ITEM 1A. RISK FACTORS
In addition to the other information in this Annual Report on Form 10-K, stockholders or prospective investors should carefully consider the following risk factors:
Risks Relating to General Economic Conditions
A downturn in general economic or business conditions, nationally or in markets where our business is concentrated, could have an adverse effect on our business, results of operations and financial condition.
Our success depends upon the business activity, population, employment rates, income levels, deposits and real estate activity in our markets in Northern and Central Indiana. Although our customers’ business and financial interests may extend well beyond these market areas, adverse economic conditions that affect these market areas could reduce our growth rate, diminish the ability of our customers to repay their loans to us, decrease the value of any collateral securing our loans and generally adversely affect our financial condition and results of operations. Moreover, because of our geographic concentration, we are less able than other regional or national financial institutions to diversify our credit risks across multiple markets.
Monetary policies of the Federal Reserve could adversely affect our financial condition and results of operations.
In the current environment, economic and business conditions are significantly affected by U.S. monetary policy, particularly the anticipated actions of the Federal Reserve to pivot from its campaign to raise short-term interest rates in an effort to fight elevated levels of inflation impacting the U.S. economy. Beginning in March of 2022, the Federal Reserve substantially increased the target Federal Funds rate in pursuit of its policy mandate to maintain maximum employment and achieve price stability and subsequently paused further rate raises starting in September 2023 as the rate of inflation had significantly subsided from levels experienced in 2022. In December 2023, the Federal Reserve indicated the possibility it would pivot from the current rate tightening cycle, forecasting a series of cuts to the Federal Funds rate in 2024. Rate increases benefited our net interest income during 2022, due to the asset sensitive nature of the Company’s balance sheet. In 2023, funding costs rose substantially as the cost to retain deposits and borrow increased due to market competition and a series of bank failures in the first quarter of 2023. The Company's increase in cost of funds negatively affected net interest income in 2023. A pivot in policy by the Federal Reserve to lower the target Federal Funds rate could further erode the Company’s net interest income due to lags in deposits repricing. However, a reduction in rates would positively impact the fair value of our investment securities portfolio, which had $174.6 million in unrealized losses in available-for-sale investment securities at December 31, 2023. Lower interest rates can also positively affect our customers’ businesses and financial condition, and increase the value of collateral securing loans in our portfolio.
Given the complex factors affecting the strength of the U.S. economy, including uncertainties regarding the persistence of inflation, international geopolitical developments, strength of the banking system, disruptions in the global energy market, labor market conditions and the impact of higher rates on consumers and businesses, there is a meaningful risk that the Federal Reserve and other central banks may underestimate the impact of their tightening policies and potentially cause an economic recession. Restrictive monetary policies could limit economic growth and potentially cause an economic recession. As noted above, this could decrease loan demand, harm the credit characteristics of our existing loan portfolio and decrease the value of collateral securing loans in the portfolio.
Continued elevated levels of inflation could adversely impact our business and results of operations.
The United States has recently experienced elevated levels of inflation, with the rate peaking in 2022 and remaining elevated in 2023. Inflation pressures are currently expected to remain elevated as the inflation rate remains above the Federal Reserve’s target rate of 2%, which is intended to help accomplish its policy. Continued high levels of inflation could have complex effects on our business and results of operations, some of which could be materially adverse. For example, elevated inflation harms consumer purchasing power, which could negatively affect our retail customers and the economic environment and, ultimately, many of our business customers, and could also negatively affect our levels of non-interest expense. In addition, if interest rates continue to rise in response to elevated levels of inflation, the value of our securities portfolio would be negatively impacted. Continued elevated levels of inflation could also cause increased volatility and uncertainty in the business environment, which could adversely affect loan demand and our clients' ability to repay indebtedness. It is also possible that governmental responses to the current inflation environment could adversely affect our business, such as changes to monetary and fiscal policy that are too strict, or the imposition or threatened imposition of price controls. The duration and severity of the current inflationary period cannot be estimated with precision.
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Adverse developments or concerns affecting the financial services industry or specific financial institutions could adversely affect our financial condition and results of operations. The 2023 United States banking crisis could continue to have adverse effects on our business.
Actual events involving limited liquidity, defaults, non-performance or other adverse developments that affect financial institutions, transactional counterparties or other companies in the financial services industry or the financial services industry generally, or concerns or rumors about any events of these kinds or other similar events, have in the past and may in the future lead to erosion of customer confidence in the banking system, deposit volatility, liquidity issues, stock price volatility and other adverse developments. For example, the failures of Silicon Valley Bank and Signature Bank in March 2023 and First Republic Bank in May 2023 led to disruption and volatility, including deposit outflows and increased need for liquidity, at certain banks. Although depositors of these banks were largely protected, it is not certain that the Federal Reserve or FDIC will treat future bank failures similarly.
Inflation and the rapid increases in interest rates have led to a decline in the trading value of previously issued debt securities with interest rates below current market interest rates. Any sale of investment securities that are held in an unrealized loss position by a financial institution for liquidity or other purposes will cause actual losses to be realized. There can be no assurance that there will not be additional bank failures or issues such as liquidity concerns in the broader financial services industry or in the U.S. financial system as a whole. Adverse financial market and economic conditions can exert downward pressure on stock prices, security prices and credit availability for financial institutions without regard to their underlying financial strength. The volatility and economic disruption resulting from the failures of Silicon Valley Bank and Signature Bank particularly impacted the market valuation of securities issued by financial institutions.
While we did not experience any abnormal changes in our total outstanding deposit balances following these bank closure events, we experienced changes in deposit balances resulting from typical seasonal fluctuations due to the nature of our business. While our deposit base primarily consists of a stable mix of retail, commercial and public fund deposits, we cannot be assured that unusual deposit withdrawal activity will not affect banks generally or the Company specifically in the future. Continued uncertainty regarding or worsening of the severity or duration of volatility in the banking industry could also adversely impact our estimate of our allowance for credit losses and related provision for credit losses.
Additionally, the cost of resolving recent bank failures may prompt the FDIC to charge higher deposit insurance premiums and/or impose special assessments on insured depository institutions, regardless of asset size. These events and any future similar events may also result in changes to laws or regulations governing bank holding companies and banks, including higher capital requirements, or the imposition of restrictions through supervisory or enforcement activities, any of which could have a material adverse effect.
Any of these impacts, or any other impacts resulting from the events described above, could have a material adverse effect on our liquidity and capital levels, and our current and/or projected business operations and financial condition and results of operations.
Labor shortages and failure to attract and retain qualified employees could negatively impact our business, results of operations and financial condition.
A number of factors may adversely affect the labor force available to us or increase labor costs, including high employment levels, and decreased labor force size and participation rates. Although we have not experienced any material labor shortage to date, we have recently observed an overall tightening and competitive local labor market, especially for commercial lenders. As of December 31, 2023, Indiana's unemployment rate was 3.6%. A sustained labor shortage or increased turnover rates within our employee base could lead to increased costs, such as increased compensation expense to attract and retain employees.
In addition, if we are unable to hire and retain employees capable of performing at a high-level, or if mitigation measures we may take to respond to a decrease in labor availability have unintended negative effects, our business could be adversely affected. An overall labor shortage, lack of skilled labor, increased turnover or labor inflation could have a material adverse impact on our operations, results of operations, liquidity or cash flows.
Interest rate shifts may reduce net interest income and otherwise negatively impact our financial condition and results of operations.
Shifts in short-term interest rates may reduce net interest income, which is the principal component of our earnings. Net interest income is the difference between the amounts received by us on our interest bearing assets and the interest paid by us on our interest bearing liabilities. When interest rates rise, the rate of interest we pay on our liabilities may rise more quickly than the rate of interest that we receive on our interest bearing assets, which may cause our profits to decrease. Conversely,
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when interest rates fall, our interest bearing assets generally reprice more quickly than our interest bearing liabilities, given our asset-sensitive balance sheet, which may cause our net interest income to decrease. The impact on earnings is more adverse when the slope of the yield curve flattens, i.e. when short-term interest rates increase more than corresponding changes in long-term interest rates or when long-term interest rates decrease more than corresponding changes in short-term interest rates. In addition, when competition for deposits increases and deposit costs rise more quickly than loan yields, net interest income may be negatively impacted.
Interest rate increases often result in larger payment requirements for our borrowers, which increase the potential for default. At the same time, the value and marketability of any underlying assets securing a loan may be adversely affected by any reduced demand resulting from higher interest rates. In a declining interest rate environment, there may be an increase in prepayments on fixed rate loans, such as mortgages, as borrowers may seek to refinance these loans at lower rates.
Changes in interest rates also can affect the value of loans, securities and other assets. An increase in interest rates that adversely affects the ability of borrowers to pay the principal and interest on loans may lead to an increase in nonperforming assets and a reduction of income recognized, which could have a material adverse effect on our results of operations and cash flows. Thus, an increase in the amount of nonperforming assets would have an adverse impact on net interest income.
A resurgence of the COVID-19 pandemic, or a similar health crisis, could adversely affect our business.
The COVID-19 pandemic had a significant economic impact on the communities in which we operate, our borrowers and depositors, and the national economy generally. While these effects have diminished, future developments and uncertainties are difficult to predict, such as the potential emergence of new variants, the course of the pandemic in other major economies, the persistence of pandemic-related work and lifestyle changes, changes in consumer preferences associated with the emergence of the pandemic, the emergence of a new health crisis and other market disruptions. Any such developments could have a complex and negative effect on our business, including with respect to the prevailing economic environment, our lending and investment activities, and our business operations.
Risks Relating to Our Business
If we do not effectively manage our credit risk, we may experience increased levels of nonperforming loans, charge offs and delinquencies, which could require further increases in our provision for credit losses.
There are risks inherent in making any loan, including risks inherent in working with individual borrowers, risks of nonpayment, risks resulting from uncertainties as to the future value of collateral and risks resulting from changes in economic and industry conditions. In general, these risks have increased as a result of the recent increases in prevailing interest rates and uncertainties associated with inflation, which have potentially increased the risk of a near-term decline in growth or an economic downturn. We cannot assure you that our loan application approval procedures, use of loan concentration limits, credit monitoring, use of independent reviews of outstanding loans or other procedures will reduce these credit risks. If the overall economic climate in the United States, generally, and our market areas, specifically, does not perform in the manner we expect, or even if it does, our borrowers may experience difficulties in repaying their loans, and the level of nonperforming loans, charge offs and delinquencies could rise and require increases in the provision for credit losses, which would cause our net income and return on equity to decrease.
If our allowance for credit losses is not sufficient to absorb losses that may occur in our loan portfolio, our financial condition and liquidity could suffer.
We establish our allowance for credit losses and maintain it at a level considered adequate by management to absorb expected credit losses within the portfolio. Allocations of the allowance are made for specific loans and for pools of similar types of loans, although the entire allowance is available for any loan that, in management's judgment, should be charged against the allowance. Additions to the allowance for credit losses, which are charged to earnings through the provision for credit losses, are determined based on a variety of factors, including an analysis of the loan portfolio, historical loss experience and an evaluation of current economic conditions in our market areas. The actual amount of credit losses is affected by changes in economic, operating and other conditions within our markets, which may be beyond our control, and such losses may exceed current estimates.
At December 31, 2023, our allowance for credit losses as a percentage of total loans was 1.46% and as a percentage of total nonperforming loans was 458%. Because of the nature of our loan portfolio and our concentration in commercial and industrial loans, which tend to be larger loans, the movement of a small number of loans to nonperforming status can have a significant impact on these ratios. Although a formal evaluation of the adequacy of the credit loss allowance is conducted
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monthly, we cannot predict credit losses with certainty and we cannot provide assurance that our allowance for credit losses will prove sufficient to cover actual credit losses in the future. Credit losses in excess of our reserves may adversely affect our business, results of operations and financial condition.
Commercial and industrial loans make up a significant portion of our loan portfolio.
Commercial and industrial loans were $1.421 billion, or approximately 29% of our total loan portfolio, as of December 31, 2023. Commercial and industrial loans are often larger and involve greater risks than other types of lending. Because payments on such loans are often dependent on the successful operation of the borrower involved, repayment of such loans is often more sensitive than other types of loans to adverse conditions in the general economy. For example, the cumulative effects of changes in the economy and overall business environment, labor availability shortages and supply chain constraints have adversely affected commercial and industrial loans, and we expect this trend to continue for certain portions of our loan portfolio, particularly if general economic conditions worsen.
Negative economic trends can also harm the value of security for our commercial and industrial loans. These loans are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. Most often, this collateral is accounts receivable, inventory, machinery or real estate. As a result of the recent increase in interest rates and other factors, we have observed a corresponding decline in the value of commercial real estate securing these loans, substantially all of which are located within our Indiana markets. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers, which could decline in the case of an economic recession.
The collateral securing other loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. Due to the larger average size of each commercial loan as compared with other loans such as residential loans, as well as collateral that is generally less readily-marketable, losses incurred on a small number of commercial loans could adversely affect our business, results of operations and growth prospects. Historically, the Bank's largest charge offs have been in this segment of the loan portfolio.
Our loan portfolio includes commercial real estate loans, which involve risks specific to real estate value.
Commercial real estate loans were $2.438 billion, or approximately 50% of our total loan portfolio, as of December 31, 2023. The market value of real estate can fluctuate significantly in a short period of time as a result of interest rates and market conditions in our Indiana markets, where substantially all of our commercial real estate collateral is located, and, as a general matter, some of these values have been significantly and negatively affected by the recent rise in prevailing interest rates.
Although a significant portion of such loans are secured by real estate as a secondary form of collateral, these developments and any future adverse developments affecting real estate values in one or more of our markets could increase the credit risk associated with our loan portfolio. Additionally, real estate lending typically involves higher loan principal amounts and the repayment of the loans generally is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service. Economic events or governmental regulations outside of the control of the borrower or lender could negatively impact the future cash flow and market values of the affected properties.
