HILLS BANCORPORATION The following is management's discussion and analysis of the financial condition ofHills Bancorporation ("Hills Bancorporation" or "the Company") and its banking subsidiaryHills Bank and Trust Company ("the Bank") for the dates and periods indicated. The discussion and analysis should be read in conjunction with the consolidated financial statements and the accompanying footnotes.
Special Note Regarding Forward Looking Statements
This report contains, and future oral and written statements of the Company and its management may contain, forward-looking statements within the meaning of such term in the Private Securities Litigation Reform Act of 1995 with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Actual results may differ materially from those included in the forward-looking statements. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, are generally identifiable by the use of words such as "believe," "expect," "anticipate," "plan," "intend," "estimate," "may," "will," "would," "could," "should" or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects of the Company include, but are not limited to, the following: •The strength ofthe United States economy in general and the strength of the local economies in which the Company conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company's assets. This includes current concerns related to higher inflation, rising energy prices, theRussia -Ukraine war and supply chain imbalances.
•The effects of recent financial market disruptions and/or an economic recession, and monetary and other governmental actions designed to address such disruptions, including in response to the COVID-19 pandemic.
•The financial strength of the counterparties with which the Company or the Company's customers do business and as to which the Company has investment or financial exposure. •The credit quality and credit agency ratings of the securities in the Company's investment securities portfolio, a deterioration or downgrade of which could lead to recognition of an allowance for credit losses on the affected securities and the recognition of a credit loss. •The effects of, and changes in, laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters as well as any laws otherwise affecting the Company, including, but not limited to, potential changes inU.S. tax laws and regulations. •The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company's assets) and the policies of theBoard of Governors of theFederal Reserve System . •The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector.
•The ability of the Company to obtain new customers and to retain existing customers.
•The timely development and acceptance of products and services, including products and services offered through alternative electronic delivery channels.
•Technological changes implemented by the Company and by other parties,
including third party vendors, which may be more difficult or more expensive
than anticipated or which may have unforeseen consequences to the Company and
its customers.
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•The ability of the Company to develop and maintain secure and reliable technology systems.
•The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner.
•Consumer spending and saving habits which may change in a manner that affects the Company's business adversely.
•The economic impact of natural disasters, diseases and/or pandemics, including any extended impact from the COVID-19 pandemic, and terrorist attacks and military actions.
•Business combinations and the integration of acquired businesses and assets which may be more difficult or expensive than expected.
•The costs, effects and outcomes of existing or future litigation.
•Changes in accounting policies and practices that may be adopted by state and
federal regulatory agencies and the
•The ability of the Company to manage the risks associated with the foregoing as well as anticipated.
These risks and uncertainties should be considered in evaluating forward-looking statements, and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company's financial results, is included in the Company's filings with theSecurities and Exchange Commission .
Economic Environment
U.S. economic activity slowed during the first nine months of 2022 reflecting the impacts of significantly higher inflation and rising interest rates as well as repercussions from theRussia -Ukraine war alongside continued economic impacts from the COVID-19 pandemic which have resulted in supply chain disruptions and increased energy prices. After contracting during the first two quarters of the year,U.S. Gross Domestic Product ("GDP") is currently forecast to grow in the third quarter of 2022, while the personal consumption expenditures price index is currently forecast to increase to an annual rate of 6.3 percent inSeptember 2022 , well above the FRB's target inflation rate. The FRB increased short-term interest rates by a total of 300 basis points during the first nine months of 2022 and has indicated that it will increase short-term interest rates further during the fourth quarter of 2022 in order to fight inflation. These conditions have created significant uncertainty about the future economic environment which will continue to evolve and potentially impact our business in future periods. Concerns over interest rate levels, energy prices, domestic and global policy issues, trade policy in theU.S. and geopolitical events, as well as the implications of those events on the markets in general, further add to the global uncertainty. There is also a risk that interest rate increases to fight inflation could lead to a recession. Interest rate levels and energy prices, in combination with global economic conditions, fiscal and monetary policy and the level of regulatory and government scrutiny of financial institutions will likely continue to impact our results for the remainder of 2022 and into 2023. Our credit administration continues to closely monitor and analyze the higher risk segments within the loan portfolio, tracking loan payment deferrals, customer liquidity and providing timely reports to senior management and the board of directors. Based on the Company's capital levels, prudent underwriting policies, loan concentration diversification and our geographic footprint, senior management is cautiously optimistic that the Company is positioned to continue managing the impact of the varied set of risks and uncertainties currently impacting the economy and remain adequately capitalized. However, the Company may be required to make additional credit loss provisions as warranted by the extremely fluid economic condition. Page 55
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Critical Accounting Policies
The Company's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America . The
financial information contained within these financial statements is, to a
significant extent, financial information that is based on approximate measures
of the financial effects of transactions and events that have already occurred.
Based on its consideration of accounting policies that involve the most complex
and subjective decisions and assessments, management has identified its most
critical accounting policies to be those which are related to the allowance for
credit losses.
