LKFN US Equity☆

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Net income in 2020 was $84.3 million, down 3.1% from $87.0 million in 2019 and up 4.9% from $80.4 million in 2018.

Diluted net income per common share was $3.30 in 2020, $3.38 in 2019 and $3.13 in 2018. Return on average total assets was 1.55% in 2020 versus 1.76% in 2019 and 1.69% in 2018. Return on average total equity was 13.51% in 2020 versus 15.47% in 2019 and 16.51% in 2018. The dividend payout ratio, with respect to diluted earnings per share, was 36.36% in 2020, 34.32% in 2019 and 31.95% in 2018. The average equity to average assets ratio was 11.51% in 2020 compared to 11.38% in 2019 and 10.24% in 2018.

Net income in 2020 was positively impacted by an $8.0 million increase in net interest income and a $1.8 million increase in noninterest income. Offsetting these positive impacts were an $11.5 million increase in the provision for loan losses and a $1.8 million increase in noninterest expense.

Net income in 2019 was $87.0 million, up 8.3% from $80.4 million in 2018 and up 51.8% from $57.3 million in 2017. Diluted net income per common share was $3.38 in 2019, $3.13 in 2018 and $2.23 in 2017. Return on average total assets was 1.76% in 2019 versus 1.69% in 2018 and 1.29% in 2017. Return on average total equity was 15.47% in 2019 versus 16.51% in 2018 and 12.72% in 2017. The dividend payout ratio, with respect to diluted earnings per share, was 34.32% in 2019, 31.95% in 2018 and 38.12% in 2017. The average equity to average assets ratio was 11.38% in 2019 compared to 10.24% in 2018 and 10.15% in 2017.

Net income in 2019 was positively impacted by a $4.7 million increase in noninterest income, a $3.8 million increase in net interest income and a $3.2 million decrease in the provision for loan losses. Offsetting these positive impacts was a $3.2 million increase in noninterest expense.

Total assets were $5.830 billion as of December 31, 2020 versus $4.947 billion as of December 31, 2019, an increase of $883.7 million or 17.9%. This increase was primarily due to a $572.6 million increase in net loans, an increase in short-term investments of $144.7 million and a $126.6 million increase in available-for-sale investment securities. Total average assets increased $482.9 million primarily due to average loans increasing $449.9 million in 2020, and a $30.4 million increase in available-for-sale investment securities.

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 loan losses and the valuation and other-than-temporary impairment of investment securities.

Allowance for Loan Losses

The Company maintains an allowance for loan losses to provide for probable incurred credit losses. Loan losses are charged against the allowance when management believes that the principal is uncollectable. 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 loan losses is taken based on management’s ongoing evaluation of the appropriate allowance balance. A formal evaluation of the adequacy of the loan 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 loan 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 conditions and historical loss analysis. In addition, management gives consideration to changes in the allocation for specific watch list credits in determining the appropriate level of the loan loss provision. Furthermore, management’s overall view on credit quality is a factor in the determination of the provision.

32

Table of Contents

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 loan losses that generally includes consideration of the following factors: changes in the nature and volume of the loan portfolio, overall portfolio quality 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. With respect to 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, allocations are assigned based upon historical experience subject to a floor, unless the rate of loss is expected to be greater than historical losses as noted below. A detailed analysis is performed on loans that are classified but determined not to be impaired which incorporates different scenarios where the risk that the borrower will be unable or unwilling to repay its debt in full or on time is combined with an estimate of loss in the event the borrower cannot pay to develop non-specific allocations for such loan pools. These allocations may be adjusted based on the other factors cited above. An appropriate level of general allowance for pooled loans is determined by portfolio segment using historical loss percentages subject to a floor, supplemented with other environmental factors based on the risks present for each portfolio segment. These factors include consideration of the following: levels of, and trends in, delinquencies and impaired loans; trends in volume and terms of loans; 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 the following could affect the overall process: social, political, economic and terrorist events or activities. All of these factors are susceptible 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 loan losses deemed adequate to cover probable 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 review officer. Specific allowances are established in cases where management has identified significant conditions or circumstances related to an individual credit that indicate the loan is impaired. Considerations with respect to specific allocations for these individual credits include, but are not limited to, the following: (a) does the customer’s cash flow or net worth appear insufficient to repay the loan; (b) is there adequate collateral to repay the loan; (c) has the loan been criticized in a regulatory examination; (d) is the loan impaired; (e) are there other reasons where the ultimate collectability of the loan is in question; or (f) are there unique loan characteristics that require special monitoring.

Allocations are also applied to categories of loans considered not to be individually impaired, 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. In addition, general allocations are made for other pools of loans, including non-classified loans. These general pooled loan allocations are performed for portfolio segments of commercial and industrial, commercial real estate and multi-family, agri-business and agricultural, other commercial, consumer 1-4 family mortgage and other consumer loans, and loans within certain industry categories believed to present unique risk of loss. General allocations of the allowance are primarily made based on a three-year historical average for loan losses for these portfolios, subject to a floor, and are adjusted for economic factors and portfolio trends.

Due to the imprecise nature of estimating the allowance for loan losses, the Company’s allowance for loan losses includes an unallocated component. The unallocated component of the allowance for loan losses incorporates the Company’s judgmental determination of inherent losses that may not be fully reflected in other allocations, including factors such as the level of classified credits, economic uncertainties, industry trends impacting specific portfolio segments, broad portfolio quality trends and trends in the composition of the Company’s large commercial loan portfolio and related large dollar exposures to individual borrowers.

Valuation and Other-Than-Temporary Impairment of Available-for-Sale Investment Securities

The fair values of securities available-for-sale are determined on a recurring basis by obtaining quoted prices on nationally recognized securities exchanges or pricing models, which utilize significant observable inputs such as matrix pricing. This is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities. Different judgments and assumptions used in pricing could result in different estimates of value. The fair value of certain securities is determined using unobservable inputs, primarily observable inputs of similar securities.

33

Table of Contents

At the end of each reporting period, securities held in the investment portfolio are evaluated on an individual security level for other-than-temporary impairment in accordance with current accounting guidance. Impairment is other-than-temporary if the decline in the fair value of the security is below its amortized cost and it is probable that all amounts due according to the contractual terms of a debt security will not be received.

Significant judgments are required in determining impairment, which includes making assumptions regarding the estimated prepayments, loss assumptions and the change in interest rates.

We consider the following factors when determining other-than-temporary impairment for a security or investment:

● the financial condition and near-term prospects of the issuer;

The assessment of whether a decline exists that is other-than-temporary, involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time. If, in management’s judgment, other-than-temporary impairment exists, the cost basis of the security will be written down to the computed net present value, and the unrealized loss will be transferred from accumulated other comprehensive loss as an immediate reduction of current earnings (as if the loss had been realized in the period of other-than-temporary impairment).

RESULTS OF OPERATIONS

Overview

In 2020 and 2019, the Company continued to grow loans and deposits organically, in its geographic footprint of northern Indiana and in central Indiana in the Indianapolis market. In addition, during 2020 the Company was an active participant in the PPP. The Company had 50 branches as of December 31, 2020. The Company’s profitability has been positively impacted by growth in loans and deposits. In addition, asset quality has remained stable. The core banking contributions to noninterest income of interest rate swap, mortgage banking, loan and wealth management fee income increased in 2020. Overall, expense growth has reflected our continued investment in people, technology and our branch infrastructure. The outlook for 2021 includes plans for continued organic loan and deposit growth, a disciplined credit philosophy, continued investment in the Company in the form of staff additions, continued expansion in our geographic footprint, and continued investments in customer- facing technology and cybersecurity risk management tools.

Selected income statement information for the years ended December 31, 2020, 2019 and 2018 is presented in the following table.

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Income Statement Summary: ​ ​ ​ ​ ​ ​

Other Data: ​ ​ ​ ​

Net charge-offs (recoveries) to average loans ​ 0.09 % 0.03 % 0.13 %

Net interest margin excluding PPP loans (3) ​ ​ 3.19 % ​ 3.38 % ​ 3.43 %

Noninterest income to total revenue ​ 22.32 % 22.49 % 21.04 %

​

34

Table of Contents

(1) Noninterest expense/Net interest income plus Noninterest income.

The Company believes that providing non-GAAP financial measures provides investors with information useful to understanding the company's financial performance. A reconciliation of these non-GAAP financial measures is provided below (dollars in thousands, except per share data).

