ITEM 7 –MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes thereto, included in Item 8 - "Financial Statements and Supplementary Data", and other financial data appearing elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under “Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995,” Item 1A – "Risk Factors” and elsewhere in this report, may cause actual results to differ materially from those projected in the forward-looking statements. We assume no obligation to update any of these forward-looking statements. Readers of our Annual Report on Form 10-K should therefore consider these risks and uncertainties in evaluating forward-looking statements and should not place undue reliance on forward-looking statements.
Overview
Midland States Bancorp, Inc. is a diversified financial holding company headquartered in Effingham, Illinois. Its wholly-owned banking subsidiary, Midland States Bank, has branches across Illinois and in Missouri, and provides a full range of commercial and consumer banking products and services, business equipment financing, merchant credit card services, and trust and investment management services and insurance and financial planning services. As of December 31, 2022, we had assets of $7.86 billion, deposits of $6.36 billion and shareholders’ equity of $758.6 million.
Our strategic plan is focused on building a performance-based, customer-centric culture, creating revenue diversification, seeking accretive acquisitions, achieving operational excellence and maintaining a robust enterprise-wide risk management program. Over the past several years, we have grown organically and through a series of acquisitions, with an over-arching focus on enhancing shareholder value and building a platform for scalability. Most recently, on June 17, 2022, the Company completed its acquisition of the deposits and certain loans and other assets associated with FNBC's branches in
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Mokena and Yorkville, Illinois. The Company acquired $79.8 million in assets, including $60.3 million in cash and $16.6 million in loans, and assumed $79.8 million in deposits. On June 1, 2021, the Company completed its acquisition of substantially all of the trust assets of ATG Trust, a trust company based in Chicago, Illinois. Additional information on recent acquisitions is presented in Note 2 to the consolidated financial statements in Item 8 of this Form 10-K.
Our principal lines of business include traditional community banking and wealth management. Our traditional community banking business primarily consists of commercial and retail lending and deposit taking. Our wealth management group provides a comprehensive suite of trust and wealth management products and services, and has $3.51 billion of assets under administration as of December 31, 2022.
Our principal business activity has been lending to and accepting deposits from individuals, businesses, municipalities and other entities. We have derived income principally from interest charged on loans and leases and, to a lesser extent, from interest and dividends earned on investment securities. We have also derived income from noninterest sources, such as: fees received in connection with various lending and deposit services; wealth management services; commercial FHA mortgage loan servicing; residential mortgage loan originations and sales; and, from time to time, gains on sales of assets. Our principal expenses include interest expense on deposits and borrowings, operating expenses, such as salaries and employee benefits, occupancy and equipment expenses, data processing costs, professional fees and other noninterest expenses, provisions for credit losses and income tax expense.
Material Trends and Developments
Community Banking. We believe the most important trends affecting community banks in the United States over the foreseeable future will be related to heightened regulatory capital requirements, increasing regulatory burdens generally, including the implementation of the Dodd-Frank Act and the regulations promulgated and to be promulgated thereunder, and net interest margin compression. We expect that community banks will face increased competition for lower cost capital as a result of regulatory policies that may offer larger financial institutions greater access to government assistance than is available for smaller institutions, including community banks. We expect that troubled community banks will continue to face significant challenges when attempting to raise capital. We also believe that heightened regulatory capital requirements will make it more difficult for even well-capitalized, healthy community banks to grow in their communities. We believe these trends will favor community banks that have sufficient capital, a diversified business model and a strong deposit franchise, and we believe we possess these characteristics.
We also believe that increased regulatory burdens will have a significant adverse effect on smaller community banks, which often lack the personnel, experience and technology to efficiently comply with new regulations in a variety of areas in the banking industry, including in the areas of deposits, lending, compensation, information security and overdraft protection. We believe the increased costs to smaller community banks from a more complex regulatory environment, coupled with challenges in the real estate lending area, present attractive acquisition opportunities for larger community banks that have already made significant investments in regulatory compliance and risk management and can acquire and quickly integrate these smaller institutions into their existing platform. Furthermore, we believe that, as a result of our significant operational investments and our experience acquiring other institutions and quickly integrating them into our organization, we are well positioned to capitalize on the challenges facing smaller community banks.
We continue to believe we have significant opportunities for further growth through additional acquisitions of banks, branches, wealth management firms and trust departments of community banks, selective de novo opportunities, continued expansion of our wealth management operations, the hiring of commercial banking and wealth management professionals from other organizations and organic growth within our existing branch network. We also believe we have the necessary experience, management and infrastructure to take advantage of these growth opportunities.
Credit Reserves. One of our key operating objectives has been, and continues to be, maintenance of an appropriate level of reserve protection against estimated losses in our loan portfolio. Our allowance for credit losses on loans totaled $61.1 million, or 0.97% of total loans, and $51.1 million, or 0.98% of total loans, at December 31, 2022 and 2021, respectively.
Regulatory Environment. As a result of regulatory changes, including the Dodd-Frank Act and the Basel III Rule, we expect to be subject to more restrictive capital requirements, more stringent asset concentration and growth limitations and new and potentially heightened examination and reporting requirements. We also expect to face a more challenging environment for customer loan demand due to the increased costs that could be ultimately borne by borrowers, and to incur higher costs to comply with these new regulations. This uncertain regulatory environment could have a detrimental impact on our ability to manage our business consistent with historical practices and cause difficulty in executing our growth plan. See Item 1A - "Risk Factors—Legal, Accounting and Compliance Risks” and Item 1 - "Business—Supervision and Regulation.”
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Additional Factors Affecting Comparability
Each factor listed below affects the comparability of our results of operations and financial condition in 2022 and 2021, and may affect the comparability of financial information we report in future fiscal periods.
Preferred Stock Issuance. On August 24, 2022, the Company issued and sold 4,600,000 depositary shares, each representing a 1/40th ownership interest in a share of the Company’s 7.75% fixed rate reset non-cumulative, non-convertible, perpetual preferred stock, Series A. A total of 115,000 shares of Series A preferred stock was issued. The Series A preferred stock qualifies as Tier 1 capital for purposes of the regulatory capital calculations. The gross proceeds were $115.0 million while net proceeds from the issuance of the Series A preferred stock, after deducting $4.5 million of offering costs including the underwriting discount and other expenses, were $110.5 million.
Termination of hedged interest rate swaps. On October 24, 2022, the Company terminated the $140.0 million notional amount of future starting pay-fixed, receive-variable interest rate swaps on certain Federal Home Loan Bank ("FHLB") or other fixed-rate advances. The Company realized a $17.5 million net gain upon termination.
Commercial FHA Mortgage Loan Servicing Rights.During the third quarter of 2022, we committed to a plan to sell the commercial servicing rights asset and transferred $24.0 million of commercial FHA loan servicing rights to held for sale. Servicing rights held for sale are recorded at the lower of their carrying amount or fair value less estimated costs to sell. Impairment expense of $1.3 million and losses on mortgage servicing rights held for sale of $3.3 million was recognized in 2022.
Recent Acquisitions. On June 17, 2022, the Company completed its acquisition of the deposits and certain loans and other assets associated with FNBC's branches in Mokena and Yorkville, Illinois. The Company acquired $79.8 million in assets, including $60.3 million in cash and $16.6 million in loans, and assumed $79.8 million in deposits.
On June 1, 2021, the Company completed its acquisition of substantially all of the trust assets of ATG Trust, a trust company based in Chicago, Illinois, with $399.7 million in assets under management.
Redemption of Subordinated Notes. On October 15, 2022, the Company redeemed the outstanding Fixed-to-Floating Rate Subordinated Notes due October 15, 2027, having an aggregate principal amount of $40.0 million, in accordance with the terms of the notes. The aggregate redemption price was 100% of the aggregate principal amount of the subordinated notes, plus accrued and unpaid interest. The interest rate on the subordinated notes was 6.25%.
On June 18, 2021, the Company redeemed all of its outstanding fixed-to-floating rate subordinated notes due June 18, 2025, having an aggregate principal amount of $31.1 million, in accordance with the terms of the notes. The aggregate redemption price was 100% of the aggregate principal amount of the subordinated notes, plus accrued and unpaid interest. The interest rate on the subordinated notes was 4.54%.
FHLB Advance Prepayments. During 2021, the Company pre-paid FHLB advances of $50.0 million in the first quarter, $85.0 million in the second quarter and $130.0 million in the fourth quarter. As a result, we paid prepayment fees of $8.5 million in 2021.
Tax Settlement. On June 29, 2021, the Company announced the settlement of a prior tax issue related to the treatment of gains recognized on FDIC-assisted transactions that resulted in a $6.8 million tax benefit that was recognized in the second quarter of 2021. The Company also recognized approximately $3.6 million in consulting and legal expenses related to the settlement of the tax issue, resulting in an after-tax gain of approximately $2.9 million.
Purchased Loans. Our net interest margin benefits from accretion income associated with purchase accounting discounts established on the purchased loans included in our acquisitions. Our reported net interest margins for 2022 and 2021 were 3.57% and 3.33%, respectively. Accretion income associated with accounting discounts established on loans acquired totaled $2.0 million and $4.3 million in 2022 and 2021, respectively, increasing the reported net interest margins by 3 and 7 basis points for each respective period.
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Results of Operations
For discussion of the results of operations for the year ended December 31, 2021 compared with the year ended December 31, 2020, refer to Item 7 of the Company’s 2021 Annual Report on Form 10-K, filed with the SEC on February 25, 2022.
Overview. The following table sets forth condensed income statement information of the Company for the years ended December 31, 2022, 2021 and 2020:
For the Years Ended December 31,
Income Statement Data:
Preferred dividends 3,169 — —
Per Share Data:
Basic earnings per common share $ 4.24 $ 3.58 $ 0.95
Diluted earnings per common share 4.23 3.57 0.95
Performance Metrics:
Return on average shareholders' equity 14.40 % 12.65 % 3.55 %
In 2022, we generated net income available to common shareholders of $95.9 million, or $4.23 per diluted share, compared to net income of $81.3 million, or $3.57 per diluted share in 2021. Earnings in 2022 increased primarily due to a $38.1 million increase in net interest income and a $10.0 million increase in noninterest income. These results were partially offset by a $16.7 million increase in provision for credit losses, a $0.6 million increase in noninterest expense and a $13.0 million increase in income tax expense. These are discussed in further detail below.
Net Interest Income and Margin. Our primary source of revenue is net interest income, which is the difference between interest income from interest-earning assets (primarily loans and securities) and interest expense of funding sources (primarily interest-bearing deposits and borrowings). Net interest income is influenced by many factors, primarily the volume and mix of interest-earning assets, funding sources, and interest rate fluctuations. Noninterest-bearing sources of funds, such as demand deposits and shareholders’ equity, also support earning assets. Net interest margin is calculated as net interest income divided by average interest-earning assets. Net interest margin is presented on a tax-equivalent basis, which means that tax-free interest income has been adjusted to a pretax-equivalent income, assuming a federal income tax rate of 21% for 2022 and 2021.
