income of $37.4 million, partially offset by common stock repurchases of $18.0 million, and cash dividends of $4.6 million. The Company repurchased 524,353 shares of its common stock during the year ended December 31, 2021, at an average price of $34.40 per share. Book value per common share was $30.75 at December 31, 2021, compared to $27.67 at December 31, 2020.

​

We calculated book value based on common shares outstanding of 8,169,887 at December 31, 2021, less 121,672 unvested restricted stock shares for the reported common shares outstanding of 8,048,215. Common shares outstanding was calculated using 8,475,912 shares at December 31, 2020, less 110,184 unvested restricted stock shares, and 51,842 of unallocated ESOP shares for the reported common shares outstanding of 8,313,886.

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Average Balances, Interest and Average Yields/Cost

The following table sets forth for the periods indicated, information regarding average balances of assets and liabilities, as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities, resultant yields, interest rate spread, net interest margin (otherwise known as net yield on interest-earning assets), and the ratio of average interest-earning assets to average interest-bearing liabilities. Also presented is the weighted average yield on interest-earning assets, rates paid on interest-bearing liabilities and the resultant spread at December 31, 2021. Income and all average balances are monthly average balances. Nonaccruing loans have been included in the table as loans carrying a zero yield. The yields on tax-exempt municipal bonds have not been computed on a tax equivalent basis.

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ Year Ended December 31,

​ Average Interest ​ Average Interest ​ Average Interest ​

Interest-earning assets: ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Interest-bearing liabilities: ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Net interest rate spread ​ 3.94 % ​ 3.75 % ​ 4.13 %

Net interest margin ​ 4.13 % ​ 4.02 % ​ 4.53 %

____________________________

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

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​

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Rate/Volume Analysis

The following table presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the changes related to outstanding balances and that due to the changes in interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate.

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

(In thousands) Volume Rate (Decrease) Volume Rate (Decrease)

Interest-earning assets: ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Taxable HTM Investment securities ​ ​ 255 ​ ​ 2 ​ ​ 257 ​ ​ 123 ​ ​ — ​ ​ 123

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Interest-bearing liabilities: ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Net change in net interest income ​ ​ ​ $ 12,529 ​ ​ ​ $ 3,812

__________________________

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

Comparison of Results of Operations for the Years Ended December 31, 2021 and 2020

General. Net income was $37.4 million for the year ended December 31, 2021, and $39.3 million for the year ended December 31, 2020. The decrease in net income was primarily impacted by a $17.8 million, or 32.2% reduction in noninterest income and a $9.6 million, or 14.5% increase in noninterest expense, partially offset by a $12.5 million, or 96.2% decrease in the provision for loan losses, and a $12.5 million, or 16.9% increase in net interest income.

Net Interest Income. Net interest income increased $12.5 million, to $86.6 million for the year ended December 31, 2021, from $74.1 million for the year ended December 31, 2020. This increase was primarily the result of an improved mix of

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loans versus other interest-earning assets and increased balances in higher yielding loans funded by lower cost deposits. Interest income increased $7.5 million, primarily due to an increase of $6.6 million in interest income on loans receivable, including fees, impacted primarily by organic loan growth and net deferred fees recognized upon SBA forgiveness of PPP loans. Interest expense decreased $5.0 million, primarily as a result of repricing deposit rates and a reduction in higher cost borrowings. For the year ended December 31, 2021, the total recognition of net deferred fees on forgiven and amortizing PPP loans was $2.3 million.

The net interest margin (“NIM”) increased 11 basis points to 4.13% for the year ended December 31, 2021, from 4.02% for the same period in the prior year. The increase in NIM reflects an improved mix of interest-bearing assets, including a higher balance of higher yielding portfolio loans and investment securities and a significant decrease of interest-bearing cash balances, earning a nominal yield combined with the reduction in our deposit and borrowing costs. Management remains focused on matching deposit/liability duration with the duration of loans/assets where appropriate.

Interest Income. Interest income for the year ended December 31, 2021, increased $7.5 million, to $96.4 million, from $88.8 million for the year ended December 31, 2020. The increase during the year was primarily attributable to an increase in the average balance of total interest-earning assets, partially offset by the decline in the average loan yield. The decrease in average yield on interest-earning assets compared to a year earlier primarily reflects decreases in the average yield for almost all interest earning assets, in particular, loan yields impacted by refinances of one-to-four-family loans and loan repricing to a lower market interest rate, and the origination last year of low-yielding PPP loans. The impact of PPP loans on loan yields will change during any period based on the volume of prepayments or amounts forgiven by the SBA as certain criteria are met, but is expected to cease completely after the maturity of the loans. Unamortized net deferred fees on PPP loans were $447,000 at December 31, 2021.

The following table compares average earning asset balances, associated yields, and resulting changes in interest income for the years ended December 31, 2021 and 2020:

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ Year Ended December 31,

​ ​ Average ​ ​ ​ Average ​ ​ ​ (Decrease)

​ ​ Balance ​ Yield/ ​ Balance ​ Yield/ ​ in Interest

(Dollars in thousands) ​ Outstanding ​ Rate ​ Outstanding ​ Rate ​ Income

___________________________

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

Interest Expense. Interest expense decreased $5.0 million, to $9.7 million for the year ended December 31, 2021, from $14.7 million for the prior year, primarily due to decreased interest expense on deposits of $5.1 million and a reduction in higher cost borrowings. The average cost of funds for total interest-bearing liabilities decreased 42 basis points to 0.65% for the year ended December 31, 2021, compared to 1.07% for the year ended December 31, 2020. This decrease was predominantly due to the decline in cost for market rate deposits and borrowings as well as managed runoff of higher cost CD funding. The average cost of interest-bearing deposits decreased 48 basis points to 0.50% for the year ended December 31, 2021, compared to 0.98% for the year ended December 31, 2020, reflecting lower market interest rates.