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ Year Ended

​ ​ Dec. 31, ​ Dec. 31, ​ Dec. 31,

Plus: Deferred tax assets related to goodwill ​ 1,176 ​ 1,181 ​ 1,191 ​

Plus: Deferred tax assets related to goodwill ​ 1,176 ​ 1,181 ​ 1,191 ​

Tangible Book Value Per Common Share ​ $ 25.70 ​ $ 23.19 ​ $ 20.47 ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

35

Table of Contents

The impact of the Paycheck Protection Program on Net Interest Margin FTE is provided below (dollars in thousands)

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ Year Ended

​ ​ Dec. 31, ​ Dec. 31, ​ Dec. 31,

Less: Average Balance of PPP Loans ​ 376,785 ​ — ​ — ​

Less: PPP Loan Income ​ (12,832) ​ — ​ — ​

Adjusted Earning Asset Yield, net of PPP Impact ​ 3.80 % 4.67 % 4.50 %

Less: Average Balance of PPP Loans ​ 376,785 ​ — ​ — ​

Less: PPP Cost of Funds ​ (956) ​ — ​ — ​

Adjusted Cost of Funds, net of PPP Impact ​ 0.61 % 1.29 % 1.07 %

Net Interest Margin FTE, net of PPP Impact ​ 3.19 % 3.38 % 3.43 %

​

Net Income

Net income was $84.3 million in 2020, a decrease of $2.7 million, or 3.1%, versus net income of $87.0 million in 2019. The decrease in net income from 2019 to 2020 was primarily due to an increase in the provision for loan losses of $11.5 million, or 356.6%, as well as an increase of $1.8 million, or 2.0%, in noninterest expense. Net interest income increased $8.0 million, or 5.1%, and noninterest income increased $1.8 million, or 4.1%. Net interest income for 2020 included $12.8 million in PPP interest and fee income. And unamortized PPP fee income was $6.3 million at December 31, 2020. The increase in provision for loan losses was driven by the potential negative impact to the Company’s borrowers due to the economic impact of the COVID-19 pandemic.

Net income was $87.0 million in 2019, an increase of $6.6 million, or 8.3%, versus net income of $80.4 million in 2018. The increase in net income from 2018 to 2019 was primarily due to the increase in noninterest income of $4.7 million, or 11.6%. In addition, net interest income increased $3.8 million, or 2.5%, to $155.0 million versus $151.3 million in 2018 and the provision for loan losses decreased $3.2 million, or 49.5%. Noninterest expense increased by $3.2 million, or 3.7% and income tax expense increased $1.8 million, or 9.7%.

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, 2020, 2019 and 2018.

36

Table of Contents

THREE YEAR AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS

​

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

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

Earning Assets ​ ​ ​ ​ ​ ​ ​ ​ ​

Loans: ​ ​ ​ ​ ​ ​ ​ ​ ​

Investments: (1) ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Nonearning Assets ​ ​ ​ ​ ​ ​ ​ ​

Premises and equipment ​ 60,492 ​ ​ ​ ​ ​ ​ 59,147 ​ ​ ​ ​ ​ ​ 56,842 ​ ​ ​ ​

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

Interest Bearing Liabilities ​ ​ ​ ​ ​ ​ ​ ​

Time deposits: ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

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

Noninterest Bearing Liabilities ​ ​ ​ ​ ​ ​ ​ ​ ​

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

Interest Margin Recap ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

(3) Nonaccrual loans are included in the average balance of taxable loans.

37

Table of Contents

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 ​ Attributable to ​ Total

​ Volume Rate Change Volume Rate Change

Interest Income (2) ​ ​ ​ ​ ​ ​

Loans: ​ ​ ​ ​ ​ ​

Investments: ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Interest Expense ​ ​ ​ ​ ​ ​ ​

Time deposits: ​ ​ ​ ​ ​ ​ ​ ​ ​

Long-term borrowings and ​ ​ ​ ​ ​ ​ ​ ​ ​

Net interest income increased by $8.0 million to $163.0 million in 2020 compared to 2019, primarily due to a $528.1 million, or 11.3%, increase in average earning assets, driven by a $469.0 million increase in average commercial loans. The yield on average earning assets decreased 90 basis points to 3.77% in 2020 from 4.67% in 2019. The growth in average commercial loans was driven by $376.8 million in average PPP loans. Average core loan growth, with excludes PPP loans, was $73.2 million, or 1.8%. The net interest margin decreased to 3.19% in 2020 versus 3.38% in 2019, driven by the Federal Reserve Bank decreasing the target Federal Funds Rate by 225 basis points since the second half of 2019, inclusive of two emergency cuts during March 2020, in response to the COVID-19 pandemic. The net interest margin decreased to 3.38% in 2019 versus 3.43% in 2018, due to higher costs on average interest bearing liabilities, which offset an increase in the yield of earning assets during 2019.

38

Table of Contents

Growth in the commercial loan portfolio accounted for most of the growth in loans, as well as total earning assets, during both 2020 and 2019 and positively impacted total interest income. Management believes that the growth in the loan portfolio unrelated to the PPP loan program will likely continue in a measured and prudent fashion as a result of our continued strategic focus on commercial and industrial lending, as well as commercial real estate lending. Loan growth, excluding PPP loans, was slower in 2020 and 2019 as compared to prior years due to a slowdown in demand for manufacturing and industrial loans. The utilization of commercial lines of credit has dropped in 2020 and 2019 due to softened loan demand to 43% at December 31, 2020 from 46% at December 31, 2019 and 49% at December 31, 2018. Management believes its organic growth strategy of continued expansion in its current geographic footprint and in Indianapolis will provide continued loan growth opportunities. During 2020 growth in average loans of $449.9 million, growth in available-for-sale investment securities of $30.4 million and growth in short-term investments and interest bearing deposits of $47.8 was funded through an increase in deposits. Average demand deposits increased $365.8 million in 2020 and average interest bearing deposit accounts increased $42.3 million. The increase in deposits for 2020 resulted from excess liquidity on our customers’ balance sheets resulting from a combination of PPP loans, stimulus payments and an increase in the savings rate as a result from the health crisis and economic downturn.

The Company’s net interest margin decreased 19 basis points to 3.19% for 2020 compared to 3.38% for 2019. The lower margin in 2020 was impacted by lower yields on loans and securities, partially offset by a lower cost of funds. The Federal Reserve Bank decreased the target Federal Funds Rate by 225 basis points since the second half of 2019, including two Federal Reserve Bank emergency cuts to the Federal Funds Rate during March 2020. The two emergency cuts in March reduced the Federal Funds Rate by 150 basis points and brought the Federal Funds Rate back to the zero-bound range of 0.00% to 0.25%.

Provision for Loan Losses

On December 27, 2020, President Trump signed into law the Consolidated Appropriations Act, 2021. This law extended relief for troubled debt restructurings and provided the opportunity to further delay CECL adoption originally provided under the CARES Act. The Company elected to defer adoption of CECL until January 1, 2021. The Company recorded a provision for loan losses of $14.8 million in 2020 compared to $3.2 million in 2019 and $6.4 million in 2018. The higher provision in 2020 was driven by the potential negative impact to the company’s borrowers as a result of the economic conditions resulting from the COVID-19 pandemic. The Company’s allowance for loan losses as of December 31, 2020 was $61.4 million compared to $50.7 million as of December 31, 2019 and $48.5 million as of December 31, 2018. The allowance for loan losses represented 1.32% of total loans as of December 31, 2020 versus 1.25% at December 31, 2019 and 1.24% at December 31, 2018. The company’s loan loss reserve to total loans excluding PPP loans was 1.45% at December 31, 2020. PPP loans are guaranteed by the United States SBA and have not been allocated for within the allowance for loan losses. Net charge-offs of $4.0 million, or 0.09% of average loans, and net charge-offs of $1.0 million, or 0.03% of average loans, were recorded in 2020 and 2019, respectively. 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 COVID-19 pandemic and other factors that may influence the assessment of the collectability of loans.

39

Table of Contents

Noninterest Income

The following table presents changes in the components of noninterest income for the years ended December 31.

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ % Change From ​

​ ​ ​ ​ ​ ​ ​ ​ ​ Prior Year

Noninterest income to total revenue ​ 22.3 % 22.5 % 21.0 % ​

​

Noninterest income was $46.8 million in 2020 versus $45.0 million in 2019, an increase of $1.8 million, or 4.1%. The increase was primarily driven by a $3.4 million increase in interest rate swap fees generated from commercial lending transactions, as well as a $2.3 million increase in mortgage banking income. Noninterest income was also positively impacted by increases in wealth advisory fees due to continued growth of client relationships. Offsetting these increases was a decrease in service charges on deposit accounts driven primarily by lower treasury management fees as well as reduced levels of overdraft fee income.

Noninterest income was $45.0 million in 2019 versus $40.3 million in 2018, an increase of $4.7 million, or 11.6%. The increase was primarily driven by a $2.0 million increase in other income related to $1.2 million of swap fees generated from commercial lending transactions, as well as $846,000 in life insurance proceeds on bank owned life insurance policies. Noninterest income was also positively impacted by increases in bank owned life insurance income, loan and service fees, mortgage banking income, and wealth advisory and brokerage fees due to continued growth of client relationships. Offsetting the increases was a decrease in service charges on deposit accounts driven by lower treasury management fees from a single commercial treasury management relationship. This relationship contributed $4.5 million to services charges on deposit accounts during 2019. The related treasury management activity was terminated and the revenue will not recur in future periods.