On December 14, 2022, the Federal Reserve announced an increase to its benchmark federal-funds rate by 0.50% to a range between 4.25% and 4.50%. Along with the increase came an indication that the Federal Reserve expects to keep rates higher through next year, with no reductions until 2024. This was the seventh rate increase announced in 2022. The year began with a federal-funds rate range of 0.00%-0.25%.
In 2022, net interest income, on a tax-equivalent basis, increased to $247.0 million with a tax-equivalent net interest margin of 3.57% compared to net interest income, on a tax-equivalent basis, of $209.2 million and a tax-equivalent net interest margin of 3.33% in 2021.
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Average Balance Sheet, Interest and Yield/Rate Analysis. The following table presents average balance sheet information, interest income, interest expense and the corresponding average yields earned and rates paid for the years ended December 31, 2022, 2021 and 2020. The average balances are principally daily averages and, for loans, include both performing and nonperforming balances. Interest income on loans includes the effects of discount accretion and net deferred loan origination costs accounted for as yield adjustments.
Years Ended December 31,
Interest-earning assets:
Investment securities:
Loans:
Interest-bearing liabilities:
Noninterest-bearing liabilities:
(1)Interest income and average rates for tax-exempt loans and securities are presented on a tax-equivalent basis, assuming a statutory federal income tax rate of 21%. Tax-equivalent adjustments totaled $1.3 million, $1.5 million and $1.8 million for the years ended December 31, 2022, 2021 and 2020, respectively.
(2)Average loan balances include nonaccrual loans. Interest income on loans includes amortization of deferred loan fees, net of deferred loan costs.
(3)Net interest margin during the periods presented represents: (i) the difference between interest income on interest-earning assets and the interest expense on interest-bearing liabilities, divided by (ii) average interest-earning assets for the period.
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Interest Rates and Operating Interest Differential. Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest-earning assets and interest-bearing liabilities, as well as changes in average interest rates. The following table shows the effect that these factors had on the interest earned on our interest-earning assets and the interest incurred on our interest-bearing liabilities. The effect of changes in volume is determined by multiplying the change in volume by the previous period’s average rate. Similarly, the effect of rate changes is calculated by multiplying the change in average rate by the previous period’s volume. Changes which are not due solely to volume or rate have been allocated proportionally to the change due to volume and the change due to rate.
Change due to: InterestVariance Change due to: InterestVariance
(tax-equivalent basis, dollars in thousands) Volume Rate Volume Rate
EARNING ASSETS:
Investment securities:
Loans:
INTEREST-BEARING LIABILITIES:
Interest Income. Interest income, on a tax-equivalent basis, increased $63.7 million to $303.0 million in 2022 as compared to 2021 primarily due to the growth in our average loan balances. The yield on earning assets increased 57 basis points to 4.38% from 3.81%, due to the impact of both the growth in earning assets and the increase in market interest rates.
Average earning assets increased to $6.92 billion in 2022 from $6.28 billion in 2021. An increase in average loans of $908.0 million was partially offset by a decrease of $262.6 million in federal funds sold and cash investments.
Average commercial loans decreased $24.6 million for the twelve months ended December 31, 2022 compared to the same period of 2021. Commercial FHA warehouse lines and Paycheck Protection Program ("PPP") loans accounted for $95.9 million and $127.1 million, respectively, of this decrease. Excluding the changes in the commercial FHA warehouse line and PPP loan portfolios, average commercial loans increased $198.4 million in 2022 compared to 2021.
Average commercial real estate loans increased in 2022 by $707.5 million, compared to 2021. Average balances in our consumer loans, construction loans and lease portfolios also increased by $198.4 million, $21.1 million and $35.7 million, respectively, compared to the prior year. These increases were partially offset by payoffs and repayments in the residential real
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estate portfolio. Consumer loan growth was primarily the result of our new relationship with an additional consumer loan origination firm and our continuing relationship with GreenSky. On January 24, 2023, we notified GreenSky of our intent to terminate our participation in their loan origination program in October 2023, our required notice period. Following the termination, GreenSky is expected to continue servicing all loans originated through the program.
Interest Expense. Interest expense increased $25.9 million to $56.0 million in 2022 compared to 2021. The cost of interest-bearing liabilities increased to 1.16% in 2022 compared to 0.66% for the prior year due to the increase in deposit costs as a result of the rate increases enacted by the Federal Reserve.
Interest expense on deposits increased to $36.1 million in 2022 from $11.0 million in 2021. The increase was primarily due to an increase in rates paid on deposits. Average balances of interest-bearing deposit accounts increased $376.6 million, or 9.8%, to $4.22 billion for the year ended December 31, 2022 compared to 2021. The increase in volume was attributable to increases of retail deposits, commercial deposits and brokered deposits of $97.2 million, $107.8 million and $65.1 million, respectively. In addition, our Insured Cash Sweep product balances increased $78.1 million.
Interest expense on FHLB advances and other borrowings increased $0.9 million for the year ended December 31, 2022, from the comparable period in 2021. While average balances decreased $118.1 million in 2022 compared to 2021, this was offset by interest rate increases throughout 2022.
Interest expense on subordinated debt decreased $1.2 million in 2022 from 2021 primarily due to the redemption of $40.0 million of subordinated debt on October 15, 2022. The interest rate on the subordinated notes was 6.25%. In addition, the Company redeemed $31.1 million of subordinated debt on June 18, 2021. The interest rate on these redeemed notes was 4.54%.
Interest expense on trust preferred debentures increased $1.1 million in 2022 compared to 2021 due to interest rate increases, as these debt instruments reprice quarterly.
Provision for Credit Losses.The Company's provision for credit losses was $20.1 million in 2022. The provision for credit losses on loans and unfunded commitments was $18.8 million and $1.6 million, respectively, partially offset by the recognition of expense reversal of $0.2 million related to investment securities. Provision expense recognized in 2021 totaled $3.4 million, with $4.0 million attributable to loans and expense reversals of $0.4 million related to unfunded loan commitments and $0.1 million related to investment securities. The increase in the provision for credit losses on loans in 2022 compared to prior year was primarily due to the growth of and mix in our loan portfolio coupled with a declining economic forecast.
The provision for credit losses on loans recognized during 2022 and 2021 was made at a level deemed necessary by management to absorb estimated losses in the loan portfolio. A detailed evaluation of the adequacy of the allowance for credit losses is completed quarterly by management, the results of which are used to determine provision for credit losses. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions and reasonable and supportable forecasts along with other qualitative and quantitative factors.
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Noninterest Income. The following table sets forth the major components of our noninterest income for the years ended December 31, 2022, 2021 and 2020:
(dollars in thousands) 2022 2021 2020 Increase (decrease) Increase (decrease)
Noninterest income:
Wealth management revenue. Income from our wealth management business for 2022 totaled $25.7 million as compared to $26.8 million in the same period of 2021. Assets under administration decreased to $3.51 billion at December 31, 2022 from $4.10 billion at December 31, 2021, primarily due to a decline in market performance in 2022 and a resulting decrease in revenue.
Residential mortgage banking revenue. Residential mortgage banking revenue for 2022 totaled $1.5 million, compared to $5.5 million in 2021, primarily attributable to a decrease in production. Loans originated for sale into the secondary market in 2022 totaled $77.0 million, with 19% representing refinance transactions versus purchase transactions. Similar loans originated during the prior year totaled $211.6 million with 48% representing refinance transactions.
Impairment of commercial mortgage servicing rights. Impairment of commercial mortgage servicing rights was $1.3 million for 2022 compared to $7.5 million for 2021. The impairment resulted from loan prepayments as borrowers refinanced their loans in the then current low interest rate environment. During the third quarter of 2022, we committed to a plan to sell the servicing rights asset associated with this portfolio and transferred $24.0 million of commercial FHA loan servicing rights to held for sale. Servicing rights held for sale are recorded at the lower of their carrying amount or fair value less estimated costs to sell. Loans serviced for others totaled $2.26 billion and $2.65 billion at December 31, 2022 and 2021, respectively.
Company owned life insurance. In the fourth quarter of 2021, the Company recognized $1.1 million of death benefits due to the passing of its former CEO and President.
Other noninterest income. Other income totaled $8.0 million for 2022, a decrease of $5.6 million, as compared to 2021. In 2021, the Company recognized $4.2 million of unrealized income on equity investments in FinTech-related venture capital funds and SBIC limited partnerships.
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Noninterest Expense. The following table sets forth the major components of noninterest expense for the years ended December 31, 2022, 2021 and 2020:
(dollars in thousands) 2022 2021 2020 Increase (decrease) Increase (decrease)
Noninterest expense:
Impairment related to facilities optimization — — 12,847 — — (12,847) (100.0)
Salaries and employee benefits. For the year ended December 31, 2022, salaries and employee benefits expense increased $3.4 million as compared to 2021, primarily due to a modest increase in staffing levels in 2022. The Company employed 935 employees at December 31, 2022 compared to 907 employees at December 31, 2021.
Professional fees. For the year ended December 31, 2022, professional fees decreased $4.1 million as compared to the same period in 2021. In 2021, the Company incurred $3.6 million of consulting and legal expenses related to the settlement of a tax issue, as previously discussed.
Other Real Estate Owned. For the year ended December 31, 2022, the Company recorded impairment charges on two properties totaling $4.3 million compared to impairment expense of $0.5 million in 2021.
Loss on mortgage servicing rights held for sale. During the third quarter of 2022, the Company committed to a plan to sell the servicing rights asset associated with this portfolio and transferred $24.0 million of commercial FHA loan servicing rights to held for sale. During the fourth quarter, we recognized a loss of $3.3 million on this asset.
Other expense. For the year ended December 31, 2022, other expense increased $1.5 million as compared to 2021, primarily as a result of increased business activities.
Income Tax Expense. Income tax expense was $30.8 million for the year ended December 31, 2022, as compared to $17.8 million for the year ended December 31, 2021. The resulting effective tax rates were 23.7% and 18.0% for the years ended December 31, 2022 and 2021, respectively. The Company's income tax expense and related effective tax rate for the year ended December 31, 2021 benefited from the $6.8 million in settlements related to the treatment of gains recognized on FDIC-assisted transactions discussed earlier.
Financial Condition
Assets. Total assets increased to $7.86 billion at December 31, 2022, as compared to $7.44 billion at December 31, 2021.
Loans. The loan portfolio is the largest category of our assets. The following table presents the balance and associated percentage of each major category in our loan portfolio at December 31, 2022, 2021 and 2020:
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December 31,
(dollars in thousands) Book Value % Book Value % Book Value %
Loans:
Commercial:
Total loans increased $1.08 billion to $6.31 billion at December 31, 2022, as compared to December 31, 2021. The loan growth was primarily reflected in our commercial loans and leases, commercial real estate and consumer portfolios, which increased $132.9 million, $616.3 million and $177.4 million, respectively. These increases were offset in part by payoffs and repayments in the residential real estate portfolio.