Allowance for Credit Losses
On
The preparation of financial statements in accordance with the accounting principles generally accepted inthe United States ("U.S. GAAP") requires management to make a number of judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, income and expense in the financial statements. Various elements of our accounting policies, by their nature, involve the application of highly sensitive and judgmental estimates and assumptions. Some of these policies and estimates relate to matters that are highly complex and contain substantial inherent uncertainties. Management has made significant estimates in several areas, including the allowance for credit losses (see Note 5 - Loans and Note 4 - Securities) and the fair value of debt securities (see Note 4 - Securities). We have identified the following accounting policies and estimates that, due to the inherent judgments and assumptions and the potential sensitivity of the financial statements to those judgments and assumptions, are critical to an understanding of our financial statements. We believe that the judgments, estimates and assumptions used in the preparation of the Company's financial statements are appropriate. For a further description of our accounting policies, see Note 1 - Summary of Significant Accounting Policies in the financial statements included in this Form 10-Q. The allowance for credit losses for loans represents management's estimate of all expected credit losses over the expected contractual life of our existing loan portfolio. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the then-existing loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for credit losses in those future periods. We employ a disciplined process and methodology to establish our allowance for credit losses that has two basic components: first, an asset-specific component involving individual loans that do not share risk characteristics with other loans and the measurement of expected credit losses for such individual loans; and second, a pooled component for estimated expected credit losses for pools of loans that share similar risk characteristics. Based upon this methodology, management establishes an asset-specific allowance for loans that do not share risk characteristics with other loans based on the amount of expected credit losses calculated on those loans and charges off amounts determined to be uncollectible. Factors we consider in measuring the extent of expected credit loss include payment status, collateral value, borrower financial condition, guarantor support and the probability of collecting scheduled principal and interest payments when due. When a loan does not share risk characteristics with other loans, we measure expected credit loss as the difference between the amortized cost basis in the loan and the present value of expected future cash flows discounted at the loan's effective interest rate except that, for collateral- dependent loans, credit loss is measured as the difference between the amortized cost basis in the loan and the fair value of the underlying collateral. The fair value of the collateral is adjusted for the estimated cost to sell if repayment or satisfaction of a loan is dependent on the sale (rather than only on the operation) of the collateral. In accordance with our appraisal policy, the fair value of collateral-dependent loans is based upon independent third-party appraisals or on collateral valuations prepared by in-house evaluations. Once a third-party appraisal is greater than one year old, or if its determined that market conditions, changes to the property, changes in intended use of the property or other factors indicate that an appraisal is no longer reliable, we perform an internal collateral valuation to assess whether a change in collateral value requires an additional adjustment to carrying value. When we receive an updated appraisal or collateral valuation, management reassesses the need for adjustments to the loan's expected credit loss measurements and, where appropriate, records an Page 56
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HILLS BANCORPORATION adjustment. If the calculated expected credit loss is determined to be permanent, fixed or nonrecoverable, the credit loss portion of the loan will be charged off against the allowance for credit losses. Loans designated having significantly increased credit risk are generally placed on nonaccrual and remain in that status until all principal and interest payments are current and the prospects for future payments in accordance with the loan agreement are reasonably assured, at which point the loan is returned to accrual status. In estimating the component of the allowance for credit losses for loans that share common risk characteristics, loans are segregated into loan classes. Loans are designated into loan classes based on loans pooled by product types and similar risk characteristics or areas of risk concentration. Credit loss assumptions are estimated using a model that categorizes loan pools based on loan type and purpose. This model calculates an expected life-of-loan loss percentage for each loan category by considering the probability of default using historical life-of-loan analysis periods for agricultural, 1 to 4 family first and junior liens, commercial and consumer segments, and the severity of loss, based on the aggregate net lifetime losses incurred per loan class. The component of the allowance for credit losses for loans that share common risk characteristics also considers factors for each loan class to adjust for differences between the historical period used to calculate historical default and loss severity rates and expected conditions over the remaining lives of the loans in the portfolio related to: •Lending policies and procedures; •International, national, regional and local economic business conditions and developments that affect the collectability of the portfolio, including the condition of various markets; •The nature of the loan portfolio, including the terms of the loans; •The experience, ability and depth of the lending management and other relevant staff; •The volume and severity of past due and adversely classified or graded loans and the volume of nonaccrual loans; •The quality of our loan review and process; •The value of underlying collateral for collateral-dependent loans; •The existence and effect of any concentrations of credit and changes in the level of such concentrations; and •The effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio. Such factors are used to adjust the historical probabilities of default and severity of loss so that they reflect management expectation of future conditions based on a reasonable and supportable forecast. To the extent the lives of the loans in the portfolio extend beyond the period for which a reasonable and supportable forecast can be made, the bank reduces, on a straight-line basis over the remaining life of the loans, the adjustments so that model reverts back to the historical rates of default and severity of loss. The credit loss expense recorded through earnings is the amount necessary to maintain the allowance for credit losses at the amount of expected credit losses inherent within the loans held for investment portfolio. The amount of expense and the corresponding level of allowance for credit losses for loans are based on our evaluation of the collectability of the loan portfolio based on historical loss experience, reasonable and supportable forecasts, and other significant qualitative and quantitative factors. The allowance for credit losses for loans, as reported in our consolidated balance sheet, is adjusted by an expense for credit losses, which is recognized in earnings, and reduced by the charge-off of loan amounts, net of recoveries. For further information on the allowance for credit losses for loans, see Note 1 - Summary of Significant Accounting Policies and Note 5 - Loans in the notes to the financial statements of this Form 10-Q. Page 57
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Overview
This overview highlights selected information and may not contain all of the
information that is important to you in understanding our performance during the
period. For a more complete understanding of trends, events, commitments,
uncertainties, liquidity, capital resources, and critical accounting estimates,
you should carefully read this entire report.
The Company is a holding company engaged in the business of commercial banking.
The Company's subsidiary is Hills Bank and Trust Company , Hills, Iowa (the
"Bank"), which is wholly-owned. The Bank was formed in Hills, Iowa in 1904.