Noninterest Expense

The following table presents changes in the components of noninterest expense for the years ended December 31.

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ % Change From

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ Prior Year

​

40

Table of Contents

Noninterest expense was $91.2 million in 2020 versus $89.4 million in 2019, an increase of $1.8 million, or 2.0%. Data processing fees increased $1.5 million in 2020 primarily due to the Company’s continued investment in customer focused, technology-based solutions and ongoing cybersecurity and data management enhancements. FDIC insurance and other regulatory fees increased $1.1 million due to the expiration of insurance assessment credits. Professional fees increased by $670,000 primarily due to higher legal expenses, increased fees to accounting firms and professional fees for innovative project implementations. Salaries and employee benefits increased primarily due to an increase in staffing in revenue producing and risk management areas as well as higher health insurance expenses. Offsetting these increases were decreases in corporate and business development as the COVID-19 pandemic forced the cancellation and postponement of events, in-person trainings and face-to-face customer and prospect meetings due to COVID-19 safety protocols. The Company spent approximately $640,000 since the pandemic began on personal protective equipment, protective barriers and enhanced social distancing measures for the safety of bank customers and employees.

Noninterest expense was $89.4 million in 2019 versus $86.2 million in 2018, an increase of $3.2 million, or 3.7%. Salaries and employee benefits increased by $1.1 million primarily due to an increase in staffing in revenue producing and risk management areas as well as normal merit increases. Professional fees increased due to higher legal expenses and increased utilization of accounting firms for outsourced services. Data processing fees also increased during 2019 primarily due to the Company’s continued investment in customer focused, technology-based solutions and ongoing cybersecurity and data management enhancements. Offsetting these increases were decreases in FDIC insurance and other regulatory fees as well as decreases in corporate and business development. In the third quarter of 2019, the FDIC announced that due to the Deposit Insurance Fund reserve ratio exceeding 1.38%, banks with consolidated assets of less than $10 billion would be receiving credits against their deposit insurance assessments. The bank’s $1.1 million credit was applied as a reduction of FDIC assessments commencing with the payment of the second quarter assessment paid in September 2019 and were fully utilized by the end of the first quarter of 2020.

As previously disclosed, in the third quarter of 2019, the Bank discovered potentially fraudulent activity by a former treasury management client involving multiple banks. The former client subsequently filed several related bankruptcy cases, captioned In re Interlogic Outsourcing, Inc. et al., which are pending in the United States Bankruptcy Court for the Western District of Michigan. The Bank and the other banks are currently subject to document and information requests in these bankruptcy cases and other related bankruptcy cases. The debtors have also requested the examinations of various current and former bank employees as part of the debtors’ investigation. On February 5, 2021, the former client and the other debtors in related bankruptcy cases filed a joint disclosure statement and a joint plan for liquidation with the bankruptcy court. In those documents, the debtors state that they have been investigating causes of action against various banks and other parties involved with the former customer, including the Bank. The debtors stated that, based on their investigation, which is ongoing, they believe that they hold claims and causes of action against the Bank. We cannot predict what legal claims, if any, will be made against the Bank. Based on current information, we have determined that a loss is neither probable nor estimable at this time, and the Bank intends to vigorously defend itself if any claim is filed.

Income Taxes

The Company recognized income tax expense in 2020 of $19.5 million, compared to $20.3 million in 2019 and $18.5 million in 2018. The effective tax rate in 2020 was 18.8% compared to 18.9% in 2019, and 18.7% in 2018. For a detailed analysis of the Company’s income taxes see Note 13 – Income Taxes.

FINANCIAL CONDITION

Overview

Total assets of the Company were $5.830 billion as of December 31, 2020, an increase of $883.7 million, or 17.9%, when compared to $4.947 billion as of December 31, 2019. Total loans increased by $583.3 million, or 14.3%, to $4.649 billion at December 31, 2020 from $4.066 billion at December 31, 2019. PPP loans originated during 2020 were $570.5 million and $412.0 remained outstanding at December 31, 2020. Cash and cash equivalents increased by $150.5 million and available-for-sale securities increased by $126.6 million. Funding for the loan and investment growth came from a $903.0 million increase in total deposits as well as a $53.8 million increase in retained earnings, offset by an $84.5 million decrease in total borrowings. The Company used wholesale funding, including brokered deposits and FHLB advances, to provide liquidity for loan growth and to help maintain its desired interest rate risk position. During 2020, reliance on wholesale funding decreased as a result of strong core deposit growth.

41

Table of Contents

Uses of Funds

Investment Portfolio

The amortized cost and the fair value of securities as of December 31, 2020, 2019 and 2018 were as follows:

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ Amortized ​ Fair ​ Amortized ​ Fair ​ Amortized ​ Fair

Securities available for sale: ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

U.S. Treasury securities ​ $ — ​ $ — ​ $ — ​ $ — ​ $ 994 ​ $ 987

​

At year-end 2020, 2019 and 2018, 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 $216.5 million in 2020, $129.5 million in 2019 and $126.6 million in 2018. Growth of the investment portfolio during the past three years serves to provide liquidity for the Company and provide longer duration as an offset to the short duration of the loan portfolio. The Company targets investment securities as a percentage of total assets in a range from 11% - 14%. During the fourth quarter of 2020, the Company deployed excess liquidity to the investment portfolio in the amount of $100.0 million. Securities sales totaled $8.0 million in 2020, $57.1 million in 2019 and $15.3 million in 2018. Paydowns from prepayments and scheduled payments of $90.4 million, $53.0 million and $42.8 million were received in 2020, 2019 and 2018, and the amortization of premiums, net of the accretion of discounts, was $4.0 million, $3.9 million and $3.2 million, respectively. Maturities and calls of securities totaled $7.6 million, $14.8 million and $11.0 million in 2020, 2019 and 2018, respectively. No other- than-temporary impairment was recognized in 2020, 2019 or 2018. 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 weighted average yields and maturity distribution for the securities portfolio at December 31, 2020, were as follows:

​

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

​ ​ Within After One After Five Years Over Ten

​ ​ One Year ​ Within Five Years ​ Within Ten years ​ Years

​ ​ Fair ​ ​ ​ Fair ​ ​ ​ Fair ​ ​ ​ Fair ​ ​

​

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 $6.7 million to $11.2 million at December 31, 2020 from $4.5 million at December 31, 2019 as a result of strong mortgage refinancing demand in response to the low interest rate environment. This asset category is subject to a high degree of variability depending on, among other things, recent mortgage loan rates and the timing of loan sales into the secondary market. The Company generally sells almost all of the mortgage loans it originates on the secondary market. Proceeds from sales totaled $114.2 million in 2020, $64.8 million in 2019 and $51.7 million in 2018.

42

Table of Contents

Loan Portfolio

The loan portfolio by class as of December 31, 2020, 2019, 2018, 2017 and 2016 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: ​ ​ ​ ​ ​ ​

​

The ratio of loans to total loans by portfolio segment as of December 31, 2020, 2019, 2018, 2017 and 2016 was as follows:

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​

In 2020, net loan balances increased by $572.6 million to $4.588 billion, which excludes approximately $117.6 million in loans originated for sale. PPP loans of $412.0 million are included in non-working capital loans of commercial and industrial loans. In 2019, net loan balances increased by $148.9 million to $4.015 billion, which excludes approximately $66.0 million in loans originated for sale. In 2018, net loan balances increased by $95.0 million to $3.866 billion, which excludes approximately $49.8 million in loans originated for sale and $316,000 transferred to other real estate in 2018.

43

Table of Contents

The mix of loan types within the Company’s portfolio continued a trend toward a higher percentage of the total loan portfolio being in commercial loans. This higher percentage of commercial loans to the total portfolio was a result of the Company’s long standing strategic plan that is focused on organic expansion and growth in commercial loans. Commercial and industrial loans together with owner-occupied commercial real estate loans represent 52.4% and 49.2% of total loans as of December 31, 2020 and 2019, respectively. The owner-occupied commercial real estate loans tend to represent the real estate holding of our commercial and industrial loan customers. Another significant loan segment are loans to the agri-business sector, which has resulted in the Company becoming one of the largest agricultural lenders in the State of Indiana.

The residential construction and land development loans class included construction loans totaling $7.2 million, $8.1 million, $12.5 million, $10.0 million and $11.4 million as of December 31, 2020, 2019, 2018, 2017 and 2016. Declines in consumer loans during 2020 resulted from paydowns due to borrower excess liquidity generated from mortgage refinancing activity. The Bank generally sells conforming mortgage loans which it originates on 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, 2020:

​

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

​ ​ ​ Commercial ​ ​ ​ ​ ​

​ ​ ​ ​ ​ Real Estate ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ and ​ Agri-business ​ ​ ​ ​ Consumer ​ ​ ​ ​ ​ ​ ​ ​

​ ​ Commercial and ​ Multi-family ​ and ​ Other ​ 1-4 Family ​ Other ​ ​ ​ ​ ​

​

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, 2020 amounted to $1.611 billion and $1.655 billion, respectively.