Commercial loans and leases, which includes commercial FHA warehouse lines and PPP loans, increased $132.9 million to $2.01 billion at December 31, 2022, as compared to December 31, 2021. Advances on commercial FHA warehouse lines decreased $66.9 million to $25.0 million at December 31, 2022. PPP loans at December 31, 2022, totaled $1.9 million, a decrease of $50.6 million from December 31, 2021. Excluding the decreases in PPP loans and commercial FHA warehouse lines, commercial loans and leases increased $250.3 million, primarily from our equipment financing business.
Consumer loans increased $177.4 million primarily as a result of our new relationship with an additional consumer loan origination firm and our continuing relationship with GreenSky. On January 24, 2023, the Company notified GreenSky that, effective October 21, 2023, the Company would terminate its participation in GreenSky’s loan origination program. Following the termination, GreenSky is expected to continue servicing all loans originated through the program.
The principal segments of our loan portfolio are discussed below:
Commercial loans. We provide a mix of variable and fixed rate commercial loans. The loans are typically made to small- and medium-sized manufacturing, wholesale, retail and service businesses for working capital needs, business expansions and farm operations. Commercial loans generally include lines of credit and loans with maturities of five years or less. The loans are generally made with business operations as the primary source of repayment, but may also include collateralization by inventory, accounts receivable and equipment, and generally include personal guarantees. The commercial loan category also includes loans originated by the equipment financing business that are secured by the underlying equipment.
Commercial real estate loans. Our commercial real estate loans consist of both real estate occupied by the borrower for ongoing operations and non-owner occupied real estate properties. The real estate securing our existing commercial real estate loans includes a wide variety of property types, such as owner occupied offices, warehouses and production facilities, office buildings, hotels, mixed-use residential and commercial facilities, retail centers, multifamily properties and assisted living facilities. Our commercial real estate loan portfolio also includes farmland loans. Farmland loans are generally made to a borrower actively involved in farming rather than to passive investors.
Construction and land development loans. Our construction and land development loans are comprised of residential construction, commercial construction and land acquisition and development loans. Interest reserves are generally established on real estate construction loans.
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Residential real estate loans. Our residential real estate loans consist of residential properties that generally do not qualify for secondary market sale.
Consumer loans. Our consumer loans include direct personal loans, indirect automobile loans, lines of credit and installment loans originated through home improvement specialty retailers and contractors. Personal loans are generally secured by automobiles, boats and other types of personal property and are made on an installment basis.
Lease financing. Our equipment leasing business provides financing leases to varying types of businesses nationwide for purchases of business equipment and software. The financing is secured by a first priority interest in the financed asset and generally requires monthly payments.
The following table shows the contractual maturities of our loan portfolio and the distribution between fixed and adjustable interest rate loans at December 31, 2022:
Within One Year One Year to Five Years Five Years to 15 Years After 15 Years
Loan Quality
We use what we believe is a comprehensive methodology to monitor credit quality and prudently manage credit concentration within our loan portfolio. Our underwriting policies and practices govern the risk profile, credit and geographic concentration for our loan portfolio. We also have what we believe to be a comprehensive methodology to monitor these credit quality standards, including a risk classification system that identifies potential problem loans based on risk characteristics by loan type as well as the early identification of deterioration at the individual loan level. In addition to our allowance for credit losses on loans, our purchase discounts on acquired loans provide additional protections against credit losses.
Analysis of the Allowance for Credit Losses on Loans. The allowance for credit losses on loans was $61.1 million, or 0.97% of total loans, at December 31, 2022 compared to $51.1 million, or 0.98% of total loans, at December 31, 2021. The following table allocates the allowance for credit losses on loans by loan category:
December 31,
(dollars in thousands) Allowance % (1) Allowance % (1) Allowance % (1)
(1)Represents the percentage of the allowance to total loans in the respective category.
We measure expected credit losses over the life of each loan utilizing a combination of models which measure probability of default and loss given default, among other things. The measurement of expected credit losses is impacted by
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loan and borrower attributes and certain macroeconomic variables. Models are adjusted to reflect the impact of certain current macroeconomic variables as well as their expected changes over a reasonable and supportable forecast period.
The allowance allocated to commercial loans totaled $14.6 million, or 0.97% of total commercial loans, at December 31, 2022, compared to $14.4 million, or 0.99%, at December 31, 2021. Modeled expected credit losses increased $1.1 million and qualitative factor ("Q-Factor") adjustments related to commercial loans increased $2.1 million. Specific allocations for commercial loans that were evaluated for expected credit losses on an individual basis decreased from $2.9 million at December 31, 2021 to $0 at December 31, 2022.
The allowance allocated to commercial real estate loans totaled $29.3 million, or 1.20% of total commercial real estate loans, at December 31, 2022 compared to $23.0 million, or 1.27% of total commercial real estate loans, at December 31, 2021. Modeled expected credit losses related to commercial real estate loans decreased $0.3 million and Q-Factor adjustments related to commercial real estate loans increased $5.2 million. Specific allocations for commercial real estate loans that were evaluated for expected credit losses on an individual basis increased from $0.1 million at December 31, 2021 to $1.5 million at December 31, 2022.
The allowance allocated to construction and land development loans totaled $2.4 million, or 0.76% of total construction and land development loans, at December 31, 2022, compared to $1.0 million, or 0.50%, at December 31, 2021. Modeled expected credit losses increased $0.6 million and Q-Factor adjustments related to construction and land development loans increased $0.9 million.
The allowance allocated to residential real estate loans totaled $4.3 million, or 1.17% of total residential real estate loans, at December 31, 2022, compared to $2.7 million, or 0.80%, at December 31, 2021. Modeled expected credit losses increased $1.1 million and Q-Factor adjustments related to residential real estate loans increased $0.5 million.
As previously stated, the overall loan portfolio increased $1.08 billion, or 20.7%, which included a $616.3 million, or 33.9%, increase in commercial real estate loans and a $250.3 million, or 14.5%, increase in commercial loans, excluding commercial FHA warehouse lines and PPP loans. The weighted average risk grade for commercial and industrial loans of 4.36 at December 31, 2022, improved from 4.53 at December 31, 2021. The weighted-average risk grade for commercial real estate loans also decreased slightly to 4.87 at December 31, 2022 from 5.02 at December 31, 2021.
In estimating expected credit losses as of December 31, 2022, we utilized certain forecasted macroeconomic variables from Oxford Economics in our models. The forecasted projections included, among other things, (i) year over year change in U.S. gross domestic product ranging from -0.5% to 1.3% over the next three quarters; (ii) U.S. unemployment rate increasing to 4.7% by the fourth quarter of 2023 with Illinois unemployment rates higher at 6.0%; and (iii) an average 10 year Treasury rate forecasted at 3.10% in the fourth quarter of 2023. These economic metrics forecast a slowing economy in 2023.
We qualitatively adjust the model results based on this scenario for various risk factors that are not considered within our modeling processes but are nonetheless relevant in assessing the expected credit losses within our loan pools. Q-Factor adjustments are based upon management judgment and current assessment as to the impact of risks related to changes in lending policies and procedures; economic and business conditions; loan portfolio attributes and credit concentrations; and external factors, among other things, that are not already captured within the modeling inputs, assumptions and other processes. Management assesses the potential impact of such items within a range of severely negative impact to positive impact and adjusts the modeled expected credit loss by an aggregate adjustment percentage based upon the assessment. As a result of this assessment as of December 31, 2022, modeled expected credit losses were adjusted upwards with a Q-Factor adjustment of approximately 50 basis points of total loans, increasing from 43 basis points at December 31, 2021. The Q-Factor adjustment at December 31, 2022 was based primarily on declining economic conditions, including rising inflation fears and an increasing risk of recession and the impact of rising fuel prices on businesses and consumers.
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The following table provides an analysis of the allowance for credit losses on loans, provision for credit losses on loans and net charge-offs for the years ended 2022, 2021, and 2020:
Years Ended December 31,
Charge-offs:
Construction and land development 6 448 376
Recoveries:
Commercial real estate 7 21 324
Construction and land development 30 221 107
Impact of adopting ASC 326 — — 8,546
Impact of adopting ASC 326 - PCD loans — — 4,237
Net charge-offs to average loans 0.15 % 0.27 % 0.50 %
Allowance for credit losses to total loans 0.97 % 0.98 % 1.18 %
Individual loans considered to be uncollectible are charged off against the allowance. Factors used in determining the amount and timing of charge-offs on loans include consideration of the loan type, length of delinquency, sufficiency of collateral value, lien priority and the overall financial condition of the borrower. Collateral value is determined using updated appraisals and/or other market comparable information. Charge-offs are generally taken on loans once the impairment is determined to be other-than-temporary. Recoveries on loans previously charged off are added to the allowance.Net charge-offs for 2022 totaled $8.8 million, compared to $13.3 million for 2021. Net charge-offs to average loans were 0.15% and 0.27% for 2022 and 2021, respectively.
Nonperforming Loans. The following table sets forth our nonperforming assets by asset categories as of the dates indicated. Nonperforming loans include nonaccrual loans, loans past due 90 days or more and still accruing interest and loans modified under troubled debt restructurings. Deferrals related to COVID-19 are not included as TDRs as of December 31, 2022
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and December 31, 2021. The balances of nonperforming loans reflect the net investment in these assets, including deductions for purchase discounts.
December 31,
Nonperforming loans:
Other real estate owned and other repossessed assets 8,401 14,488 21,362
Nonperforming loans to total loans 0.78 % 0.81 % 1.06 %
Nonperforming assets to total assets 0.74 % 0.77 % 1.10 %
Allowance for credit losses to nonperforming loans 123.53 % 119.92 % 111.79 %
We did not recognize interest income on nonaccrual loans during the years ended December 31, 2022 or 2021 while the loans were in nonaccrual status. Additional interest income that would have been recorded on nonaccrual loans had they been current in accordance with their original terms was $2.8 million and $2.7 million for the year ended December 31, 2022 and 2021 respectively. We recognized interest income on commercial and commercial real estate loans modified under troubled debt restructurings of $0.1 million during each of the years ended December 31, 2022 and 2021.
We utilize an asset risk classification system in compliance with guidelines established by the Federal Reserve as part of our efforts to improve asset quality. In connection with examinations of insured institutions, examiners have the authority to identify problem assets and, if appropriate, classify them. There are three classifications for problem assets: “substandard,” “doubtful,” and “loss.” Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full questionable and there is a high probability of loss based on currently existing facts, conditions and values. An asset classified as loss is not considered collectable and is of such little value that continuance of booking the asset is not warranted.
We use a ten grade risk rating system to categorize and determine the credit risk of our loans. Potential problem loans include loans with a risk grade of 7, which are "special mention," and loans with a risk grade of 8, which are "substandard" loans that are not considered to be nonperforming. These loans generally require more frequent loan officer contact and receipt of financial data to closely monitor borrower performance. Potential problem loans are managed and monitored regularly through a number of processes, procedures and committees, including oversight by a loan administration committee comprised of executive officers and other members of the Bank's senior management team.
The following table presents the recorded investment of potential problem commercial loans by loan category at the dates indicated:
Commercial Commercialreal estate Construction &land development
Risk category Risk category Risk category
(dollars in thousands) 7 8 (1) 7 8 (1) 7 8 (1) Total
(1)Includes only those 8-rated loans that are not included innonperformingloans.