The Bank is a full-service commercial bank extending its services to
individuals, businesses, governmental units and institutional customers
primarily in the communities of Hills, Iowa City, Coralville , North Liberty ,
Lisbon , Mount Vernon , Kalona , Wellman , Cedar Rapids , Marion , and Washington ,
Iowa . At September 30, 2022 , the Bank has nineteen full-service locations.
Net income for the nine month period ended September 30, 2022 was $35.72 million
compared to $41.93 million for the same nine months of 2021, a decrease of $6.21
million or 14.82%. The principal factors in the decrease in net income for the
first nine months of 2022 were a credit loss expense of $7.83 million , primarily
due to increased loan growth, increased outstanding loan commitments and lower
prepayment and curtailment rates with increasing interest rates; a decrease in
noninterest income of $4.29 million ; and offset by an increase in net interest
income of $4.73 million .
The Company achieved a return on average assets of 1.05% and a return on average
equity of 9.85% for the twelve months ended September 30, 2022 , compared to the
twelve months ended September 30, 2021 , which were 1.32% and 12.14%,
respectively. The return on average assets and return on average equity for the
nine months ended September 30, 2022 were 1.19% and 11.28%, respectively,
compared to the nine months ended September 30, 2021 , which were 1.42% and
13.30%, respectively. Dividends of $1.00 per share were paid in January 2022 to
2,727 shareholders. The dividend paid in January 2021 was $0.94 per share.
The Company's net interest income is the largest component of revenue and it is
primarily a function of the average earning assets and the net interest margin
percentage. The Company achieved a net interest margin on a tax-equivalent
basis of 2.92% for the nine months ended September 30, 2022 compared to 2.83%
for the same nine months of 2021. Average earning assets were $3.924 billion
year to date in 2022 and $3.823 billion in 2021.
Highlights noted on the balance sheet as of
•Total assets were$4.000 billion , a decrease of$44.18 million sinceDecember 31, 2021 . •Cash and cash equivalents were$242.12 million , a decrease of$539.80 million sinceDecember 31, 2021 . A portion of the decrease can be attributed to increased investments of approximately$196.20 million sinceDecember 31, 2021 , primarily inU.S Treasury and mortgage-backed securities as well as loan growth of approximately$285.86 million since year-end. •Net Loans, net of allowance for credit losses, were$2.910 billion , an increase of$279.30 million sinceDecember 31, 2021 . The increase is primarily attributable to approximately$47.30 million growth in construction loans,$52.87 million in multi-family loans,$151.32 million growth in 1-4 family first mortgages and$26.18 million in commercial and financial loans sinceDecember 31, 2021 . Loans held for sale decreased$3.05 million sinceDecember 31, 2021 . •Deposits decreased$18.23 million sinceDecember 31, 2021 , primarily due to decreases in brokered deposits and insured cash sweep (ICS) deposits.
Refer to Note 7 for a discussion of fair value measurements which relate to methods used by the Company in recording assets and liabilities on its financial statements.
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Financial Condition
There has been continued loan demand in 2022, primarily in commercial and
financial, construction, farmland mortgages, 1 to 4 family first mortgages and
multi-family mortgages. The lingering supply chain and labor market disruptions,
as well as significant inflationary pressures have created significant
uncertainty regarding projecting loan demand throughout the remainder of 2022.
However, outstanding loan commitments continue to be significantly elevated
compared to historical levels.
The following table sets forth the composition of the loan portfolio as of
September 30, 2022 December 31, 2021
Amount Percent Amount Percent
(Amounts In Thousands) (Amounts In Thousands)
Agricultural $ 98,555 3.35 % $ 106,933 4.02 %
Commercial and financial 248,179 8.42 222,002 8.35
Real estate:
Construction, 1 to 4 family residential 89,379 3.03 80,486 3.03
Construction, land development and commercial 165,431 5.62 127,021 4.77
Mortgage, farmland 248,103 8.42 232,744 8.75
Mortgage, 1 to 4 family first liens 1,060,888 36.01 909,564 34.19
Mortgage, 1 to 4 family junior liens 118,326 4.02 114,342 4.30
Mortgage, multi-family 435,666 14.79 382,792 14.39
Mortgage, commercial 397,048 13.47 401,377 15.09
Loans to individuals 35,355 1.20 32,687 1.23
Obligations of state and political subdivisions 49,191 1.67 50,285 1.88
$ 2,946,121 100.00 % $ 2,660,233 100.00 %
Net unamortized fees and costs 274 299
$ 2,946,395 $ 2,660,532
Less allowance for credit losses 38,980 35,470
$ 2,907,415 $ 2,625,062
The Bank has an established formal loan origination policy. In general, the
loan origination policy attempts to reduce the risk of credit loss to the Bank
by requiring, among other things, maintenance of minimum loan to value ratios,
evidence of appropriate levels of insurance carried by borrowers and
documentation of appropriate types and amounts of collateral and sources of
expected payment. The collateral relied upon in the loan origination policy is
generally the property being financed by the Bank. The source of expected
payment is generally the income produced from the property being financed.
Personal guarantees are required of individuals owning or controlling at least
20% of the ownership of an entity. Limited or proportional guarantees may be
accepted in circumstances if approved by the Company's Board of Directors.
Financial information provided by the borrower is verified as considered
necessary by reference to tax returns, or audited, reviewed or compiled
financial statements. The Bank does not originate subprime loans. In order to
modify, restructure or otherwise change the terms of a loan, the Bank's policy
is to evaluate each borrower situation individually. Modifications,
restructures, extensions and other changes are done to improve the Bank's
position and to protect the Bank's capital. If a borrower is not current with
its payments, any additional loans to such borrowers are evaluated on an
individual borrower basis.