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The following table details average balances for cost of funds on interest-bearing liabilities and the change in interest expense for the years ended December 31, 2021 and 2020:

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ Year Ended December 31,

​ Average ​ Average ​ Increase

​ ​ Balance ​ Yield/ ​ Balance ​ Yield/ ​ in Interest

(Dollars in thousands) ​ Outstanding ​ Rate ​ Outstanding ​ Rate ​ Expense

​

Provision for Loan Losses. For the year ended December 30, 2021, the provision for loan losses was $500,000, compared to $13.0 million for the year ended December 31, 2020. The reduction of the provision for loan losses reflects improved economic factors on credit deterioration related to the COVID-19 pandemic utilized to calculate the allowance for loan losses and also reflects loan-level improvements for previously downgraded loans due to the COVID-19 pandemic at December 31, 2021, compared to the same time last year. During the year ended December 31, 2021, net charge-offs totaled $1.0 million compared to $93,000 during the year ended December 31, 2020, primarily due to increased consumer loan charge-offs.

The following table details activity and information related to the allowance for loan losses for the years ended December 31, 2021 and 2020:

​ ​ ​ ​ ​ ​ ​ ​

​ ​ At or For the Year Ended December 31,

Provision for loan losses ​ $ 500 ​ $ 13,036 ​

Net charge-offs ​ $ 1,037 ​ $ 93 ​

Non-accrual and 90 days or more past due loans ​ $ 5,823 ​ $ 7,761 ​

​

Management considers the ALLL at December 31, 2021, to be adequate to cover estimated losses inherent in the loan portfolio based on the assessment of the above-mentioned factors affecting the loan portfolio. While management believes the estimates and assumptions used in its determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact the Company’s financial condition and results of operations. In addition, the determination of the amount of allowance for loan losses is subject to review by bank regulators, as part of the routine examination process, which may result in the establishment of additional reserves based upon their judgment of information available to them at the time of their examination.

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Noninterest Income. Noninterest income decreased $17.8 million, to $37.5 million for the year ended December 31, 2021, from $55.4 million for the year ended December 31, 2020. The following table provides a detailed analysis of the changes in the components of noninterest income:

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ Year Ended December 31, ​ Increase/(Decrease)

(Dollars in thousands) 2021 2020 Amount Percent

Gain on sale of investment securities ​ — ​ 300 ​ (300) (100.0) ​

Earnings on cash surrender value of BOLI ​ 866 ​ 870 ​ (4) (0.5) ​

​

The year over year decreases include a $17.8 million, or 36.4% decrease in gain on sale of loans, primarily due to a reduction in the amount of originated and sold refinance loans, and a $1.8 million, or 59.1% decrease in other noninterest income mostly due to the net gain from a one-time sale of Class B Visa stock shares of $1.5 million during the last year, partially offset by a $2.0 million, or 83.3% increase in net service charges and fee income. The Company recorded net losses of $1.1 million and $3.7 million on gross contractually specified servicing fees, late fees, and other ancillary fees, net of mortgage servicing rights amortization, resulting from servicing of loans for the years ended December 31, 2021 and 2020, respectively. The net losses were included in service charges and fee income.

​

Noninterest Expense. Noninterest expense increased $9.6 million, or 14.5%, to $76.2 million for the year ended December 31, 2021, from $66.6 million for the year ended December 31, 2020. The following table provides an analysis of the changes in the components of noninterest expense:

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ Year Ended December 31, ​ Increase/(Decrease)

(Dollars in thousands) 2021 2020 Amount Percent

Loss on sale of OREO ​ ​ 9 ​ ​ 2 ​ ​ 7 ​ 350.0 ​

OREO expenses ​ — ​ 4 ​ (4) (100.0) ​

Amortization of core deposit intangible ​ 691 ​ 706 ​ (15) (2.1) ​

​

The increase in noninterest expense was primarily due a $11.6 million increase in salaries and benefits, primarily attributable to a reduction in recognized deferred costs on direct loan origination activities of $9.7 million and increases in compensation of $4.2 million and medical expenses of $2.0 million, partially offset by a decrease in incentives and commissions of $5.3 million. Compensation increased due to increased staffing as full-time employees increased by 30 and upward market pressure on salaries and wages. The primary offset to the increase in noninterest expense was due to the $4.0 million net change in the value of servicing rights resulting in a $2.1 million recovery of servicing rights, from a $2.0 million impairment recognized last year due to the low interest rate environment from the government’s response to the COVID-19 pandemic.

The efficiency ratio, which is noninterest expense as a percentage of net interest income and noninterest income, rose to, 61.41% for the year ended December 31, 2021, compared to 51.43% for the year ended December 31, 2020, primarily representing the decrease in noninterest income and the increase in noninterest expense noted above.