Commercial loans with a risk rating of 7 or 8 decreased $26.4 million to $22.3 million as of December 31, 2022, compared to $48.7 million as of December 31, 2021. Commercial real estate loans with a risk rating of 7 or 8 decreased $29.2
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million to $125.7 million as of December 31, 2022, compared to $154.9 million as of December 31, 2021, primarily due to risk rating upgrades within the portfolio.
Investment Securities. Our investment strategy aims to maximize earnings while maintaining liquidity in securities with minimal credit risk. The types and maturities of securities purchased are primarily based on our current and projected liquidity and interest rate sensitivity positions.
The following table sets forth the book value and percentage of each category of investment securities at December 31, 2022, 2021 and 2020. The book value for investment securities classified as available for sale is equal to fair market value.
December 31,
Investment securities available for sale:
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The following table sets forth the book value, maturities and weighted average yields for our investment portfolio at December 31, 2022. The book value for investment securities classified as available for sale is equal to fair market value.
(dollars in thousands) Book value % of total Weighted average yield
Investment securities available for sale:
U.S. Treasury securities:
Maturing in five to ten years — — —
Maturing after ten years — — —
U.S. government sponsored entities and U.S. agency securities:
Maturing after ten years — — —
Mortgage-backed securities - agency:
Total mortgage-backed securities - agency $ 448,150 58.3 % 2.30 %
Mortgage-backed securities - non-agency:
Maturing within one year $ — — % — %
Maturing in one to five years — — —
Maturing in five to ten years — — —
Total mortgage-backed securities - non-agency $ 20,754 2.7 % 2.55 %
State and municipal securities (1):
Total state and municipal securities $ 94,636 12.3 % 3.16 %
Corporate securities:
Maturing within one year $ — — % — %
Maturing after ten years — — —
Total investment securities, available for sale $ 768,234 100.0 % 2.47 %
(1)Weighted average yield for tax-exempt securities are presented on a tax-equivalent basis assuming a federal income tax rate of 21%.
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The table below presents the credit ratings for our investment securities classified as available for sale, at fair value, at December 31, 2022.
Amortized Estimated Average credit rating
(dollars in thousands) cost fair value AAA AA+/- A+/- BBB+/- <BBB- Not Rated
Investment securities available for sale:
Cash and Cash Equivalents. Cash and cash equivalents decreased $530.1 million to $150.3 million at December 31, 2022 compared to December 31, 2021, as the excess liquidity was used to fund loan growth during the year.
Loans Held for Sale. Loans held for sale totaled $1.3 million at December 31, 2022, comprised entirely of residential real estate loans, compared to $32.0 million at December 31, 2021, comprised of $19.2 million of commercial real estate and $12.8 million of residential real estate loans.
Liabilities. At December 31, 2022, liabilities totaled $7.10 billion compared to $6.78 billion at December 31, 2021.
Deposits. We emphasize developing total client relationships with our customers in order to increase our retail and commercial core deposit bases, which are our primary funding sources. Our deposits consist of noninterest-bearing and interest-bearing demand, savings and time deposit accounts.
Total deposits increased $254.0 million to $6.36 billion at December 31, 2022, as compared to December 31, 2021. Deposits acquired in the second quarter of 2022 from FNBC totaled $79.8 million. Increases in interest-bearing checking and money market accounts of $257.4 million and $315.0 million, respectively, during this period, were partially offset by a decrease in noninterest-bearing demand account balances.
Noninterest-bearing demand accounts decreased $309.9 million to $1.94 billion at December 31, 2022, compared to December 31, 2021, as servicing deposits decreased $374.7 million. Interest-bearing checking accounts and money market accounts increased $257.4 million and $315.0 million, respectively, from December 31, 2021 to December 31, 2022. These increases were the result of strategic relationships with non-bank financial services companies, consumers' flight to safety from the equities markets and increasing deposit rates in response to the rate increases announced by the Federal Reserve.
December 31,
Book Value % of Total Book Value % of Total Book Value % of Total
Interest-bearing:
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The following table summarizes our average deposit balances and weighted average rates for the years ended December 31, 2022, 2021 and 2020:
December 31,
Deposits:
Interest-bearing:
The following table sets forth the maturity of uninsured time deposits as of December 31, 2022:
(dollars in thousands) Amount
Three months or less $ 15,862
Three to six months 19,795
Short-Term Borrowings. In addition to deposits, we use short-term borrowings, such as federal funds purchased and securities sold under agreements to repurchase, as a source of funds to meet the daily liquidity needs of our customers and fund growth in earning assets. Short-term borrowings were $42.3 million at December 31, 2022 compared to $76.8 million at December 31, 2021. The weighted average interest rate on our short-term borrowings was 0.26% and 0.13% at December 31, 2022 and 2021, respectively.
Subordinated Debt. Subordinated debt totaled $99.8 million and $139.1 million as of December 31, 2022 and 2021, respectively. On October 15, 2022, the Company redeemed the outstanding fixed-to-floating rate subordinated notes due October 15, 2027, having an aggregate principal amount of $40.0 million, in accordance with the terms of the notes. The interest rate on the subordinated notes was 6.25%.
Capital Resources and Liquidity Management
Capital Resources. Shareholders’ equity is influenced primarily by earnings, dividends, issuances and redemptions of common and preferred stock and changes in accumulated other comprehensive income caused primarily by fluctuations in unrealized holding gains or losses, net of taxes, on available-for-sale investment securities and cash flow hedges.
Shareholders’ equity increased $94.7 million to $758.6 million at December 31, 2022 as compared to December 31, 2021. The Company generated net income of $99.0 million during 2022. Offsetting this increase to shareholders’ equity were dividends to common shareholders of $25.9 million, dividends to preferred shareholders of $3.2 million, stock repurchases of $1.1 million and a decrease in accumulated other comprehensive loss of $89.0 million. In addition, the Company completed its preferred stock offering in August 2022, generating net proceeds of $110.5 million as described in Note 17. The Company intends to use the net proceeds from the offering for general corporate purposes, which may include providing capital to support its organic growth or growth through strategic acquisitions, repaying or redeeming outstanding indebtedness, financing investments, capital expenditures, repurchasing shares of its common stock and for further investments in the Bank as regulatory capital.
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The Company had a share repurchase program, whereby the Board of Directors authorized the Company to repurchase up to $75.0 million of its common stock. This program terminated December 31, 2022. As of December 31, 2022, $56.4 million, or 2,996,778 shares of the Company’s common stock, had been repurchased under the program. On December 6, 2022, the Company’s Board of Directors authorized a new share repurchase program, pursuant to which the Company is authorized to repurchase up to $25.0 million of common stock through December 31, 2023.
Liquidity Management. Liquidity refers to the measure of our ability to meet the cash flow requirements of depositors and borrowers, while at the same time meeting our operating, capital and strategic cash flow needs, all at a reasonable cost. We continuously monitor our liquidity position to ensure that assets and liabilities are managed in a manner that will meet all short-term and long-term cash requirements. We manage our liquidity position to meet the daily cash flow needs of customers, while maintaining an appropriate balance between assets and liabilities to meet the return on investment objectives of our shareholders.
Integral to our liquidity management is the administration of short-term borrowings. To the extent we are unable to obtain sufficient liquidity through core deposits, we seek to meet our liquidity needs through wholesale funding or other borrowings on either a short- or long-term basis.
Securities sold under agreements to repurchase, which are classified as secured borrowings, generally mature within one to four days from the transaction date. Securities sold under agreements to repurchase are reflected at the amount of cash received in connection with the transaction, which represents the amount of the Bank’s obligation. The Bank may be required to provide additional collateral based on the fair value of the underlying securities. Investment securities with a carrying amount of $46.1 million and $78.3 million at December 31, 2022 and December 31, 2021, respectively, were pledged for securities sold under agreements to repurchase.
The Company had available lines of credit of $12.2 million and $55.9 million at December 31, 2022 and December 31, 2021, respectively, from the Federal Reserve Discount Window. The lines are collateralized by a collateral agreement with respect to a pool of commercial real estate loans totaling $14.3 million and $64.8 million at December 31, 2022 and December 31, 2021, respectively. There were no outstanding borrowings under these lines at December 31, 2022 and December 31, 2021.
At December 31, 2022, the Company had available federal funds lines of credit totaling $394.0 million, which were unused.
The Company is a corporation separate and apart from the Bank and, therefore, must provide for its own liquidity. The Company’s main source of funding is dividends declared and paid to it by the Bank. There are statutory, regulatory and debt covenant limitations that affect the ability of the Bank to pay dividends to the Company. Management believed at December 31, 2022, that these limitations will not impact our ability to meet our ongoing short-term cash obligations.
Regulatory Capital Requirements
We are subject to various regulatory capital requirements administered by the federal and state banking regulators. Failure to meet regulatory capital requirements may result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for “prompt corrective action”, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting policies.
In December 2018, the Office of the Comptroller of the Currency, the Federal Reserve, and the FDIC approved a final rule to address changes to credit loss accounting under GAAP, including banking organizations’ implementation of CECL. The final rule provides banking organizations the option to phase in over a three-year period the day-one adverse effects on regulatory capital that may result from the adoption of the CECL accounting standard. In March 2020, the Office of the Comptroller of the Currency, the Federal Reserve, and the FDIC published an interim final rule to delay the estimated impact on regulatory capital stemming from the implementation of CECL. The interim final rule maintains the three-year transition option in the previous rule and provides banks the option to delay for two years an estimate of CECL’s effect on regulatory capital, relative to the incurred loss methodology’s effect on regulatory capital, followed by a three-year transition period (five-year transition option). The Company is adopting the capital transition relief over the permissible five-year period.
At December 31, 2022, the Company and the Bank exceeded the regulatory minimums and met the regulatory definition of well-capitalized.
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The following table presents the Company's and the Bank’s capital ratios and the minimum requirements at December 31, 2022:
Ratio Actual MinimumRegulatoryRequirements (1) WellCapitalized
Total risk-based capital ratio
Midland States Bancorp, Inc. 12.38 % 10.50 % N/A
Tier 1 risk-based capital ratio
Midland States Bancorp, Inc. 10.21 8.50 N/A
Common equity tier 1 risk-based capital ratio
Midland States Bancorp, Inc. 7.77 7.00 N/A
Tier 1 leverage ratio
Midland States Bancorp, Inc. 9.43 4.00 N/A
(1)Total risk-based capital ratio, Tier 1 risk-based capital ratio and Common equity tier 1 risk-based capital ratio include the capital conservation buffer of 2.5%.
Off-Balance Sheet Arrangements
We have limited off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources.
In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in our consolidated balance sheets. Most of these commitments mature within two years and are expected to expire without being drawn upon. Standby letters of credit are included in the determination of the amount of risk-based capital that the Company and the Bank are required to hold.
We enter into contractual loan commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of our commitments to extend credit are contingent upon customers maintaining specific credit standards until the time of loan funding. We decrease our exposure to losses under these commitments by subjecting them to credit approval and monitoring procedures. We assess the credit risk associated with certain commitments to extend credit and establish a liability for probable credit losses.