If the loans that are collateralized by real estate become troubled and the value of the real estate has been significantly impaired, then we may not be able to recover the full contractual amount of principal and interest that we anticipated at the time of originating the loan, which could cause us to increase our provision for credit losses and adversely affect our operating results and financial condition.
Our loan portfolio has a notable concentration in agri-business, which has a higher level of uncontrolled risk.
Our agri-business loans, which totaled $388.8 million, or approximately 8% of our total loan portfolio, as of December 31, 2023, are subject to risks outside of our or the borrower’s control. Although our agriculture portfolio is well-diversified, the risks, specific to the agricultural industry, include decreases in livestock and crop prices, increases in labor and input prices, increase in stockpiles of agricultural commodities, the strength of the U.S. dollar, the potential impact of tariffs and other trade restrictions on commodities and the nature of climate and weather conditions. To the extent these or other factors affect the performance or financial condition of our agri-business borrowers, our results of operations and financial performance could suffer.
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Our consumer loans generally have a higher degree of risk of default than our other loans.
At December 31, 2023, consumer loans totaled $96.0 million, or 2% of our total loan portfolio. Consumer loans typically have shorter terms and lower balances with higher yields as compared to commercial loans, but generally carry higher risks of default. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on these loans.
Nonperforming assets take significant time to resolve and adversely affect our results of operations and financial condition and could result in further losses in the future.
Our nonperforming assets adversely affect our net income in various ways. We do not record interest income on nonaccrual loans or other real estate owned, which adversely affects our net income and returns on assets and equity, increases our loan administration costs and adversely affects our efficiency ratio. When we take collateral in foreclosure and similar proceedings, we are required to mark the collateral to its current fair market value at the time of transfer, which may result in a loss. These nonperforming loans and other real estate owned also increase our risk profile and our regulatory capital requirements may increase in light of such risks. The resolution of nonperforming assets requires significant time commitments from management and can be detrimental to the performance of their other responsibilities. If we experience increases in nonperforming loans and other nonperforming assets, our net interest income and provision expense may be negatively impacted and our loan administration costs could increase, each of which could have an adverse effect on our net income and related ratios, such as return on assets and equity.
Liquidity risks could affect operations and jeopardize our business, results of operations and financial condition.
Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a substantial, negative effect on our liquidity. Our primary sources of funds consist of deposits, cash from operations and investment security maturities and sales. Additional liquidity is provided by brokered deposits, Certificate of Deposit Account Registry Service ("CDARS") deposits, American Financial Exchange overnight borrowings and IntraFi Network’s insured cash sweep program. We are able to borrow from several federal funds lines at correspondent banks and are eligible to borrow from the Federal Reserve and the Federal Home Loan Bank (the “FHLB”) subject to collateral availability. At December 31, 2023, $379.0 million of unpledged investment securities were eligible to serve as collateral for liquidity availability at the FHLB and the Federal Reserve Bank. Our access to funding sources in amounts adequate to finance or capitalize our activities or on terms that are acceptable to us could be impaired by factors that affect us directly or the financial services industry or economy in general, such as disruptions in the financial markets or negative views and expectations about the prospects for the financial services industry. In addition, increased competition with banks and credit unions in our fooprint, brokerage firms and online deposit gatherers for retail deposits may impact our ability to raise funds through deposits and could have a negative effect on our liquidity. For example, as customer deposit levels have increased over the past year, we have observed that our sensitivity to rising deposits costs has increased as competition for deposits has risen.
Any decline in available funding could adversely impact our ability to originate loans, purchase investment securities, meet our expense obligations, pay dividends to our stockholders, or fulfill obligations such as repaying our borrowings or meeting deposit withdrawal demands, any of which could have a material adverse impact on our liquidity, business, results of operations and financial condition.
Any action or steps to change coverages or eliminate Indiana’s Public Deposit Insurance Fund could require us to find alternative, higher-cost funding sources to replace public fund deposits or to provide for collateralization of these deposits.
At December 31, 2023, approximately 27% of our deposits are concentrated in public funds from municipalities and government agencies located in the Bank’s geographic footprint. These accounts represent less than 1% of total customer deposit accounts atDecember 31, 2023. A shift in funding away from public fund deposits would impact liquidity availability and could increase our cost of funds, as the alternate funding sources, such as brokered certificates of deposit, can be higher-cost, are less favorable deposits and could require additional collateral to be pledged. The inability to maintain these public funds on deposit could result in a material adverse effect on the Bank’s liquidity and could materially impact our ability to grow and remain profitable.
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Declines in asset values may result in impairment charges and adversely affect the value of our investment securities, financial performance and capital.
We maintain an investment securities portfolio that includes, but is not limited to, mortgage-backed securities and municipal securities. The market value of these investment securities has been, and may continue to be, affected by factors other than the underlying performance of the servicer of the securities or the mortgages underlying the securities, such as changes in the interest rate environment, negative trends in the residential and commercial real estate markets, ratings downgrades, adverse changes in the business climate and a lack of liquidity in the secondary market for certain investment securities. On a quarterly basis, we evaluate investment securities and other assets for credit and other impairment indicators. We may be required to record additional credit reserve charges if our investment securities suffer a decline in fair value that has resulted from credit losses or other factors. If we determine that a significant reserve is needed, we would be required to charge against earnings the credit-related portion, which could have a material adverse effect on our results of operations in the periods in which the write-offs occur. In addition, we may determine to sell securities in our available-for-sale investment securities portfolio, and any such sale could cause us to realize currently unrealized losses that resulted from the recent increases in the prevailing interest rates.
Risks Relating to Our Corporate Strategy
We may need to raise additional capital in the future to achieve our growth plans, but that capital may not be available when it is needed.
We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. Accordingly, we may need to raise additional capital to support our future growth plans. Our ability to raise additional capital depends on conditions in the capital markets, economic conditions and a number of other factors, including investor perceptions regarding the banking industry, market conditions and governmental activities, and on our financial condition and performance. Accordingly, we cannot make assurances of our ability to raise additional capital, if needed, on terms acceptable to us. In particular, if we were required to raise additional capital in the current interest rate environment, we believe the pricing and other terms investors may require in such an offering may not be attractive to use. If we cannot raise additional capital when needed, our financial condition and our ability to further expand our operations through internal growth or acquisitions could be materially impaired.
We may experience difficulties in managing our growth, and our growth strategy involves risks that may negatively impact our net income.
In addition to our continuing expansion in Indianapolis and larger cities in Northern Indiana, we may expand into additional communities or attempt to strengthen our position in our current markets through opportunistic acquisitions of all or part of other financial institutions, or by opening new branches in or within three hours of our contiguous geographic footprint. To the extent that we undertake acquisitions or new branch openings, we are likely to experience the effects of higher operating expenses relative to operating income from the new operations, which may have an adverse effect on our levels of reported net income, return on average equity and return on average assets. Other effects of engaging in such growth strategies may include potential diversion of our management’s time and attention and general disruption to our business.
To the extent that we grow through acquisitions and branch openings, we cannot assure you that we will be able to adequately and profitably manage this growth. Acquiring other banks and businesses will involve similar risks to those commonly associated with branching but may also involve additional risks, including:
•potential exposure to unknown or contingent liabilities of banks and businesses we acquire;
•exposure to potential asset quality issues of the acquired bank or related business;
•difficulty and expense of integrating the operations and personnel of banks and businesses we acquire; and
•the possible loss of key employees and customers of the banks and businesses we acquire.
We face intense competition in all phases of our business from other banks, financial institutions, private credit funds and nonbank financial service providers.
The banking and financial services business in our market is highly competitive. Our competitors include large national, regional and local community banks, credit unions, Fintech and nonbank financial service providers, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market mutual funds and farm
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credit services. Many of these competitors are not subject to the same operating costs or regulatory restrictions as we are and are able to provide customers with a feasible alternative to traditional banking services.
Increased competition may also result in a decrease in the amounts of our loans and deposits, reduced spreads between loan rates and deposit rates or loan terms that are more favorable to the borrower, particularly in the case of incremental loan growth. Any of these results could have a material adverse effect on our ability to grow and remain profitable. If increased competition causes us to significantly discount the interest rates we offer on loans or increase the amount we pay on deposits, our net interest income could be adversely impacted. If increased competition causes us to relax our underwriting standards, we could be exposed to higher losses from lending activities. Moreover, we rely on deposits to be a low-cost source of funding, and a loss in our deposit base could cause us to incur higher funding costs from wholesale funding sources.
The financial services industry is constantly undergoing rapid technological changes with frequent introductions of new technology-driven products and services. We invest from time to time in investment funds that seek to promote the development of such new and emerging financial technologies. However, there can be no assurance that we will be able to effectively incorporate, or otherwise benefit from, such developments.
Additionally, many of our competitors are much larger in total assets and capitalization, have greater access to capital markets, possess larger lending limits and offer a broader range of financial services than we can offer.
Attractive acquisition opportunities may not be available to us in the future.
We expect that other banking and financial service companies, many of which have significantly greater resources than we do, will compete with us in acquiring other financial institutions if we pursue such acquisitions. This competition could increase prices for potential acquisitions that we believe are attractive. Also, acquisitions are subject to various regulatory approvals. If we fail to receive the appropriate regulatory approvals, we will not be able to consummate an acquisition that we believe is in our best interests. Among other things, our regulators consider our capital, liquidity, profitability, regulatory compliance and levels of goodwill and intangibles when considering acquisition and expansion proposals. Any acquisition could be dilutive to our earnings and stockholders’ equity per share of our common stock.
Risks Relating to Regulation, Tax and Accounting
We may be materially and adversely affected by the highly regulated environment in which we operate.
We are subject to extensive federal and state regulation, supervision and examination. A more detailed description of the primary federal and state banking laws and regulations that affect us is contained in the section of this Annual Report on Form 10-K captioned “Supervision and Regulation of the Bank”. Banking regulations are primarily intended to protect depositors’ funds, FDIC funds, customers and the banking system as a whole, rather than our shareholders. These regulations affect our lending practices, capital structure, investment practices, dividend policy and growth, among other things.
As a bank holding company, we are subject to extensive regulation and supervision and undergo periodic examinations by our regulators, who have extensive discretion and authority to prevent or remedy unsafe or unsound practices or violations of law by banks and bank holding companies. Failure to comply with applicable laws, regulations or policies could result in sanctions by regulatory agencies, civil monetary penalties and/or damage to our reputation, which could have a material adverse effect on us. Although we have policies and procedures designed to mitigate the risk of any such violations, there can be no assurance that such violations will not occur.
The laws, regulations, rules, standards, policies and interpretations governing us are constantly evolving and may change significantly over time. For example, on July 21, 2010, the Dodd-Frank Act was signed into law, which significantly changed the regulation of financial institutions and the financial services industry. The Dodd-Frank Act, together with the regulations to be developed thereunder, includes provisions affecting large and small financial institutions alike, including several provisions that affect how community banks, thrifts and small bank and thrift holding companies operate. In addition, the Federal Reserve, in recent years, has adopted numerous new regulations addressing banks’ overdraft and mortgage lending practices. Further, the CFPB has broad powers to supervise and enforce consumer protection laws, and additional consumer protection legislation and regulatory activity is anticipated in the near future, including with respect to fees charged by banks and other financial companies. Any enforcement actions or other rule-making in these areas could negatively affect our business and our ability to maintain or grow levels of noninterest income.
The recent failures of Silicon Valley Bank and Signature Bank are expected to result in modifications to existing laws or the passage of additional laws and regulations governing banks and bank holding companies, including increasing capital
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requirements, modifications to regulatory requirements with respect to liquidity risk management, deposit concentrations, capital adequacy, stress testing and contingency planning, safe and sound banking practices and enhanced supervisory or enforcement activities. Other legislative initiatives could detrimentally impact our operations in the future. Regulatory bodies may enact new laws or promulgate new regulations or view matters or interpret existing laws and regulations differently than they have in the past or commence investigations or inquiries into our business practices. For example, the Biden Administration announced a government-wide effort to eliminate “junk fees” which could subject our business practices to further scrutiny. The CFBP’s action on junk fees thus far has largely focused on fees associated with deposit products, such as “surprise” overdraft fees and non-sufficient funds fees. However, what constitutes a “junk fee” remains undefined. The CFPB is actively soliciting consumer input on fee practices associated with other consumer financial products or services, signaling that the “junk fee” initiative is likely to continue to broaden in scope. As a result of this regulatory focus, we have changed how we assess overdraft and non-sufficient funds fees and may be required to implement additional changes based on regulatory directives or guidance. Such changes have led to and may continue to cause a reduction in our noninterest income and thus impact our overall net income.
These provisions, as well as any other aspects of current or proposed regulatory or legislative changes to laws applicable to the financial industry, may impact the profitability of our business activities and may change certain of our business practices, including our ability to offer new products, obtain financing, attract deposits, make loans and achieve satisfactory interest spreads and could expose us to additional costs, including increased compliance costs.
Regulations of the Federal Reserve could adversely affect our business, financial condition and results.
An important function of the Federal Reserve is to regulate the money supply and credit conditions. Among the instruments used by the Federal Reserve to implement these objectives are open market operations in U.S. government securities, adjustments of the discount rate and changes in reserve requirements against bank deposits. These instruments are used in varying combinations to influence overall economic growth and the distribution of credit, bank loans, investments and deposits. Their use also affects interest rates charged on loans or paid on deposits.
The monetary policies and regulations of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. The effects of such policies upon our business, financial condition and results of operations cannot be predicted.
We are required to maintain capital to meet regulatory requirements, and, if we fail to maintain sufficient capital, whether due to losses, an inability to raise additional capital or otherwise, our financial condition, liquidity and results of operations, as well as our ability to maintain regulatory compliance, would be adversely affected.