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Provision for Income Tax. For the year ended December 31, 2021, the Company recorded a provision for income tax expense of $10.0 million on pre-tax income of $47.4 million, as compared to a provision of income tax expense of $10.6 million on pre-tax income of $49.9 million for the year ended December 31, 2020. There was a net deferred tax liability of $1.2 million and $58,000 at December 31, 2021 and 2020, respectively. The effective corporate income tax rates for the years ended December 31, 2021 and 2020 were 21.1% and 21.2%, respectively. For additional information regarding income taxes, see “Note 11 - Income Taxes” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

Asset and Liability Management and Market Risk

Risk When Interest Rates Change. The rates of interest the Company earns on assets and pays on liabilities generally is established contractually for a period of time. Market rates change over time. Like other financial institutions, the Company’s results of operations are impacted by changes in interest rates and the interest rate sensitivity of the Company’s assets and liabilities. The risk associated with changes in interest rates and the Company’s ability to adapt to these changes is known as interest rate risk and is the most significant market risk.

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. Consequently, the fair value of the Company’s consolidated financial instruments will change when interest rate levels change, and that change may either be favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed interest rate obligations are less likely to prepay in a rising interest rate environment and more likely to prepay in a falling interest rate environment. Conversely, depositors who are receiving fixed interest rates are more likely to withdraw funds before maturity in a rising interest rate environment and less likely to do so in a falling interest rate environment. Management monitors interest rates and maturities of assets and liabilities, and attempts to minimize interest rate risk by adjusting terms of new loans, and deposits, and by investing in securities with terms that mitigate the Company’s overall interest rate risk.

How The Company Measures Risk of Interest Rate Changes. As part of an attempt to manage exposure to changes in interest rates and comply with applicable regulations, the Company monitors interest rate risk. In doing so, the Company analyzes and manages assets and liabilities based on their interest rates and payment streams, timing of maturities, repricing opportunities, and sensitivity to actual or potential changes in market interest rates.

The Company is subject to interest rate risk to the extent that its interest-bearing liabilities, primarily deposits, subordinated notes, and FHLB advances, reprice more rapidly or at different rates than the interest-earning assets. In order to minimize the potential for adverse effects of material prolonged increases or decreases in interest rates on the Company’s results of operations, the Company has adopted an Asset and Liability Management Policy. The Board of Directors sets the Asset and Liability Management Policy for the Bank, which is implemented by the Asset/Liability Committee (“ALCO”), an internal management committee. The board-level oversight for ALCO is performed by the Audit Committee of the Board of Directors.

The purpose of the ALCO is to communicate, coordinate, and control asset/liability management consistent with the business plan and board-approved policies. The committee establishes and monitors the volume and mix of assets and funding sources, taking into account relative costs and spreads, interest rate sensitivity and liquidity needs. The objectives are to manage assets and funding sources to produce results that are consistent with liquidity, capital adequacy, growth, risk, and profitability goals.

The committee generally meets monthly to, among other things, protect capital through earnings stability over the interest rate cycle; maintain the Bank’s well capitalized status; and provide a reasonable return on investment. The committee recommends appropriate strategy changes based on this review. The committee is responsible for reviewing and reporting the effects of the policy implementations and strategies to the Board of Directors at least quarterly. The Chief Financial Officer oversees the process on a daily basis.

A key element of the Bank’s asset/liability management plan is to protect net earnings by managing the maturity or repricing mismatch between interest-earning assets and rate-sensitive liabilities. The Company seeks to accomplish this by extending funding maturities through wholesale funding sources, including the use of FHLB advances and brokered

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certificates of deposit, and through asset management, including the use of adjustable-rate loans and selling certain fixed-rate loans in the secondary market. Management is also focused on matching deposit duration with the duration of earning assets as appropriate.

As part of the efforts to monitor and manage interest rate risk, a number of indicators are used to monitor overall risk. Among the measurements are:

Market Risk. Market risk is the potential change in the value of investment securities if interest rates change. This change in value impacts the value of the Company and the liquidity of the securities. Market risk is controlled by setting a maximum average maturity/average life of the securities portfolio to 10 years.

Economic Risk. Economic risk is the risk that the underlying value of a bank will change when rates change. This can be caused by a change in value of the existing assets and liabilities (this is called Economic Value of Equity or EVE), or a change in the earnings stream (this is caused by interest rate risk). The Company takes economic risk primarily when fixed rate loans are made, or purchase fixed-rate investments, or issue long term certificates of deposit or take fixed-rate FHLB advances. It is the risk that interest rates will change and these fixed-rate assets and liabilities will change in value. This change in value usually is not recognized in the earnings, or equity (other than marking to market securities available-for-sale or fair value adjustments on loans held for sale). The change is recognized only when the assets and liabilities are liquidated. Although the change in market value is usually not recognized in earnings or in capital, the impact is real to the long-term value of 1st Security Bank of Washington. Therefore, the Company will control the level of economic risk by limiting the amount of long-term, fixed-rate assets the Company will have and by setting a limit on concentrations and maturities of securities.

Interest Rate Risk. If the Federal Reserve Board changes the Fed Funds rate 100, 200 or 300 basis points, the Bank policy dictates that a change in net interest income should not change more that 15%, 25% and 40%, respectively.