Standby letters of credit are written conditional commitments issued by us to guarantee the performance of a customer to a third party. In the event that the customer does not perform in accordance with the terms of the agreement with the third party, we would be required to fund the commitment. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, we would be entitled to seek recovery from the customer. Our policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.
We guarantee the distributions and payments for redemption or liquidation of the trust preferred securities issued by our wholly owned subsidiary business trusts to the extent of funds held by the trusts. Although this guarantee is not separately recorded, the obligation underlying the guarantee is fully reflected on our consolidated balance sheets as junior subordinated debentures held by subsidiary trusts. The junior subordinated debentures currently qualify as Tier 1 capital under the Federal Reserve capital adequacy guidelines.
Quantitative and Qualitative Disclosures About Market Risk
Market Risk. Market risk represents the risk of loss due to changes in market values of assets and liabilities. We incur market risk in the normal course of business through exposures to market interest rates, equity prices, and credit spreads. We
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are primarily exposed to interest rate risk as a result of offering a wide array of financial products to our customers and secondarily to price risk from investments in securities backed by mortgage loans.
Interest Rate Risk. Interest rate risk is the risk to earnings arising from changes in market interest rates. Interest rate risk arises from timing differences in the repricings and maturities of interest-earning assets and interest-bearing liabilities (reprice risk), changes in the expected maturities of assets and liabilities arising from embedded options, such as borrowers’ ability to prepay residential mortgage loans at any time and depositors’ ability to redeem certificates of deposit before maturity (option risk), changes in the shape of the yield curve where interest rates increase or decrease in a nonparallel fashion (yield curve risk), and changes in spread relationships between different yield curves, such as U.S. Treasuries and LIBOR (basis risk).
We actively manage interest rate risk, as changes in market interest rates may have a significant impact on reported earnings. Changes in market interest rates may result in changes in the fair market value of our financial instruments, cash flows, and net interest income. We seek to achieve consistent growth in net interest income while managing volatility arising from shifts in market interest rates. Our Board of Directors’ Risk Policy and Compliance Committee oversees interest rate risk, as well as the establishment of risk measures, limits, and policy guidelines for managing the amount of interest rate risk and its effect on net interest income. The Committee meets quarterly to monitor the level of interest rate risk sensitivity to ensure compliance with the board of directors’ approved risk limits.
Interest rate risk management is an active process that encompasses monitoring loan and deposit flows complemented by investment and funding activities. Effective management of interest rate risk begins with understanding the dynamic characteristics of assets and liabilities and determining the appropriate interest rate risk posture given business forecasts, management objectives, market expectations, and policy constraints.
An asset sensitive position refers to a balance sheet position in which an increase in short-term interest rates is expected to generate higher net interest income, as rates earned on our interest-earning assets would reprice upward more quickly than rates paid on our interest-bearing liabilities, thus expanding our net interest margin. Conversely, a liability sensitive position refers to a balance sheet position in which an increase in short-term interest rates is expected to generate lower net interest income, as rates paid on our interest-bearing liabilities would reprice upward more quickly than rates earned on our interest-earning assets, thus compressing our net interest margin.
Interest rate risk measurement is calculated and reported to the Risk Policy and Compliance Committee at least quarterly. The information reported includes period-end results and identifies any policy limits exceeded, along with an assessment of the policy limit breach and the action plan and timeline for resolution, mitigation, or assumption of the risk.
We use Net Interest Income at Risk (“NII at Risk”) to model interest rate risk utilizing various assumptions for assets, liabilities, and derivatives. NII at Risk uses net interest income simulation analysis which involves forecasting net interest earnings under a variety of scenarios including changes in the level of interest rates, the shape of the yield curve, and spreads between market interest rates. The sensitivity of net interest income to changes in interest rates is measured using numerous interest rate scenarios including shocks, gradual ramps, curve flattening, curve steepening as well as forecasts of likely interest rates scenarios. Modeling the sensitivity of net interest earnings to changes in market interest rates is highly dependent on numerous assumptions incorporated into the modeling process. To the extent that actual performance is different than what was assumed, actual net interest earnings sensitivity may be different than projected. We use a data warehouse to study interest rate risk at a transactional level and use various ad-hoc reports to continuously refine assumptions. Assumptions and methodologies regarding administered rate liabilities (e.g., savings accounts, money market accounts and interest-bearing checking accounts), balance trends, and repricing relationships reflect our best estimate of expected behavior and these assumptions are reviewed periodically.
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The following table shows NII at Risk at the dates indicated:
Net interest income sensitivity (Shocks)
Immediate change in rates
Percent change (4.2) % 3.6 % 7.2 %
Percent change (3.1) % 2.7 % 4.9 %
We report NII at Risk to isolate the change in income related solely to interest-earning assets and interest-bearing liabilities. The NII at Risk results included in the table above reflect the analysis used quarterly by management. It models −100, +100 and +200 basis point parallel shifts in market interest rates, implied by the forward yield curve over the next twelve months. We were within board policy limits for the -100, +100 and +200 basis point scenarios at December 31, 2022.
Tolerance levels for risk management require the continuing development of remedial plans to maintain residual risk within approved levels as we adjust the balance sheet. NII at Risk reported at December 31, 2022 projects that our earnings exhibit reduced sensitivity to changes in interest rates for all three scenarios compared to December 31, 2021.
Price Risk. Price risk represents the risk of loss arising from adverse movements in the prices of financial instruments that are carried at fair value and are subject to fair value accounting. We have price risk from mortgage-backed securities, derivative instruments, and equity investments.
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Critical Accounting Estimates
Our most significant accounting policies are described in Note 1 to the consolidated financial statements. Certain of these accounting policies require management to use significant judgment and estimates, which can have a material impact on the carrying value of certain assets and liabilities, and we consider these policies to be our critical accounting estimates. The judgment and assumptions made are based upon historical experience, future forecasts, or other factors that management believes to be reasonable under the circumstances. Because of the nature of the judgment and assumptions, actual results could differ from estimates, which could have a material effect on our financial condition and results of operations.
The following accounting estimate materially affects our reported earnings and financial condition and requires significant judgments and assumptions. Management has reviewed this critical accounting estimate and related disclosures with our Audit Committee.
Allowance for Credit Losses on Loans. Management’s evaluation process used to determine the appropriateness of the allowance for credit losses on loans is subject to the use of estimates, assumptions, and judgments. The evaluation process combines many factors: management’s ongoing review and grading of the loan portfolio leveraging probability of default and loss given default, consideration of historical loan loss and delinquency experience, trends in past due and nonaccrual loans, risk characteristics of the various classifications of loans, concentrations of loans to specific borrowers or industries, existing economic conditions and forecasts, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect future credit losses. Because current economic conditions and forecasts can change and future events are inherently difficult to predict, the anticipated amount of estimated credit losses on loans, and therefore the appropriateness of the allowance for credit losses on loans, could change significantly. It is difficult to estimate how potential changes in any one economic factor or input might affect the overall allowance because a wide variety of factors and inputs are considered in estimating the allowance and changes in those factors and inputs considered may not occur at the same rate and may not be consistent across all product types. Additionally, changes in factors and inputs may be directionally inconsistent, such that improvement in one factor may offset deterioration in others. As an integral part of their examination process, various regulatory agencies also review the allowance for credit losses on loans. Such agencies may require additions to the allowance for credit losses on loans or may require that certain loan balances be charged off or downgraded into criticized loan categories when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. The Company believes the level of the allowance for credit losses on loans is appropriate. See Note 1 - Summary of Significant Accounting Policies and Note 4 - Loans of the notes to consolidated financial statements.
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ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The quantitative and qualitative disclosures about market risk are included under Item 7 – "Management’s Discussion and Analysis of Financial Condition and Results of Operations – Quantitative and Qualitative Disclosures about Market Risk.”
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ITEM 8 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm (PCAOB ID 173) 55
Consolidated Balance Sheets 56
Consolidated Statements of Income 57
Consolidated Statements of Comprehensive Income 58
Consolidated Statements of Shareholders' Equity 59
Consolidated Statements of Cash Flows 60
Note 1. Summary of Significant Accounting Policies 61
Note 2. Acquisitions 70
Note 3. Investment Securities 71
Note 4. Loans 73
Note 5. Premises, Equipment and Leases 86
Note 6. Loan Servicing Rights 88
Note 7. Goodwill and Intangible Assets 89
Note 8. Derivative Instruments 89
Note 9. Deposits 91
Note 10. Short-term Borrowings 91
Note 11. FHLB Advances and Other Borrowings 92
Note 12. Subordinated Debt 93
Note 13. Trust Preferred Debentures 93
Note 14. Income Taxes 95
Note 15. Retirement Plans 97
Note 16. Share-Based Compensation 99
Note 17. Preferred Stock 101
Note 18. Earnings Per Common Share 101
Note 19. Capital Requirements 102
Note 20. Fair Value of Financial Instruments 103
Note 21. Commitments, Contingencies and Credit Risk 109
Note 22. Segment Information 110
Note 23. Revenue from Contracts with Customers 110
Note 24. Parent Company Only Financial Information 112
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Shareholders and the Board of Directors of Midland States Bancorp, Inc.
Effingham, Illinois
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of Midland States Bancorp, Inc. (the "Company") as of December 31, 2022 and 2021, the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2022, 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, 2022, based on criteria established in Internal Control – Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2022 and 2021, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2022 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2022, based on criteria established in Internal Control – Integrated Framework: (2013) issued by COSO.
Basis for Opinions
The Company’s management is responsible for these 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 Annual 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.
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 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 financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Allowance for Credit Losses on Loans – Modeling Techniques and Qualitative Factor Adjustments
As described in Notes 1 and 4 to the consolidated financial statements, the Allowance for Credit Losses on Loans (“ACL”) represents the Company’s estimate of amounts that are not expected to be collected over the contractual life of the Company’s held for investment loan portfolio. The estimate of the ACL is based on historical experience, current conditions, and reasonable and supportable forecasts. As of December 31, 2022, the Company’s ACL was $61,051,000, and the provision for credit losses on loans was $18,797,000 for the year then ended.
The Company employed a probability of default (“PD”) and loss given default (“LGD”) modeling approach to estimate the ACL, which were then adjusted for qualitative factors. The estimated PD and LGD rates are applied to the estimated exposure at default to calculate expected credit losses. The Company’s ACL model utilizes regression analysis to develop default rates based on forecasted macroeconomic variables that correlate to and are predictive of losses. The methodologies utilized to develop and implement the macroeconomic factors that drive the loss estimates in the forecasting model were complex in their use of regression modeling techniques. The process involved the selection of the macroeconomic variables and the evaluation of regression analysis outputs to determine the statistical fit of the macroeconomic variables used to forecast expected credit losses. The Company also developed a qualitative analysis framework to address asset-specific risks, changes in economic and business conditions, or other risks management determines are not adequately considered by the model for each portfolio segment. Significant management judgment was applied in evaluating the qualitative factor adjustments used in the analysis.