The Company has not experienced any significant time lapses in recognizing the
required provisions for collateral dependent loans, nor has the Company delayed
appropriate charge offs. When an updated appraisal value has been obtained, the
Company has used the appraisal amount in determining the appropriate charge off
or required reserve. The Company also evaluates any changes in the financial
condition of the borrower and guarantors (if applicable), economic conditions,
and the Company's loss experience with the type of property in question. Any
information utilized in addition to the appraisal is intended to identify
additional charge offs or provisions, not to override the appraised value.
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In accordance with Staff Accounting Bulletin No. 102, Selected Loan Loss
Allowance Methodology and Documentation Issues, and Staff Accounting Bulletin
No. 119, which aligns the staff's guidance with FASB ASC Topic 326, or CECL, the
Company determines and assigns ratings to loans using factors that include the
following: an assessment of the financial condition of the borrower; a realistic
determination of the value and adequacy of underlying collateral; the condition
of the local economy and the condition of the specific industry of the borrower;
an analysis of the levels and trends of loan categories; and a review of
delinquent and classified loans.
Through the credit risk rating process, loans are reviewed to determine if they
are performing in accordance with the original contractual terms. If the
borrower has failed to comply with the original contractual terms, further
action may be required by the Company, including a downgrade in the credit risk
rating, movement to non-accrual status, a charge-off or the establishment of a
specific reserve. In the event a collateral shortfall is identified during the
credit review process, the Company will work with the borrower for a principal
reduction and/or a pledge of additional collateral and/or additional guarantees.
In the event that these options are not available, the loan may be subject to a
downgrade of the credit risk rating. If the Company determines a loan amount or
portion thereof, is uncollectible, the loan's credit risk rating may be
downgraded and the uncollectible amount charged-off or recorded as a specific
allowance for losses. The Bank's credit and legal departments undertake a
thorough and ongoing analysis to determine if additional specific reserves
and/or charge-offs are appropriate and to begin a workout plan for the loan to
minimize actual losses.
The following table presents the allowance for credit losses as of September 30,
2022 and December 31, 2021 by loan category, the percentage of the allowance for
each category to the total allowance, and the percentage of all loans in each
category to total loans:
September 30, 2022 December 31, 2021
% of Total % of Loans to % of Total % of Loans to
Amount Allowance Total Loans Amount Allowance Total Loans
(In Thousands) (In Thousands)
Agricultural $ 2,470 6.34 % 3.35 % $ 2,261 6.37 % 4.02 %
Commercial and financial 5,196 13.33 8.42 4,269 12.04 8.35
Real estate:
Construction, 1 to 4 family
residential 991 2.54 3.03 818 2.31 3.03
Construction, land development
and commercial 2,473 6.34 5.62 1,482 4.18 4.77
Mortgage, farmland 2,862 7.34 8.42 3,433 9.68 8.75
Mortgage, 1 to 4 family first
liens 9,873 25.34 36.01 8,340 23.52 34.19
Mortgage, 1 to 4 family junior
liens 2,912 7.47 4.02 3,158 8.90 4.30
Mortgage, multi-family 4,429 11.36 14.79 3,715 10.47 14.39
Mortgage, commercial 6,485 16.64 13.47 6,783 19.12 15.09
Loans to individuals 840 2.15 1.20 771 2.17 1.23
Obligations of state and
political subdivisions 449 1.15 1.67 440 1.24 1.88
$ 38,980 100.00 % 100.00 % $ 35,470 100.00 % 100.00 %
The allowance for credit losses (ACL) totaled $38.98 million at September 30,
2022 compared to the allowance of $35.47 million at December 31, 2021 . The
percentage of the allowance to outstanding loans was 1.32% and 1.33% at
September 30, 2022 and December 31, 2021 , respectively. The allowance was based
on management's consideration of a number of factors, including composition of
the loan portfolio, loans with higher credit risks and the overall amount of
loans outstanding. The changes in the ACL in 2022 compared to December 31, 2021
is the result of the following factors: improvements in the economic factor
forecasts, primarily Iowa unemployment, used in the ACL calculation which
resulted in a decrease of $1.09 million ; increase in loan volume which resulted
in an increase of $3.34 million ; changes in prepayment and curtailment
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rates and loss driver analysis resulting in an increase of
The adequacy of the allowance is reviewed quarterly and adjusted as appropriate after consideration has been given to the impact of economic conditions on the borrowers' ability to repay, loan collateral values, past collection experience, the risk characteristics of the loan portfolio and such other factors that deserve current recognition. The growth of the loan portfolio and the trends in problem and watch loans are significant elements in the determination of the provision for credit losses. Quantitative factors include the Company's historical loss experience, which is then adjusted for levels and trends in past due, levels and trends in charged-off and recovered loans, trends in volume growth, trends in problem and watch loans, trends in restructured loans, local economic trends and conditions, industry and other conditions, and effects of changing interest rates. Management has determined that the allowance for credit losses was adequate atSeptember 30, 2022 , and that the loan portfolio is diversified and secured, without undue concentration in any specific risk area. This process involves a high degree of management judgment; however, the allowance for credit losses is based on a comprehensive, well documented, and consistently applied analysis of the Company's loan portfolio. This analysis takes into consideration all available information existing as of the financial statement date, including environmental factors such as economic, industry, geographical and political factors. The relative level of allowance for credit losses is reviewed and compared to industry data. This review encompasses levels of total collateral-dependent loans, portfolio mix, portfolio concentrations, current geographic risks and overall levels of net charge-offs. Investment securities available for sale held by the Company increased by$196.20 million fromDecember 31, 2021 toSeptember 30, 2022 . The fair value of securities available for sale was$67.26 million less than the amortized cost of such securities as ofSeptember 30, 2022 . AtDecember 31, 2021 , the fair value of the securities available for sale was$1.97 million more than the amortized cost of such securities. Deposits decreased$18.23 million in the first nine months of 2022 primarily due to decreases in brokered deposits and insured cash sweep (ICS) deposits. In the opinion of the Company's management, the Company continues to have sufficient liquidity resources available to fund expected additional loan growth. Brokered deposits are included in total deposits and totaled$31.67 million as ofSeptember 30, 2022 with an average rate of 1.97%. Brokered deposits were$51.59 million as ofDecember 31, 2021 with an average interest rate of 0.36%. As ofSeptember 30, 2022 andDecember 31, 2021 , brokered deposits were 0.90% and 1.46% of total deposits, respectively.