Paycheck Protection Program

As of December 31, 2020, 900 loans with an aggregate principal amount of $142 million, representing 37% of the 2,409 total PPP loans originated with an aggregate amount of $570.5 million, were forgiven during the fourth quarter. In addition, the Company had submitted an additional 10% of the total PPP loans originated in 2020, totaling $159.3 million, to the Small Business Administration (SBA) for forgiveness as of year-end. As of February 17, 2021, 1,527, or 63%, of the total PPP loans originated in 2020 totaling $232.7 million, were forgiven and $198.1 million, or 35%, had been submitted to the SBA for forgiveness. Additionally, the Company has started accepting, submitting and funding loan applications for the second round of PPP loans. As of February 17, 2021, the Company had received 776 applications for second round PPP loans totaling $133.7 million. Of these applications, 531, or 68%, had been approved by the SBA and 56, or 7%, were submitted and awaiting SBA approval. PPP round two loans totaling $104.0 million have been approved by the SBA and an additional $13.2 million in PPP loans have been submitted to the SBA for approval.

During the third quarter, the Company began to process PPP loan forgiveness applications for its customers and in November 2020, the SBA began to approve forgiveness applications. In addition, the Bank has engaged a third-party Fintech technology partner to assist the bank and its customers to automate the forgiveness application process. This application will also be used for the second round of PPP loan originations and forgiveness. Most of the PPP loans are for existing customers and 51% of the number of PPP loans are for amounts less than $50,000. As of December 31, 2020, the Bank has submitted 1,145 loan forgiveness applications to the SBA in the amount of $300 million, which represented 48% of total PPP loans originated. The SBA has approved forgiveness for 900 loans in the amount of $142 million.

44

Table of Contents

Bank Owned Life Insurance

Bank owned life insurance increased by $11.4 million to $95.2 million at December 31, 2020 and by $6.7 million to $83.8 million at December 31, 2019 from $77.1 million at December 31, 2018. The increases during 2020 and 2019 were primarily due to the purchase of additional life insurance policies on officers of the Bank. Bank owned life insurance provides investment income from the securities the life insurance is invested in and offsets benefit plan expenses.

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, 2020, 2019 and 2018 are summarized in the following table:

​

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

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ % Balance Change

(dollars in thousands) ​ Balance Rate Balance Rate Balance Rate 2020 2019

Savings and transaction accounts: ​ ​ ​ ​

Time deposits: ​ ​ ​ ​ ​ ​ ​ ​

​

Time deposits as of December 31, 2020 will mature as follows:

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

(dollars in thousands) or more or less Total Total ​

​

Deposits

Total deposits increased by $903.0 million to $5.037 billion, comparing December 31, 2020 to December 31, 2019. The growth in deposits consisted of $1.002 billion in core deposit growth offset by a decrease of $98.5 million in brokered deposits. Total deposit growth was led by an increase of $664.3 million in commercial deposits. In addition, retail deposits increased by $301.9 million while public funds deposits increased by $35.3 million. The growth in deposits in 2020 resulted primarily from increased deposit balances from new and existing customers, as well as a decreased utilization of brokered deposits. Deposit growth was impacted by excess liquidity on customer balance sheets resulting from PPP loans, due to both economic stimulus payments made to retail customers and an increase in savings rates. Core deposit growth enabled the Company to reduce reliance on public funds and wholesale funding during 2020.

45

Table of Contents

Total deposits increased by $89.8 million to $4.134 billion, comparing December 31, 2019 to December 31, 2018. The growth in deposits consisted of $141.1 million in core deposit growth offset by a decrease of $51.4 million in brokered deposits. Total deposit growth was led by an increase of $200.6 million in commercial deposits. In addition, retail deposits increased by $28.9 million while public funds deposits decreased by $88.4 million. The growth in deposits in 2019 resulted from increased deposit balances from new and existing customers, as well as a decreased utilization of brokered deposits. Core deposit growth enabled the Company to reduce reliance on wholesale funding during 2019.As previously noted, 23% of the Company’s deposit base is attributable to public fund entities which primarily represent customers in the Company’s geographic footprint. 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” below. The following table presents total deposits by portfolio segment as of December 31, 2020, 2019 and 2018:

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​

FHLB Advances and Other Borrowings

During 2020, average total short-term borrowings decreased by $27.0 million to $34.3 million, primarily due to lower short-term FHLB borrowings. Ending balances of short-term and miscellaneous borrowings decreased $159.5 million during 2020 to $10.5 million. The decrease was due to the payoff of outstanding short-term FHLB borrowings. During 2020, the Company utilized $10.5 million of its holding company $30.0 million revolving line of credit in connect with its share repurchase activity. Short-term FHLB borrowings are used to fund short-term balance sheet growth due to the flexible nature of the financial instrument and allows the Company to prudently lend to commercial or retail borrowers when opportunities are presented. Average total long-term borrowings increased by $31.5 million to $62.3 million, primarily due to a $75.0 million long-term FHLB borrowing and the repayment of the Company’s subordinated debentures in December 2019.

During 2019, average total short-term borrowings decreased by $54.5 million to $61.3 million, primarily due to the discontinuance of securities sold under agreements to repurchase products in 2019. In addition, on December 30, 2019, the Company redeemed $30.0 million of subordinated debentures priced at three-month LIBOR plus 305 basis points. Ending balances of total short- term borrowings decreased $75.6 million during 2019 to $170.0 million, due to decreases in securities sold under agreements to repurchase.

Capital

The Company believes that a strong, appropriately managed capital position is critical to long-term earnings and continuing growth in loans. Capital is used primarily to fund continued organic loan growth and to support dividends per share to shareholders. The Company had a total risk-based capital ratio of 14.7%, a Tier I risk-based capital ratio of 13.4% and a common Tier 1 risk-based capital ratio of 13.4% as of December 31, 2020. 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 10.9% and a tangible equity ratio of 11.2%. See Note 16 – Capital Requirements 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 9.9% to $657.2 million as of December 31, 2020 from $598.1 million as of December 31, 2019. The Company earned $84.3 million in 2020 and $87.0 million in 2019. The Company declared cash dividends of $1.20 per share in 2020, which decreased equity by $30.6 million. The Company declared cash dividends of $1.16 per share in 2019, which decreased equity by $29.7 million. The change in accumulated other comprehensive income was due to changes in the fair values of available-for-sale securities and the defined benefit pension which increased equity by $15.7 million in 2020 compared to an increase of $18.3 million in 2019. The impact to equity due to other comprehensive income is not included in regulatory capital. In addition, during 2020 the

46

Table of Contents

Company repurchased 289,101 shares of its common stock for $10.0 million. Share repurchases under the repurchase plan were suspended in March of 2020 with $20.0 million of authorization remaining under the plan.

RISK MANAGEMENT

Overview

The Company, with the oversight of the Corporate Risk Committee of the Board, has developed a company-wide risk management program intended to help identify, manage and mitigate the various business risks the Company is exposed to. 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.

Investment Portfolio

The Company’s investment portfolio consists of government agencies and municipal bonds subject to an investment security policy that is approved annually by the Board. During 2020, purchases in the securities portfolio consisted of primarily municipal bonds, agency securities and mortgage-backed securities. As of December 31, 2020, the Company’s investment in U.S government sponsored mortgage-backed securities represented approximately 43% of total securities consisting of Collateralized Mortgage Obligations, Commercial Mortgage-Backed Securities and 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 2020 were within risk tolerances for price, prepayment, extension and original life risk characteristics contained in the Company’s investment policy. Municipal securities represent 52% of total securities as of December 31, 2020 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, 2020, the securities in the available-for-sale portfolio had approximately a 3.1 year effective duration. The analysis indicated a negative 11.87% change in market value in the event of a 300 basis point upward, instantaneous rate shock and an approximate positive 2.85% change in market value in the event of a 100 basis point downward, instantaneous rate shock. As of December 31, 2020, all mortgage-backed securities were performing in a manner consistent with management’s ALCO modeled expectations at time of purchase.

Loan Portfolio

The Company has a relatively 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, by adjusting its pricing to the perceived risk of each individual credit and by diversifying the portfolio by customer, product, industry and market area and by obtaining loan guarantees.

There were no loan concentrations within industries, which exceeded ten percent of total loans, except commercial real estate and manufacturing. Commercial real estate was $1.895 billion, or 40.7%, of total loans and manufacturing was $510.8 million, or 11.0%, of total loans at December 31, 2020. The Company’s in-house lending limit was raised from $30.0 million to $40.0 million during 2020. Manufacturing loans are included in the commercial and industrial loans total and are well diversified by industry. Agri- business and agricultural loans represent 9.2% of total loans as of December 31, 2020 and are not concentrated to any agricultural sector. Nearly 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.