The audit procedures over the modeling techniques used to determine loss estimates and the selection and application of the macroeconomic variables involved a high degree of auditor judgment and required significant audit effort, including the use of more experienced audit personnel and use of credit and valuation specialists due to its complexity. Additionally, the audit procedures over the qualitative factor adjustments utilized in management’s methodology involved challenging and subjective auditor judgment. Therefore, we identified auditing the ACL modeling techniques and qualitative factor adjustments as a critical audit matter.
The primary audit procedures we performed to address this critical audit matter included:
•Tested the operating effectiveness of the Company’s controls over:
◦The Company’s allowance committee’s oversight and approval of management’s application of accounting policies, and selection and implementation of PD and LGD assumptions.
◦Management’s review relating to selection and application of relevant macroeconomic variables and their appropriateness.
◦Management’s review over the model methodologies, assumptions, judgments, and validation of inputs to the model.
◦Management’s review over the appropriateness of the framework for the qualitative factor adjustments.
◦The completeness and accuracy of internal data used in the loss estimation models and in the qualitative analysis framework.
◦Management’s review over the relevance and reliability of external data used in the loss estimation model and qualitative analysis framework.
◦The mathematical accuracy of the qualitative factor adjustments.
•Evaluated the reasonableness and appropriateness of the methodologies employed for suitability under the standard including, but not limited to, evaluating their conceptual soundness, and testing the PD models and LGD assumptions and judgments that were applied in the model.
•Tested the completeness and accuracy of internal data and relevance and reliability of external data used in the loss estimation models and in the qualitative analysis framework
•Specific to the qualitative analysis, we performed the following procedures, among others:
◦Assessed the appropriateness and reasonableness of the framework developed for the qualitative analysis including evaluating management’s judgments as to which factors impacted the qualitative analysis for each portfolio segment.
◦Performed testing over the accuracy of inputs utilized in the calculation of qualitative analysis for each portfolio segment.
◦Tested the mathematical accuracy of the calculation of the qualitative factor adjustments.
Crowe LLP
We have served as the Company’s auditor since 2017.
Oak Brook, Illinois
February 24, 2023
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MIDLAND STATES BANCORP, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except per share data)
Assets
Equity securities, at fair value 8,626 9,529
Allowance for credit losses on loans (61,051) (51,062)
Loan servicing rights, at lower of cost or fair value 1,205 28,865
Commercial FHA mortgage loan servicing rights held for sale 20,745 —
Liabilities and Shareholders’ Equity
Liabilities:
Deposits:
Federal Home Loan Bank advances and other borrowings 460,000 310,171
Accrued interest payable and other liabilities 80,217 93,881
Shareholders’ Equity:
Accumulated other comprehensive (loss) income, net of tax (83,797) 5,237
The accompanying notes are an integral part of the consolidated financial statements.
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MIDLAND STATES BANCORP, INC.
CONSOLIDATED STATEMENTS OF INCOME
(dollars in thousands, except per share data)
Years Ended December 31,
Interest income:
Loans including fees:
Investment securities:
Interest expense:
Federal Home Loan Bank advances and other borrowings 9,335 8,443 12,033
Provision for credit losses:
(Recapture of) provision for other credit losses (221) (145) 366
Noninterest income:
(Loss) gain on sales of investment securities, net (230) 537 1,721
Gain on termination of hedged interest rate swaps 17,531 2,159 —
Impairment on commercial mortgage servicing rights (1,263) (7,532) (12,337)
Noninterest expense:
Loss on mortgage servicing rights held for sale 3,250 222 1,692
Impairment related to facilities optimization — — 12,847
Federal Home Loan Bank advances prepayment fees — 8,536 4,872
Preferred dividends 3,169 — —
Per common share data:
Basic earnings per common share $ 4.24 $ 3.58 $ 0.95
Diluted earnings per common share $ 4.23 $ 3.57 $ 0.95
The accompanying notes are an integral part of the consolidated financial statements.
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MIDLAND STATES BANCORP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(dollars in thousands)
Years Ended December 31,
Other comprehensive (loss) income:
Investment securities available for sale:
(Recapture of) provision for credit loss expense (221) (145) 366
Cash flow hedges:
Net unrealized derivative gains on cash flow hedges 2,438 6,851 403
Reclassification adjustment for gains realized in net income (17,531) (2,159) —
Other comprehensive (loss) income, net of tax (89,034) (6,194) 3,989
The accompanying notes are an integral part of the consolidated financial statements.
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MIDLAND STATES BANCORP, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
YEARS ENDED December 31, 2022, 2021, AND 2020
(dollars in thousands, except per share data)
Other comprehensive income — — — — 3,989 3,989
Common dividends declared ($1.07 per share) — — — (24,958) — (24,958)
Share-based compensation expense — — 2,175 — — 2,175
Issuance of common stock under employee benefit plans — 2 2,522 — — 2,524
Other comprehensive loss — — — — (6,194) (6,194)
Common dividends declared ($1.12 per share) — — — (25,172) — (25,172)
Share-based compensation expense — — 1,938 — — 1,938
Issuance of common stock under employee benefit plans — 3 2,246 — — 2,249
Issuance of preferred stock, net of offering costs 110,548 — — — — 110,548
Common dividends declared ($1.16 per share) — — — (25,923) — (25,923)
Preferred dividends — — — (3,169) — (3,169)
Common stock repurchased — (1) (1,108) — — (1,109)
Share-based compensation expense — — 2,211 — — 2,211
Issuance of common stock under employee benefit plans — 2 2,186 — — 2,188
The accompanying notes are an integral part of the consolidated financial statements.
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MIDLAND STATES BANCORP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
Years Ended December 31,
Cash flows from operating activities:
Amortization of operating lease right-of-use asset 1,831 1,742 2,547
Increase in cash surrender value of life insurance (3,320) (3,451) (3,581)
Gain on proceeds from company-owned life insurance (264) (1,045) —
Gain on termination of hedged interest rate swaps (17,531) (2,159) —
Loss (gain) on sales of investment securities, net 230 (537) (1,721)
Loss (gain) on sales of other real estate owned 118 (473) (78)
Impairment on commercial mortgage servicing rights 1,263 7,532 12,337
Loss on mortgage servicing rights held for sale 3,250 222 1,692
Impairment related to facilities optimization — — 12,847
Net change in operating assets and liabilities:
Cash flows from investing activities:
Proceeds from sale of commercial FHA origination platform — — 7,502
Proceeds from sale of premises and equipment 175 647 —
Purchases of nonmarketable equity securities (24,787) — (12,091)
Proceeds from sales of nonmarketable equity securities 14,927 20,255 —
Proceeds from sales of other real estate owned 1,453 9,210 2,225
Purchases of company-owned life insurance — (550) —
Proceeds from settlements of company-owned life insurance 1,518 2,672 —
Net cash acquired (paid) in acquisitions 60,275 (2,715) —
Cash flows from financing activities:
Net (decrease) increase in short-term borrowings (34,492) 7,846 (13,072)
FHLB advances prepayment fees — 8,536 4,872
Subordinated debt prepayment fees — — 193
Proceeds from issuance of preferred stock 110,548 — —
Cash dividends paid on preferred stock (3,169) — —
Cash and cash equivalents:
Theaccompanying notes are an integral part of the consolidated financial statements.
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MIDLAND STATES BANCORP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations
Midland States Bancorp, Inc. (the “Company,” “we,” “our,” or “us”) is a diversified financial holding company headquartered in Effingham, Illinois. Our wholly owned banking subsidiary, Midland States Bank (the “Bank”), has branches across Illinois and in Missouri, and provides a full range of commercial and consumer banking products and services, business equipment financing, merchant credit card services, trust and investment management services, and insurance and financial planning services.
Our principal business activity has been lending to and accepting deposits from individuals, businesses, municipalities and other entities. We have derived income principally from interest charged on loans and, to a lesser extent, from interest and dividends earned on investment securities. We have also derived income from noninterest sources, such as: fees received in connection with various lending and deposit services; wealth management services; commercial Federal Housing Administration ("FHA") mortgage loan servicing; residential mortgage loan originations, sales and servicing; and, from time to time, gains on sales of assets. Our principal expenses include interest expense on deposits and borrowings, operating expenses, such as salaries and employee benefits, occupancy and equipment expenses, data processing costs, professional fees and other noninterest expenses, provisions for credit losses and income tax expense.
Basis of Presentation
The accompanying consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and conform to predominant practices within the banking industry. Management of the Company has made a number of estimates and assumptions related to the reporting of assets and liabilities to prepare the consolidated financial statements in conformity with GAAP. Actual results may differ from those estimates. In the opinion of management, all adjustments, consisting of normal recurring accruals considered necessary for a fair presentation of the results of operations for annual periods presented herein, have been included. Certain reclassifications of 2021 and 2020 amounts have been made to conform to the 2022 presentation but do not have an effect on net income or shareholders’ equity.
Principles of Consolidation
The consolidated financial statements include the accounts of the parent company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated. Assets held for customers in a fiduciary or agency capacity, other than trust cash on deposit with the Bank, are not assets of the Company and, accordingly, are not included in the accompanying consolidated financial statements.
Subsequent Events
Management has evaluated subsequent events for recognition and disclosure through February 24, 2023, which is the date the financial statements were available to be issued.
Business Combinations
The Company accounts for business combinations under the acquisition method of accounting in accordance with ASC 805, Business Combinations. Under the acquisition method of accounting, tangible and intangible identifiable assets acquired, liabilities assumed and any noncontrolling interests in the acquiree are recorded at fair value as of the acquisition date. The Company includes the results of operations of the acquired company in the consolidated statements of income from the date of acquisition. Transaction costs and costs to restructure the acquired company are expensed as incurred. Goodwill is recognized as the excess of the acquisition price over the estimated fair value of the net assets acquired. If the fair value of the net assets acquired is greater than the acquisition price, a bargain purchase gain is recognized and recorded in noninterest income.
Cash and Cash Equivalents and Cash Flows
For the presentation in the accompanying consolidated statement of cash flows, cash and cash equivalents are defined as cash on hand, amounts due from banks, which includes amounts on deposit with the Federal Reserve, interest-bearing deposits with banks or other financial institutions and federal funds sold. Generally, federal funds are sold for one-day periods, but not longer than 30 days.
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The following table summarizes supplemental cash flow information:
Years Ended December 31,
Supplemental disclosures of cash flow information:
Cash payments for:
Supplemental disclosures of noncash investing and financing activities:
Transfer of loans to other real estate owned 517 805 16,736
Transfer of premises and equipment, net to assets held for sale — 23 11,344
Investment Securities
The Company classifies its debt investment securities as available for sale or held to maturity at the time of purchase. Securities held to maturity are those debt instruments which the Company has the positive intent and ability to hold until maturity. Securities held to maturity are recorded at cost, adjusted for the amortization of premiums or accretion of discounts. All other debt securities are classified as available for sale. As of December 31, 2022, all investment securities were classified as available for sale. Investment securities available for sale are recorded at fair value with the unrealized gains and losses, net of the related tax effect, included in other comprehensive income. The related accumulated unrealized holding gains and losses are reported as a separate component of shareholders’ equity until realized.