There were no
Dividends and Equity InJanuary 2022 ,Hills Bancorporation paid a dividend of$9.31 million or$1.00 per share. The dividend paid inJanuary 2021 was$0.94 per share. After payment of the dividend and the adjustment for accumulated other comprehensive income, stockholders' equity as ofSeptember 30, 2022 totaled$409.06 million . OnJanuary 1, 2015 , the final rules of theFederal Reserve Board went into effect implementing inthe United States the Basel III regulatory capital reforms from theBasel Committee on Banking Supervision . The final rule also adopted changes to the agencies' regulatory capital requirements that meet the requirements of section 171 and section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under the BASEL III rules, the minimum capital ratios are 4% for Tier 1 Leverage Capital Ratio, 4.5% for the Common Equity Tier 1 Capital Ratio, 6% for the Tier 1 Risk-Based Capital Ratio and 8% for the Total Risk-Based Capital Ratio. The Bank elected to use the Community Bank Leverage Ratio (CBLR) framework as provided for in the Economic Growth, Regulatory Relief and Consumer Protection Act. Under the CBLR framework, the Bank is required to maintain a CBLR of greater than 9%. The CARES Act reduced the minimum ratio to 8% beginning in the 2nd quarter of 2020 throughDecember 31, 2020 , increasing to 8.5% for 2021 and returning to 9% beginningJanuary 1, 2022 . As ofSeptember 30, 2022 andDecember 31, 2021 , the Company had regulatory capital in excess of theFederal Reserve's minimum and well-capitalized definition requirements. The actual amounts and capital ratios as ofSeptember 30, 2022 andDecember 31, 2021 are presented below (amounts in thousands): Page 61
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Actual For Capital Adequacy Purposes
Amount Ratio Ratio
As of September 30, 2022 :
Company:
Community Bank Leverage ratio $ 508,533 12.84 % 9.000 %
Bank:
Community Bank Leverage ratio 510,806 12.91 9.000
Actual For Capital Adequacy Purposes
Amount Ratio Ratio
As of December 31, 2021 :
Company:
Community Bank Leverage ratio $ 484,486 11.80 % 8.50 %
Bank:
Community Bank Leverage ratio 484,429 11.80 8.50
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Discussion of operations for the nine months ended
Net Income Overview Total net income was$35.72 million in 2022 and$41.93 million in the comparable period in 2021, a decrease of$6.21 million or 14.82%. The change in net income in 2022 from the first nine months of 2021 was primarily the result of the following: •Net interest income increased by$4.73 million , before credit loss expense. •For the nine months endedSeptember 30, 2022 , a credit loss expense was$3.27 million . This represents an increase in expense of$7.83 million from the reversal of credit loss reserves of$4.56 million for the nine months endedSeptember 30, 2021 . •Noninterest income decreased by$4.29 million . •Noninterest expenses decreased by$0.56 million . •Income tax expense decreased by$1.74 million . For the nine month period endedSeptember 30, 2022 andSeptember 30, 2021 basic earnings per share was$3.85 and$4.50 , respectively. Diluted earnings per share was$3.85 for the nine months endedSeptember 30, 2022 compared to$4.50 for the same period in 2021. The Company's net income for the period was driven primarily by three factors. The first factor is credit loss expense recorded under CECL. The majority of the Company's interest-earning assets are in loans outstanding, which amounted to more than$2.910 billion atSeptember 30, 2022 . Credit loss expense was$3.27 million in 2022 compared to a reduction of expense of$4.56 million in 2021. The increase in expense when compared to the same period in 2021 is attributable to increases in outstanding loan commitments, loan volume, lower prepayment and curtailment rates with the increasing interest rates and qualitative factor increases determined by management. The reduction in expense in 2021 was primarily due to the increases to the allowance taken in 2020 in response to the COVID-19 pandemic that were released in 2021. The Company believes that credit loss expense is expected to be dependent on the Company's loan growth, local economic conditions and asset quality. The second factor affecting the Company's net income is the interaction between changes in net interest margin and changes in average volumes of the Bank's earnings assets. Net interest income of$84.19 million for the first nine months of 2022 was derived from the Company's$3.924 billion of average earning assets during that period and its tax-equivalent net interest margin of 2.92%. Average earning assets in the nine months endedSeptember 30, 2021 were$3.823 billion and the tax-equivalent net interest margin was 2.83%. Net interest income for the Company increased primarily as a result of interest income on increased loan volume as well as lower interest expense from lower certificate of deposits volume and no FHLB borrowings. Also, interest