The Company, on a consolidated basis, and the Bank, on a stand-alone basis, must meet certain regulatory capital requirements and maintain sufficient liquidity. We face significant capital and other regulatory requirements as a financial institution, which were heightened with the implementation of the Basel III Rule and the phase-in of capital conservation buffer requirement and could be further impacted by the proposed Basel III Endgame Rule. Our ability to raise additional capital depends on conditions in the capital markets, economic conditions and a number of other factors, including investor perceptions regarding the banking industry, market conditions and governmental activities and on our financial condition and performance. Accordingly, we cannot assure you that we will be able to raise additional capital if needed or on terms acceptable to us. If we fail to maintain capital to meet regulatory requirements, our financial condition, liquidity and results of operations would be materially and adversely affected.
We may be subject to a higher consolidated effective tax rate if there is a change in tax laws relating to LCB Investments II, Inc. or if LCB Funding, Inc. fails to qualify as a real estate investment trust.
The Bank holds certain investment securities in its wholly owned subsidiary LCB Investments II, Inc., which is incorporated in Nevada. Pursuant to the State of Indiana’s current tax laws and regulations, we are not subject to Indiana income tax for income earned through that subsidiary. If there are changes in Indiana’s tax laws or interpretations thereof requiring us to pay state taxes for income generated by LCB Investments II, Inc., the resulting tax consequences could increase our effective tax rate or cause us to have a tax liability for prior years.
The Bank also holds certain commercial real estate loans, residential real estate loans and other loans in a real estate investment trust through LCB Investments II, Inc., which is incorporated in Maryland. Qualification as a real estate investment trust involves application of specific provisions of the Internal Revenue Code relating to various asset tests. If LCB Funding, Inc. fails to meet any of the required provisions for real estate investment trusts, it could no longer qualify as a real estate investment trust and the resulting tax consequences would increase our effective tax rate or cause us to have a tax liability for
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prior years. Additionally, changes to the State of Indiana's current tax laws and regulations for real estate investment trust income disallowance could increase our effective tax rate or cause us to have a tax liability for prior years.
Our accounting policies and methods are the basis for how we prepare our consolidated financial statements and how we report our financial condition and results of operations, and they require management to make estimates about matters that are inherently uncertain.
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. Our management must exercise judgment in selecting and applying many of these accounting policies and methods in order to ensure they comply with GAAP and reflect management’s judgment as to the most appropriate manner in which to record and report our financial condition and results of operations. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which might be reasonable under the circumstances. The application of that chosen accounting policy or method might result in the Company reporting different amounts than would have been reported under a different alternative. If management’s estimates or assumptions are incorrect, the Company may experience material losses.
Management has identified one accounting policy as being “critical” to the presentation of the Company’s financial condition and results of operations because it requires management to make particularly subjective and complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. This critical accounting policy relates to the allowance for credit losses. Because of the inherent uncertainty of this estimate, no assurance can be given that the application of alternative policies or methods might not result in the reporting of a different amount of the allowance for credit losses and, accordingly, net income.
From time to time, the FASB and the SEC change the financial accounting and reporting standards or the interpretation of those standards that govern the preparation of our external financial statements. In addition, trends in financial and business reporting, including environmental, social and governance (ESG) related disclosures, could require us to incur additional reporting expense. These changes are beyond our control, can be difficult to predict and could materially impact how we report our financial condition and results of operations. Changes in these standards are continuously occurring, and given the current economic environment, more drastic changes may occur. The implementation of such changes could have a material adverse effect on our financial condition and results of operations.
We may experience increases to, and volatility in, the balance of the allowance for credit losses and related provision expense due to the adoption of the Current Expected Credit Loss ("CECL") methodology.
We adopted CECL, effective as of January 1, 2021, following the delayed adoption period permitted by the CARES Act and extended by the Consolidated Appropriations Act, 2021. The CECL methodology requires measurement of anticipated credit losses to occur when a financial asset is first added to the balance sheet and periodically thereafter. These measurements require significant use of management judgments as well as forward-looking information and forecasts. Any failure of these judgments or forecasts to be correct could negatively affect our results of operations and financial condition.
We may be adversely affected by changes in U.S. tax laws and regulations.
Any change in federal or state tax laws or regulations, including any increase in the federal corporate income tax rate from the current level of 21%, could negatively affect our business and results of operations, including as a result of our income tax expense and any impact to the profitability of our loan customers.
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Risks Relating to our Operations
Our ability to attract and retain management and key personnel and any damage to our reputation may affect future growth and earnings.
Much of our success and growth has been influenced strongly by our ability to attract and retain management experienced in banking and financial services and familiar with the communities in our market areas. Our ability to retain the executive officers, management teams, branch managers and loan officers at the Bank will continue to be important to the successful implementation of our strategy. It is also critical, as we grow, to be able to attract and retain qualified additional management and loan officers with the appropriate level of experience and knowledge about our market areas to implement our community-based operating strategy. The unexpected loss of services of any key management personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse effect on our business, results of operations and financial condition.
In addition, our business depends on earning and maintaining the trust of our customers and communities. Harm to our reputation could arise from numerous sources, including employee misconduct, compliance failures, internal control deficiencies, litigation or our failure to deliver appropriate levels of service. If any events or circumstances occur which could undermine our reputation, there can be no assurance that the additional costs and expenses we may incur as a result would not have an adverse impact on our business.
We have a continuing need to adapt to technological change and we may not have the resources to effectively implement new technology.
The financial services industry is constantly undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend in part upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations as we continue to grow and expand our market areas. Many of our larger competitors have substantially greater resources to invest in technological improvements, such as articifical intelligence. As a result, they may be able to offer additional or superior products to those that we will be able to offer, which would put us at a competitive disadvantage. Accordingly, we cannot provide assurances that we will be able to effectively implement new technology-driven products and services or be successful in marketing such products and services to our customers.
The Company’s information systems may experience an interruption or breach in security and cyber-attacks, all of which could have a material adverse effect on the Company’s business.
The Company relies heavily on internal and outsourced technologies, communications, and information systems to conduct its business, particularly with respect to our core processing provider and our digital banking provider. Additionally, in the normal course of business, the Company collects, processes and retains sensitive and confidential information regarding our customers. As the Company’s reliance on technology has increased, so have the potential risks of a technology-related operation interruption (such as disruptions in the Company’s core provider, general ledger, deposit, loan, digital banking or other systems) or the occurrence of a cyber-attack (such as unauthorized access to the Company’s systems). These risks have increased for all financial institutions as new technologies, the use of the Internet and telecommunications technologies (including mobile devices) to conduct financial and other business transactions and the increased sophistication and activities of organized crime, perpetrators of fraud, hackers, terrorists and others have increased. In addition to cyber-attacks, business e-mail compromise campaigns or other security breaches involving the theft of sensitive and confidential information, hackers recently have engaged in attacks against financial institutions, particularly denial of service attacks, which are designed to disrupt key business services, such as customer-facing web sites and social engineering attacks that could influence an employee of the Company to click on a link that downloads malware or ransomware to the Company’s system or prompts the employee to enter system credentials. The Company is not able to anticipate or implement effective preventive measures against all security breaches of these types, especially because the techniques used change frequently and because attacks can originate from a wide variety of sources. In addition, it is possible that we may not be able to detect security breaches on a timely basis, or at all, which could increase the costs and risks associated with any such breach.
The Company also faces risks related to cyber-attacks and other security breaches in connection with credit card and debit card transactions that typically involve the transmission of sensitive information regarding the Company’s customers through various third parties, including merchant acquiring banks, payment processors, payment card networks and its processors. Some of these parties have in the past been the target of security breaches and cyber-attacks, and because the
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transactions involve third parties and environments such as the point of sale that the Company does not control or secure, future security breaches or cyber-attacks affecting any of these third parties could impact the Company through no fault of its own, and in some cases it may have exposure and suffer losses for breaches or attacks relating to them. In addition, the Company offers its customers protection against fraud and certain losses for unauthorized use of debit cards in order to stay competitive with other financial institutions. Offering such protection exposes the Company to losses that could adversely affect its business, financial condition and results of operations. Further cyber-attacks or other breaches in the future, whether affecting the Company or others, could intensify consumer concern and regulatory focus and result in reduced use of payment cards and increased costs, all of which could have a material adverse effect on the Company’s business. To the extent we are involved in any future cyber-attacks or other breaches, the Company’s reputation could be affected, which could also have a material adverse effect on the Company’s business, financial condition or results of operations.
We are subject to certain operational risks, including, but not limited to, customer or employee fraud and data processing system failures and errors.
Employee errors and misconduct could subject us to financial losses or regulatory sanctions and seriously harm our reputation. Misconduct by our employees could include hiding their own unauthorized activities from us, improper or unauthorized activities on behalf of our customers or improper use of confidential information. It is not always possible to prevent employee errors and misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Employee errors could also subject us to financial claims for negligence, among others.
In addition, as a bank, we are susceptible to fraudulent activity that may be committed against us, third parties or our clients, which may result in financial losses or increased costs to us or our clients, disclosure or misuse of our information or our client information, misappropriation of assets, privacy breaches against our clients, litigation or damage to our reputation. Such fraudulent activity may take many forms, including check fraud, electronic fraud, wire fraud, phishing, social engineering and other dishonest acts. For example, as previously disclosed in the second quarter of 2023, the Bank was the victim of international wire fraud resulting in an estimated loss of $18.1 million, prior to additional insurance and loss recoveries of $6.3 million in the fourth quarter of 2023.
We maintain a system of internal controls and insurance coverage to mitigate operational risks, including data processing system failures and errors, cyber-attacks, and customer or employee fraud. Should our internal controls fail to prevent or detect an occurrence, or if any resulting loss is not insured or exceeds applicable insurance limits, it could have a material adverse effect on our business, results of operations and financial condition.
The Company is and may become involved from time to time in suits, legal proceedings, information-gathering requests, investigations and proceedings by governmental and self-regulatory agencies that may lead to adverse consequences.
Many aspects of our business and operations involve the risk of legal liability, and in some cases we or our subsidiaries have been named or threatened to be named as defendants in various lawsuits arising from our business activities. For example, as previously disclosed in the third quarter of 2019, the Bank discovered potentially fraudulent activity by a former treasury management client involving multiple banks. In the context of resulting bankruptcy proceedings involving the former client, the liquidating trustee has filed a complaint against the Bank, focused on a series of business transactions among the former client, related entities and the Bank. In addition, companies in our industry are frequently the subject of governmental and self-regulatory agency information-gathering requests, reviews, investigations and proceedings. The results of such proceedings could lead to significant civil or criminal penalties, including monetary penalties, damages, adverse judgments, settlements, fines, injunctions, restrictions on the way in which we conduct our business, or reputational harm.
Although we establish accruals for legal proceedings when information related to the loss contingencies represented by those matters indicates both that a loss is probable and that the amount of loss can be reasonably estimated, we do not have accruals for all legal proceedings where we face a risk of loss. In addition, due to the inherent subjectivity of the assessments and unpredictability of the outcome of legal proceedings, amounts accrued may not represent the ultimate loss to us from the legal proceedings in question. Accordingly, our ultimate losses may be higher, and possibly significantly so, than the amounts accrued for legal loss contingencies, which could adversely affect our financial condition and results of operations.
ITEM 1B. UNRESOLVED STAFF COMMENTS
We have no unresolved SEC staff comments.
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ITEM 1C. CYBERSECURITY
We rely extensively on various information systems and other electronic resources to operate our business. In addition, nearly all of our customers, service providers and other business partners on whom we depend, including the providers of our online banking, mobile banking and accounting systems, use these systems and their own electronic information systems. Any of these systems can be compromised, including through the employees, customers and other individuals who are authorized to use them, and threat actors use a sophisticated and constantly evolving set of software, tools and strategies to do so. The nature of our business, as a financial services provider, and our relative size, make us and our business partners high-value targets for these bad actors to pursue. See section “Risks Relation to our Operations”.
Accordingly, we have long devoted significant resources to assessing, identifying and managing risks associated with cybersecurity threats, including:
•an internal information security team that is responsible for conducting regular assessments of our information systems, existing controls, vulnerabilities and potential improvements;
•continuous monitoring tools that can detect and help respond to cybersecurity threats in real-time;
•performing due diligence with respect to our third-party service providers, including their cybersecurity practices, and requiring contractual commitments from our service providers to take certain cybersecurity measures;
•third-party information security and cybersecurity consultants, who conduct periodic penetration testing, vulnerability assessments and other procedures to identify potential weaknesses in our systems and processes; and
•ongoing cybersecurity training and phishing testing for our employees.
This information security program is a key part of our overall risk management system. The program includes administrative, technical and physical safeguards to help ensure the security and confidentiality of customer records and information. These security and privacy policies and procedures are in effect across all of our businesses and geographic locations.
From time-to-time, we have identified cybersecurity threats and cybersecurity incidents that require us to make changes to our processes and to implement additional safeguards. While none of these identified threats or incidents have materially affected us, it is possible that threats and incidents we identify in the future could have a material adverse effect on our business strategy, results of operations and financial condition.
Our management team is responsible for the day-to-day management of risks we face, including our Vice President – Information Security Officer. Our current Information Security Officer has over 15 years of experience, including prior work in the healthcare field, and is a Certified Information Systems Security Professional and CompTIA Security+ certified.
In addition, our board of directors, as a whole and through the Bank's Corporate Risk Committee (the “Risk Committee”), is responsible for the oversight of risk management. In that role, our board of directors and Risk Committee, with support from the Company’s cybersecurity advisors, are responsible for ensuring that the risk management processes designed and implemented by management are adequate and functioning as designed. To carry out those duties, our board of directors receives reports, at least quarterly, from our management team regarding cybersecurity risks, and the Company’s efforts to prevent, detect, mitigate and remediate any cybersecurity incidents.