Available-for-sale debt securities in an unrealized loss position are evaluated, at least quarterly, for impairment related to credit losses. The Company first assesses whether it intends to sell, or it is more likely than not that it will be required to sell, the security before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the security’s amortized cost basis is written down to fair value through income. For debt securities available for sale that do not meet the aforementioned criteria, the Company evaluates whether the decline in fair value has resulted from credit losses or other factors. In making this assessment, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency, and adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, and the present value of cash flows expected to be collected from the security is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an allowance for credit losses is recorded in other comprehensive income.
Changes in the allowance for credit losses are recorded as provision for, or reversal of, credit loss expense. Losses are charged against the allowance when management believes the uncollectibility of an available-for-sale security is confirmed or when either of the criteria regarding intent or requirement to sell is met.
Purchase premiums are amortized over the estimated life or to the earliest call date and purchase discounts are accreted over the estimated life of the related investment security as an adjustment to yield using the effective interest method. Unamortized premiums, unaccreted discounts, and early payment premiums are recognized in interest income upon disposition of the related security. Interest and dividend income are recognized when earned. Realized gains and losses from the sale of investment securities available for sale are determined using the specific identification method and are included in noninterest income. Also, when applicable, realized gains and losses are reported as a reclassification adjustment, net of tax, in other comprehensive income.
Equity Securities
Investments in stock of a publicly traded company or in mutual funds are classified as equity securities. Equity securities are recorded at fair value with unrealized gains and losses recognized in net income.
Nonmarketable Equity Securities
Nonmarketable equity securities include the Bank’s required investments in the stock of the Federal Home Loan Bank (“FHLB”) and the Federal Reserve Bank (“FRB”). The Bank is a member of the FHLB system as well as its regional FRB. Members of the FHLB are required to own a certain amount of stock based on the level of borrowings and other factors, and
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may invest in additional amounts. FHLB stock and FRB stock are both carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash dividends and stock dividends are reported as income.
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are classified as portfolio loans. Portfolio loans are carried at the principal balance outstanding, net of purchase premiums and discounts, and deferred loan fees and costs. Interest income is accrued on the unpaid principal balance. Accrued interest receivable on loans totaled $17.0 million and $15.9 million at December 31, 2022 and 2021, respectively, and was reported in accrued interest receivable on the consolidated balance sheets.
Interest income on mortgage and commercial loans is discontinued and the loan is placed on nonaccrual status at the time the loan is 90 days delinquent unless the loan is well secured and in process of collection. Mortgage loans are charged off at 180 days past due, and commercial loans are charged-off to the extent principal or interest is deemed uncollectible. Consumer loans continue to accrue interest until they are charged off or at an earlier date if collection of principal or interest is considered doubtful.
All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cost-recovery or cash-basis method, until qualifying for return to accrual. Under the cost-recovery method, interest income is not recognized until the loan balance is reduced to zero. Under the cash-basis method, interest income is recorded when the payment is received in cash. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Leases. The Company provides financing leases to small businesses for purchases of business equipment. Under the direct financing method of accounting, the minimum lease payments to be received under the lease contract, together with the estimated unguaranteed residual values (approximately 3% to 15% of the cost of the related equipment), are recorded as lease receivables when the lease is signed and the leased property is delivered to the customer. The excess of the minimum lease payments and residual values over the cost of the equipment is recorded as unearned lease income. Unearned lease income is recognized over the term of the lease on a basis that results in an approximately level rate of return on the unrecovered lease investment.
Purchased Credit Deteriorated ("PCD") Loans. The Company has purchased loans, some of which have experienced more than insignificant credit deterioration since origination. Purchased credit deteriorated loans are recorded at the amount paid. An allowance for credit losses on loans is determined using the same methodology as other loans held for investment. The initial allowance for credit losses on loans determined on a collective basis is allocated to individual loans. The sum of the loan’s purchase price and allowance for credit losses on loans becomes its initial amortized cost basis. The difference between the initial amortized cost basis and the par value of the loan is a noncredit discount or premium, which is amortized into interest income over the life of the loan. Subsequent changes to the allowance for credit losses on loans are recorded through provision expense for credit losses.
Nonperforming Loans. A loan is considered nonperforming when it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Nonperforming loans include loans on nonaccrual status, loans past due 90 days or more and still accruing interest, and performing troubled debt restructured loans. Depending on a particular loan’s circumstances, we measure impairment based upon either the present value of expected future cash flows discounted at the effective interest rate, the observable market price, or the fair value of the collateral less estimated costs to sell if the loan is collateral dependent. A loan is considered collateral dependent when repayment is based solely on the liquidation of the collateral. Fair value, where possible, is determined by independent appraisals, typically on an annual basis. Between appraisal periods, the fair value may be adjusted based on specific events, such as if deterioration of quality of the collateral comes to our attention as part of our problem loan monitoring process, or if discussions with the borrower lead us to believe the last appraised value no longer reflects the actual market for the collateral. The impairment amount is charged-off to the allowance if deemed not collectible or is set up as a specific reserve.
Allowance for Credit Losses on Loans
The Company adopted the current expected credit loss model under Accounting Standards Update (“ASU”) 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”) on January 1, 2020 using the modified retrospective approach. The transition adjustment included an increase in the allowance for credit losses on loans of $12.8 million and an increase in the allowance on unfunded commitments of $0.3 million.
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The allowance for credit losses on loans is a valuation account that is deducted from the loans’ amortized cost basis to present the net amount expected to be collected on the loans. The amount of the allowance represents management's best estimate of current expected credit losses on loans considering available information, from internal and external sources, relevant to assessing collectibility over the loans' contractual terms, adjusted for expected prepayments when appropriate. The contractual term excludes expected extensions, renewals, and modifications. unless either of the following applies: management has a reasonable expectation at the reporting date that a troubled debt restructuring will be executed with an individual borrower or the extension or renewal options are included in the original or modified contract at the reporting date and are not unconditionally cancellable by the Company.
Management estimates the allowance balance using relevant information, from internal and external sources, relating to historical credit loss experience, current conditions, and reasonable and supportable forecasts. While historical credit loss experience provides the basis for the estimation of expected credit losses, adjustments to historical loss information may be made for differences in current loan-specific risk characteristics, environmental conditions or other relevant factors. Allowance for credit losses on loans is measured on a collective basis and reflects impairment in groups of loans aggregated on the basis of similar risk characteristics. Loans that do not share risk characteristics are evaluated for expected credit losses on an individual basis and excluded from the collective evaluation. Expected credit losses for collateral dependent loans, including loans where the borrower is experiencing financial difficulty but foreclosure is not probable, are based on the fair value of the collateral at the reporting date, adjusted for selling costs as appropriate.
Credit loss expense related to loans reflects the totality of actions taken on all loans for a particular period including any necessary increases or decreases in the allowance related to changes in credit loss expectations associated with specific loans or pools of loans. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged-off. While management utilizes its best judgment and information available, the ultimate appropriateness of the allowance is dependent upon a variety of factors beyond our control, including the performance of our loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.
In calculating the allowance for credit losses, most loans are segmented into pools based upon similar characteristics and risk profiles. Common characteristics and risk profiles may include internal credit ratings, risk ratings or classification, financial asset type, collateral type, size, industry of the borrower, historical or expected credit loss patterns, and reasonable and supportable forecast periods. For modeling purposes, our loan pools include (i) commercial, (ii) commercial real estate, (iii) construction and land development, (iv) residential real estate, (v) consumer, and (vi) lease financing. We periodically reassess each pool to ensure the loans within the pool continue to share similar characteristics and risk profiles and to determine whether further segmentation is necessary.
The table below identifies the Company’s loan portfolio segments and classes.
Segment Class
Commercial Commercial
Commercial Other
Commercial Real Estate Commercial Real Estate Non-Owner Occupied
Commercial Real Estate Owner Occupied
Multi-Family
Farmland
Construction and Land Development Construction and Land Development
Residential Real Estate Residential First Lien
Other Residential
Consumer Consumer
Consumer Other
Lease Financing Lease Financing
For each loan pool, we measure expected credit losses over the life of each loan utilizing a combination of models which measure (i) probability of default (“PD”), which is the likelihood that loan will stop performing or default, (ii) loss given default (“LGD”), which is the expected loss rate for loans in default, (iii) assumed prepayment speed, which is the likelihood that a loan will prepay or pay-off prior to maturity, and (iv) exposure at default (“EAD”), which is the estimated outstanding principal balance of the loans upon default, including the expected funding of unfunded commitments outstanding as of the measurement date. For certain commercial loan portfolios, the PD is calculated using a transition matrix to determine the likelihood of a customer’s risk grade migrating from one specified range of risk grades to a different specified range. Expected
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credit losses are calculated as the product of PD (adjusted for prepayment), LGD and EAD. This methodology builds on default probabilities already incorporated into our risk grading process by utilizing pool-specific historical loss rates to calculate expected credit losses. These pool-specific historical loss rates may be adjusted for current macroeconomic assumptions, as further discussed below, and other factors such as differences in underwriting standards, portfolio mix, or when historical asset terms do not reflect the contractual terms of the financial assets being evaluated as of the measurement date. Each time we measure expected credit losses, we assess the relevancy of historical loss information and consider any necessary adjustments to address any differences in asset-specific characteristics.
The measurement of expected credit losses is impacted by loan and borrower attributes and certain macroeconomic variables. Significant loan and borrower attributes utilized in our modeling processes include, among other things, (i) origination date, (ii) maturity date, (iii) payment type, (iv) collateral type and amount, (v) current risk grade, (vi) current unpaid balance and commitment utilization rate, (vii) payment status and delinquency history and (viii) expected recoveries of previously charged-off amounts. Significant macroeconomic variables utilized in our modeling processes include, among other things, (i) US and Illinois Disposable Income and Gross Domestic Product, (ii) selected market interest rates including U.S. Treasury rates and government bond rates, (iii) Consumer Price Index, (iv) commercial and residential property prices in Illinois and the US as a whole, and (v) Illinois Housing Starts and Retail Sales for the State of Illinois and US.
The probability of default and prepayment assumptions were estimated by analyzing internally-sourced data related to historical performance of each loan pool. They are adjusted to reflect the current impact of certain macroeconomic variables as well as their expected changes over a reasonable and supportable forecast period. We have determined that we are reasonably able to forecast the macroeconomic variables used in our modeling processes with an acceptable degree of confidence for a total of two years with the last twelve months of the forecast period encompassing a reversion process whereby the forecasted macroeconomic variables are reverted to their historical mean utilizing a straight line basis. The macroeconomic variables utilized as inputs in our modeling processes were subjected to a variety of analysis procedures and were selected primarily based on statistical relevancy and correlation to our historical credit losses. By reverting these modeling inputs to their historical mean and considering loan and borrower specific attributes, our models are intended to yield a measurement of expected credit losses that reflects our average historical loss rates for periods subsequent to the twelve-month reversion period. The LGD is based on historical recovery averages for each loan pool, adjusted to reflect the current impact of certain macroeconomic variables as well as their expected changes over a two-year forecast period, with the final twelve months of the forecast period encompassing a reversion process, which management considers to be both reasonable and supportable. The same forecast and reversion periods are used for all macroeconomic variables in our models.