47

Table of Contents

The following is a summary of nonperforming loans as of December 31, 2020, 2019, 2018, 2017 and 2016.

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Commercial and industrial loans ​ ​ ​ ​ ​

Past due accruing loans (90 days or more) ​ $ — ​ $ — ​ $ — ​ $ — ​ $ —

Commercial real estate and multi-family residential loans ​ ​ ​ ​ ​

Past due accruing loans (90 days or more) ​ — ​ — ​ — ​ — ​ —

Agri-business and agricultural loans ​ ​ ​ ​ ​

Past due accruing loans (90 days or more) ​ — ​ — ​ — ​ — ​ —

Other commercial loans ​ ​ ​ ​ ​

Past due accruing loans (90 days or more) ​ — ​ — ​ — ​ — ​ —

Nonaccrual loans(1) ​ — ​ — ​ — ​ — ​ —

Subtotal nonperforming loans ​ — ​ — ​ — ​ — ​ —

Consumer 1-4 family mortgage loans ​ ​ ​ ​ ​

Past due accruing loans (90 days or more) ​ 116 ​ 45 ​ — ​ 6 ​ 53

Other consumer loans ​ ​ ​ ​ ​

Past due accruing loans (90 days or more) ​ — ​ — ​ — ​ — ​ —

Nonaccrual loans(1) ​ — ​ 17 ​ — ​ 235 ​ —

Subtotal nonperforming loans ​ — ​ 17 ​ — ​ 235 ​ —

​

(1) Includes nonaccrual troubled debt restructured loans.

Nonperforming assets of the Company include nonperforming loans (as indicated above), nonaccrual investments and other real estate owned and repossessions, the total of which amounted to $12.4 million and $19.0 million at December 31, 2020 and 2019, respectively. Nonperforming loans decreased by $6.6 million during 2020, due primarily to a $3.7 million charge-off resulting from a single commercial manufacturing borrower and due to paydowns of existing nonaccrual loans. As of December 31, 2020, management believed that there were no significant foreseeable losses relating to nonperforming assets, except as discussed below.

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 loans 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.

A loan is impaired when full payment under the original loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature not in nonaccrual or troubled debt restructured status such as residential mortgage, consumer, and credit card loans, and on an individual loan basis for other loans. If a loan is impaired, 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.

48

Table of Contents

Total nonperforming loans were $12.1 million, or 0.26% of total loans, at year end 2020 versus $18.7 million, or 0.46% of total loans, at year end 2019. There were 39 loans totaling $20.2 million classified as impaired as of December 31, 2020 versus 54 loans totaling $27.8 million at the end of 2019. The decrease in impaired loans during 2020 resulted primarily from a $3.7 million charge-off resulting from a single commercial manufacturing borrower as well as payments received on impaired credits.

Loans renegotiated as troubled debt restructurings are those loans for which either the contractual interest rate has been reduced below market rates and/or other concessions to market terms are granted to the borrower because of a deterioration in the financial condition of the borrower which results in the inability of the borrower to meet the terms of the loan.

As of December 31, 2020, there were 31 loans totaling $11.7 million renegotiated as troubled debt restructurings of which $5.5 million were modified in 2020. Of these loans, $6.5 million were included in nonaccrual loans in the previous table and the remaining $5.2 million were performing under their modified terms. The increase in troubled debt restructurings during 2020 resulted primarily from the addition of a single commercial relationship. As of December 31, 2019, there were 35 loans totaling $9.1 million renegotiated as troubled debt restructurings of which $35,000 were modified in 2019. Of these loans, $3.2 million were included in nonaccrual loans in the previous table and the remaining $5.9 million were performing under their modified terms. The Company has no commitments to lend additional funds to any of the borrowers.

49

Table of Contents

The following is a summary of the loan loss experience for the years ended December 31, 2020, 2019, 2018, 2017 and 2016.

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Loans charged-off: ​ ​ ​ ​ ​ ​

Agri-business and agricultural loans ​ — ​ — ​ — ​ — ​ — ​

Other commercial loans ​ — ​ — ​ — ​ — ​ — ​

Recoveries of loans previously charged-off: ​ ​ ​ ​ ​ ​

Agri-business and agricultural loans ​ — ​ 8 ​ 42 ​ 23 ​ 19 ​

Other commercial loans ​ — ​ — ​ — ​ — ​ — ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​

50

Table of Contents

The following is a summary of the allocation for loan losses as of December 31, 2020, 2019, 2018, 2017 and 2016.

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Allocated allowance for loan losses: ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​

At December 31, 2020, the allowance for loan losses was 1.32% of total loans outstanding, versus 1.25% of total loans outstanding at December 31, 2019. The allowance for loan losses was 1.45% of total loans outstanding, excluding PPP loans of $412.0 million, as of December 31, 2020. This reflects a more comparable ratio to prior periods, as PPP loans are fully guaranteed by the SBA and have not been allocated for within the allowance for loan losses calculation. Management believes the allowance for loan losses is at a level commensurate with the overall risk exposure of the loan portfolio. However, if economic conditions fail to recover or continue to deteriorate due to the COVID-19 pandemic, certain borrowers may experience difficulty and the level of nonperforming loans, charge-offs and delinquencies could rise and require increases in the allowance for loan losses. The process of identifying probable incurred credit losses is a subjective process. Therefore, the Company maintains a general allowance to cover probable incurred credit losses within the entire portfolio. The methodology management uses to determine the adequacy of the loan loss reserve includes the considerations below.

Loans are charged against the allowance for loan 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 to absorb probable incurred credit losses relating to specifically identified loans based on an evaluation of the loans by management, as well as other probable incurred 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 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 general allowance is determined after considering the following factors: changes in the nature and volume of the loan portfolio, overall portfolio quality 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 loan losses for any assets where management has identified conditions or circumstances that indicate an asset is impaired. If an asset or portion thereof is classified as loss, the Company’s policy is to either establish specific allowances for loan losses in the amount of 100% of the portion of the asset classified loss or charge-off such amount.

At December 31, 2020, on the basis of management’s review of the loan portfolio, the Company had 96 credits totaling $286.1 million on the classified loan list versus 103 credits totaling $180.2 million on December 31, 2019. The increase in classified loans during 2020 reflects the challenges some of the Company’s borrowers are experiencing, particularly in the hotel and entertainment industries. As of December 31, 2020, the Company had $251.9 million of assets classified as Special Mention, $34.3 million classified as Substandard, $0 classified as Doubtful and $0 classified as Loss as compared to $96.6 million, $84.6 million, $0 and $0, respectively, at December 31, 2019. The balances reported in Note 4 – Allowance for Loan Losses and Credit Quality include deferred fees and costs.

Included in the classified loan amounts for December 31, 2020 above were the following troubled debt restructured loans: 12 mortgage loans totaling $1.1 million with total allocations of $220,000 and 12 commercial loans totaling $8.9 million with total allocations of $4.1 million. Included in the classified loan amounts for December 31, 2019 above were the following troubled debt

51

Table of Contents

restructured loans: 17 mortgage loans totaling $1.1 million with total allocations of $247,000, and 18 commercial loans totaling $8.0 million with total allocations of $2.3 million.

In accordance with Section 4013 of the CARES Act, loan deferrals granted to customers that resulted from the impact of COVID-19 and who were not past due at the time of deferral were not considered trouble debt restructurings as of December 31, 2020. This provision was extended to January 1, 2022 under the Consolidated Appropriations Act, 2021. Management continues to monitor these deferrals and has adequately considered these credits in the December 31, 2020 allowance for loan losses balance.

As of February 17, 2021, nine borrowers with loans outstanding of $20.8 million were in their second deferral period and 11 borrowers with loans outstanding of $40.2 million were in their third deferral period, most of which were additional 90-day deferrals. Additionally, 14 borrowers with loans outstanding of $26.6 million were in their fourth-deferral period. Of the fourth deferral borrowers, two represented 89% of the fourth deferral population and were commercial real estate nonowner occupied loans supported by adequate collateral and personal guarantors and consist of loans to the hotel and accommodation industry.

The company’s retail loan portfolio is comprised of 1-4 family mortgage loans, home equity lines of credit and other direct and indirect installment loans. A third-party vendor manages the company’s retail and commercial credit card program and the company does not have any balance sheet exposure with respect to this program except for nominal recourse on limited commercial card accounts.