ITEM 2. PROPERTIES
The Company is headquartered in the main office building of the Bank at 202 E. Center Street, Warsaw, Indiana 46580. The Company operates in 60 locations, 51 of which are owned by the Bank and nine of which are leased from third parties.
None of the Company’s real property assets are the subject of any material encumbrances.
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ITEM 3. LEGAL PROCEEDINGS
Lakeland Financial Corporation and its subsidiaries are subject in the normal course of business to various pending and threatened legal proceedings and other matters in which claims for monetary damages are asserted. On an ongoing basis management, after consultation with legal counsel, assesses the Company's liabilities and contingencies in connection with such proceedings. For those matters where it is probable that the Company will incur losses and the amounts of the losses can be reasonably estimated, the Company records an expense and corresponding liability in its consolidated financial statements. To the extent the pending or threatened litigation could result in exposure in excess of that liability, the amount of such excess is not currently estimable. Although the Company does not believe that the outcome of pending legal matters will be material to the Company's consolidated financial position, it cannot rule out the possibility that such outcomes will be material to the consolidated results of operations for a particular reporting period in the future. See "Note 1 - Summary of Significant Accounting Policies - Loss Contingencies" in our audited financial statements included in this Annual Report on Form 10-K.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
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PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The quarterly high and low prices for the Company’s common stock and the cash dividends declared and paid on that common stock are set forth in the table below.
High* Low* Cash Dividend High* Low* Cash Dividend
The common stock of the Company was first quoted on The Nasdaq Stock Market under the symbol “LKFN” on August 14, 1997. Currently, the Company’s common stock is listed for trading on the Nasdaq Global Select Market under the symbol “LKFN.” On February 13, 2024, the Company had approximately 299 stockholders of record.
The Company paid dividends on its common stock as set forth in the table above. The Company’s ability to pay dividends to stockholders is largely dependent upon the dividends it receives from the Bank, and the Bank is subject to regulatory limitations on the amount of cash dividends it may pay. See “Supervision and Regulation of the Company – Dividend Payments” for additional information.
Equity Compensation Plan Information
The table below sets forth the following information as of December 31, 2023 for (i) all compensation plans previously approved by the Company’s stockholders and (ii) all compensation plans not previously approved by the Company’s stockholders:
(a)the number of securities to be issued upon the exercise of outstanding options, warrants and rights;
(b)the weighted-average exercise price of such outstanding options, warrants and rights; and
(c)other than securities to be issued upon the exercise of such outstanding options, warrants and rights, the number of securities remaining available for future issuance under the plans.
EQUITY COMPENSATION PLAN INFORMATION
Equity compensation plans approved by security holders(1) 0 $ 0 279,618
Equity compensation plans not approved by security holders 0 0 0
(1)Lakeland Financial Corporation 2017 Equity Incentive Plan was adopted on April 12, 2017 by the board of directors.
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STOCK PRICE PERFORMANCE GRAPH
The graph below compares the cumulative total return of the Company, the Nasdaq Market Index, the KBW Nasdaq Bank Index, and the S&P U.S. BMI Banks Index.
Lakeland Financial Corporation
Period Ending
The above returns assume that $100 was invested on December 31, 2018 and that all dividends were reinvested.
PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PARTIES
On January 8, 2019, the Company's board of directors approved a share repurchase program, under which the Company is authorized to repurchase, from time to time as the Company deems appropriate, shares of the Company's common stock with an aggregate purchase price of up to $30 million. Repurchases may be made in the open market, through block trades or otherwise, and in privately negotiated transactions. On April 11, 2023, the Company's board of directors reauthorized and extended the share repurchase program through April 30, 2025. As extended, the repurchase program has remaining aggregate purchase price authority of $30 million as of December 31, 2023. The repurchase program does not obligate the Company to repurchase any dollar amount or number of shares, and the program may be extended, modified, suspended or discontinued at any time. There were no repurchases under this plan during the year ended December 31, 2023.
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During the quarter ended December 31, 2023, no director or officer of the Company adopted or terminated any Rule 10b5-1 trading arrangement or any non-Rule 10b5-1 trading arrangement, in each case as defined in Item 408 of Regulation S-K.
The following table provides information about purchases by the Company and its affiliates during the quarter ended December 31, 2023 of equity securities that are registered by the Company pursuant to Section 12 of the Exchange Act:
(a) The shares purchased during the quarter were credited to the deferred share accounts of non-employee directors under the Company’s directors’ deferred compensation plan. These shares are held in treasury stock of the Company and were purchased in the ordinary course of business and consistent with past practice.
(b) Following the renewal and extension of the Company's share repurchase program on April 11, 2023, the maximum dollar value of shares that may bet be repurchased under the program is $30 million as of December 31, 2023. The share repurchase program terminates April 30, 2025.
ITEM 6. [Reserved]
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
Net income in 2023 was $93.8 million, down 9.7%, from $103.8 million in 2022. Net income for 2022 was 8.4% higher than $95.7 million in 2021.
Diluted net income per common share was $3.65 in 2023, $4.04 in 2022 and $3.74 in 2021. Return on average total assets was 1.45% in 2023, versus 1.62% in 2022 and 1.56% in 2021. Return on average total equity was 15.93% in 2023, versus 17.40% in 2022 and 14.19% in 2021. The dividend payout ratio, with respect to diluted earnings per share, was 50.41% in 2023, versus 39.60% in 2022 and 36.36% in 2021. The average equity to average assets ratio was 9.11% in 2023, compared to 9.28% in 2022 and 10.96% in 2021.
Net income in 2023 was negatively impacted by a $20.5 million increase in noninterest expense and a $5.9 million decrease in net interest income. Offsetting these decreases were an $8.0 million increase in noninterest income and a $3.5 million decrease in provision for credit losses.
On June 30, 2023, the Company discovered that it had been the victim of an international wire fraud resulting in a loss of $18.1 million. During the fourth quarter of 2023, the Company recognized $6.3 million in insurance and loss recoveries associated with the wire fraud loss. During 2023, the total impact of the wire fraud loss to income before income tax expense was $10.4 million, net of recoveries and adjustments to salaries and benefits expense, or $7.8 million net of tax, and $0.30 diluted earnings per common share.
Core operational profitability, a non-GAAP financial measure that excludes the impact of the wire fraud loss and related insurance and loss recoveries as well as adjustments to the Company's salaries and employee benefits expense, was $101.6 million for the twelve months ended December 31, 2023, a decrease of $2.2 million, or 2.2%, from the full year 2022. Core operational diluted earnings per common share, a non-GAAP financial measure, for the twelve months ended December 31, 2023, was $3.95, also a decrease of 2.2%, from the full year 2022.
Net income in 2022 was positively impacted by a $24.8 million increase in net interest income. Offsetting the positive impact of net interest income were an $8.3 million increase in provision for credit losses, a $5.9 million increase in noninterest expense and a $2.9 million decrease in noninterest income.
Total assets were $6.524 billion as of December 31, 2023 versus $6.432 billion as of December 31, 2022, an increase of $91.7 million or 1.4%. Balance sheet expansion in 2023 was driven by loan growth of $206.1 million, or 4.4%. Offsetting the increase in loan growth was a decrease in investments securities of $132.1 million, or 10.1%. Balance sheet expansion in 2023 was funded by an increase in deposits of $259.9 million, or 4.8%, and was offset by a decrease in borrowings of $247.0 million.
CRITICAL ACCOUNTING POLICIES
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. Some of the facts and circumstances which could affect these judgments include changes in interest rates, in the performance of the economy or in the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for credit losses.
Allowance for Credit Losses
The Company maintains an allowance for credit losses to provide for expected credit losses. Losses are charged against the allowance when management believes that the principal is uncollectible. Subsequent recoveries, if any, are credited to the allowance. Allocations of the allowance are made for specific loans and for pools of similar types of loans, although the entire allowance is available for any loan that, in management’s judgment, should be charged against the allowance. A provision for credit losses is taken based on management’s ongoing evaluation of the appropriate allowance balance. A formal evaluation of the adequacy of the credit loss allowance is conducted monthly. The ultimate recovery of all loans is susceptible to future market factors beyond the Company’s control.
The level of credit loss provision is influenced by growth in the overall loan portfolio, emerging market risk, emerging concentration risk, commercial loan focus and large credit concentration, new industry lending activity, general economic
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conditions and historical loss analysis. In addition, management gives consideration to changes in the facts and circumstances of watch list credits, which includes the security position of the borrower, in determining the appropriate level of the credit loss provision. Furthermore, management’s overall view on credit quality is a factor in the determination of the provision.
The determination of the appropriate allowance is inherently subjective, as it requires significant estimates by management. The Company has an established process to determine the adequacy of the allowance for credit losses that generally includes consideration of changes in the nature and volume of the loan portfolio and overall portfolio quality, along with current and forecasted economic conditions that may affect borrowers’ ability to repay. Consideration is not limited to these factors although they represent the most commonly cited factors. To determine the specific allocation levels for individual credits, management considers the current valuation of collateral and the amounts and timing of expected future cash flows as the primary measures. Management also considers trends in adversely classified loans based upon an ongoing review of those credits. With respect to pools of similar loans, an appropriate level of general allowance is determined by portfolio segment using a probability of default-loss given default (“PD/LGD”) model, subject to a floor. A default can be triggered by one of several different asset quality factors, including past due status, nonaccrual status, material modification to a borrower experiencing financial difficulty or if the loan has had a charge off. This PD is then combined with a LGD derived from historical charge off data to construct a default rate. This loss rate is then supplemented with adjustments for reasonable and supportable forecasts of relevant economic indicators, particularly the unemployment rate forecast from the Federal Open Market Committee’s Summary of Economic Projections, and other environmental factors based on the risks present for each portfolio segment. These environmental factors include consideration of the following: levels of, and trends in, delinquencies and nonperforming loans; trends in volume and terms of loans; changes in collateral strength; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedure, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. It is also possible that these factors could include social, political, economic, and terrorist events or activities. All of these factors are subject to change, which may be significant. As a result of this detailed process, the allowance results in two forms of allocations, specific and general. These two components represent the total allowance for credit losses deemed adequate to cover expected losses inherent in the loan portfolio.
Commercial loans are subject to a dual standardized grading process administered by the credit administration function. These grade assignments are performed independent of each other and a consensus is reached by credit administration and the loan officer. Specific allowances are established in cases where management has identified significant conditions or circumstances related to an individual credit that indicate it should be evaluated on an individual basis. Considerations with respect to specific allocations for these individual credits include, but are not limited to, the following: (a) the sufficiency of the customer’s cash flow or net worth to repay the loan; (b) the adequacy of the discounted value of collateral relative to the loan balance; (c) whether the loan has been criticized in a regulatory examination; (d) whether the loan is nonperforming; (e) any other reasons the ultimate collectability of the loan may be in question; or (f) any unique loan characteristics that require special monitoring.
Allocations are also applied to categories of loans considered not to be individually analyzed, but for which the rate of loss is expected to be consistent with or greater than historical averages. Such allocations are based on past loss experience and information about specific borrower situations and estimated collateral values. These general pooled loan allocations are performed for portfolio segments of commercial and industrial; commercial real estate, multi-family, and construction; agri-business and agricultural; other commercial loans; and consumer 1-4 family mortgage and other consumer loans. General allocations of the allowance are determined by a historical loss rate based on the calculation of each pool’s probability of default-loss given default, subject to a floor. The length of the historical period for each pool is based on the average life of the pool. The historical loss rates are supplemented with consideration of economic conditions and portfolio trends.
Due to the imprecise nature of estimating the allowance for credit losses, the Company’s allowance for credit losses includes an unallocated component. The unallocated component of the allowance for credit losses incorporates the Company’s judgmental determination of potential expected losses that may not be fully reflected in other allocations. As a practical expedient, the Company has elected to state accrued interest separately from loan principal balances on the consolidated balance sheet. Additionally, when a loan is placed on non-accrual, interest payments are reversed through interest income.
For off balance sheet credit exposures outlined in the ASU at 326-20-30-11, it is the Company’s position that nearly all of the unfunded amounts on lines of credit are unconditionally cancellable, and therefore not subject to having a liability recorded.
The allowance is inherently uncertain as it represents the Company’s expectation of the future collectability of loans in its portfolio; actual collections may be greater than or less than expectations. Actual collections may be impacted by wider economic conditions such as changes in the competitive environment or in the levels of business investment or consumer
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spending, or by the quality of borrowers’ management teams and the success of their strategy execution. Borrowers’ ability to repay may also change due to the effects of government monetary or fiscal policy, which could affect the level of demand for borrowers’ products or services.
The Company’s allowance for credit losses is subject to changes in the inputs to the model, including the following: the number of delinquent loans, nonaccrual loans, material modification due to a borrower experiencing financial difficulty, or charge offs; the levels of charge offs and recoveries; projected unemployment rates and other economic indicators; the Company’s collateral position on adversely classified loans; or management’s qualitative judgment of the implication of trends in its loan portfolio or in the broader economy.
RESULTS OF OPERATIONS
Overview
The Company's net income in 2023 decreased $10.1 million, or 9.7%, as a result of an increase in noninterest expense of $20.5 million, or 18.6%, and a decrease in net interest income of $5.9 million, or 2.9%. Noninterest income increased $8.0 million, or 19.1%. Provision for credit losses decreased $3.5 million, or 37.6%.
The increases to noninterest expense and noninterest income were primarily driven by the wire fraud loss that occurred during the second quarter of 2023 and related insurance and loss recoveries and adjustments to salaries and benefits expense recorded by the Company as a result of the loss. The wire fraud loss of $18.1 million was the primary driver of the increase to noninterest expense. Insurance and loss recoveries associated with the event of $6.3 million were recorded as noninterest income during the fourth quarter of 2023. Salaries and employee benefits expense was reduced by $1.4 million as a result of adjustments to the Company's long term incentive accrual due to the negative impact of the loss on the Company's net income for the year.