Management qualitatively adjusts model results for risk factors that are not considered within our modeling processes but are nonetheless relevant in assessing the expected credit losses within our loan pools. These qualitative factor (“Q-Factor”) adjustments may increase or decrease management's estimate of expected credit losses by a calculated percentage or amount based upon the estimated level of risk. The various risks that may be considered in making Q-Factor adjustments include, among other things, the impact of (i) changes in lending policies and procedures, including changes in underwriting standards and practices for collections, write-offs, and recoveries, (ii) actual and expected changes in economic and business conditions and developments that affect the collectibility of the loan pools, (iii) changes in the nature and volume of the loan pools and in the terms of the underlying loans, (iv) changes in the experience, ability, and depth of our lending management and staff, (v) changes in volume and severity of past due financial assets, the volume of non-accrual assets, and the volume and severity of adversely classified or graded assets, (vi) changes in the quality of our credit review function, (vii) changes in the value of the underlying collateral for loans that are non-collateral dependent, (viii) the existence, growth, and effect of any concentrations of credit and (ix) other factors such as the regulatory, legal and technological environments; competition; and events such as natural disasters or health pandemics.
In some cases, management may determine that an individual loan exhibits unique risk characteristics which differentiate the loan from other loans within our loan pools. In such cases, the loans are evaluated for expected credit losses on an individual basis and excluded from the collective evaluation. Specific allocations of the allowance for credit losses are determined by analyzing the borrower’s ability to repay amounts owed, collateral deficiencies, the relative risk grade of the loan and economic conditions affecting the borrower’s industry, among other things. A loan is considered to be collateral dependent when, based upon management's assessment, the borrower is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the collateral. In such cases, expected credit losses are based on the fair value of the collateral at the measurement date, adjusted for estimated selling costs if satisfaction of the loan depends on the sale of the collateral. We reevaluate the fair value of collateral supporting collateral dependent loans on a quarterly basis.
Specific reserves reflect expected credit losses on loans identified for evaluation or individually considered nonperforming. These loans no longer have similar risk characteristics to collectively evaluated loans due to changes in credit risk, borrower circumstances, recognition of write-offs, or cash collections that have been fully applied to principal on the basis
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of nonaccrual policies. At a minimum, the population of loans subject to individual evaluation include individual loans where it is probable we will be unable to collect all amounts due, according to the original contractual terms. These include, nonaccrual loans with a balance greater than $500,000, accruing loans 90 days past due or greater with a balance greater than $100,000, specialty lending relationships and other loans as determined by management. Allowance for credit losses for consumer and residential loans are, primarily, determined by meaningful pools of similar loans and are evaluated on a quarterly basis.
The provision for credit losses on loans individually evaluated is recognized on the basis of the present value of expected future cash flows discounted at the effective interest rate, the fair value of collateral adjusted for estimated costs to sell, or the observable market price as of the relevant date. Allowance for credit losses on loans adjustments for estimated costs to sell are not appropriate when the repayment of the collateral-dependent loan is expected from the operation of the collateral.
Loans Held for Sale
Loans held for sale may consist of residential and commercial FHA mortgage loans originated with the intent to sell. Loans held for sale are carried at fair value, determined individually, as of the balance sheet date. The Company believes the fair value method better reflects the economic risks associated with these loans. Fair value measurements on loans held for sale are based on quoted market prices for similar loans in the secondary market, market quotes from anticipated sales contracts and commitments, or contract prices from firm sales commitments. The changes in the fair value of loans held for sale are reflected in commercial FHA revenue and residential mortgage banking revenue on the consolidated statements of income.
Mortgage Repurchase Reserve
The Company sells residential mortgage loans to investors in the normal course of business. Residential mortgage loans sold to investors are predominantly conventional residential first lien mortgages originated under our usual underwriting procedures, and are sold on a nonrecourse basis. The Company’s agreements to sell residential mortgage loans usually require general representations and warranties on the underlying loans sold, related to credit information, loan documentation, collateral, and insurability, which if subsequently untrue or breached, could require the Company to indemnify or repurchase certain loans affected. The balance in the repurchase reserve at the balance sheet date reflects the estimated amount of potential loss the Company could incur from repurchasing a loan, as well as loss reimbursements, indemnification, and other “make whole” settlement resolutions. Refer to Note 21 in the consolidated financial statements for additional information on the mortgage repurchase reserve.
Premises and Equipment
Premises, furniture and equipment, and leasehold improvements are stated at cost less accumulated depreciation. Depreciation expense is computed principally on the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized on a straight-line basis over the shorter of the life of the asset or the lease term. Estimated useful lives of premises and equipment range from 10 to 40 years and from 3 to 10 years, respectively. Maintenance and repairs are charged to operating expenses as incurred, while improvements that extend the useful life of assets are capitalized and depreciated over the estimated remaining life.
We periodically review the carrying value of our long-lived assets to determine if impairment has occurred or whether changes in circumstances have occurred that would require a revision to the remaining useful life. In making such determination, we evaluate the performance, on an undiscounted basis, of the underlying operations or assets which give rise to such amount.
Operating Lease Right of Use Assets and Liabilities
The Company determines if a lease is present at the inception of an agreement. Operating leases are capitalized at commencement and are discounted using the Company’s FHLB borrowing rate for a similar term borrowing unless the lease defines an implicit rate within the contract.
The operating lease right of use assets represent the Company’s right to use an underlying asset for the lease term, and the operating lease liabilities represent the obligation to make lease payments arising from the lease. Operating lease right of use assets and operating lease liabilities are recognized on the lease commencement date based on the present value of lease payments over the lease term. No significant judgments or assumptions were involved in developing the estimated operating lease liabilities as the Company’s operating lease liabilities largely represent future rental expenses associated with operating leases and the borrowing rates are based on publicly available interest rates.
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Other Real Estate Owned
Other real estate owned (“OREO”) represents properties acquired through foreclosure or other proceedings and is initially recorded at fair value at the date of foreclosure less estimated costs of disposal, which establishes a new cost basis. After foreclosure, OREO is held for sale and is carried at the lower of cost or fair value less estimated costs of disposal. Any write-down to fair value at the time of transfer to OREO is charged to the allowance for credit losses on loans. Fair value for OREO is based on an appraisal performed upon foreclosure. Property is evaluated regularly to ensure the recorded amount is supported by its fair value less estimated costs to dispose. After the initial foreclosure appraisal, fair value is generally determined by an annual appraisal unless known events warrant adjustments to the recorded value. Revenue from the operations of OREO is included in other income in the consolidated statements of income, and expense and decreases in valuations are included in other real estate owned expense in the consolidated statements of income.
Goodwill and Intangible Assets
Goodwill resulting from a business combination is generally determined as the excess of the fair value of consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually or more frequently if events and circumstances exist that indicate that a goodwill impairment test should be performed.
Other intangible assets, which consist of core deposit and acquired customer relationship intangible assets, are typically amortized over a period ranging from 1 to 20 years using an accelerated method of amortization. On a periodic basis, we evaluate events and circumstances that may indicate a change in the recoverability of the carrying value.
Loan Servicing Rights
When loans are sold with servicing retained, a servicing rights asset is capitalized, which represents the then current fair value of future net cash flows expected to be realized for performing servicing activities. As the Company has not elected to subsequently measure servicing assets under the fair value measurement method, the Company follows the amortization method. Loan servicing rights are amortized in proportion to and over the period of estimated net servicing income, and assessed for impairment at each reporting date. Loan servicing rights are carried at the lower of the initial capitalized amount, net of accumulated amortization, or estimated fair value.
Loan servicing rights do not trade in an active market with readily observable prices. The fair value of loan servicing rights and their sensitivity to changes in interest rates is influenced by the mix of the servicing portfolio and characteristics of each segment of the portfolio. The Company’s servicing portfolio consists of distinct portfolios of government-insured residential and commercial mortgages, conventional residential mortgages and Small Business Administration (“SBA”) loans. The Company periodically evaluates its loan servicing rights asset for impairment. Impairment is assessed based on the fair value of net servicing cash flows at each reporting date using estimated prepayment speeds of the underlying loans serviced and stratifications based on the risk characteristics of the underlying loans. The fair value of our servicing rights is estimated by using a cash flow valuation model which calculates the present value of estimated future net servicing cash flows, taking into consideration expected mortgage loan prepayment rates, discount rates, servicing costs, replacement reserves and other economic factors which are determined based on current market conditions. To the extent the amortized cost of the mortgage servicing rights exceeds the estimated fair value by stratification, the Company records an impairment expense and reduces the carrying value of the loan servicing rights.
We recognize revenue from servicing commercial FHA mortgages, residential mortgages and SBA loans as earned based on the specific contractual terms. This revenue, along with amortization of and changes in impairment on servicing rights, is reported in commercial FHA revenue, residential mortgage banking revenue and other noninterest income, respectively, in the consolidated statements of income.
Loans Servicing Rights Held for Sale
Mortgage servicing rights held for sale consist of commercial FHA mortgage servicing rights that management has committed to a plan to sell and has the ability to sell them to a buyer in their present condition. Mortgage servicing rights held for sale are carried at the lower of their carrying value or fair value less estimated costs to sell. Decreases in the valuation of mortgage servicing rights held for sale are included in loss on mortgage servicing rights held for sale in the consolidated statements of income.
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Cash Surrender Value of Life Insurance Policies
We have purchased life insurance policies on the lives of certain officers and key employees and are the owner and beneficiary of the policies. These policies provide an efficient form of funding for long-term retirement and other employee benefits costs. These policies are recorded as cash surrender value of life insurance policies in the consolidated balance sheets at each policy’s respective cash surrender value, adjusted for other charges or other amounts due that are probable at settlement, with changes in value recorded in noninterest income in the consolidated statements of income.
Derivative Financial Instruments
All derivatives are recognized on the consolidated balance sheet as a component of other assets or other liabilities at their fair value. On the date the derivative contract is entered into, the derivative is designated as a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability “cash flow” hedge. Changes in the fair value of a derivative that is highly effective as—and that is designated and qualifies as—a cash flow hedge are recorded in accumulated other comprehensive income, until earnings are affected by the variability of cash flows (e.g., when periodic settlements on a variable-rate asset or liability are recorded in earnings).
We formally document all relationships between hedging instruments and hedged items, as well as the risk-management objective and strategy for undertaking various hedged transactions. This process includes linking all derivatives that are designated as cash flow hedges to specific assets and liabilities on the balance sheet or forecasted transactions. We also formally assess, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in cash flows of hedged items.
Hedge accounting is prospectively discontinued when (a) it is determined that the derivative is no longer effective in offsetting changes in the cash flows of a hedged item (including forecasted transactions); (b) the derivative expires or is sold, terminated, or exercised; (c) the derivative is no longer designated as a hedge instrument because it is unlikely that a forecasted transaction will occur; or (d) management determines that designation of the derivative as a hedge instrument is no longer appropriate.