income on investment securities was higher due to increased volume ofU.S. Treasuries, mortgage-backed securities and municipal securities though this was offset by no PPP fee income in 2022 compared to 2021. The Company expects net interest compression to impact earnings for the foreseeable future due to competition for loans and deposits. The Company believes growth in net interest income will be contingent on the growth of the Company's earning assets, increasing yield on loans and the continued interest rate increases by theFederal Reserve Board . The third factor affecting the Company's net income is noninterest income, primarily the decrease in net gain on the sale of loans. The net gain on the sale of loans was$1.38 million and$6.24 million for the nine months endedSeptember 30, 2022 and 2021, respectively, a decrease of 77.94% for the nine months endedSeptember 30, 2022 compared to the same period in 2021. The amount of the net gain on sale of secondary market mortgage loans in each year can vary significantly. The volume of activity in these types of loans is directly related to the level of interest rates as well as the current origination and refinancing activity. The volume has been significantly impacted by theFederal Reserve Board's increases to the federal funds rate so far in 2022, resulting in a significant decline in the amount of mortgage loan origination and refinance activity. Page 63
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Discussion of operations for the nine months ended
Net Interest Income
Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. Net interest income on a tax equivalent basis increased$4.76 million for the nine months endedSeptember 30, 2022 compared to the comparable period in 2021. The increase was primarily attributable to lower interest expense from lower time deposits volume and no FHLB borrowings. Also, interest income on taxable and nontaxable securities was higher due to increased volume ofU.S. Treasuries, mortgage-backed securities and municipal securities and higher rates earned on excess cash. There was no PPP fee income recorded in loan interest income in 2022 compared to$5.48 million for the comparable period in 2021. The net interest margin for the first nine months of 2022 was 2.92% compared to 2.83% in 2021 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 21% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the nine months ended in 2022 compared to the comparable period in 2021 are shown in the following table: Increase (Decrease) in Net Interest Income Change in Average Change in Balance Average Rate Volume Changes Rate Changes Net Change (Amounts in Thousands) Interest income: Loans, net$ 67,793 (0.32) %$ 1,717 $ (5,921) $ (4,204) Taxable securities 266,077 0.13 3,012 479 3,491 Nontaxable securities 26,081 (0.14) 458 (249) 209 Interest-bearing bank balances (258,601) 0.61 (236) 2,086 1,850$ 101,350 $ 4,951 $ (3,605) $ 1,346 Interest expense: Interest-bearing demand deposits$ 76,593 0.04 %$ (134) $ (265) $ (399) Savings deposits 108,376 0.03 (103) (290) (393) Time deposits (85,899) (0.21) 1,073 881 1,954 FHLB borrowings (105,000) (2.82) 2,248 - 2,248 Interest-bearing other liabilities 21 0.98 - - -$ (5,909) $ 3,084 $ 326$ 3,410 Change in net interest income$ 8,035 $ (3,279) $ 4,756 Rate/volume variances are allocated on a consistent basis using the absolute values of changes in volume compared to the absolute values of the changes in rates. Interest on nontaxable securities and loans is shown on a tax-equivalent basis.
A summary of the net interest spread and margin is as follows:
(Tax Equivalent Basis) 2022 2021
Yield on average interest-earning assets 3.27 % 3.30 %
Rate on average interest-bearing liabilities 0.48 0.63
Net interest spread 2.79 % 2.67 %
Effect of noninterest-bearing funds 0.13 0.16
Net interest margin (tax equivalent net interest income divided by average interest-earning assets)
2.92 % 2.83 %
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Discussion of operations for the nine months ended
In pricing loans and deposits, the Bank considers theU.S. Treasury indexes as benchmarks in determining interest rates. TheFederal Open Market Committee met six times during the first nine months of 2022. The federal funds target rate increased to 3.25% as ofSeptember 30, 2022 from 0.25% as of the same period in 2021. Interest rates on loans are generally affected by the federal funds target rate since interest rates for theU.S. Treasury market normally increase or decrease when theFederal Reserve Board raises or lowers the federal funds rate. As ofSeptember 30, 2022 , the rate indexes for the one, three and five year indexes were 4.05%, 4.25% and 4.06%, respectively. The one year index increased 4,400% from 0.09% atSeptember 30, 2021 , the three year index increased 701.89% and the five year index increased 314.29%. The three year index was 0.53% and the five year index was 0.98% atSeptember 30, 2021 .