Core operational profitability, a non-GAAP financial measure which excludes the impact of the wire fraud loss and related insurance and loss recoveries and adjustments to the Company's salaries and employee benefits expense, was $101.6 million for the twelve months ended December 31, 2023, a decrease of $2.2 million, or 2.2%, from the full year 2022. Core operational diluted earnings per common share, a non-GAAP financial measure, for the twelve months ended December 31, 2023, was $3.95, also a decrease of 2.2%, from the full year 2022.
The Company's net interest income was negatively impacted in 2023 by increased funding costs, primarily driven by deposit repricing as deposit rates adjusted to the higher interest rate environment as a result of tightened monetary policy by the Federal Reserve. The rise in deposit costs combined with a shift in deposit mix from noninterest bearing deposits to interest bearing deposits were the primary drivers behind the 2.9% decrease in net interest income during 2023.
Asset quality metrics remained stable with watch list loans as a percentage of total loans remaining near historic lows at 3.72% at December 31, 2023, as compared to 3.42% at December 31, 2022. The provision for credit losses decreased $3.5 million, or 37.6%. The near-term outlook includes plans for continued loan growth, disciplined credit philosophy, continued investments in human capital and technological innovations and enhancements, and targeted expansion of our branch network in the Indianapolis market with two new offices planned in the next 24 months.
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Selected income statement information for the years ended December 31, 2023, 2022 and 2021 is presented in the following table.
Income Statement Summary:
Other Data:
Net charge offs to average loans 0.13 0.10 0.09
(1)Non-GAAP financial measure. Calculated by excluding the wire fraud loss and related insurance and loss recoveries and adjustments to salary and benefits. Management believes this is an important measure because meaningful to understanding the company’s core business performance for these periods. See reconciliation on the following pages.
(2)Noninterest expense (c)/(Net interest income (a) plus Noninterest income (b)).
(3)Non-GAAP financial measure. Calculated by subtracting intangible assets, net of deferred tax, from total assets and total equity. Management believes this is an important measure because it is useful for planning and forecasting purposes. See reconciliation on the following pages.
(4)Non-GAAP financial measure. Calculated by removing the fair market value adjustment impact of the available-for-sale investment securities portfolio included in accumulated other comprehensive income ("AOCI") from tangible equity and tangible assets. Management believes this is an important measure because it provides better comparability to periods preceding the recent significant rise in prevailing interest rates. See reconciliation on the following pages.
(5)Non-GAAP financial measure. Calculated by subtracting the impact PPP loans had on average earnings assets, loan interest income, average interest bearing liabilities, and interest expense. Management believes this is an important measure because it provides for better comparability to subsequent periods, given the expectation that PPP represented a limited governmental intervention in the lending market, designed to support small businesses through the pandemic, its low fixed interest rate of 1.0% and because the accretion of net loan fee income can be accelerated upon borrower forgiveness and repayment by the SBA. See reconciliation on the following pages.
(6)Non-GAAP financial measure. Pretax pre-provision earnings is calculated by adding net interest income to noninterest income and subtracting noninterest expense. Management believes this is an important measure because it may enable investors to identify the trends in the Company's earnings exclusive of the effects of tax and provision expense, which may vary significantly from period to period. See reconciliation on the following pages.
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The Company believes that providing non-GAAP financial measures provides investors with information useful to understanding the company's financial performance. Reconciliations of these non-GAAP financial measures is provided below.
The impact of the wire fraud loss, insurance and loss recoveries and adjustments to salaries and benefits is presented below. Management considers these measures of core financial performance to be meaningful to understanding the Company’s business performance for these periods.
Year Ended
Plus: Salaries and Employee Benefits 1,397 0 0
Adjusted Core Impact:
Total Adjusted Core Impact 10,361 0 0
Diluted Earnings Per Share $ 3.65 $ 4.04 $ 3.74
Impact of Wire Fraud Loss, Net of Recoveries 0.30 0.00 0.00
Core Operational Diluted Earnings Per Common Share $ 3.95 $ 4.04 $ 3.74
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Year Ended
Plus: Deferred Tax Assets Related to Goodwill 1,167 1,167 1,176
Plus: Deferred Tax Assets Related to Goodwill 1,167 1,167 1,176
Tangible Common Equity/Tangible Assets 9.91 % 8.79 % 10.70 %
Adjusted Tangible Common Equity/Adjusted Tangible Assets 11.99 11.38 10.47
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The impact of the Paycheck Protection Program on Net Interest Margin FTE for the years ended December 31, 2022 and 2021 is presented below (dollars in thousands). The impact of the Paycheck Protection Program on Net Interest Margin FTE for the year ended December 31, 2023 is excluded as the Program had an immaterial impact on average earning assets, interest income and cost of funds during the period.
Year Ended
Less: Average Balance of PPP Loans (7,942) (237,951)
Adjusted Earning Asset Yield, net of PPP Impact 4.00 % 3.21 %
Less: Average Balance of PPP Loans (7,942) (237,951)
Less: PPP Cost of Funds (20) (595)
Adjusted Cost of Funds, net of PPP Impact 0.60 % 0.26 %
Net Interest Margin FTE, net of PPP Impact 3.40 % 2.95 %
Net Income
Net income was $93.8 million in 2023, a decrease of $10.1 million, or 9.7%, versus net income of $103.8 million in 2022. The decrease in net income from 2022 to 2023 was driven by an increase in noninterest expense of $20.5 million, or 18.6% and a decrease in net interest income of $5.9 million, or 2.9%. Offsetting these decreases was an increase in noninterest expense of $8.0 million, or 19.1%, and a decrease in the provision for credit losses of $3.5 million, or 37.6%.
The increases to noninterest expense and noninterest income were a result of the wire fraud loss and related insurance and loss recoveries and adjustments to salaries and employee benefits expense recorded by the Company during 2023. The wire fraud loss, which occurred during the second quarter of 2023, was $18.1 million and was the primary driver of the increase to noninterest expense. Insurance and loss recoveries associated with the event of $6.3 million were recorded as noninterest income during the fourth quarter of 2023. Salaries and employee benefits expense was reduced by $1.4 million as a result of adjustments to the Company's long term incentive accrual due to the negative impact of the loss on the Company's net income for the year.
Core operational profitability, a non-GAAP financial measure which excludes the impact of the wire fraud loss and related insurance and loss recoveries as well as adjustments to the Company's salaries and employee benefits expense, was $101.6 million for the twelve months ended December 31, 2023, a decrease of $2.2 million, or 2.2%, from the comparable period of 2022. Core operational diluted earnings per common share, a non-GAAP financial measure, for the twelve months ended December 31, 2023, was $3.95, also a decrease of 2.2%, from the comparable period of 2022.
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Net income was $103.8 million in 2022, an increase of $8.1 million, or 8.4%, versus net income of $95.7 million in 2021. The increase in net income from 2021 to 2022 was primarily due to an increase in net interest income of $24.8 million, or 13.9%, and an increase in the provision for credit losses of $8.3 million, or 770.5%. Noninterest expense increased $5.9 million, or 5.7%, and noninterest income decreased $2.9 million, or 6.4%. Net interest income for 2022 included $772,000 in PPP interest and fee income, compared to $14.9 million for 2021. The increase in provision expense for 2022 was driven primarily by the downgrade of a single commercial relationship, with the remaining increase attributable to loan growth.
Net Interest Income
The following table presents a three-year average balance sheet and, for each major asset and liability category, its related interest income and yield or its expense and rate for the years ended December 31, 2023, 2022 and 2021.
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THREE YEAR AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS
Earning Assets
Loans:
Investments: (3)
Nonearning Assets
Interest Bearing Liabilities
Time deposits:
Noninterest Bearing Liabilities
Interest Margin Recap
(1)Loan fees are included as taxable loan interest income. Net loan fees attributable to PPP loans were $10,000, $692,000 and $12.5 million for the years ended December 31, 2023, 2022 and 2021, respectively.
(2)Nonaccrual loans are included in the average balance of taxable loans.
(3)Tax exempt income was converted to a fully taxable equivalent basis at a 21 percent tax rate. The tax equivalent rate for tax exempt loans and tax exempt securities acquired after January 1, 1983 included the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) adjustment applicable to nondeductible interest expenses. Taxable equivalent basis adjustments were $5.3 million, $5.6 million and $3.6 million for the years ended December 31, 2023, 2022 and 2021, respectively.
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The following table shows fluctuations in net interest income attributable to changes in the average balances of assets and liabilities and the yields earned or rates paid for the years ended December 31.
NET INTEREST INCOME – RATE/VOLUME ANALYSIS (fully tax equivalent basis, dollars in thousands)
Attributable to Total Change Attributable to Total Change
Volume Rate Volume Rate
Interest Income (2)
Loans:
Investments:
Interest Expense
Time deposits:
Long-term borrowings and
(1)The earning assets and interest bearing liabilities used to calculate interest differentials are based on average daily balances for 2023, 2022 and 2021. The changes in net interest income are created by changes in interest rates and changes in the volumes of loans, investments, deposits and borrowings. In the table above, changes attributable to volume are computed using the change in volume from the prior year multiplied by the previous year’s rate, and changes attributable to rate are computed using the change in rate from the prior year multiplied by the previous year’s volume. The change in interest or expense due to both rate and volume has been allocated between factors in proportion to the relationship of the absolute dollar amounts of the change in each.
(2)Tax exempt income was converted to a fully taxable equivalent basis at a 21 percent tax rate. The tax equivalent rate for tax exempt loans and tax exempt securities acquired after January 1, 1983 included the TEFRA adjustment applicable to nondeductible interest expense.
Net interest income decreased by $5.9 million to $197.0 million in 2023 compared to $202.9 million in 2022, primarily as a result of increased funding costs. Total interest expense increased $109.6 million, or 298.7%. Of this increase, deposit interest expense increased $101.5 million, or 279.8%, as a result of increased rates paid for customer deposits and a shift in deposit mix from noninterest bearing deposits to interest bearing deposits. Funding costs for deposits increased 183 basis points to 2.46% during 2023, a 290.5% increase compared to 0.63% during 2022. Average noninterest bearing deposits decreased $367.5 million, or 19.9%, to $1.48 billion for 2023 as compared to $1.84 billion for 2022. Average interest bearing deposits increased $254.3 million, or 6.6%, to $4.13 billion for 2023 as compared to $3.87 billion for 2022. Contributing further to the increased funding costs was an increase in borrowings expense of $8.0 million, as a result of increased average short-term borrowings to meet the Company's funding needs. Average wholesale funding reliance remained low at 2.90% as of December 31, 2023 compared to 0.70% at December 31, 2022.
Investment securities interest income decreased $4.1 million, or 12.3%, and contributed to the decline in net interest income during 2023. The decrease in investment securities income was driven by a decrease in average securities balances of $247.6 million, or 17.3%, during 2023 as a result of available-for-sale investment securities sales of $105.2 million, maturities, calls and paydowns of $71.8 million, and offset by purchases of CRA securities of $7.2 million. Realized losses of $25,000
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were recognized on the securities sales during 2023. The yield on average investment securities increased 15 basis points to 2.86% for 2023, as compared to 2.71% for 2022, partially offsetting the impact of the decrease in securities average balances.
An increase in loans interest income offset the negative impacts to net interest income, increasing $104.3 million, or 51.2%, to $308.0 million during 2023 compared to $203.7 million during 2022. The increase in average loans was driven by loan growth during the period as average loan balances increased $386.5 million, or 8.7%, from $4.43 billion during 2022 to $4.81 billion during 2023. An increase in loan yields of 181 basis points, or 39.3%, from 4.61% for 2022 to 6.42% for 2023 as a result of continued Federal Reserve tightening during 2023 and loan repricing opportunities.
As a result of these effects, net interest margin decreased 9 basis points to 3.31% in 2023 versus 3.40% in 2022. Net interest margin increased to 3.40% in 2022 from 3.07% in 2021, driven by the dramatic tightening of monetary policy by the Federal Reserve during 2022 and 2023 and deposit repricing to reflect the increased rate environment that lagged into 2023. Additionally, net interest margin during the year ended December 31, 2022 was positively impacted by the recognition of nonaccrual interest resulting from the interest recovery of two nonaccrual commercial borrowers during the fourth quarter of 2022. The interest recovery was from two loans placed on nonaccrual status in 2009 and 2021. The $1.9 million of nonaccrual interest income was recognized into loan interest income and contributed 3 basis points to the Company's net interest margin during 2022.
The utilization of commercial and retail lines of credit decreased to 39% at December 31, 2023, down from 42% at December 31, 2022 and 2021. However, available lines of credit have increased by $124.0 million to $4.786 billion at December 31, 2023 compared to $4.662 billion at December 31, 2022, or 2.7% growth. The decrease in line usage is attributable to the conservative approach commercial and industrial borrowers continue to take since the pandemic, due to continued elevated levels of average commercial demand deposits relative to pre-pandemic levels.