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Total Loan Deferrals

​ Peak ​ ​ ​ ​ ​ ​ % change from

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

(in millions) ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

% of Total Loan Portfolio ​ 16 % 15 % 2 % 2 % NA ​

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Total Commercial Loan Deferrals

​ ​ Peak ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ % change from

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

(in millions) ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

% of Commercial Loan Portfolio ​ 18 % 16 % 2 % 2 % NA ​

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Total Retail Loan Deferrals

​ ​ Peak ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ % change from

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Amount ​ $ 7 ​ $ 6 ​ $ 3 ​ $ 2 (71) %

(in millions) ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

% of Retail Loan Portfolio ​ 2 % 1 % 1 % 1 % NA ​

​

Allowance estimates are developed by management taking into account actual loss experience, subject to a floor, adjusted for current economic conditions. Allowance estimates are considered a prudent measurement of the risk in the Company’s loan portfolio and are applied to individual loans based on loan type. In accordance with the incurred loan loss reserve accounting guidance, the allowance is provided for losses that have been incurred as of the balance sheet date and is based on past events and current economic conditions and does not include the effects of expected losses on specific loans or groups of loans that are related to future events or

52

Table of Contents

expected changes in economic conditions. For a more thorough discussion of the allowance for loan losses methodology see the Critical Accounting Policies section of this Item 7.

The allowance for loan losses increased 21.2%, or $10.7 million, from $50.7 million at December 31, 2019 to $61.4 million at December 31, 2020 due to the increased risk in the loan portfolio resulting from the impact of COVID-19 on the economy. Pooled loan allocations increased $12.3 million from $37.9 million at December 31, 2019 to $50.2 million at December 31, 2020, which was primarily due to management’s view of current credit quality, the current economic environment, the impacts of COVID-19 and loan growth. The unallocated component of the allowance for loan losses was $3.1 million at December 31, 2020, which increased from $2.3 million reported at December 31, 2019, and increased primarily due to the high level of uncertainty that exists regarding near term economic conditions. The unallocated component of the allowance for loan losses incorporates the Company’s judgmental determination of inherent losses that may not be fully reflected in other allocations, including factors such as the level of classified credits, economic uncertainties, industry trends impacting specific portfolio segments, broad portfolio quality trends and trends in the composition of the Company’s large commercial loan portfolio and related large dollar exposures to individual borrowers.

The Company has experienced growth in total loans over the last several years with growth of $583.3 million, or 14.3%, from December 31, 2019 to December 31, 2020 including $412.0 million in PPP loans, and $151.1 million, or 3.9%, from December 31, 2018 to December 31, 2019. The concentration of this loan growth was 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 loan loss allocations. Management believes that it is prudent to continue to provide for loan losses in a manner consistent with its historical approach due to the loan growth described above and current economic conditions.

Prior to the pandemic, economic conditions in the Company’s markets were stable. During the last nine months some industries have performed well during the pandemic, while others have not. The Company is actively monitoring industries and borrowers impacted by the pandemic. As of March 31, 2020 the initial review identified approximately 19% of the total loan portfolio and included the following industries with their respective percentage of the loan portfolio: recreational vehicle - 4%, nursing home and assisted living - 4%, hotel and accommodations - 2%, self-storage units - 2%, automotive, boating, trailer and truck - 2%, transportation and trucking contractors - 1%, C&I building construction - 1%, restaurants - 2% and entertainment and recreation - 1%. The Company expanded the universe of industries and clients under review to significantly broaden the scope of the semi-annual Loan Portfolio Meetings, in addition to actively working with borrowers on COVID-19 related loan deferral requests. The Company’s December 31, 2020 list of industries under review represents approximately 3.3%, or $141 million, of the total loan portfolio, excluding PPP loans. The current list of industries under review, along with their respective percentage of the loan portfolio, is hotel and accommodations – 2.3%, entertainment and recreation – 0.6% and full-service restaurants – 0.4%, for a total of 3.3% of the total loan portfolio. The Company has no direct exposure to oil and gas and limited exposure to retail shopping centers. The Company’s continued growth strategy promotes diversification among industries, as well as continued focus on enforcement of a strong credit environment and a disciplined approach 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 $126.4 million of potential contingent funding in 2021.

53

Table of Contents

The Company has approval of $2.774 billion in secondary funding sources available as of December 31, 2020, of which $90.0 million was utilized. The Company had $350.0 million of availability in federal funds lines with eleven correspondent banks, none of which was drawn on as of December 31, 2020. The Company has Board 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, 2020, the Company could have only borrowed up to $317.3 million under this authority based on utilization of $75.0 million of advances at December 31, 2020. The Company also has additional collateral that could be pledged to the FHLB of $191.8 million as of December 31, 2020 to generate additional liquidity. Further, the Company had available capacity at the Federal Reserve Bank of Chicago of up to $490.4 million given its current collateral structure at the Federal Reserve Bank discount window program and the terms of these facilities at December 31, 2020, with no balances outstanding at December 31, 2020. During 2020 the Company also completed the actions required to activate participation in the Federal Reserve Bank’s Paycheck Protection Program Liquidity Facility (PPPLF); however, of the $412.0 million in eligible PPP loans there were no PPP loans pledged to the PPPLF as of December 31, 2020. The Company also has established relationships in the brokered time deposit and brokered money market sectors, as well as the IntraFi Network CD Option One-Way Buy program, to access these funds when desired with settlement of funds in one to two weeks’ time. Additionally, during 2020 the Bank entered into agreements with IntraFi Network relative to their Insured Cash Sweep One-Way Buy program. As of December 31, 2020, the total amount available to the Bank via this program was $100.0 million, of which $10.0 million was drawn on. 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, 2020, the total amount approved for Lake City Bank via AFX banks was $394.0 million and none was outstanding at year end.

The Company had all of its securities in the available-for-sale portfolio at December 31, 2020, allowing the Company maximum flexibility to sell securities to meet funding demands. Management believes the majority of the securities in the available- for-sale 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. 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. 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 (CD Option and ICS) and Fed Funds. The CFP also addresses the Bank’s ability to liquidate its securities portfolio. 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 $10.5 million was drawn up as of December 31, 2020. The line of credit was subsequently repaid in January of 2021.

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, 2020.

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ Payments Due by Period

​ ​ ​ One year ​ ​ ​ ​ ​ ​ ​ After 5

(dollars in thousands) ​ Total or less 1-3 years 3-5 years years

​

54

Table of Contents

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 18 – Commitments, Off-Balance Sheet Risks and Contingencies.

The following table discloses information on the maturity of the Company’s commitments.

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ Amount of Commitment Expiration Per Period

​ ​ Total ​ ​ ​ ​ ​ ​

​ ​ Amount ​ One year ​ Over one

(dollars in thousands) Committed or less 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. Given the Company’s mix of interest bearing liabilities and interest bearing assets on December 31, 2020 and using changes in the interest rate environment over a one-year period, the net interest margin could be expected to decline in a falling interest rate environment and increase in a rising interest rate environment. Earnings can also be affected by the monetary and fiscal policies of the U.S. Government and its agencies, particularly the Federal Reserve Board.

During 2020 the Federal Reserve Board’s Federal Open Market Committee (“FOMC”) reduced interest rates by a combined 150 basis points on two different occasions in March. The effect of these combined decreases lowered the target federal funds rate back to the zero-bound range of 0% - .25%. At the FOMC meeting in December 2020 rates were left unchanged. At that time the Committee was more optimistic in regards to the economy than reported with their previously issued economic projections, but did continue to clearly state that the path of the economy will depend significantly on the course of the COVID-19 virus and pandemic. The updated economic projections released at the December meeting project no rate changes in 2021, 2022 and 2023; conversely, the longer run Fed median forecast for the federal funds rate was left unchanged at 2.50%. The combined result of the decrease in the yield on earning assets offset by a decrease in the cost of funding earning assets led to decrease in the net interest margin from 3.38% for 2019 to 3.19% for 2020 given the Company’s asset sensitive balance sheet. The Company’s yield on earning assets decreased 90 basis points during 2020. Contributing to this decrease was the full year impact of the combined 75 basis point FOMC rate decrease made during the second half of 2019 and the 150 basis point decrease made in March 2020. The commercial loan portfolio represents 90% of the total loan portfolio. Approximately 62% of the commercial loan portfolio are variable rate loans which are primarily indexed to 30 day LIBOR, prime and FHLB indices. The rate paid on deposit accounts and purchased funds decreased 76 basis points for 2020 mainly due to decreased rates paid on public fund accounts, including transactional accounts and time deposit accounts, as these accounts are typically more sensitive to interest rates. Deposit rates also decreased due to the rates paid on various other transactional and time deposit accounts due to the Company’s proactive reduced pricing structure implemented early in 2020 to offset the FOMC easing. The realized decrease in the rate paid on deposit accounts and purchased funds was benefited by an increase in the average balance of non-interest bearing demand deposit accounts for 2020 verses 2019, which was largely influenced by PPP loan proceeds deposited into borrower checking and savings accounts at the Bank as well as an overall increase in the savings rate.