Credit Loss Expense
Credit loss expense was$3.27 million for the nine months endedSeptember 30, 2022 compared to a reduction of expense of$4.56 million in 2021, an increase of expense of$7.83 million . Credit loss expense is the amount necessary to adjust the allowance for credit losses to the level considered by management to appropriately account for the estimated current expected credit losses within the Bank's loan portfolio. The allowance for credit losses totaled$38.98 million atSeptember 30, 2022 compared to$35.59 million as ofSeptember 30, 2021 . The allowance represented 1.32% and 1.34% of loans held for investment atSeptember 30, 2022 and 2021, respectively. A significant component in estimating expected credit losses are economic forecasts such asIowa unemployment, all-transactions house price index forIowa andIowa real gross domestic product. The increase in expense when compared to the same period in 2021 is attributable to increases in outstanding loan commitments, loan volume, lower prepayment and curtailment rates with the increasing interest rates and qualitative factor increases determined by management. The reduction in the allowance for credit losses in 2021 was primarily due to the increases to the allowance taken in 2020 in response to the COVID-19 pandemic that were released in 2021. The allowance for credit losses balance is impacted by charge-offs, net of recoveries, for the periods presented. For the nine months endedSeptember 30, 2022 and 2021, recoveries were$1.70 million and$2.19 million , respectively; and charge-offs were$1.19 million in 2022 and$0.86 million in 2021. The allowance for credit losses totaled$38.98 million atSeptember 30, 2022 compared to$35.47 million as ofDecember 31, 2021 . The allowance represented 1.32% and 1.33% of loans held for investment atSeptember 30, 2022 andDecember 31, 2021 . Noninterest Income
The following table sets forth the various categories of noninterest income for
the nine months ended
Nine Months Ended September
30,
2022 2021 $ Change % Change
(Amounts in thousands)
Net gain on sale of loans $ 1,377 $ 6,243 $ (4,866) (77.94) %
Trust fees 9,338 9,645 (307) (3.18)
Service charges and fees 9,444 8,729 715 8.19
Other noninterest income 814 647 167 25.81
$ 20,973 $ 25,264 $ (4,291) (16.98)
In the nine months ended September 30, 2022 and 2021, the net gain on sale of
loans was $1.38 million and $6.24 million , respectively. The amount of the net
gain on sale of secondary market mortgage loans in each period can vary
significantly. The volume of activity, margin and demand in these types of
loans is directly related to the changes in interest rates and new originations
and refinancing activity. The primary reason for the decrease in 2022 compared
to 2021 is the increased mortgage interest rates in 2022 leading to the
significant decrease in loans originated for sale. The servicing of the loans
sold into the secondary market is not retained by the Company so these loans do
not provide an ongoing stream of income.
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Service charges and fees increased
Other noninterest income categories experienced marginal period-to-period
fluctuations for the nine months ended
Noninterest Expenses
The following table sets forth the various categories of noninterest expenses
for the nine months ended
Nine Months Ended September
30,
2022 2021 $ Change % Change
(Amounts in thousands)
Salaries and employee benefits $ 31,990 $ 31,484 $ 506 1.61 %
Occupancy 3,265 3,135 130 4.15
Furniture and equipment 5,150 5,523 (373) (6.75)
Office supplies and postage 1,377 1,268 109 8.60
Advertising and business development 1,874 1,480 394 26.62
Outside services 9,407 9,781 (374) (3.82)
FDIC insurance assessment 815 777 38 4.89
Other noninterest expense 1,802 1,668 134 8.03
$ 55,680 $ 55,116 $ 564 1.02
All noninterest expense categories experienced marginal period-to-period
fluctuations for the nine months ended
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Discussion of operations for the three months ended
Net Income Overview
Net income increased$0.62 million for the three months endedSeptember 30, 2022 compared to the same period in 2021. Total net income was$13.74 million in 2022 and$13.13 million in the comparable period in 2021, an increase of 4.69%. For the three month periods endedSeptember 30, 2022 and 2021 basic earnings per share was$1.48 and$1.41 , respectively. Diluted earnings per share was$1.48 for the three months endedSeptember 30, 2022 compared to$1.41 for the same period in 2021. Net Interest Income Net interest income is the excess of the interest and fees earned on interest-earning bearing assets over the interest expense of the interest-bearing liabilities. Net interest income on a tax equivalent basis increased$3.31 million for the three months endedSeptember 30, 2022 compared to the comparable period in 2021. The increase was a result of higher loan volume and interest income on taxable and nontaxable securities due to increased volume ofU.S. Treasuries, mortgage-backed securities and municipal securities and rate earned on excess cash. The increase is also attributable to lower interest expense from lower time deposits volume and no FHLB borrowings. This is offset by higher interest expense attributable to higher rates on interest-bearing demand and savings deposits. The net interest margin for the three months endedSeptember 30, 2022 was 3.15% compared to 2.82% in 2021 for the same period. The measure is shown on a tax-equivalent basis using a tax rate of 21% to make the interest earned on taxable and non-taxable assets more comparable. The change in average balances and average rates between periods and the effect on the net interest income on a tax equivalent basis for the three months ended in 2022 compared to the comparable period in 2021 are shown in the following table: Increase (Decrease) in Net Interest Income Change in Change in Average Balance Average Rate Volume Changes Rate Changes Net Change (Amounts in Thousands)
Interest income: Loans, net$ 187,486 (0.23) %$ 2,012 $ (1,548) $ 464 Taxable securities 314,410 0.34 1,108 495 1,603 Nontaxable securities 13,659 0.02 79 19 98 Interest-bearing bank balances (510,827) 2.11 (196) 1,273 1,077 $ 4,728$ 3,003 $ 239$ 3,242 Interest expense: Interest-bearing demand deposits $ 11,338 0.21 % $ (6)$ (571) $ (577) Savings deposits 48,829 0.14 (6) (441) (447) Time deposits (61,584) (0.07) 241 93 334 FHLB borrowings (105,000) (2.82) 758 - 758 Interest-bearing other liabilities 30 2.16 - - -$ (106,387) $ 987$ (919) $ 68 Change in net interest income$ 3,990 $ (680) $ 3,310 Rate/volume variances are allocated on a consistent basis using the absolute values of changes in volume compared to the absolute values of the changes in rates. Interest on nontaxable securities and loans is shown on a tax-equivalent basis. Page 67
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HILLS BANCORPORATION Discussion of operations for the three months ended
A summary of the net interest spread and margin is as follows:
(Tax Equivalent Basis) 2022 2021
Yield on average interest-earning assets 3.53 % 3.24 %
Rate on average interest-bearing liabilities 0.58 0.57
Net interest spread 2.95 % 2.67 %
Effect of noninterest-bearing funds 0.20 0.15
Net interest margin (tax equivalent net interest income divided by average interest-earning assets)
3.15 % 2.82 %
Credit Loss Expense
Credit loss expense was a reduction of expense of $0.34 million for the three
months ended September 30, 2022 compared to expense of $0.08 million in 2021, a
decrease of expense of $0.42 million . The decrease in credit loss expense when
compared to the same period in 2021 is primarily attributable to improvements in
economic forecasts for Iowa unemployment. Credit loss expense is the amount
necessary to adjust the allowance for credit losses to the level considered by
management to appropriately account for the estimated current expected credit
losses within the Bank's loan portfolio. A significant component in estimating
expected credit losses are economic forecasts such as Iowa unemployment,
all-transactions house price index for Iowa and Iowa real gross domestic
product.