The table presented below, as of December 31, 2021, is an analysis prepared for 1st Security Bank of Washington by a third-party consultant utilizing various market and actual experience-based assumptions. The table represents a static shock to the net interest income using instantaneous and sustained shifts in the yield curve, in 100 basis point increments, up and down 100 basis points. No rates in the model are allowed to go below zero. Given that the current targeted Fed Funds rate is a range of 0.00% to 0.25%, a 100, 200 or 300 basis point reduction in rates is not reported. The results reflect a projected income statement with minimal exposure to instantaneous changes in interest rates. These results are primarily based upon historical prepayment speeds within the consumer lending portfolio in combination with the above average yields associated with the consumer portfolio if those prepayments do not occur. The table illustrates the estimated change in our net interest income over the next 12 months from December 31, 2021.

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Change in Interest ​ Net Interest Income

Rates in Basis Points Amount Change Change

​ ​ (Dollars in thousands)

​

In managing the assets/liability mix the Company typically places an equal emphasis on maximizing net interest margin and matching the interest rate sensitivity of the assets and liabilities. From time to time, however, depending on the relationship between long- and short-term interest rates, market conditions and consumer preference, the Company may place somewhat greater emphasis on maximizing net interest margin than on strict dollar for dollar categories matching the interest rate sensitivity of the assets and liabilities. Management also believes that the increased net income which may result from a prepayment assumption mismatch in the actual maturity or repricing of the asset and liability portfolios can, during periods of changing interest rates, provide sufficient returns to justify the increased exposure to sudden and unexpected increases in interest rates which may result from such a mismatch. Management believes that 1st Security Bank of Washington’s level of interest rate risk is acceptable under this approach.

In evaluating 1st Security Bank of Washington’s exposure to interest rate movements, certain shortcomings inherent in the method of analysis presented in the foregoing table must be considered. For example, although certain assets and

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liabilities may have similar maturities or repricing periods, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in interest rates. Additionally, certain assets, such as adjustable-rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a significant change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed above. Finally, the ability of many borrowers to service their debt may decrease in the event of an interest rate increase. 1st Security Bank of Washington considers all of these factors in monitoring its exposure to interest rate risk.

Liquidity and Capital Resources

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

The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund its operations. The Bank generally maintains sufficient cash and short-term investments to meet short-term liquidity needs. At December 31, 2021, the Bank’s total borrowing capacity was $527.2 million with the FHLB of Des Moines, with unused borrowing capacity of $483.9 million. The FHLB borrowing limit is based on certain categories of loans, primarily real estate loans that qualify as collateral for FHLB advances. At December 31, 2021, the Bank held approximately $761.6 million in loans that qualify as collateral for FHLB advances.

In addition to the availability of liquidity from the FHLB of Des Moines, the Bank maintained a short-term borrowing line of credit with the FRB, with a current limit of $200.1 million, and a combined credit limit of $101.0 million in written federal funds lines of credit through correspondent banking relationships as of December 31, 2021. The FRB borrowing limit is based on certain categories of loans, primarily consumer loans that qualify as collateral for the FRB’s line of credit. At December 31, 2021, the Bank held approximately $428.7 million in loans that qualify as collateral for the FRB line of credit. Subject to market conditions, we expect to utilize these borrowing facilities from time to time in the future to fund loan originations and deposit withdrawals, to satisfy other financial commitments, repay maturing debt and to take advantage of investment opportunities to the extent feasible.

Liquidity management is both a daily and long-term function of the Company’s management. Excess liquidity is generally invested in short-term investments, such as overnight deposits and federal funds. On a longer-term basis, a strategy is maintained of investing in various lending products and investment securities, including U.S. Government obligations and U.S. agency securities. The Company uses sources of funds primarily to meet ongoing commitments, pay maturing deposits and fund withdrawals, and to fund loan commitments. At December 31, 2021, the approved outstanding loan commitments, including unused lines of credit, of $376.3 million and $182.3 million of undisbursed construction and development loan commitments, amounted to $558.6 million. For information regarding our commitments and off-balance sheet arrangements, see “Note 12 - Commitments and Contingencies” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K. Securities purchased during the years ended December 31, 2021 and 2020 totaled $130.1 million and $106.9 million, respectively, and securities repayments, maturities and sales in those periods were $29.9 million and $49.9 million, respectively.

The Bank’s liquidity is also affected by the volume of loans sold and loan principal payments. During the years ended December 31, 2021 and 2020, the Bank sold $1.40 billion and $1.64 billion in loans and loan participation interests, respectively. During the years ended December 31, 2021 and 2020, the Bank received $899.3 million and $757.8 million in principal repayments, respectively.

The Bank’s liquidity has been positively impacted by increases in deposit levels. During the years ended December 31, 2021 and 2020, deposits increased by $241.5 million and $281.7 million, respectively. As a result, our liquid assets in the form of cash and cash equivalents, CDs at other financial institutions and investment securities increased to $315.9 million

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at December 31, 2021 from $289.4 million at December 31, 2020. Certificates of deposit scheduled to mature in one year or less at December 31, 2021, totaled $211.8 million. It is management’s policy to offer deposit rates that are competitive with other local financial institutions. Based on this management strategy, the Company believes that a majority of maturing relationship deposits will remain with the Bank.