Provision for Credit Losses
The Company recorded a provision for credit losses of $5.9 million in 2023 compared to $9.4 million in 2022 and $1.1 million in 2021. Provision expense during 2023 was driven primarily by increases in the qualitative and environmental risk factors for certain segments of the Company's loan portfolio that could be impacted by higher borrowing costs and potential economic weakness in the Company's markets. The remainder of expense was driven by growth in the loan portfolio during the year. The Company’s allowance for credit losses as of December 31, 2023 was $72.0 million compared to $72.6 million as of December 31, 2022 and $67.8 million as of December 31, 2021. The allowance for credit losses represented 1.46% of total loans as of December 31, 2023 versus 1.54% at December 31, 2022 and 1.58% at December 31, 2021. The company’s credit loss reserve to total loans, excluding PPP loans, which are guaranteed by the United States SBA and have not been allocated for within the allowance for credit losses, was 1.59% at December 31, 2021. The impact of PPP loans had an immaterial impact on the allowance coverage ratio at December 31, 2023 and 2022. Net charge offs of $6.5 million, or 0.13%, and $4.5 million, or 0.10% of average loans, were recorded in 2023 and 2022, respectively. The charge offs for 2023 and 2022 resulted primarily from the deterioration of a single commercial credit. Management believes the charge offs related to this credit were an isolated instance as a result of negative impacts caused by unique circumstances from the pandemic and are not reflective of deteriorating trends in the loan portfolio. The Company’s management continues to monitor the adequacy of the provision based on loan levels, asset quality, economic conditions including the impact of the increased interest rate environment, inflation levels, and other factors that may influence the assessment of the collectability of loans.
The Company adopted CECL on January 1, 2021. Adoption of the standard resulted in a day one impact to the allowance for credit losses of $9.1 million, with an offset, net of taxes, to stockholders' equity.
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Noninterest Income
The following table presents changes in the components of noninterest income for the years ended December 31, 2023, 2022 and 2021.
% Change From Prior Year
Noninterest income to total revenue 20.2 % 17.1 % 20.1 %
Noninterest income was $49.9 million in 2023 versus $41.9 million in 2022, an increase of $8.0 million, or 19.1%. Adjusted core noninterest income, which excludes the net wire fraud loss, was $43.6 million in 2023, an increase of $1.7 million, or 4.1% compared to 2022. Wealth advisory fees increased by 5.1%, or $444,000, during 2023, from $8.6 million to $9.1 million reflecting continued growth in the business and improving equity market valuations. Service charges on deposit accounts decreased by 7.1%, or $822,000, during 2023 from $11.6 million to $10.8 million due primarily to an increase to earnings allowances on business checking accounts and reduced overdraft and other deposit fees. Loan and service fees declined by 3.8%, or $464,000, during 2023 primarily due to a decline in interchange revenue due to reduced volume and spend per debit card as compared to higher trends during the pandemic. Merchant fee income improved by 2.6%, or $91,000, during 2023.
Other income increased $7.3 million, or 387.8%, due primarily to insurance and loss recoveries of $6.3 million that were recognized during the fourth quarter of 2023. Bank owned life insurance increased $2.7 million, or 625.2%, from improved performance for the Company's variable life insurance policies, which track with the performance of the equity markets. The purchase of traditional bank owned life policies in December 2022 contributed further to the increase in bank owned life insurance income. These increases were offset by decreases to mortgage banking income of $887,000, or 140.1%, and a decrease in investment brokerage fees of $503,000, or 21.7%.
Noninterest income was $41.9 million in 2022 versus $44.7 million in 2021, a decrease of $2.9 million, or 6.4%. Market value declines impacted the overall decrease in noninterest income. Bank owned life insurance income for the year ended December 31, 2022 decreased by $2.0 million, primarily due to declines in the market value of variable life insurance policies that are tied to the equity markets. A reduction of market value of $950,000 was recorded during 2022 compared to market value gains of $1.1 million for 2021. The valuation changes to the variable life insurance policies are offset by similar changes to the deferred compensation expense that is recognized in salary and employee benefits. Excluding the impact of the variable life insurance policy market value changes, noninterest income was $42.8 million for the year ended December 31, 2022, compared to $43.7 million for the year ended December 31, 2021, a decline of $840,000, or 2.1%. In addition, other income decreased $851,000, mortgage banking income decreased by $785,000, gains on securities sales decreased by $776,000 and interest rate swap fee income decreased by $456,000. Notably, fee-based noninterest income increased by a cumulative $2.0 million primarily due to volume, including improvements in service charges on deposit accounts of $987,000, or 9.3%, merchant and interchange fee income of $537,000, or 17.8%, investment brokerage fees of $343,000, or 17.4%, and loan and service fees of $292,000, or 2.4%. Wealth advisory fees declined by $114,000, or 1.3%, and were negatively impacted by market value declines of 8.0% in trust assets from $2.5 billion at December 31, 2021 to $2.3 billion at December 31, 2022.
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Noninterest Expense
The following table presents changes in the components of noninterest expense for the years ended December 31, 2023, 2022 and 2021.
% Change From Prior Year
Noninterest expense increased by $20.5 million, or 18.6%, for 2023 from $110.2 million to $130.7 million. The increase to noninterest expense during the year was driven by an $18.1 million wire fraud loss that occurred during the second quarter of 2023. Contributing to the increase in noninterest expense during 2023 was an increase to professional fees expense of $2.1 million, or 32.4%, an increase to FDIC insurance and other regulatory fees of $1.4 million, or 68.2%, from increased assessments due to a blanket increase to the assessment rate used by the FDIC to calculate premiums. Data processing fees and supplies expense increased $1.2 million, or 9.2%. Offsetting these increases was a decrease in other expense of $2.4 million, or 18.0%, driven by reduced accruals related to ongoing litigation matters. Adjusted core noninterest expense, a non-GAAP measure, which excludes the impact of the wire fraud loss and corresponding adjustments to salaries and employee benefits, was $114.0 million during 2023, an increase of $3.8 million, or 3.5%, compared to 2022.
Noninterest expense increased by $5.9 million, or 5.7%, for 2022, to $110.2 million compared to $104.3 million for 2021. The increase was due primarily to an increase of $4.2 million in other expense caused by accruals for ongoing legal matters of $3.5 million. See "Note 1 – Summary of Significant Accounting Policies" for additional details regarding loss contingencies. Corporate and business development expense increased $936,000, or 22.0%, driven by increased corporate development spending, advertising expense and charitable and foundation contributions, including contributions associated with the Company's sesquicentennial celebration. Salaries and benefits expense increased $648,000, or 1.1%. Offsetting these increases was a decrease in professional fees of $581,000, or 8.2%, due to a decrease in legal expense incurred during the year. FDIC insurance and other regulatory fee expense decreased by $243,000, or 10.8%, due to declining deposits and reduced total assets of the Company.
Income Taxes
The Company recognized income tax expense in 2023 of $16.6 million, compared to $21.3 million in 2022 and $21.7 million in 2021. The effective tax rate was 15.0% in 2023, compared to 17.1% in 2022 and 18.5% in 2021. The effective tax rate declined due to negative impact of the wire fraud loss and related effects on net income, which lowered income tax expense by $2.6 million for 2023. Additionally, changes to the Indiana Financial Institution Tax rate to 4.9% in 2023, 5.0% in 2022 and 5.5% in 2021, as well as tax-free interest income from municipal securities and loans during 2023 contributed to the decreased effective tax rate. For a detailed analysis of the Company’s income taxes see "Note 12 – Income Taxes".
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CERTAIN STATISTICAL DISCLOSURES BY BANK HOLDING COMPANIES
We are required to provide certain statistical disclosures as a bank holding company under the SEC's Industry Guide 3. The following table provides certain of those disclosures.
Year ended December 31,
Return on average assets is computed by dividing net income by average assets for each indicated fiscal year. Average assets is computed by adding total assets as of each date during the indicated fiscal year and dividing by the number of days in the fiscal year.
Return on average total equity is computed by dividing net income by average equity for each indicated fiscal year. Average equity is computed by adding the total equity attributable to the Company as of each date during the indicated fiscal year and dividing by the number of days in the fiscal year.
Average equity to average assets is computed by dividing average equity by average assets for each indicated fiscal year, as calculated in accordance with the previous explanation.
Dividend payout ratio is computed by dividing dividends declared per common share by earnings per diluted common share for each indicated fiscal year. The dividend payout ratio increased to 50.4% for 2023 as compared to prior periods due to the wire fraud loss and its negative impact to net income.
Refer to the "Financial Condition - Loan Portfolio", "Financial Condition - Sources of Funds" and "Risk Management - Loan Portfolio" sections of this MD&A and to the Notes to Consolidated Financial Statements of this Form 10-K for the other required statistical disclosures.
FINANCIAL CONDITION
Overview
Total assets of the Company were $6.524 billion as of December 31, 2023, an increase of $91.7 million, or 1.4%, when compared to $6.432 billion as of December 31, 2022. Total loans outstanding increased by $206.1 million, or 4.4%, to $4.917 billion at December 31, 2023 from $4.710 billion at December 31, 2022. Total deposits increased $259.9 million, from $5.461 billion at December 31, 2022, to $5.721 billion at December 31, 2023, driven by increased commercial and public funds deposits and offset by net retail outflows.
Total cash and equivalents increased $21.5 million, to $151.8 million at December 31, 2023 from $130.3 million at December 31, 2022. Total investment securities decreased by $132.1 million, to $1.182 billion at December 31, 2023 from $1.314 billion at December 31, 2022. The decrease was attributable to a decrease in available-for-sale securities, which decreased by $133.8 million, primarily as a result of investment sales of $105.2 million and maturities, calls and paydowns of $71.8 million, and offset by purchases of $7.2 million and improvement in fair market valuations of $40.7 million. Losses of $25,000 were realized from the sale of available-for-sale securities in 2023. Total borrowings decreased at December 31, 2023, as a result of the liquidity provided by increased levels of deposits at period end and cash inflows from the investment securities portfolio. Total borrowings decreased by $247.0 million to $50.0 million at December 31, 2023 compared to $297.0 million at December 31, 2022.
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Uses of Funds
Investment Portfolio
At year end 2023, 2022 and 2021, there were no holdings of securities of any one issuer, other than the U.S. government, government agencies and government sponsored agencies, in an amount greater than 10% of stockholders’ equity. See "Note 2 – Securities" for more information on these investments.
Purchases of securities available-for-sale totaled $7.2 million in 2023, $315.3 million in 2022 and $835.0 million in 2021. Growth of the investment portfolio during 2021 and 2022 served to provide an earning asset alternative for excess balance sheet liquidity stemming from increased levels of liquidity provided by government stimulus programs in response to the COVID-19 pandemic. Prior to the recent Federal Reserve monetary tightening cycle starting in March of 2022, the Company deployed $250 million of excess liquidity to the investment securities portfolio during 2022 and $652 million in 2021 to preserve net interest margin. Investment securities represented 18.1% of total assets on December 31, 2023 compared to 20.4% on December 31, 2022 and 21.3% on December 31, 2021. Management expects the investment securities portfolio as a percentage of assets to decrease over time and return to historical levels of approximately 12%-14% during 2014 to 2020 as the proceeds from paydowns and maturities of these investment securities provide liquidity to fund future loan growth.
On April 1, 2022, the Company elected to transfer $151.4 million in net book value of municipal bonds from the available-for-sale securities portfolio to held-to-maturity as an overall balance sheet management strategy. The fair value of these securities transferred was $127.0 million.
Securities sales totaled $105.2 million in 2023, $25.3 million in 2022 and $14.0 million in 2021. Paydowns from prepayments and scheduled payments of $56.2 million, $98.8 million and $113.1 million were received in 2023, 2022 and 2021, and the amortization of premiums, net of the accretion of discounts, was $4.9 million, $6.3 million and $5.0 million, respectively. Maturities and calls of securities totaled $13.6 million, $9.3 million and $24.7 million in 2023, 2022 and 2021, respectively. No provision for allowance for credit loss was recorded in connection with the investment securities portfolio in 2023, 2022 or 2021. The investment portfolio is managed to provide for an appropriate balance between liquidity, credit risk and investment return and to limit the Company’s exposure to risk to an acceptable level. The longer duration of the investment security portfolio serves to balance the shorter duration of the loan portfolio.
The weighted average yields and maturity distribution for the securities portfolio at December 31, 2023, were as follows:
The Company does not trade or invest in or sponsor certain unregistered investment companies defined as hedge funds and private equity funds in the Volcker Rule.
Real Estate Mortgage Loans Held-For-Sale
Real estate mortgages held-for-sale increased by $801,000 to $1.2 million at December 31, 2023 from $357,000 at December 31, 2022 as a result of fluctuations in secondary market sales activity. This asset category is subject to a high degree of variability depending on, among other things, recent mortgage loan rates and the quantity and timing of loan sales into the secondary market. The Company generally sells almost all of the conforming mortgage loans it originates in the secondary market. Proceeds from sales totaled $8.0 million in 2023, $36.5 million in 2022 and $126.4 million in 2021.
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Loan Portfolio
The loan portfolio by class as of December 31, 2023, 2022 and 2021 was as follows:
Commercial and industrial loans:
Commercial real estate and multi-family residential loans:
Agri-business and agricultural loans:
Consumer 1-4 family mortgage loans:
Residential construction and land development loans 8,421 19,249 11,921
The ratio of loans to total loans by portfolio segment as of December 31, 2023, 2022 and 2021 was as follows:
Commercial real estate and multi-family residential loans 49.54 46.23 45.56
Agri-business and agricultural loans 7.90 9.17 10.39
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In 2023, net loan balances increased by $206.8 million to $4.845 billion, and excludes approximately $8.6 million in loans originated for sale. In 2022, net loan balances increased by $417.7 million to $4.638 billion, and excluded approximately $28.7 million in loans originated for sale. In 2021, net loan balances decreased by $367.7 million to $4.220 billion, and excluded approximately $119.4 million in loans originated for sale.
The mix of The Company's loan portfolio consists primarily of commercial loans, and the Bank's lending focus is on the commercial sector of the Lake City Bank footprint. Owner occupied commercial real estate loans represent in many instances the buildings and factories of our commercial and industrial borrowers. Commercial and industrial loans together with owner occupied commercial real estate loans represented 45.7% and 47.8% of total loans as of December 31, 2023 and 2022, respectively. The Company has limited exposure to commercial office space borrowers, all of which are located in the Bank's Indiana markets. Loans totaling $71.2 million for this sector represented 1.5% of total loans at December 31, 2023. Loans to the agriculture and agri-business sector of our Indiana footprint represent a significant loan segment of the overall loan portfolio. This loan segment is well diversified with loans to corn, soybean, poultry, dairy, swine, beef and egg growers.