The allowance for credit losses balance is impacted by charge-offs, net of
recoveries, for the periods presented. For the three months ended September 30,
2022 and 2021, recoveries were $0.47 million and $0.65 million , respectively;
and charge-offs were $0.40 million in 2022 and $0.59 million in 2021.
Noninterest Income
The following table sets forth the various categories of noninterest income for
the three months ended
Three Months Ended September
30,
2022 2021 $ Change % Change
(Amounts in thousands)
Net gain on sale of loans $ 240 $ 1,512 $ (1,272) (84.13) %
Trust fees 2,859 3,568 (709) (19.87)
Service charges and fees 3,282 3,075 207 6.73
Other noninterest income 164 89 75 84.27
$ 6,545 $ 8,244 $ (1,699) (20.61)
In the three months ended September 30, 2022 and 2021, the net gain on sale of
loans was $0.24 million and $1.51 million , respectively. The amount of the net
gain on sale of secondary market mortgage loans in each period can vary
significantly. The volume of activity is directly related to changes in
interest rates and new originations and refinancing activity. The primary reason
for the decrease in 2022 compared to 2021 is the increased mortgage interest
rates in 2022 leading to the significant decrease in loans originated for sale.
The servicing of the loans sold into the secondary market is not retained by the
Company so these loans do not provide an ongoing stream of income. Trust fees
decreased $0.70 million to $2.86 million for the quarter ended September 30,
2022 compared to the same period in 2021 due to the decrease in assets under
management of $0.327 billion from $2.429 billion as of September 30, 2021 to
$2.102 billion as of September 30, 2022 . Other noninterest income categories
experienced marginal period-to-period fluctuations for the three months ended
September 30, 2022 .
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Noninterest Expenses
The following table sets forth the various categories of noninterest expenses
for the three months ended
Three Months Ended
September 30,
2022 2021 $ Change % Change
(Amounts in thousands)
Salaries and employee benefits $ 10,818 $ 10,281 $ 537 5.22 %
Occupancy 1,024 955 69 7.23
Furniture and equipment 1,770 1,652 118 7.14
Office supplies and postage 425 428 (3) (0.70)
Advertising and business development 586 496 90 18.15
Outside services 3,491 3,496 (5) (0.14)
FDIC insurance assessment 267 267 - -
Other noninterest expense 650 623 27 4.33
$ 19,031 $ 18,198 $ 833 4.58
All noninterest expense categories experienced marginal period-to-period
fluctuations for the three months ended
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Income Taxes
Federal and state income tax expenses were $10.49 million and $12.23 million for
the nine months ended September 30, 2022 and 2021, respectively. Income taxes as
a percentage of income before taxes were 22.70% in 2022 and 22.58% in 2021.
Federal and state income tax expenses were $4.43 million and $3.86 million for
the three months ended September 30, 2022 and 2021, respectively. Income taxes
as a percentage of income before taxes were 24.36% in 2022 and 22.74% in 2021.
In the quarter ended September 30, 2022 , the Company's income tax expense
included a one-time increase in state income tax expense related to the 2022
enactment of changes in the Iowa bank franchise tax rates. This legislation
reduces the Iowa bank franchise tax rate applied to apportioned income for 2023
and future years and required the Company to reduce net deferred tax assets and
caused the one-time increase in tax expense for the three months ended September
30, 2022 .
Liquidity
The Company actively monitors and manages its liquidity position with the
objective of maintaining sufficient cash flows to fund operations, meet
commitments, take advantage of market opportunities and provide a margin against
unforeseeable liquidity needs. Federal funds sold and investment securities
available for sale are readily marketable assets. Maturities of all investment
securities are managed to meet the Company's normal liquidity needs, to respond
to market changes or to adjust the Company's interest rate risk position.
Investment securities available for sale comprised 18.69% of the Company's total
assets at September 30, 2022 compared to 13.63% at December 31, 2021 .
The Company has historically maintained a stable deposit base and a relatively
low level of large deposits, which has mitigated the volatility in the Company's
liquidity position. As of September 30, 2022 , the Company had no outstanding
borrowings from the Federal Home Loan Bank ("FHLB") of Des Moines . Advances are
used as a means of providing both long and short-term, fixed-rate funding for
certain assets and for managing interest rate risk. The Company had additional
borrowing capacity available from the FHLB of approximately $966.77 million at
September 30, 2022 .
As additional sources of liquidity, the Company has the ability to borrow up to
$10.00 million from the Federal Reserve Bank of Chicago , and has lines of credit
with three banks totaling $570.81 million . The borrowings under these credit
lines would be secured by the Bank's investment securities. The combination of
high levels of potentially liquid assets, low dependence on volatile liabilities
and additional borrowing capacity provided sources of liquidity for the Company
which management considered sufficient at September 30, 2022 .
As of
Contractual Obligations
There have been no material changes with regard to contractual obligations
disclosed in the Company's Form 10-K for the year ended
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