We incur capital expenditures on an ongoing basis to expand and improve our product offerings, enhance and modernize our technology infrastructure, and to introduce new technology-based products to compete effectively in our markets. We evaluate capital expenditure projects based on a variety of factors, including expected strategic impacts (such as forecasted impact on revenue growth, productivity, expenses, service levels and customer retention) and our expected return on investment. The amount of capital investment is influenced by, among other things, current and projected demand for our services and products, cash flow generated by operating activities, cash required for other purposes and regulatory considerations. Based on current capital allocation objectives, there are no projects scheduled for capital investments in premises and equipment during the year ending December 31, 2022 that would materially impact liquidity. We also have purchase obligations, generally with remaining terms of less than three years and contracts with various vendors to provide services, including information processing, for periods generally ranging from one to five years, for which our financial obligations are dependent upon acceptable performance by the vendor.

​

For the year ending December 31, 2022, we project that fixed commitments will include $1.4 million of operating lease payments. There are $15.0 million of scheduled payments and maturities of FHLB borrowings during the year ending December 31, 2022. For information regarding our operating leases, see “Note 6 - Leases” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

The Bank's management believes that the liquid assets combined with the available lines of credit provide adequate liquidity to meet current financial obligations for at least the next 12 months.

As a separate legal entity from the Bank, FS Bancorp, Inc. must provide for its own liquidity. Sources of capital and liquidity for FS Bancorp, Inc. include distributions from the Bank and the issuance of debt or equity securities. During the year ended December 31, 2021, the Company repaid $10.0 million in subordinated notes with an interest rate fixed at 6.5% and issued $50.0 million in aggregate principal amount of its 3.75% fixed-to-floating rate subordinated notes in a private placement transaction announced on February 10, 2021, at an offering price equal to 100% of the aggregate principal amount of the Notes, of which $50.0 million have been exchanged for subordinated notes registered under the Securities Act of 1933. Net proceeds, after placement agent fees and offering expenses, was approximately $49.3 million. The Notes will mature on February 15, 2031. For regulatory capital purposes, the subordinated notes have been structured to qualify initially as Tier 2 Capital for the Company. Dividends and other capital distributions from the Bank are subject to regulatory notice. If our capital deteriorates such that our Bank is unable to pay dividends to us for an extended period of time, we may not be able to service our debt. At December 31, 2021, FS Bancorp, Inc. had $19.9 million in unrestricted cash to meet liquidity needs.

The Company currently expects to continue the current practice of paying quarterly cash dividends on common stock subject to the Board of Directors' discretion to modify or terminate this practice at any time and for any reason without prior notice. Our current quarterly common stock dividend rate is $0.20 per share, as approved by our Board of Directors, which we believe is a dividend rate per share which enables us to balance our multiple objectives of managing and investing in the Bank, and returning a substantial portion of our cash to our shareholders. Assuming continued payment during 2022 at this rate of $0.20 per share, our average total dividend paid each quarter would be approximately $1.1 million based on the number of our current outstanding shares (which assumes no increases or decreases in the number of shares, except in connection with the anticipated vesting of currently outstanding equity awards).

The Bank is subject to minimum capital requirements imposed by the FDIC. Based on its capital levels at December 31, 2021, the Bank exceeded these requirements as of that date. Consistent with our goals to operate a sound and profitable organization, our policy is for the Bank to maintain a well capitalized status under the capital categories of the FDIC. Based on capital levels at December 31, 2021, the Bank was considered to be well capitalized. Effective January 1, 2020, a bank that elects to use the Community Bank Leverage Ratio (“CBLR”) will generally be considered well capitalized and to have met the risk-based and leverage capital requirements of the capital regulations if it has a leverage ratio greater than 9.0%. At December 31, 2021, the Bank qualified and elected to use the CBLR to measure capital adequacy. The CBLR calculated for the Bank at December 31, 2021 was 12.2%, compared to 10.9% at December 31, 2020.

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As a bank holding company registered with the Federal Reserve, the Company is subject to the capital adequacy requirements of the Federal Reserve. Bank holding companies with less than $3.0 billion in assets are generally not subject to compliance with the Federal Reserve’s capital regulations, which are generally the same as the capital regulations applicable to the Bank. The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to the holding company’s subsidiary bank and the Federal Reserve expects the holding company’s subsidiary bank to be well capitalized under the prompt corrective action regulations. If FS Bancorp, Inc. were subject to regulatory capital guidelines for bank holding companies with $3.0 billion or more in assets at December 31, 2021, FS Bancorp would have exceeded all regulatory capital requirements. The Tier 1 leverage-based capital ratio calculated for FS Bancorp, Inc. at December 31, 2021 was 10.8%. For additional information regarding regulatory capital compliance, see the discussion included in “Note 14 - Regulatory Capital” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

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Recent Accounting Pronouncements

For a discussion of recent accounting standards, please see “Note 1- Basis of Presentation and Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” of this Form 10-K.

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises principally from interest rate risk inherent in lending, investing, deposit and borrowings activities. Management actively monitors and manages its interest rate risk exposure. In addition to other risks that are managed in the normal course of business, such as credit quality and liquidity, management considers interest rate risk to be a significant market risk that could potentially have a material effect on the Company’s financial condition and result of operations. The information contained in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management” of this Form 10-K is incorporated herein by reference.