The residential construction and land development loans class included construction loans totaling $1.0 million and $12.0 million as of December 31, 2023 and 2022. Increases in consumer loans during 2023 resulted from an increased focus on indirect lending to consumers and the introduction of a new adjustable rate mortgage product. The Bank generally sells conforming mortgage loans, which it originates locally, into the secondary market. These loans generally represent mortgage loans that are made to clients with long-term or substantial relationships with the Bank on terms consistent with secondary market requirements. The loan classifications are based on the nature of the loans as of the loan origination date. There were no foreign loans included in the loan portfolio for the periods presented.
Repricing opportunities of the loan portfolio occur either according to predetermined float rate indices, adjustable rate schedules included in the related loan agreements or upon maturity of each principal payment. The following table indicates the scheduled maturities of the loan portfolio as of December 31, 2023:
At maturity, credits are reviewed and, if renewed, are renewed at rates and conditions that prevail at the time of maturity.
Based upon the table above, all loans due after one year which have a predetermined interest rate and loans due after one year which have floating or adjustable interest rates as of December 31, 2023 amounted to $2.290 billion and $1.188 billion, respectively.
Bank Owned Life Insurance
Bank owned life insurance increased by $707,000 to $109.1 million at December 31, 2023 and by $10.8 million to $108.4 million at December 31, 2022 from $97.7 million at December 31, 2021. The increase during 2023 was primarily due to increased income from traditional policies purchased in December 2022 and from improved market performance of the Bank's variable bank owned life insurance policies which track with the performance of the equity markets. The increase during 2022 was primarily due to the purchase of life insurance policies on officers of the Bank. Bank owned life insurance investment income is used as an offset to the cost of life insurance purchased by the Bank as a benefit for bank officers.
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Sources of Funds
The average daily deposits and borrowings together with the average rates paid on those deposits and borrowings for the years ended December 31, 2023, 2022 and 2021 are summarized in the following table:
(dollars in thousands) Balance Rate Balance Rate Balance Rate 2023 2022
Savings and transaction accounts:
Time deposits:
Time deposits as of December 31, 2023 will mature as follows:
(dollars in thousands) $100,000or more $100,000 or less Total % of Total
Deposits
Deposits by portfolio segment for December 31, 2023, 2022 and 2021 are presented below:
Total deposits increased by $259.9 million to $5.721 billion, at December 31, 2023 compared to $5.461 billion at December 31, 2022. The increase in deposits was attributable to increases in commercial and public fund deposits. Commercial deposits increased $141.2 million, or 6.8% and represented 38.9% and 38.2% of total deposits at December 31, 2023 and 2022, respectively. Public fund deposits increased $133.1 million, or 9.3% and represented 27.3% and 26.1% of total deposits at December 31, 2023 and 2022, respectively. Additionally, brokered deposits increased $125.4 million, and represented 2.4% and 0.3% of total deposits at December 31, 2023 and 2022, respectively. Retail deposits decreased $139.8 million, or 7.2%, and represented 31.4% and 35.4% of deposits at December 31, 2023 and 2022, respectively. The decline in retail deposits represents a continued utilization of retail deposits from peak savings levels during 2021.
Total deposits decreased by $274.8 million to $5.461 billion, at December 31, 2022 compared to December 31, 2021. The decrease in deposits was attributable to a decrease in core deposits. Total deposit contraction was led by a decrease of $243.7 million, or 11.2%, in retail deposits. In addition, commercial deposits decreased $176.3 million, or 7.8%, while public funds deposits increased by $145.2 million, or 11.3%. The decrease in deposits during 2022 reflects the normalization of excess
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liquidity in our customer's deposit accounts and occurred primarily during the fourth quarter of 2022. Rising inflation is considered a contributor to the decline in deposits during 2022 after the surge in deposits experienced during 2020 and 2021 from PPP funding and COVID-related stimulus programs.
As previously noted, 27.3% of the Company’s deposit base is attributable to public fund entities which consist primarily of customers in the Company’s geographic footprint. A majority of public fund balances represent customers with operating accounts at the Bank. The public fund segment is a stable source of deposit funding and a focus in the treasury management area due to their business needs. A shift in funding away from public fund deposits could require the Company to execute alternative funding plans under the Contingency Funding Plan discussed in further detail under “Liquidity Risk”.
FHLB Advances and OtherBorrowings
During 2023, average total short-term borrowings increased by $160.3 million to $166.8 million. Ending balances of short-term and miscellaneous borrowings decreased to $50.0 million at December 31, 2023 compared to $297.0 million at December 31, 2022. Average total long-term borrowings decreased by $32.1 million to zero, as no long-term FHLB advances were outstanding during 2023.
During 2022, average total short-term borrowings increased by $6.2 million to $6.6 million, as the Company's excess liquidity position normalized after experiencing a reduction in cash and short-term investments. Ending balances of short-term and miscellaneous borrowings increased to $297.0 million at December 31, 2022, from zero at December 31, 2021. Average total long-term borrowings decreased by $42.9 million to $32.1 million, due to the repayment of an outstanding long-term advance during the second quarter of 2022.
Capital
The Company believes that a strong, appropriately managed capital position is critical to support continued growth of loans and earnings. Capital is used primarily to fund continued organic loan growth and to support dividends to shareholders. The Company had a total risk-based capital ratio of 15.47%, a Tier I risk-based capital ratio of 14.21% and a common Tier 1 risk-based capital ratio of 14.21% as of December 31, 2023. These ratios met or exceeded the Federal Reserve Bank’s “well-capitalized” minimums of 10.0%, 8.0% and 6.5%, respectively. The Company also had a Tier 1 leverage ratio of 11.82% and a tangible equity ratio of 9.91%. When excluding the impact of accumulated other comprehensive income (loss) on tangible common equity, the Company's adjusted tangible common equity to adjusted tangible assets was 11.99%. See "Note 15 – Capital Requirements and Restrictions on Retained Earnings" for more information.
The ability to maintain these ratios is a function of the balance between net income and a prudent dividend policy. Total stockholders’ equity increased by 14.2% to $649.8 million as of December 31, 2023 from $568.9 million as of December 31, 2022. The Company earned $93.8 million in 2023 and $103.8 million in 2022. The Company declared cash dividends of $1.84 per share in 2023, which decreased equity by $47.1 million. The Company declared cash dividends of $1.60 per share in 2022, which decreased equity by $40.9 million. Total stockholder's equity has been impacted by declines in the market value of the Company's available-for-sale investment securities portfolio. The market value decline, resulting from higher interest rate environment, has generated unrealized losses in the available-for-sale portfolio. Unrealized losses from the available-for-sale investment securities portfolio are recorded, net of tax, in accumulated other comprehensive income (loss) in the statement of stockholders' equity. Improvements in the fair value of available-for-sale securities and net defined pension plan gains positively impacted equity by $33.7 million in 2023 compared to a decrease of $205.0 million in 2022. The impact to equity due to other comprehensive income (loss) is not included in regulatory capital.
RISK MANAGEMENT
Overview
The Company, with the oversight of the Corporate Risk Committee of the board of directors, has developed a company-wide risk management program intended to help identify, manage and mitigate the various business risks it faces. Following is a discussion addressing the risks identified as most significant to the Company – Credit, Liquidity, Interest Rate and Market Risk. Item 7A. includes additional discussion about market risk.
Credit Risk
Credit risk represents the risk of loss arising from an obligor’s inability or failure to meet contractual payment or performance terms. Our primary credit risks result from lending and to a lesser extent, investment activities.
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Investment Portfolio
The Company’s investment portfolio consists of U.S. treasuries, government agencies and municipal bonds subject to an investment security policy that is approved annually by the board of directors. As of December 31, 2023, the Company’s investment in U.S government sponsored mortgage-backed securities represented approximately 38% of total investment securities fair value consisting of mortgage pools issued by Ginnie Mae, Fannie Mae and Freddie Mac. Ginnie Mae, Fannie Mae and Freddie Mac securities are each guaranteed by their respective agencies as to principal and interest. All mortgage securities purchased by the Company in 2023 were within risk tolerances for price, prepayment, extension and original life risk characteristics contained in the Company’s investment policy. As of December 31, 2023, all mortgage-backed securities were performing in a manner consistent with management’s expectations at time of purchase. Municipal securities represent 52% of total investment securities fair value as of December 31, 2023 and were rated investment grade at the time of purchase and continue to be rated investment grade. The Company uses analytics provided by its third party portfolio advisor to evaluate and monitor credit risk for all investments on a quarterly basis. Based upon these analytics as of December 31, 2023, the securities in the combined available-for-sale and held-to-maturity portfolios had an effective duration of approximately 6.5 years. The analysis indicated a negative 18.1% change in market value in the event of a 300 basis point upward, instantaneous rate shock and an approximate positive 6.5% change in market value in the event of a 100 basis point downward, instantaneous rate shock.
Loan Portfolio
The Company has a high percentage of commercial and commercial real estate loans extended to businesses with a broad range of revenue and within a wide variety of industries. Traditionally, this type of lending may have more credit risk than other types of lending because of the size and diversity of the credits. The Company manages this risk by utilizing conservative credit structures, adjusting its pricing to the perceived risk of each individual credit, diversifying the portfolio by customer, product, industry and market area and by obtaining personal loan guarantees.
There were no loan concentrations within industries, which exceeded ten percent of total loans, except commercial real estate. Commercial real estate was $2.438 billion, or 49.5%, of total loans at December 31, 2023. The owner occupied commercial real estate portfolio generally represents the financing of factories and operational facilities for the Bank's commercial and industrial borrowers. The Company’s in-house lending limit is $40.0 million. Manufacturing loans are included in the commercial and industrial loans total and are well diversified by industry. Agri-business and agricultural loans represent 7.9% of total loans as of December 31, 2023 and are not concentrated to any agricultural sector. Substantially all of the Bank’s commercial, industrial, agricultural real estate mortgage, real estate construction mortgage and consumer loans are made within its geographic market areas and to diverse industries. When segmenting the Bank's loan portfolio by North American Industry Classification System code as of December 31, 2023, the largest segments are multifamily housing, agriculture, industrial warehouses and the recreational vehicle industry which represented 11%, 9%, 4% and 4% of total loans, respectively.
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The following is a summary of nonperforming loans on an amortized cost basis as of December 31, 2023 and 2022.
Commercial and industrial loans
Past due accruing loans (90 days or more) 0 1
Commercial real estate and multi-family residential loans
Past due accruing loans (90 days or more) 0 0
Agri-business and agricultural loans
Past due accruing loans (90 days or more) 0 0
Subtotal nonperforming loans 100 145
Other commercial loans
Past due accruing loans (90 days or more) 0 0
Nonaccrual loans 0 0
Subtotal nonperforming loans 0 0
Consumer 1-4 family mortgage loans
Past due accruing loans (90 days or more) 27 122
Subtotal nonperforming loans 858 603
Other consumer loans
Past due accruing loans (90 days or more) 0 0
Subtotal nonperforming loans 112 209
Ratio:
Nonperforming loans to total loans 0.32 % 0.36 %
Nonperforming assets of the Company include nonperforming loans (as indicated above), nonaccrual investments, other real estate owned and repossessions, the total of which amounted to $16.1 million and $17.2 million at December 31, 2023 and 2022, respectively. Nonperforming loans remained stable at 0.3% of total loans at December 31, 2023 compared to 0.4% at December 31, 2022. Nonperforming loans decreased by $1.4 million during 2023, due to the net activity of charge offs, paydowns and upgrades. One commercial relationship placed on nonaccrual during 2023 subsequently received a modification to loan terms due to financial difficulty experienced by the borrower.
Loans for which the borrower appears to be unable or unwilling to repay its debt in full or on time, and the collateral is insufficient to cover all principal and accrued interest, will be reclassified as nonperforming to the extent they are unsecured, on or before the date when the loan becomes 90 days delinquent, with the exception of small dollar other consumer loans which are not placed on nonaccrual status since these loans are charged-off when they have been delinquent from 90 to 180 days, and when the related collateral, if any, is not sufficient to offset the indebtedness. When a loan is classified as a nonaccrual loan, interest on the loan is no longer accrued, all unpaid accrued interest is reversed and interest income is subsequently recorded only to the extent cash payments are received. Accrual status is resumed when all contractually due payments are brought current and future payments are reasonably assured.
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A loan is individually analyzed when full payment under the original loan terms is not expected. Reserves are evaluated in total for smaller-balance loans of similar nature not in nonaccrual status such as residential mortgage, consumer, and credit card loans, and on an individual loan basis for other loans including material modifications made to borrowers experiencing financial difficulty. If a loan is individually analyzed, a portion of the allowance may be allocated so that the loan is reported, net, at the present value of estimated future cash flow or at the fair value of collateral if repayment is expected solely from the collateral.
Total nonperforming loans were $15.7 million, or 0.32% of total loans, at December 31, 2023 versus $17.1 million, or 0.36% of total loans, at December 31, 2022. There were 33 relationships totaling $16.1 million classified as individually analyzed as of December 31, 2023 versus 39 relationships totaling $31.3 million at the end of 2022. The decrease in individually analyzed loans during 2023 resulted primarily from the payoff of two large commercial relationships and the partial charge off of another commercial relationship. Paydowns and upgrades of other individually analyzed loans further contributed to the decrease for individually analyzed loans for the year ended December 31, 2023.
Loans renegotiated as modifications to borrowers experiencing financial difficulty are those loans for which the Company modifies the terms of loans for borrowers experiencing financial distress by providing the following forms of relief: forgiveness of loan principal, extension of repayment terms, reduction of interest rate or an other than insignificant payment delay. For the twelve months ended December 31, 2023, there were three loans to three financially distressed commercial borrowers with balances totaling $4.4 million at December 31, 2023 that received such modifications. The Company has no material commitments to lend additional funds to these borrowers. For the twelve months ended December 31, 2022, no loan modifications were made to borrowers experiencing financial difficulty.
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The following is a summary of the credit loss experience for the years ended December 31, 2023, 2022 and 2021.
Loans charged-off:
Commercial real estate and multi-family residential loans 0 597 70
Agri-business and agricultural loans 0 0 0
Other commercial loans 0 0 0
Recoveries of loans previously charged-off:
Commercial real estate and multi-family residential loans 322 277 14
Agri-business and agricultural loans 0 0 320
Other commercial loans 0 0 0
Provision for credit loss charged to expense 5,850 9,375 1,077
Ratios:
Net charge offs (recoveries) to average daily loans outstanding:
Commercial and industrial loans 0.13 % 0.09 % 0.09 %
Commercial real estate and multi-family residential loans (0.01) 0.01 0.00
Agri-business and agricultural loans 0.00 0.00 0.00
Total ratio of net charge offs (recoveries) 0.13 % 0.10 % 0.09 %
Allowance for credit losses on loans to:
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The following is a summary of the allocation for credit losses as of December 31, 2023 and 2022.
Allocated allowance for credit losses:
Commercial real estate and multi-family residential loans 31,335 27,394
Agri-business and agricultural loans 4,150 4,429
Total allocated allowance for credit losses 71,600 72,052
Unallocated allowance for credit losses 372 554
Total allowance for credit losses $ 71,972 $ 72,606
At December 31, 2023, the allowance for credit losses was 1.46% of total loans outstanding, versus 1.54% of total loans outstanding at December 31, 2022. Management believes the allowance for credit losses is at a level commensurate with the overall risk exposure of the loan portfolio. The process of identifying expected credit losses is a subjective process. Therefore, the Company maintains a general allowance to cover expected credit losses within the entire portfolio. The methodology management uses to determine the adequacy of the credit loss reserve includes the considerations below.
Loans are charged against the allowance for credit losses when management believes that the principal is uncollectible. Subsequent recoveries, if any, are credited to the allowance. The allowance is an amount that management believes will be adequate for expected credit losses relating to specifically identified loans based on an evaluation of the loans by management, as well as other expected credit losses inherent in the loan portfolio. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current and forecasted economic conditions that may affect the borrower’s ability to repay. Management also considers trends in adversely classified loans based upon a monthly review of those credits. An appropriate level of qualitative and environmental allowance is determined after considering the following factors: changes in the nature and volume of the loan portfolio, overall portfolio quality, changes in collateral strength and current economic conditions that may affect the borrowers’ ability to repay. Consideration is not limited to these factors although they represent the most commonly cited factors. Federal regulations require insured institutions to classify their own assets on a regular basis. The regulations provide for three categories of classified loans: Substandard, Doubtful and Loss. The regulations also contain a Special Mention category. Special Mention is defined as loans that do not currently expose an insured institution to a sufficient degree of risk to warrant classification as Substandard, Doubtful or Loss but do possess credit deficiencies or potential weaknesses deserving management’s close attention. The Company’s policy is to establish a specific allowance for credit losses for any assets where management has identified conditions or circumstances that indicate an asset is nonperforming. If an asset or portion thereof is classified as loss, the Company’s policy is to either establish specific allocations for credit losses in the amount of 100% of the portion of the asset classified loss or charge off such amount.
At December 31, 2023, on the basis of management’s review of the loan portfolio, the Company had68credits totaling $183.1 million on the classified loan list versus 58 credits totaling $161.0 million on December 31, 2022. These amounts represent outstanding balances, excluding deferred fees and costs. While the increase in classified loans during 2023 raises concern for the potential for an economic slowdown in the Company's Indiana footprint, it has not translated to broader loan quality issues in the portfolio as the ratio of watch list loans as a percentage of total loans remains near historic lows and was accompanied by a reduction in nonperforming loans during 2023. As of December 31, 2023, the Company had $143.6 million of assets classified as Special Mention, $39.4 million classified as Substandard, $0 classified as Doubtful and $0 classified as Loss as compared to $115.7 million, $45.3 million, $0 and $0, respectively, at December 31, 2022. The balances reported in "Note 4 – Allowance for Credit Losses and Credit Quality" include deferred fees and costs.
Included in the classified loan amounts above for December 31, 2023 were loans receiving modifications due to financial difficulty experienced by the borrower during the twelve months ended December 31, 2023 for three commercial loans to three commercial borrowers totaling $4.4 million million with total allocations of $2.3 million. There were no loan modifications made to borrowers experiencing financial difficulty during the twelve months ended December 31, 2022.
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Allowance estimates are developed by management taking into account actual loss experience, subject to a floor, adjusted for current economic conditions and a reasonably supportable forecast period. The Company has regular discussions regarding this methodology with regulatory authorities. Allowance estimates are considered a prudent measurement of the risk in the Company's loan portfolio based upon loan segment. In accordance with accounting guidance, the allowance is based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the reported amounts. For a more thorough discussion of the allowance for credit losses methodology see the "Critical Accounting Policies" section of this Item 2.
The allowance for credit losses decreased 0.9%, or $634,000, from $72.6 million at December 31, 2022 to $72.0 million at December 31, 2023 due primarily to net charge offs of $6.5 million and offset by provision expense of $5.9 million recorded during 2023. Pooled loan allocations increased $5.6 million from $58.2 million at December 31, 2022 to $63.8 million at December 31, 2023. The unallocated component of the allowance for credit losses was $372,000 at December 31, 2023, which decreased from $554,000 reported at December 31, 2022. The unallocated component of the allowance for credit losses incorporates the Company’s judgmental determination of expected losses that may not be fully reflected in other allocations.
The Company has experienced organic growth in total loans over the last several years with an increase in gross loans of $206.5 million, or 4.4%, from December 31, 2022 to December 31, 2023. This growth is primarily concentrated in the commercial loan portfolio, which can result in overall asset quality being influenced by a small number of credits. Management has historically considered growth and portfolio composition when determining credit loss allocations. Management believes that it is prudent to continue to provide for credit losses in a manner consistent with its historical approach due to the loan growth described above and current economic conditions.
Watch list loans increased $22.1 million to $183.1 million as of December 31, 2023, compared to $161.0 million at December 31, 2022, or an increase of 13.7%. Watch list loans represent 3.7% of total loans at December 31, 2023 compared to a historical low of 3.4% at December 31, 2022. PPP loans outstanding of $1.3 million and $1.5 million at December 31, 2023 and 2022, respectively, had an immaterial impact on these asset quality ratios. The increase in watch list loans resulted primarily from downgraded credits of approximately $112.4 million and offset by upgrades of approximately $55.8 million in addition to paydowns to watch list credits. The Company's continued growth strategy promotes diversification among industries as well as continued focus on the enforcement of a disciplined credit culture and a conservative posture in loan work-out situations.
Liquidity Risk
Liquidity risk arises from the possibility that the Company may not be able to satisfy current or future financial commitments or may become unduly reliant on alternative funding sources. Liquidity is monitored and closely managed by the ALCO Committee.
Management maintains a liquidity position that it believes will adequately provide funding for loan demand and deposit run-off that may occur in the normal course of business. The liquidity structure is expressly detailed in the Company’s Contingency Funding Plan, which is discussed below. The Company relies on a number of different sources in order to meet these potential liquidity demands. The primary sources are increases in deposit accounts and cash flows from loan payments and the securities portfolio. The cash flow from the securities portfolio is expected to provide approximately $103.9 million of potential contingent funding in 2024.
The Bank had total available sources of liquidity totaling $3.4 billion at December 31, 2023 compared to $3.0 billion at December 31, 2022. The Company has approval of $3.593 billion in secondary funding sources available as of December 31, 2023, of which $185.4 million was utilized. The Company had $325.0 million of availability in federal funds lines with eleven correspondent banks, of which none was drawn on as of December 31, 2023. The Company has board of directors approval to borrow up to $800.0 million at the FHLB, but given the Company’s current collateral structure and outstanding borrowings as of December 31, 2023, the Company could have only borrowed up to $574.9 million under this authority. The Company has additional collateral that could be pledged to the FHLB of $8.4 million as of December 31, 2023 to generate additional liquidity. Further, the Company had available capacity at the Federal Reserve Bank of Chicago of up to $1.259 billion given its current collateral structure at the Federal Reserve Bank discount window program and the terms of that facility at December 31, 2023, with no balances outstanding at December 31, 2023. During 2023 the Company also became eligible to borrow funds under the Federal Reserve Bank's Bank Term Funding Program (BTFP); available capacity secured by pledged eligible investment securities was $150.5 million with no outstanding balance at December 31, 2023. The BTFP is scheduled to expire in March 2024. The Company also has established relationships in the brokered time deposit and brokered money market sectors, as well as the IntraFi Network CDARS One-Way Buy program, to access these funds when desired with settlement of funds in one to two weeks’ time. Additionally, the Bank has entered agreements with IntraFi Network relative to their Insured
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Cash Sweep One-Way Buy program. As of December 31, 2023, the total amount available to the Bank via this program was $100.0 million, of which $10.0 million was drawn. The Bank is also a member of the American Financial Exchange (AFX) where overnight fed funds purchased can be obtained from other banks on the exchange that have approved the Bank for an unsecured, overnight line. These funds are only available if the approving banks have an ‘offer’ out to sell that day. As of December 31, 2023, the total amount approved for the Bank via AFX banks was $319.0 million and none was outstanding at year end.
The Company had 90% of its securities in the available-for-sale portfolio at December 31, 2023, allowing the Company extensive flexibility to sell securities to meet funding demands. The remaining portion of investments securities were designated as held-to-maturity. Management believes the majority of the securities in investment portfolio are of high quality and marketable. Approximately 48% of this portfolio is comprised of U.S. government agency securities or mortgage-backed securities directly or indirectly backed by the U.S. government. At December 31, 2023, 92% of municipal securities owned by the Company were AAA or AA rated with a diversified geography of state issuer. In addition, the Company has historically sold the majority of its originated mortgage loans on the secondary market to reduce interest rate risk and to create an additional source of funding.
The Company has a formalized Contingency Funding Plan (“CFP”). The Board and management recognize the importance of liquidity during times of normal operations and in times of stress. The CFP was developed to ensure that the multiple liquidity sources available to the Company are readily available. All liquidity sources are tested annually. The CFP specifically considers liquidity at the Bank and the Company level. The CFP identifies the potential funding sources at the Bank level, which includes the FHLB, the Federal Reserve Bank, brokered deposits, one-way buy products via the IntraFi Network (CDARS and ICS) and Federal Funds. The CFP also addresses the Bank’s ability to liquidate its securities portfolio or other liquid assets. The CFP funding sources at the holding company level include a holding company committed line of credit, as well as the ability to transfer securities from the investment subsidiary of the Bank to the Company. The Company’s committed line of credit has availability up to $30.0 million, of which $0 was drawn upon as of December 31, 2023.
Further, the CFP identifies CFP team members and expressly details their respective roles. Potential risk scenarios are identified and the plan includes multiple scenarios, including short-term and long-term funding crisis situations. Under the long-term funding crisis, two additional scenarios are identified: a moderate risk scenario and a highly stressed scenario. The CFP details the responsibilities and the actions to be taken by the CFP team under each scenario. Quarterly reports to management and the Board under the CFP include an early warning indicator matrix and pro forma cash flows for the various scenarios.
The following table discloses information on the maturity of the Company’s contractual long-term obligations as of December 31, 2023.
Payments Due by Period
(dollars in thousands) Total One year or less 2-3 years 4-5 years After 5 years
During the normal course of business, the Company becomes a party to financial instruments with off-balance sheet risk in order to meet the financing needs of its customers. These financial instruments include commitments to make loans and open-ended revolving lines of credit. The Company follows the same credit policy (including requiring collateral, if deemed appropriate) to make such commitments as it follows for those loans that are recorded in its financial statements.
The Company’s exposure to credit losses in the event of nonperformance is represented by the contractual amount of the commitments. Management does not expect any significant losses as a result of these commitments. Off-balance sheet transactions are more fully discussed in "Note 17 – Commitments, Off-Balance Sheet Risks and Contingencies".
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The following table discloses information on the maturity of the Company’s commitments.
Amount of Commitment Expiration Per Period
(dollars in thousands) Total Amount Committed One year or less Over one year
Interest Rate Risk
Interest rate risk is the risk that the estimated fair value of the Company’s assets, liabilities and derivative financial instruments will decline as a result of changes in interest rates or financial market volatility, or that net income will be significantly reduced by interest rate changes.
Interest rate risk represents the Company’s primary market risk exposure. The Company does not have material exposure to foreign currency exchange risk and does not maintain a trading portfolio. The Corporate Risk Committee of the Board annually reviews and approves the ALCO policy and the Derivatives and Hedging policy used to manage interest rate risk. These policies set guidelines for balance sheet structure, which are designed to protect the Company from the impact that interest rate changes could have on net income, but it does not necessarily indicate the effect on future net interest income. Generally, the Bank is asset sensitive due to the impact of the variable rate commercial loan portfolio on the Bank's sensitivity to market rates. During 2023, asset sensitivity declined due to a shift to short-term interest bearing deposit accounts such as money market accounts. As a result, the Company expects net interest margin to remain stable in the first 25-50 basis points potential declines in the federal funds rate due to a more neutral posture for balance sheet sensitivity. Deposit re-pricing in a declining interest rate environment is expected to exceed past easing cylces. Earnings can also be affected by the monetary and fiscal policies of the U.S. Government and its agencies, particularly the Federal Reserve Board.