55

Table of Contents

Future changes in the net interest margin will be dependent upon multiple factors including further actions by the FOMC during 2021 in response to the COVID-19 pandemic, economic conditions and geopolitical concerns, the results of any of the new administration’s changes to economic policy and laws, competitive pressures in the various markets served, and changes in the structure of the balance sheet as a result of changes in customer demands for products and services. In general, we expect loans to reprice quicker than deposits in a rising and falling rate environment as quantified in the sensitivity to market rates table in Item 7A.

The effects of price changes and inflation can vary substantially for most financial institutions. While management believes that inflation affects the growth of total assets, it believes that it is difficult to assess the overall impact. Management believes this to be the case due to the fact that generally neither the timing nor the magnitude of the inflationary changes in the consumer price index (“CPI”) coincides with changes in interest rates. The price of one or more of the components of the CPI may fluctuate considerably and thereby influence the overall CPI without having a corresponding effect on interest rates or upon the cost of those goods and services normally purchased by the Company. In years of high inflation and high interest rates, intermediate and long-term interest rates tend to increase, thereby adversely impacting the market values of investment securities, mortgage loans and other long-term fixed rate loans. In addition, higher short-term interest rates caused by inflation tend to increase the cost of funds. In other years, the reverse situation may occur.

​

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market Risk

The Company’s primary market risk exposure is interest rate risk. The Company does not have a material exposure to foreign currency exchange rate risk and does not maintain a trading portfolio.

The following table provides information regarding the Company’s financial instruments that are sensitive to changes in interest rates. For loans, securities and liabilities with contractual maturities, the table presents principal cash flows and related weighted-average interest rates by contractual maturities, as well as the Company’s assumptions relative to the impact of interest-rate fluctuations on the prepayment of certain commercial, residential and home equity loans and mortgage-backed securities. Core deposits such as noninterest bearing deposits, interest bearing checking, savings and money market deposits that have no contractual maturity, are shown based on management’s judgment and historical experience that indicates some portion of the balances are retained over time. Weighted-average variable rates are based upon rates existing at the reporting date.

56

Table of Contents

​

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

​ ​ Principal/Notional Amount Maturing in:

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ Fair

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ Value

Rate sensitive assets: ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Rate sensitive liabilities: ​ ​ ​ ​ ​ ​ ​ ​ ​

Cumulative rate sensitivity ratio ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​

The Company utilizes computer modeling software to stress test the balance sheet under a wide variety of interest rate scenarios. The model quantifies the income impact of changes in customer preference for products, basis risk between the assets and the liabilities that support them and the risk inherent in different yield curves as well as other factors. The ALCO committee reviews these possible outcomes and makes loan, investment and deposit decisions that maintain reasonable balance sheet structure in light of potential interest rate movements. It is the objective of the Company to monitor and manage risk exposure to net interest income caused by changes in interest rates. It is the goal of the Company’s asset/liability function to provide optimum and stable net interest income. To accomplish this, management uses two asset liability tools: GAP/Interest Rate Sensitivity Reports and Net Interest Income Simulation Modeling, which are constructed, presented and monitored quarterly. Management believes that the Company’s liquidity and interest sensitivity position at December 31, 2020, remained adequate to meet the Company’s primary goal of achieving optimum interest margins while avoiding undue interest rate risk. The Company places a greater level of credence in net interest income simulation modeling. The GAP/Interest Rate Sensitivity Report is believed by the Company’s management to have two major shortfalls. The GAP/Interest Rate Sensitivity Report fails to precisely gauge how often an interest rate sensitive product reprices, nor is it able to measure the magnitude of potential future rate movements. Although management does not consider GAP ratios in planning, the information can be used in a general fashion to look at asset and liability mismatches. The Company’s cumulative repricing GAP ratio as of December 31, 2020 for the next 12 months using a scenario in which interest rates remained unchanged was a negative 0.99% of earning assets.

57

Table of Contents

Net interest income simulation modeling, or earnings-at-risk, measures the sensitivity of net interest income to various interest rate movements. The Company’s asset liability process monitors simulated net interest income under three separate interest rate scenarios; base, rising and falling. Estimated net interest income for each scenario is calculated over a twelve-month horizon. The immediate and parallel changes to the base case scenario used in the model are presented below. The interest rate scenarios are used for analytical purposes and do not necessarily represent management’s view of future market movements. Rather, these are intended to provide a measure of the degree of volatility interest rate movements may introduce into the earnings of the Company.

The base scenario is highly dependent on numerous assumptions embedded in the model. While the base sensitivity analysis incorporates management’s best estimate of interest rate and balance sheet dynamics under various market rate movements, the actual behavior and resulting earnings impact will likely differ from that projected. For certain assets, the base simulation model captures the expected prepayment behavior under changing interest rate environments. Assumptions and methodologies regarding the interest rate or balance behavior of indeterminate maturity core deposit products, such as savings, money market, NOW and demand deposits reflect management’s best estimate of expected future behavior.

Results for the base, falling 25 basis points, rising 25 basis points, rising 50 basis points, rising 100 basis points, rising 200 basis points, and rising 300 basis points interest rate scenarios are listed below based upon the Company’s rate sensitive assets and liabilities at December 31, 2020. The net interest income shown represents cumulative net interest income over a twelve-month time horizon.

​

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

​ ​ ​ ​ Falling Rising Rising Rising Rising Rising

​

For more information on the Company’s interest rate sensitivity see the Interest Rate Risk discussion in Item 7A. above.

​

58

Table of Contents

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

​

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Stockholders and Board of Directors

Lakeland Financial Corporation

Warsaw, Indiana

Opinions on the Financial Statements and Internal Control over Financial Reporting

We have audited the accompanying consolidated balance sheets of Lakeland Financial Corporation (the "Company") as of December 31, 2020 and 2019, the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2020, and the related notes (collectively referred to as the "financial statements"). We also have audited the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control – Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control – Integrated Framework: (2013) issued by COSO.

Basis for Opinions

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

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

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

59

Table of Contents

Definition and Limitations of Internal Control Over Financial Reporting

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

​

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

Critical Audit Matter

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

Allowance for Loan Losses – Qualitative Factors

As described in Notes 1 and 4 to the consolidated financial statements, the Company’s allowance for loan losses is a valuation account that reflects the Company’s estimation of probable incurred losses in its loan portfolio.The allowance for loan losses was $61,408,000 at December 31, 2020, which consists of two components: the valuation allowance for loans individually evaluated for impairment (“specific component”), representing $8,041,000, and the valuation allowance for loans collectively evaluated for impairment (“general component”), representing $53,367,000. The general component is based on the Company’s historical loss experience over the most recent three years subject to a floor, adjusted for qualitative factors.

The qualitative factors include consideration of the following: levels of, and trends in, delinquencies and impaired loans; trends in volume and terms of loans; 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. Due to the significant judgment applied by management to determine the effect of the qualitative factors, we identified the effect of the qualitative factors on the allowance for loan losses as a critical audit matter as it involved especially subjective auditor judgment to audit management’s determination of the qualitative factors.

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

o Management’s review of the mathematical accuracy of the allowance calculation.

60

Table of Contents

/s/ Crowe LLP

We have served as the Company’s auditor since 1983.

South Bend, Indiana

February 23, 2021

​

61

Table of Contents

CONSOLIDATED BALANCE SHEETS (in thousands, except share data)

​

​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​

ASSETS ​ ​

​ ​ ​ ​ ​ ​ ​

Securities available-for-sale (carried at fair value) ​ 734,845 ​ 608,233

Real estate mortgage loans held-for-sale ​ 11,218 ​ 4,527

​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​

Land, premises and equipment, net ​ 59,298 ​ 60,365

Federal Reserve and Federal Home Loan Bank Stock ​ 13,772 ​ 13,772

​ ​ ​ ​ ​ ​ ​

LIABILITIES AND STOCKHOLDERS’ EQUITY ​ ​

​ ​ ​ ​ ​ ​ ​

LIABILITIES ​ ​

​ ​ ​ ​ ​ ​ ​

Borrowings ​ ​

Miscellaneous borrowings ​ 10,500 ​ —

​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​

Commitments, off-balance sheet risks and contingencies (Notes 1 and 18) ​ ​

​ ​ ​ ​ ​ ​ ​

STOCKHOLDERS’ EQUITY ​ ​

Common stock: 90,000,000 shares authorized, no par value ​ ​

Accumulated other comprehensive income ​ 27,744 ​ 12,059

Noncontrolling interest ​ 89 ​ 89

​

The accompanying notes are an integral part of these consolidated financial statements.