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Item 8. Financial Statements and Supplementary Data

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FS BANCORP, INC. AND SUBSIDIARY

INDEX TO FINANCIAL STATEMENTS

Index to Consolidated Financial Statements

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​ Page

Consolidated Balance Sheets at December 31, 2021 and 2020 ​ 83

Notes to Consolidated Financial Statements ​ 89

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Report of Independent Registered Public Accounting Firm

To the Shareholders and the Board of Directors of

FS Bancorp, Inc.

​

Opinions on the Financial Statements and Internal Control over Financial Reporting

​

We have audited the accompanying consolidated balance sheets of FS Bancorp, Inc. and subsidiary (the “Company”) as of December 31, 2021 and 2020, the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2021, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).

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In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2021 and 2020, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2021, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO.

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Basis for Opinions

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The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control over Financial Reporting included in Item 9A. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

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We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.

​

Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

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Definition and Limitations of Internal Control Over Financial Reporting

​

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded

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as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

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Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

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Critical Audit Matter

The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.

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Allowance for Loan Losses

As described in Notes 1 and 3 to the consolidated financial statements, the Company’s consolidated allowance for loan losses balance was $25.6 million at December 31, 2021. The allowance for loan losses is maintained to provide for probable losses on existing loans based on evaluating risks in the loan portfolio and is based upon the Company’s analysis of the factors underlying the quality of the loan portfolio. These factors include, among others, changes in the size and composition of the loan portfolio, the estimated value of any underlying collateral, actual loan loss experience, current economic conditions, and detailed analysis of individual loans for which full collectability may not be assured. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information is available.

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We identified management’s risk ratings of loans and the estimation of qualitative factors, both of which are used in the allowance for loan losses calculation, as a critical audit matter. The Company uses internally determined risk ratings to classify loans into pools and to estimate loss rates for each of the loan pools, which are used in the calculation of the allowance for loan losses. Determination of the risk grades involves significant management judgement. The qualitative factors are used to estimate probable losses incurred related to factors that are not captured in the past loss experience, are based on management’s evaluation of available internal and external data, and involve significant management judgement. Auditing management’s judgments regarding the determination of risk grades and qualitative factors applied to the allowance for loan losses involved a high degree of subjectivity.

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The primary procedures we performed to address this critical audit matter included:

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/s/ Moss Adams LLP

​

Everett, Washington

March 16, 2022

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We have served as the Company’s auditor since 2006.

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FS BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

DECEMBER 31, 2021 AND 2020

(Dollars in thousands, except share data)

​

​

​ ​ ​ ​ ​ ​ ​

​ December 31, December 31,

Interest-bearing deposits at other financial institutions ​ 14,448 ​ 80,022

Certificates of deposit at other financial institutions ​ 10,542 ​ 12,278

Securities available-for-sale, at fair value ​ 271,359 ​ 178,018

Accrued interest receivable ​ 7,594 ​ 7,030

Operating lease right-of-use (“ROU”) assets ​ ​ 4,557 ​ ​ 4,949

Federal Home Loan Bank (“FHLB”) stock, at cost ​ 4,778 ​ 7,439

Other real estate owned (“OREO”) ​ ​ — ​ ​ 90

Bank owned life insurance (“BOLI”), net ​ 37,092 ​ 36,226

Servicing rights, held at the lower of cost or fair value ​ 16,970 ​ 12,595

Core deposit intangible, net ​ 4,060 ​ 4,751

LIABILITIES ​ ​

Deposits: ​ ​

Subordinated notes: ​ ​ ​ ​

Unamortized debt issuance costs ​ (606) ​ —

Total subordinated notes less unamortized debt issuance costs ​ 49,394 ​ 10,000

Operating lease liabilities ​ ​ 4,792 ​ ​ 5,176

Deferred tax liability, net ​ 1,183 ​ 58

COMMITMENTS AND CONTINGENCIES (NOTE 12) ​ ​

STOCKHOLDERS’ EQUITY ​ ​

Accumulated other comprehensive income, net of tax ​ ​ 252 ​ ​ 2,533

Unearned shares – Employee Stock Ownership Plan (“ESOP”) ​ — ​ (291)

Share and per share data has been adjusted for all periods to reflect a two-for-one stock split effective July 14, 2021.

​

See accompanying notes to these consolidated financial statements.

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FS BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

FOR THE YEARS ENDED DECEMBER 31, 2021 and 2020

(Dollars in thousands, except earnings per share data)

_________________________________________________________________________________________________________________________

​

​ ​ ​ ​ ​ ​ ​

​ Year Ended

​ ​ December 31,

INTEREST INCOME ​ ​ ​

Loans receivable, including fees ​ $ 90,737 ​ $ 84,128

Total interest and dividend income ​ 96,374 ​ 88,837

INTEREST EXPENSE ​ ​ ​ ​

NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES ​ 86,149 ​ 61,084

NONINTEREST INCOME ​ ​ ​ ​

Service charges and fee income ​ 4,349 ​ 2,373

Gain on sale of investment securities ​ ​ — ​ ​ 300

Earnings on cash surrender value of BOLI ​ 866 ​ 870

NONINTEREST EXPENSE ​ ​ ​ ​

Loss on sale of OREO ​ 9 ​ 2

OREO expenses ​ ​ — ​ ​ 4

Professional and board fees ​ 3,181 ​ 2,797

Federal Deposit Insurance Corporation (“FDIC”) insurance ​ 636 ​ 829

Marketing and advertising ​ 634 ​ 530

Amortization of core deposit intangible ​ ​ 691 ​ ​ 706

(Recovery) impairment of servicing rights ​ ​ (2,059) ​ ​ 1,969

INCOME BEFORE PROVISION FOR INCOME TAXES ​ 47,420 ​ 49,850

Basic earnings per share ​ $ 4.42 ​ $ 4.57

Diluted earnings per share ​ $ 4.32 ​ $ 4.49

Share and per share data has been adjusted for all periods to reflect a two-for-one stock split effective July 14, 2021.

​

See accompanying notes to these consolidated financial statements.

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FS BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

FOR THE YEARS ENDED DECEMBER 31, 2021 and 2020

​

(In thousands)

​

​

​ ​ ​ ​ ​ ​ ​

​ Year Ended

​ ​ December 31,

Other comprehensive (loss) income: ​ ​

Securities available-for-sale: ​ ​

Unrealized holding (loss) gain during period ​ (5,150) ​ 3,754

Cash flow hedges: ​ ​ ​ ​ ​ ​

Unrealized derivative gains (losses) during period ​ 1,706 ​ (1,429)

Income tax benefit related to reclassification, net ​ (116) ​ (43)

Other comprehensive (loss) income, net of tax ​ (2,281) ​ 1,745

​

See accompanying notes to these consolidated financial statements.

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FS BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

FOR THE YEARS ENDED DECEMBER 31, 2021 and 2020

​

(Dollars in thousands, except share amounts)

​

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ Accumulated ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ Other ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ Additional ​ ​ ​ ​ Comprehensive ​ Unearned ​ Total

​ ​ Common Stock ​ Paid-in ​ Retained ​ Income, ​ ESOP ​ Stockholders’

​ ​ Shares ​ Amount ​ Capital ​ Earnings ​ Net of Tax ​ Shares ​ Equity

Dividends paid ($0.42 per share) — ​ $ — ​ — ​ (3,574) ​ — ​ — ​ $ (3,574)

Share-based compensation — ​ $ — ​ 1,020 ​ — ​ — ​ — ​ $ 1,020

Restricted stock awards ​ 49,760 ​ $ 1 ​ ​ — ​ ​ — ​ ​ — ​ ​ — ​ $ 1

Stock options exercised 28,796 ​ $ — ​ (161) ​ — ​ — ​ — ​ $ (161)

Other comprehensive income, net of tax — ​ $ — ​ — ​ — ​ 1,745 ​ — ​ $ 1,745

ESOP shares allocated — ​ $ — ​ 1,025 ​ — ​ — ​ 282 ​ $ 1,307

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Dividends paid ($0.56 per share) — ​ $ — ​ — ​ (4,602) ​ — ​ — ​ $ (4,602)

Share-based compensation — ​ $ — ​ 1,446 ​ — ​ — ​ — ​ $ 1,446

Restricted stock awards 41,350 ​ $ — ​ — ​ — ​ — ​ — ​ $ —

Stock options exercised, net 176,978 ​ $ 1 ​ (2,077) ​ — ​ — ​ — ​ $ (2,076)

Other comprehensive loss, net of tax — ​ $ — ​ — ​ — ​ (2,281) ​ — ​ $ (2,281)

ESOP shares allocated — ​ $ — ​ 1,482 ​ — ​ — ​ 291 ​ $ 1,773

Share and per share data has been adjusted for all periods to reflect a two-for-one stock split effective July 14, 2021.

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See accompanying notes to these consolidated financial statements.

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FS BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE YEARS ENDED DECEMBER 31, 2021 and 2020

​

(In thousands)

​

​

​ ​ ​ ​ ​ ​ ​

​ Year Ended December 31,

CASH FLOWS FROM (USED BY) OPERATING ACTIVITIES 2021 2020

Depreciation, amortization and accretion ​ 15,183 ​ 13,618

ESOP compensation expense for allocated shares ​ 1,773 ​ 1,307

Provision (benefit) for deferred income taxes ​ ​ 1,750 ​ ​ (2,390)

Increase in cash surrender value of BOLI ​ (866) ​ (870)

Gain on sale of loans held for sale ​ (30,977) ​ (48,842)

Gain on sale of portfolio loans ​ ​ (106) ​ ​ —

Gain on sale of investment securities ​ ​ — ​ ​ (300)

(Recovery) impairment of servicing rights ​ ​ (2,059) ​ ​ 1,969

Loss on sale of OREO ​ 9 ​ 2

Changes in operating assets and liabilities ​ ​

Accrued interest receivable ​ (564) ​ (1,122)

Net cash from (used by) operating activities ​ 109,009 ​ (32,317)

CASH FLOWS USED BY INVESTING ACTIVITIES ​ ​

Activity in securities available-for-sale: ​ ​

Proceeds from sale of investment securities ​ ​ — ​ ​ 12,214

Maturities, prepayments, and calls ​ 29,863 ​ 37,964

Activity in securities held-to-maturity: ​ ​ ​ ​ ​ ​

Purchases ​ ​ — ​ ​ (7,500)

Purchase of portfolio loans ​ ​ (1,618) ​ ​ (32,743)

Proceeds from sale of portfolio loans ​ 2,699 ​ —

Proceeds from sale of OREO ​ ​ 81 ​ ​ 76

Purchase of premises and equipment ​ ​ (1,984) ​ ​ (1,379)

Change in FHLB stock, net ​ 2,661 ​ 606

Net cash used by investing activities ​ (310,833) ​ (270,690)

CASH FLOWS FROM FINANCING ACTIVITIES ​ ​

Dividends paid on common stock ​ (4,602) ​ (3,574)

Net proceeds from issuance of subordinated notes ​ ​ 49,333 ​ ​ —

Repayment of subordinated notes ​ ​ (10,000) ​ ​ —

Disbursements from stock options exercised, net ​ (2,076) ​ (161)

Restricted stock awards ​ ​ (211) ​ ​ (34)

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS ​ (65,085) ​ 45,798

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FS BANCORP, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE YEARS ENDED DECEMBER 31, 2021 and 2020 (Continued)

​

​ ​ ​ ​ ​ ​ ​

CASH AND CASH EQUIVALENTS, beginning of year ​ 91,576 ​ 45,778

CASH AND CASH EQUIVALENTS, end of year ​ $ 26,491 ​ $ 91,576

SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION ​ ​

Cash paid during the year for: ​ ​

Interest on deposits and borrowings ​ $ 8,174 ​ $ 14,584

​ ​ ​ ​ ​ ​ ​

Change in unrealized (loss) gain on investment securities ​ $ (5,150) ​ $ 3,454

Change in unrealized gain (loss) on cash flow hedges ​ ​ 2,244 ​ ​ (1,231)

Right-of-use assets in exchange for lease liabilities ​ ​ 979 ​ ​ 1,202

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See accompanying notes to these consolidated financial statements.

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NOTE 1 - BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations -FS Bancorp, Inc. (the “Company”) was incorporated in September 2011 as the holding company for 1st Security Bank of Washington (the “Bank” or “1st Security Bank”) in connection with the Bank’s conversion from the mutual to stock form of ownership which was completed on July 9, 2012. The Bank is a community-based savings bank with 21 full-service bank branches, a headquarters that also originates loans and accepts deposits, and 10 loan production offices in suburban communities in the greater Puget Sound area which includes Snohomish, King, Pierce, Jefferson, Kitsap, Clallam, Grays Harbor, Thurston, and Lewis counties, and one loan production office in the market area of the Tri-Cities, Washington. The Bank provides loan and deposit services to customers who are predominantly small- and middle-market businesses and individuals. The Company and its subsidiary are subject to regulation by certain federal and state agencies and undergo periodic examination by these regulatory agencies.

Financial Statement Presentation -The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) and with prevailing practices within the banking and securities industries. In preparing such financial statements, management is required to make certain estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the balance sheet and the reported amounts of revenues and expenses for the reporting period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan and lease losses, fair value of financial instruments, the valuation of servicing rights, deferred income taxes, and if needed, a deferred tax asset valuation allowance.

Amounts presented in the consolidated financial statements and footnote tables are rounded and presented to the nearest thousands of dollars except per share amounts. If the amounts are above $1.0 million, they are rounded one decimal point, and if they are above $1.0 billion, they are rounded two decimal points.

Principles of Consolidation -The consolidated financial statements include the accounts of FS Bancorp, Inc. and its wholly owned subsidiary, 1st Security Bank of Washington. All material intercompany accounts have been eliminated in consolidation.

Segment Reporting - The Company operates in two business segments through the Bank: commercial and consumer banking and home lending. The Company’s business segments are determined based on the products and services provided, as well as the nature of the related business activities, and they reflect the manner in which financial information is regularly reviewed for the purpose of allocating resources and evaluating performance of the Company’s businesses. The results for these business segments are based on management’s accounting process, which assigns income statement items and assets to each responsible operating segment. This process is dynamic and is based on management’s view of the Company’s operations. See “Note 20 - Business Segments.”

Subsequent Events - The Company has evaluated events and transactions subsequent to December 31, 2021 for potential recognition or disclosure.

Cash and Cash Equivalents - Cash and cash equivalents include cash and due from banks, and interest-bearing balances due from other banks and the Federal Reserve Bank of San Francisco (“FRB”) and have an original maturity of 90 days or less at the time of purchase. At times, cash balances may exceed Federal Deposit Insurance Corporation (“FDIC”) insured limits. At December 31, 2021 and 2020, the Company had $327,000 and $17.0 million, respectively, of cash and due from banks and interest-bearing deposits at other financial institutions in excess of FDIC insured limits.

Securities - Securities are classified as held-to-maturity when the Company has the ability and positive intent to hold them to maturity. Securities classified as held-to-maturity are carried at cost, adjusted for amortization of premiums to the earliest callable date and accretion of discounts to the maturity date and, if appropriate, any other-than-temporary impairment losses. Securities available-for-sale consist of debt securities that the Company has the intent and ability to hold for an indefinite period, but not necessarily to maturity. Such securities may be sold to implement the Company’s asset/liability management strategies and in response to changes in interest rates and similar factors. Securities available-for-sale are reported at fair value. Realized gains and losses on securities available-for-sale, determined using the specific identification method, are included in results of operations. Amortization of premiums and accretion of discounts are recognized as adjustments to yield over the contractual lives of the related securities with the exception of premiums for

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