​

62

Table of Contents

CONSOLIDATED STATEMENTS OF INCOME (in thousands, except share and per share data)

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

NET INTEREST INCOME ​ ​ ​

Interest and fees on loans ​ ​ ​ ​

Interest and dividends on securities ​ ​ ​ ​ ​

Interest on short-term investments ​ 368 ​ 1,490 ​ 909

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Interest on borrowings ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

NET INTEREST INCOME AFTER PROVISION FOR ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

NONINTEREST INCOME ​ ​ ​ ​

Interest rate swap fee income ​ ​ 5,089 ​ ​ 1,691 ​ ​ 475

Net securities gains (losses) ​ 433 ​ 142 ​ (50)

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

NONINTEREST EXPENSE ​ ​ ​ ​

FDIC insurance and other regulatory fees ​ 1,707 ​ 638 ​ 1,701

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

BASIC EARNINGS PER COMMON SHARE ​ $ 3.31 ​ $ 3.40 ​ $ 3.18

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

DILUTED EARNINGS PER COMMON SHARE ​ $ 3.30 ​ $ 3.38 ​ $ 3.13

​

The accompanying notes are an integral part of these consolidated financial statements.

​

63

Table of Contents

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (in thousands)

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Other comprehensive income (loss) ​ ​ ​ ​ ​ ​ ​ ​ ​

Change in securities available -for-sale: ​ ​ ​ ​ ​ ​ ​ ​ ​

Defined benefit pension plans: ​ ​ ​ ​ ​ ​ ​ ​ ​

Net gain (loss) on defined benefit pension plans ​ (105) ​ (409) ​ 269

Amortization of net actuarial loss ​ 251 ​ 205 ​ 266

Net gain (loss) on activity during the period ​ 146 ​ (204) ​ 535

Total other comprehensive income (loss), net of tax ​ 15,685 ​ 18,250 ​ (5,280)

​

The accompanying notes are an integral part of these consolidated financial statements.

​

64

Table of Contents

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (in thousands, except share and per share data)

​

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

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ Accumulated ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ Other ​ ​ ​ ​ Total ​ ​ ​ ​ ​

​ Shares Amount Earnings Income (Loss) Stock Equity Interest Equity

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

Adoption of ASU 2018-02 ​ ​ ​ ​ ​ ​ 173 ​ (173) ​ ​ — ​ ​ ​ ​ ​ —

Adoption of ASU 2016-01 ​ ​ ​ ​ ​ ​ 68 ​ (68) ​ ​ — ​ ​ ​ ​ ​ —

directors’ plan ​ (9,625) ​ 463 ​ ​ ​ ​ ​ ​ ​ (463) ​ — ​ ​ ​ ​ ​ —

directors’ plan ​ 5,636 ​ ​ (115) ​ ​ ​ ​ ​ ​ ​ ​ 115 ​ ​ — ​ ​ ​ ​ ​ —

Stock based compensation expense ​ ​ ​ 5,608 ​ ​ ​ ​ 5,608 ​ ​ ​ ​ ​ 5,608

directors’ plan ​ (11,481) ​ 515 ​ ​ ​ ​ ​ ​ ​ (515) ​ — ​ ​ ​ ​ ​ —

directors’ plan 5,699 ​ (118) ​ ​ ​ ​ ​ ​ ​ 118 ​ — ​ ​ ​ ​ ​ —

Stock based compensation expense ​ ​ ​ 4,187 ​ ​ ​ ​ 4,187 ​ ​ ​ ​ ​ 4,187

directors’ plan ​ (11,566) ​ 535 ​ ​ ​ ​ ​ ​ ​ (535) ​ — ​ ​ ​ ​ ​ —

directors’ plan 5,748 ​ (119) ​ ​ ​ ​ ​ ​ ​ 119 ​ — ​ ​ ​ ​ ​ —

Stock based compensation expense ​ ​ ​ 1,790 ​ ​ ​ ​ ​ 1,790 ​ ​ ​ ​ ​ 1,790

​

The accompanying notes are an integral part of these consolidated financial statements.

​

65

Table of Contents

CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)

​

​ ​ ​ ​ ​ ​ ​ ​ ​ ​

Cash flows from operating activities: ​ ​ ​ ​

Adjustments to reconcile net income to net cash from operating activities: ​ ​ ​

Net loss on sale and write down of other real estate owned ​ 0 ​ — ​ 16

Amortization of loan servicing rights ​ 772 ​ 528 ​ 503

Net change in loan servicing rights valuation allowance ​ 715 ​ — ​ —

Net (gain) loss on sale of premises and equipment ​ 86 ​ (3) ​ 1

Net amortization of available -for-sale securities ​ 3,998 ​ 3,947 ​ 3,177

Gain on life insurance ​ (730) ​ (841) ​ (206)

Tax benefit of stock award issuances ​ (71) ​ (529) ​ (761)

Net change: ​ ​ ​

Interest receivable and other assets ​ (6,315) ​ (4,733) ​ (3,301)

Interest payable and other liabilities ​ (7,762) ​ 6,534 ​ 8,481

Cash flows from investing activities: ​ ​ ​

Proceeds from sale of securities available- for-sale ​ 8,018 ​ 57,114 ​ 15,302

Proceeds from sales of land, premises and equipment ​ 658 ​ 14 ​ 461

Purchases of land, premises and equipment ​ (5,719) ​ (7,998) ​ (7,968)

Proceeds from sales of other real estate owned ​ 0 ​ — ​ 21

Cash flows from financing activities: ​ ​ ​ ​

Payments on short-term FHLB borrowings ​ ​ (170,000) ​ ​ — ​ ​ (80,000)

Payments on long-term FHLB borrowings ​ ​ 0 ​ ​ — ​ ​ (30)

Proceeds from long-term FHLB borrowings ​ 75,000 ​ — ​ —

Payments on subordinated debentures ​ 0 ​ (30,928) ​ —

Preferred dividends paid ​ (13) ​ (13) ​ (13)

Payments related to equity incentive plan ​ (2,137) ​ (2,109) ​ (2,435)

Cash paid during the year for: ​ ​ ​

Supplemental non-cash disclosures: ​ ​ ​

Loans transferred to other real estate owned ​ 35 ​ — ​ 316

Property transferred to held for sale ​ 0 ​ — ​ 221

Right-of-use assets obtained in exchange for lease liabilities ​ 0 ​ 5,483 ​ —

​

The accompanying notes are an integral part of these consolidated financial statements.

​

66

Table of Contents

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations and Principles of Consolidation:

The consolidated financial statements include Lakeland Financial Corporation (the “Holding Company”) and its wholly owned subsidiaries, Lake City Bank (the “Bank”) and LCB Risk Management, Inc., together referred to as (the “Company”). On December 18, 2006, LCB Investments II, Inc. was formed as a wholly owned subsidiary of the Bank incorporated in Nevada to manage a portion of the Bank’s investment portfolio beginning in 2007. On December 21, 2006, LCB Funding, Inc., a real estate investment trust incorporated in Maryland, was formed as a wholly owned subsidiary of LCB Investments II, Inc. On December 28, 2012, LCB Risk Management, Inc., a captive insurance company incorporated in Nevada, was formed as a wholly owned subsidiary of the Holding Company. All intercompany transactions and balances are eliminated in consolidation.

The Company provides financial services through the Bank, a full-service commercial bank with 50 branch offices in fifteen counties in Northern and Central Indiana. The Company provides commercial, retail, trust and investment services to its customers. Commercial products include commercial loans and technology-driven solutions to meet commercial customers’ treasury management needs such as internet business banking and on-line treasury management services. Retail banking clients are provided a wide array of traditional retail banking services, including lending, deposit and investment services. Retail lending programs are focused on mortgage loans, home equity lines of credit and traditional retail installment loans. The Company provides credit card services to retail and commercial customers through its retail card program and merchant processing activity. The Company provides wealth advisory and trust clients with traditional personal and corporate trust services. The Company also provides retail brokerage services, including an array of financial and investment products such as annuities and life insurance. Other financial instruments, which represent potential concentrations of credit risk, include deposit accounts in other financial institutions.

Use of Estimates:

To prepare financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”), management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided and future results could differ.

Cash Flows:

Cash and cash equivalents include cash, demand deposits in other financial institutions and short-term investments and certificates of deposit with maturities of 90 days or less. Cash flows are reported net for customer loan and deposit transactions, and short-term borrowings.

Securities:

Securities are classified as available-for-sale when they might be sold before maturity. Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income (loss), net of tax. Securities are classified as held-to-maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity.

Purchase premiums or discounts are recognized in interest income using the interest method over the terms of the securities or over estimated lives for mortgage-backed securities. Gains and losses on sales are based on the amortized cost of the security sold and recorded on the trade date. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) other-than-temporary impairment (OTTI) related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. Equity securities which are included in other assets, are carried at fair value with changes in fair value recorded through earnings.

​

67

Table of Contents

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

Real Estate Mortgage Loans Held-for-Sale:

Loans held for sale are reported at the lower of cost or fair value on an aggregate basis. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings.

Loan sales occur on the delivery date agreed to in the relevant commitment agreement. The Company retains servicing on the majority of loans sold. The carrying value of loans sold is reduced by the amount allocated to the servicing right. The gain or loss on the sale of loans is the difference between the carrying value of the loans sold and the funds received from the sale.

Loans: