WILSON BANK HOLDING COMPANY The purpose of this discussion is to provide insight into the financial condition and results of operations of the Company and its bank subsidiary,Wilson Bank (the "Bank") andEncompass Home Loan Lending, LLC ("Encompass"), a company offering mortgage banking services that is 51% owned by the Bank and 49% owned by two home builders operating in the Bank's market areas. The results of Encompass, which commenced operations onJune 1, 2022 , are consolidated in the Company's financial statements included elsewhere in this Quarterly Report. This discussion should be read in conjunction with the Company's consolidated financial statements appearing elsewhere in this report. Reference should also be made to the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 for a more complete discussion of factors that impact the Company's liquidity, capital and results of operations. Forward-Looking Statements This Form 10-Q contains certain forward-looking statements within the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act") regarding, among other things, the anticipated financial and operating results of the Company. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to publicly release any modifications or revisions to these forward-looking statements to reflect events or circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events. The Company cautions investors that future financial and operating results may differ materially from those projected in forward-looking statements made by, or on behalf of, the Company. The words "expect," "intend," "should," "may," "could," "believe," "suspect," "anticipate," "seek," "plan," "estimate" and similar expressions are intended to identify such forward-looking statements, but other statements not based on historical fact may also be considered forward-looking. Such forward-looking statements involve known and unknown risks and uncertainties, including, but not limited to those described in the Company's Annual Report on Form 10-K for the year endedDecember 31, 2021 , and also include, without limitation, (i) deterioration in the financial condition of borrowers resulting in significant increases in credit losses and provisions for these losses, (ii) deterioration in the real estate market conditions in the Company's market areas including demand for residential real estate loans as a result of rising rates on residential real estate mortgage loans, (iii) the impact of increased competition with other financial institutions, including pricing pressures on loans and deposits, and the resulting impact on the Company's results, including as a result of compression to net interest margin, (iv) adverse conditions in local or national economies, including the economy in the Company's market areas, including as a result of inflationary pressures on our customers and on their businesses (v) fluctuations or differences in interest rates on earning assets and interest bearing liabilities from those that the Company is modeling or anticipating, including as a result of the Bank's inability to maintain deposit rates or defer increases to those rates in a rising rate environment in connection with the changes in the short-term rate environment, or that affect the yield curve, (vi) the ability to grow and retain low-cost core deposits, (vii) significant downturns in the business of one or more large customers, (viii) the inability of the Company to comply with regulatory capital requirements, including those resulting from changes to capital calculation methodologies, required capital maintenance levels, or regulatory requests or directives, (ix) changes in state or Federal regulations, policies, or legislation applicable to banks and other financial service providers, including regulatory or legislative developments arising out of current unsettled conditions in the economy, including implementation of the Dodd Frank Wall Street Reform and Consumer Protection Act, (x) changes in capital levels and loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments, (xi) inadequate allowance for credit losses, (xii) the effectiveness of the Company's activities in improving, resolving or liquidating lower quality assets, (xiii) results of regulatory examinations, (xiv) the vulnerability of the Company's network and online banking portals, and the systems of parties with whom the Company contracts, to unauthorized access, computer viruses, phishing schemes, spam attacks, human error, natural disasters, power loss, and other security breaches, (xv) the possibility of additional increases to compliance costs or other operational expenses as a result of increased regulatory oversight, (xvi) loss of key personnel, (xvii) adverse results (including costs, fines, reputational harm and/or other negative effects) from current or future litigation, examinations or other legal and/or regulatory actions, (xviii) the effects of new outbreaks of COVID-19, including actions taken by governmental officials to curb the spread of the virus, and the resulting impact on general economic and financial market conditions and on the Company's and its customers' business, results of operations, asset quality and financial condition, and (xix) the efficacy of vaccines against the COVID-19 virus, including new variants. These risks and uncertainties may cause the actual results or performance of the Company to be materially different from any future results or performance expressed or implied by such forward-looking statements. The Company's future operating results depend on a number of factors which were derived utilizing numerous assumptions that could cause actual results to differ materially from those projected in forward-looking statements. Impact of COVID-19
Information regarding the impact of the COVID-19 pandemic on our financial
condition and results of operations as of and for the three and nine months
ended
Application of Critical Accounting Policies and Accounting Estimates
We follow accounting and reporting policies that conform, in all material respects, to accounting principles generally accepted inthe United States and to general practices within the financial services industry. The preparation of financial statements in conformity with accounting principles generally accepted inthe United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While we base estimates on historical experience, current information, forecasted economic conditions, and other factors deemed to be relevant, actual results could differ from those estimates. We consider accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on our financial statements. 33
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Accounting policies related to the allowance for credit losses on financial instruments including loans and off-balance-sheet credit exposures are considered to be critical as these policies involve considerable subjective judgment and estimation by management. As discussed in Note 1 - Summary of Significant Accounting Policies, our policies related to allowances for credit losses changed onJanuary 1, 2022 in connection with the adoption of a new accounting standard update as codified in Accounting Standards Codification ("ASC") Topic 326 ("ASC 326") Financial Instruments - Credit Losses. In the case of loans, the allowance for credit losses is a contra-asset valuation account, calculated in accordance with ASC 326, that is deducted from the amortized cost basis of loans to present the net amount expected to be collected. In the case of off-balance-sheet credit exposures, the allowance for credit losses is a liability account, calculated in accordance with ASC 326, reported as a component of accrued interest payable and other liabilities in our consolidated balance sheets. The amount of each allowance account represents management's best estimate of current expected credit losses on these financial instruments considering available information, from internal and external sources, relevant to assessing exposure to credit loss over the contractual term of the instrument. Relevant available information includes 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 portfolio-specific risk characteristics, environmental conditions or other relevant factors. While management utilizes its best judgment and information available, the ultimate adequacy of our allowance accounts is dependent upon a variety of factors beyond our control, including the performance of our portfolios, the economy, changes in interest rates and the view of the regulatory authorities toward classification of assets. For additional information regarding critical accounting policies, refer to Note 1 - Summary of Significant Accounting Policies and Note 2 - Loans and Allowance for Credit Losses in the notes to consolidated financial statements contained elsewhere in this Quarterly Report. Non-GAAP Financial Measures This Quarterly Report contains certain financial measures that are not measures recognized underU.S. GAAP and, therefore, are considered non-GAAP financial measures. Members of Company management use these non-GAAP financial measures in their analysis of the Company's performance, financial condition, and efficiency of operations. Management of the Company believes that these non-GAAP financial measures provide a greater understanding of ongoing operations and enhance comparability of results with prior periods. Management of the Company also believes that investors find these non-GAAP financial measures useful as they assist investors in understanding underlying operating performance and identifying and analyzing ongoing operating trends. However, the non-GAAP financial measures discussed herein should not be considered in isolation or as a substitute for the most directly comparable or other financial measures calculated in accordance withU.S. GAAP. Moreover, the manner in which the non-GAAP financial measures discussed herein are calculated may differ from the manner in which measures with similar names are calculated by other companies. You should understand how other companies calculate their financial measures similar to, or with names similar to, the non-GAAP financial measures we have discussed herein when comparing such non-GAAP financial measures. The non-GAAP measures in this Quarterly Report include "pre-tax pre-provision income," "pre-tax pre-provision basic earnings per share," "pre-tax pre-provision annualized return on average stockholders' equity," and "pre-tax pre-provision annualized return on average assets." A reconciliation of these measures to the comparable GAAP measures is included below. 34
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Selected Financial Information
The executive management and Board of Directors of the Company evaluate key
performance indicators (KPIs) on a continuing basis. These KPIs serve as
benchmarks of Company performance and are used in making strategic decisions.
The following table represents the KPIs that management presently has determined
to be important in making decisions for the Bank:
As of or For the Three Months As of or For the Nine Months
Ended September 30, Ended September 30,
2022 - 2021 2022 - 2021
Percent Increase Percent Increase
2022 2021 (Decrease) 2022 2021 (Decrease)
PER SHARE DATA:
Basic earnings per common share
(GAAP) $ 1.33 $ 1.19 11.76 % $ 3.59 $ 3.21 11.84 %
Pre-tax pre-provision basic
earnings per share (1) $ 1.90 $ 1.58 20.55 % $ 5.15 $ 4.31 19.49 %
Diluted earnings per common
share (GAAP) $ 1.33 $ 1.19 11.76 % $ 3.58 $ 3.20 11.88 %
Cash dividends per common share $ 0.75 $ 0.75 - % $ 1.85 $ 1.35 37.04 %
Dividends declared per common
share as a percentage of basic
earnings per common share 56.39 % 63.03 % (10.53 )% 51.53 % 42.06 % 22.53 %
As of or For the Three Months As of or For the Nine Months
Ended September 30, Ended September 30,
2022 - 2021 2022 - 2021
Percent Increase Percent Increase
2022 2021 (Decrease) 2022 2021 (Decrease)
PERFORMANCE RATIOS:
Annualized return on average
stockholders' equity (GAAP) (1) 16.67 % 13.10 % 27.25 % 14.58 % 12.13 % 20.20 %
Pre-tax pre-provision annualized
return on average stockholders'
equity (2) 23.86 % 17.30 % 37.92 % 20.96 % 16.31 % 28.51 %
Annualized return on average
assets (GAAP) (3) 1.46 % 1.42 % 2.82 % 1.33 % 1.33 % - %
Pre-tax pre-provision annualized
return on average assets (2) 2.09 % 1.87 % 11.76 % 1.91 % 1.79 % 6.70 %
Efficiency ratio (4) 51.63 % 56.41 % (8.47 )% 54.78 % 58.49 % (6.34 )%
(1) Annualized return on average stockholders' equity is the result of net income for the reported period on an annualized basis, divided by average stockholders' equity for the period.
(2) Excludes income tax expense, and for 2022 provision for credit losses and provision for credit losses on unfunded commitments. For 2021 excludes income tax expense, provision for loan losses, and provision for unfunded commitments.
(3) Annualized return on average assets is the result of net income for the reported period on an annualized basis, divided by average assets for the period.
(4) Efficiency ratio is the ratio of noninterest expense to the sum of net interest income and non-interest income.
2022 - 2021
September 30, December 31, Percent Increase
2022 2021 (Decrease)
BALANCE SHEET RATIOS:
Total capital to assets ratio 8.29 % 10.37 % (20.06 )%
Equity to asset ratio (Average equity
divided by average total assets) 9.13 % 10.86 % (15.93 )%
Tier 1 capital to average assets 10.96 % 10.77 % 1.76 %
Non-performing asset ratio 0.02 % 0.01 % 100.00 %
Book value per common share $ 29.89 $ 36.93 (19.06 )%
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Reconciliation of Non-GAAP Financial Measures
Three Months Ended Nine Months Ended
September 30, September 30, September 30, September 30,
2022 2021 2022 2021
Pre-tax pre-provision income:
Net income attributable to common
stockholders (GAAP) $ 15,190 $ 13,342 $ 40,702 $ 35,625
Add: provision for credit losses 2,543 130 6,060 1,012
Add: provision expense (benefit) for
credit losses on unfunded commitments (515 ) 84 (298 ) 221
Add: income tax expense 4,523 4,063 12,037 11,021
Pre-tax pre-provision income $ 21,741 $ 17,619 $ 58,501 $ 47,879
Pre-tax pre-provision basic earnings per
share:
Pre-tax pre-provision income $ 21,741 $ 17,619 $ 58,501 $ 47,879
Weighted average shares 11,429,027 11,165,313 11,348,628 11,110,006
Basic earnings per common share (GAAP)
$ 3.59 $ 3.21 Provision for credit losses$ 0.22 $ 0.01 $ 0.53 $ 0.09 Provision expense (benefit) for credit losses on unfunded commitments$ (0.05 ) $ 0.01 $ (0.03 ) $ 0.02 Income tax expense$ 0.40 $ 0.37 $ 1.06 $ 0.99 Pre-tax pre-provision basic earnings per common share$ 1.90 $ 1.58
.
Pre-tax pre-provision annualized return
on average assets:
Pre-tax pre-provision income $ 21,741 $ 17,619 $ 58,501 $ 47,879
Average assets 4,135,538 3,732,561 4,086,409 3,583,758
Annualized return on average assets (GAAP) 1.46 % 1.42 % 1.33 % 1.33 % Provision for credit losses 0.24 % 0.01 % 0.20 % 0.04 % Provision expense (benefit) for credit losses on unfunded commitments (0.05 )% 0.01 % (0.01 )% 0.01 % Income tax expense 0.44 % 0.43 % 0.39 % 0.41 % Pre-tax pre-provision annualized return on average assets 2.09 % 1.87 % 1.91 % 1.79 % Pre-tax pre-provision annualized return on average stockholders' equity: Pre-tax pre-provision income$ 21,741 $ 17,619 $ 58,501 $ 47,879 Average total stockholders' equity 361,549 404,134 373,238 392,580 Annualized return on average stockholders' equity (GAAP) 16.67 % 13.10 % 14.58 % 12.13 % Provision for credit losses 2.79 % 0.13 % 2.17 % 0.34 % Provision expense (benefit) for credit losses on unfunded commitments (0.57 )% 0.08 % (0.11 )% 0.08 % Income tax expense 4.97 % 3.99 % 4.32 % 3.76 % Pre-tax pre-provision annualized return on average stockholders' equity 23.86 % 17.30 % 20.96 % 16.31 % Results of Operations Net earnings of the Company increased$5,077,000 , or 14.25%, to$40,702,000 for the nine months endedSeptember 30, 2022 , from$35,625,000 in the first nine months of 2021. Net earnings of the Company were$15,190,000 for the quarter endedSeptember 30, 2022 , an increase of$1,848,000 , or 13.85%, from$13,342,000 for the three months endedSeptember 30, 2021 and an increase of$1,051,000 , or 7.43%, over the quarter endedJune 30, 2022 . The increase in net earnings during the three and nine months endedSeptember 30, 2022 as compared to the prior year comparable period was primarily due to an increase in net interest income, partially offset by an increase in provision for credit losses, a decrease in non-interest income, and an increase in non-interest expense. The increase in net interest income for the three months endedSeptember 30, 2022 compared to the comparable period in 2021 is due to an increase in average interest earning asset balances between the relevant periods, partially offset by decreased yield on loans and an increase in cost of funds. The increase in net interest income for the nine months endedSeptember 30, 2022 compared to the comparable period in 2021 is due to an increase in average interest earning asset balances between the relevant periods and a decrease in cost of funds, partially offset by decreased yield on loans. The decrease in yield on loans was primarily due to decreased PPP loan fees during the three and nine months endedSeptember 30, 2022 from the comparable periods in 2021, though such decline was partially offset by rising interest rates. The increase in cost of funds for the three months endedSeptember 30, 2022 when compared to the comparable period in 2021 occurred as we increased the rates we are paying on our deposit products as a result of competitive pressures in our markets and the impact of the rising rate environment. The decrease in non-interest income for the three and nine months endedSeptember 30, 2022 compared to the comparable periods in 2021 primarily resulted from a decrease in the gain on sale of loans which resulted from a decrease in the volume of refinancing and purchase money transactions for residential real estate loans due to rising mortgage interest rates. The increase in non-interest expense for the three and nine months endedSeptember 30, 2022 compared to the comparable periods in 2021 resulted from the Company's continued growth. Return on average assets (ROA) and return on average stockholders' equity (ROE) are common benchmarks for bank profitability and are calculated by taking our annualized net earnings for the relevant period and dividing by the average assets and average equity for the relevant periods, respectively. ROA and ROE measure a company's return on investment in a format that is easily comparable to other financial institutions. ROA is particularly important to the Company as it serves as the basis for certain executive and employee bonuses. The ROA for the nine month periods endedSeptember 30, 2022 and 2021 was 1.33%. The ROA for the three month periods endedSeptember 30, 2022 and 2021 was 1.46% and 1.42%, respectively. The ROE for the nine month periods endedSeptember 30, 2022 and 2021 was 14.58% and 12.13%, respectively. The ROE for the three month periods endedSeptember 30, 2022 and 2021 was 16.67% and 13.10%, respectively. 36
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Table of Contents Net Interest Income The average balances, interest, and average rates of our assets and liabilities for the three and nine-month periods endedSeptember 30, 2022 andSeptember 30, 2021 are presented in the following table (dollars in thousands): Three Months Ended Three Months Ended Net Change Three Months Ended September 30, 2022 September 30, 2021
Income/ Income/ Due to Percent
Average Balance Interest Rate
Expense Average Balance Interest Rate Expense Volume Due to Rate Net Change Change
Loans, net of unearned
interest (1) (2)
5.10 % $ 36,566 $ 2,394,042 5.19 % $ 30,773 $ 9,242 $ (3,449 ) $ 5,793
Investment
securities-taxable 834,871 2.08 4,374 686,671 1.37 2,372 590 1,412 2,002
Investment
securities-tax exempt 72,159 1.93 351 80,146 1.63 329 (161 ) 183 22
Taxable equivalent
adjustment (3) - 0.51 93 - 0.43 87 (43 ) 49 6
Total tax-exempt
investment securities 72,159 2.44 444 80,146 2.06 416 (204 ) 232 28
Total investment
securities 907,030 2.11 4,818 766,817 1.44 2,788 386 1,644 2,030
Loans held for sale 4,177 6.08 64 13,293 2.39 80 (307 ) 291 (16 )
Federal funds sold 5,971 1.93 29 35,227 0.05 4 (25 ) 50 25
Accounts with
depository institutions 123,519 1.88 585 374,536 0.14 128 (624 ) 1,081 457
Restricted equity
securities 4,548 4.80 55 5,089 2.57 33 (22 ) 44 22
Total earning assets 3,934,423 4.30 42,117 3,589,004 3.80 33,806 8,650 (339 ) 8,311 24.58 %
Cash and due from banks 24,934 23,450
Allowance for credit
losses (35,166 ) (39,316 )
Bank premises and
equipment 61,493 60,621
Other assets 149,854 98,802
Total assets $ 4,135,538 $ 3,732,561 Three Months Ended Three Months Ended Net Change Three Months Ended September 30, 2022 September 30, 2021
Income/ Income/ Due to Percent
Average Balance Interest Rate Expense Average Balance Interest Rate Expense Volume Due to Rate Net Change ChangeDeposits: Negotiable order of withdrawal accounts$ 1,095,614 0.19 %$ 522 $ 935,771 0.20 %$ 475 $ 205 $ (158 ) $ 47 Money market demand accounts 1,272,022 0.51 1,643 1,103,871 0.13 364 63 1,216 1,279 Time Deposits 580,352 0.96 1,406 607,838 1.23 1,884 (82 ) (396 ) (478 ) Other savings 346,317 0.34 299 266,825 0.18 118 43 138 181 Total interest-bearing deposits 3,294,305 0.47 3,870 2,914,305 0.39 2,841 229 800 1,029 Finance leases 2,291 2.94 17 - - - - 17 17 Fed funds purchased 364 7.44 7 - - - - 7 7 Total interest-bearing liabilities 3,296,960 0.47 3,894 2,914,305 0.39 2,841 229 824 1,053 37.06 % Non-interest bearing deposits 433,421 392,455 Other liabilities 43,608 21,667 Stockholders' equity 361,549 404,134 Total liabilities and stockholders' equity$ 4,135,538 $ 3,732,561 Net interest income, on a tax equivalent basis$ 38,223 $ 30,965 $ 8,421 $ (1,163 ) $ 7,258 23.44 % Net interest margin (4) 3.91 % 3.48 % Net interest spread (5) 3.83 % 3.41 % Notes:
(1) Yields on loans and total earning assets include the impact of State income tax credits related to incentive loans at below market rates and tax exempt loans to municipalities.
(2) Loan fees of
2021 in SBA fees related to PPP loans.
(3) The tax equivalent adjustment has been computed using a 21% Federal tax rate.
(4) Annualized net interest income on a tax equivalent basis divided by average interest-earning assets.
(5) Average interest rate on interest-earning assets less average interest rate on interest-bearing liabilities.
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Nine Months Ended Nine Months Ended Net Change Nine Months Ended
September 30, 2022 September 30, 2021
Income/ Income/ Percent
Average Balance Interest Rate
Expense Average Balance Interest Rate Expense Due to Volume Due to Rate Net Change Change
Loans, net of unearned
interest (1) (2)
4.95 % $ 98,474 $ 2,352,977 5.10 % $ 88,211 $ 14,661 $ (4,398 ) $ 10,263
Investment
securities-taxable 833,037 1.85 11,548 601,697 1.37 6,167 2,807 2,574 5,381
Investment
securities-tax exempt 74,528 1.85 1,030 79,338 1.53 905 (86 ) 211 125 Taxable equivalent adjustment (3) - 0.49 274 - 0.41 241 (23 ) 56 33 Total tax-exempt investment securities 74,528 2.34 1,304 79,338 1.94 1,146 (109 ) 267 158 Total investment securities 907,565 1.89 12,852 681,035 1.44 7,313 2,698 2,841 5,539 Loans held for sale 8,513 3.64 232 18,002 2.53 340 (278 ) 170 (108 ) Federal funds sold 20,118 0.63 95 32,448 0.04 9 (8 ) 94 86 Accounts with depository institutions 252,697 0.60 1,126 351,906 0.12 315 (168 ) 979 811 Restricted equity securities 4,906 3.13 115 5,089 2.21 84 (5 ) 36 31 Total earning assets 3,902,153 3.93 112,894 3,441,457 3.80 96,272 16,900 (278 ) 16,622 17.27 % Cash and due from banks 24,608 34,384 Allowance for credit losses (36,102 ) (39,072 ) Bank premises and equipment 62,212 58,782 Other assets 133,538 88,207 Total assets$ 4,086,409
$ 3,583,758 Nine Months Ended Nine Months Ended Net Change Nine Months Ended September 30, 2022 September 30, 2021
Income/ Income/ Percent
Average Balance Interest Rate Expense Average Balance Interest Rate Expense Due to Volume Due to Rate Net Change Change
Deposits:
Negotiable order of
withdrawal accounts $ 1,083,667 0.18 % $ 1,444 $ 885,129 0.21 % $ 1,383 $ 365 $ (304 ) $ 61
Money market demand
accounts 1,250,454 0.27 2,546 1,057,663 0.15 1,216 254 1,076 1,330
Time Deposits 574,958 0.86 3,717 609,602 1.32 6,027 (326 ) (1,984 ) (2,310 )
Other savings 329,618 0.21 514 243,435 0.20 371 135 8 143
Total interest-bearing
deposits 3,238,697 0.34 8,221 2,795,829 0.43 8,997 428 (1,204 ) (776 )
Federal Home Loan Bank
advances - - - 1,147 15.50 133 (66 ) (67 ) (133 )
Finance leases 1,807 3.70 50 - - - - 50 50
Fed funds purchased 126 1.06 7 - - - - 7 7
Total interest-bearing
liabilities 3,240,630 0.34 8,278 2,796,976 0.44 9,130 362 (1,214 ) (852 ) (9.33 %)
Non-interest bearing
deposits 435,279 373,817
Other liabilities 37,262 20,385
Stockholders' equity 373,238 392,580
Total liabilities and
stockholders' equity $ 4,086,409 $ 3,583,758
Net interest income, on
a tax equivalent basis $ 104,616 $ 87,142 $ 16,538 $ 936 $ 17,474 20.05 %
Net interest margin (4) 3.64 % 3.45 %
Net interest spread (5) 3.59 % 3.36 %
Notes:
(1) Yields on loans and total earning assets include the impact of State income tax credits related to incentive loans at below market rates and tax exempt loans to municipalities.
(2) Loan fees of$10.4 million are included in interest income in 2022, inclusive of$129,000 in 2022 in SBA fees related to PPP loans. Loan fees of$12.3 million are included in interest income in 2021, inclusive of$3.2 million in 2021 in SBA fees related to PPP loans.
(3) The tax equivalent adjustment has been computed using a 21% Federal tax rate.
(4) Annualized net interest income on a tax equivalent basis divided by average interest-earning assets.
(5) Average interest rate on interest-earning assets less average interest rate on interest-bearing liabilities.
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The components of our loan yield, a key driver to our net interest margin for the three and nine months endedSeptember 30, 2022 and 2021, were as follows: Three Months Ended September 30, 2022 2021 Interest Interest Income Average Yield Income Average Yield Loan yield components: Contractual interest rates 32,716 4.49 % 25,977 4.31 % Origination and other fee income 3,840 0.53 % 3,870 0.64 % PPP loan fee income 10 - % 926 0.15 % Loan tax credits 570 0.08 % 529 0.09 % Total $ 37,136 5.10 %$ 31,302 5.19 % Nine Months Ended September 30, 2022 2021 Interest Interest Income Average Yield Income Average Yield Loan yield components: Contractual interest rates 88,073 4.35 % 75,950 4.32 % Origination and other fee income 10,272 0.51 % 9,050 0.51 % PPP loan fee income 129 0.01 % 3,211 0.18 % Loan tax credits 1,710 0.08 % 1,588 0.09 % Total$ 100,184 4.95 %$ 89,799 5.10 % Net interest margin for the nine months endedSeptember 30, 2022 and 2021 was 3.64% and 3.45%, respectively, and 3.91% and 3.48% for the quarter endedSeptember 30, 2022 and 2021, respectively. The increase in net interest margin for the nine months endedSeptember 30, 2022 was due to an increase in the yield earned on our earning assets, with the exception of loans, and a decrease in rates paid on our interest-bearing liabilities. The increase in net interest margin for the three months endedSeptember 30, 2022 was due to an increase in the yield earned on our earning assets, other than loans, partially offset by an increase in rates paid on our interest bearing liabilities. TheFederal Reserve influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. Our loan portfolio is significantly affected by changes in the prime interest rate. The prime interest rate, which is the rate offered on loans to borrowers with strong credit, increased 300 basis points in the nine months endedSeptember 30, 2022 , as theFederal Reserve sought to address high levels of inflation. The direction and speed with which short-term interest rates move has an impact on our net interest income. At present, we believe theFederal Reserve plans to raise short-term rates to 4.50% as long as inflation remains elevated. OnNovember 2, 2022 the Federal Reserve Open Market Committee raised short-term interest rates by an additional 75 basis points to a target of 4.00%. If short term interest rates continue to increase and we continue to experience loan growth that outpaces our deposit growth, then our net interest income should increase during the remainder of 2022 and into 2023, though, as noted below, the rates we pay on our deposits may increase as well and such increases to the extent they outpace increases in our loan yields could cause compression to our net interest margin. Similarly, if loan growth slows as we believe is possible, increases in our rates we pay on deposits would similarly cause compression in our net interest margin. The yield on loans decreased during the three and nine months endedSeptember 30, 2022 when compared to the comparable periods in 2021 due to a decrease in loan fees related to PPP loans. Loan fees related to PPP loans for the nine months endedSeptember 30, 2022 and 2021 accounted for 1 basis point versus 18 basis points, respectively, of our loan yields. Loan fees related to PPP loans for the quarter endedSeptember 30, 2022 and 2021 accounted for no basis points versus 15 basis points, respectively, of our loan yields. The yield on securities increased due to management's decision to utilize the Company's excess liquidity to purchase additional higher yielding securities. The net interest spread was 3.59% and 3.36% for the nine months endedSeptember 30, 2022 andSeptember 30, 2021 , respectively, and 3.83% and 3.41% for the quarter endedSeptember 30, 2022 and 2021, respectively. The rates we pay on our deposits decreased in the nine months endedSeptember 30, 2022 when compared to the comparable period in 2021, as higher paying time deposits repriced at lower rates throughout 2021 and some of those deposits have yet to reprice again, though this decrease was partially offset by an increase in rates we paid on other deposits in 2022. The rate we pay on our deposits increased in the three months endedSeptember 30, 2022 when compared to the comparable period in 2021, as we increased the rates we paid on several of our deposit products as a result of competitive pressures in our markets and increases in short-term rates. We expect deposit costs to continue to increase during the remainder of 2022 and into 2023 due to those same reasons and the expected repricing of a portion of those time deposits that repriced in 2021. Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities and is the most significant component of the Company's earnings. Net interest income, excluding tax equivalent adjustments relating to tax exempt securities and loans, for the three and nine months endedSeptember 30, 2022 totaled$38,130,000 and$104,342,000 , respectively compared to$30,878,000 and$86,901,000 for the same periods in 2021, an increase of$7,252,000 and$17,441,000 between respective periods. The increase in interest income for the three and nine months endedSeptember 30, 2022 when compared to the three and nine months endedSeptember 30, 2021 was primarily attributable to an increase in interest and fees earned on loans as well as as increase in interest and dividends earned on securities. The increase in interest and fees earned on loans resulted from an overall increase in average loans, partially offset by the decreased yield discussed above. The increase in interest and dividends earned on securities resulted from an overall increase in the average balance of securities, due to management's decision to purchase additional securities to utilize excess liquidity, and an increase in rates. The ratio of average earning assets to total average assets for the three and nine months endedSeptember 30, 2022 was 95.1% and 95.5%, respectively, compared to 96.2% and 96.0% for the same periods in 2021. The increase in interest expense for the three months endedSeptember 30, 2022 as compared to the prior year's comparable period was primarily due to an increase in the rate and volume of average interest bearing deposits (other than time deposits), reflecting a rising interest rate environment and competitive pressures in our markets. The decrease in interest expense for the nine months endedSeptember 30, 2022 as compared to the prior year's comparable period was primarily due to a decrease in the rates of average time deposit renewal rates, reflecting the low rate environment that we were experiencing prior to the first quarter of 2022. The decrease in rates was partially offset by an overall increase in the volume of average interest-bearing deposits. Should our liquidity decrease, including as a result of loan growth that outpaces deposit growth and continued interest rate increases by theFederal Reserve , the rates we pay on our deposits may increase at levels that exceed those levels we experienced in the first half of 2022. In addition, if interest rates remain elevated when those time deposits that were priced in 2021 mature in 2023, our interest expense will likely increase if such deposits are renewed. 39
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Table of Contents
Provision for Credit Losses and Allowance for Credit Losses
OnJanuary 1, 2022 , we adopted FASB ASU 2016-13, which introduces the current expected credit losses (CECL) methodology and requires us to estimate all expected credit losses over the remaining life of our loan portfolio. The provision for credit losses represents a charge to earnings necessary to establish an allowance for credit losses that, in management's evaluation, is adequate to provide coverage for all expected credit losses. The provision for credit losses for the nine months endedSeptember 30, 2022 was$6,060,000 calculated under the CECL methodology, compared to$1,012,000 incurred in the first nine months of 2021 under the incurred loss methodology. The provision for credit losses for the three months endedSeptember 30, 2022 was$2,543,000 calculated under the CECL methodology, compared to$130,000 recorded in the three months endedSeptember 30, 2021 under the incurred loss methodology. The increase in provision expense for the three and nine months endedSeptember 30, 2022 from the comparable periods in 2021 is primarily attributable to an increase in the volume of loans originated during the period. Upon and subsequent to adoption of CECL, for available-for-sale debt securities in an unrealized loss position, we evaluate the securities at each measurement date to determine whether the decline in the fair value below the amortized cost basis is due to credit-related factors or noncredit-related factors. Any impairment that is not credit related is recognized in other comprehensive income, net of applicable taxes. Credit-related impairment is recognized through the allowance for credit losses on the balance sheet, limited to the amount by which the amortized cost basis exceeds the fair value, with a corresponding adjustment to earnings via provision for credit loss. AtJanuary 1, 2022 andSeptember 30, 2022 , we determined that available-for-sale securities that experienced a decline in fair value below the amortized cost basis were due to noncredit-related factors, principally the result of the rising interest rate environment we have been experiencing. Therefore, there was no provision for credit loss recognized during the three or nine months endedSeptember 30, 2022 with respect to our available-for-sale securities. The Bank's charge-off policy for collateral dependent loans is similar to its charge-off policy for all loans in that loans are charged-off in the month when a determination is made that the loan is uncollectible. The volume of net loans charged off for the first nine months of 2022 totaled approximately$548,000 compared to approximately$240,000 in net loans charged off during the first nine months of 2021. The volume of net loans charged off for the third quarter ofSeptember 30, 2022 totaled approximately$201,000 compared to approximately$133,000 in net charge offs during the third quarter of 2021. The increase in net loans charged off for the three and nine months endedSeptember 30, 2022 was primarily attributable to an increase in overdrafts. Our allowance for credit losses atSeptember 30, 2022 reflects an amount deemed appropriate to adequately cover all expected future losses as of the date the allowance is determined based on our allowance for credit losses assessment methodology. The allowance for credit losses (net of charge-offs and recoveries) was$37,580,000 atSeptember 30, 2022 , a decrease of$2,052,000 or 5.18%, from an allowance for loan losses of$39,632,000 atDecember 31, 2021 and a decrease of$1,731,000 , or 4.40%, from an allowance for loan losses of$39,311,000 atSeptember 30, 2021 . The decrease in the allowance for credit losses is the result of the implementation of CECL onJanuary 1, 2022 , which resulted in a downward adjustment to the opening balance of the allowance for credit losses of$7.6 million ; offset by increased provisioning during the nine months endedSeptember 30, 2022 largely due to an increase in loan growth. The allowance for credit losses was 1.26% of total loans outstanding atSeptember 30, 2022 , compared to an allowance for loan losses of 1.60% of total loans atDecember 31, 2021 and 1.63% atSeptember 30, 2021 . The internally classified loans as a percentage of the allowance for credit losses and allowance for loan losses, as applicable, were 15.1%, 19.4%, and 21.5% respectively, atSeptember 30, 2022 ,December 31, 2021 , andSeptember 30, 2021 . The level of the allowance and the amount of the provision for credit losses involve evaluation of uncertainties and matters of judgment. The Company maintains an allowance for credit losses which management believes is adequate to absorb losses in the loan portfolio. A formal calculation is prepared quarterly by the Company's Chief Financial Officer and provided to the Board of Directors to determine the adequacy of the allowance for credit losses. The calculation includes an evaluation of historical default and loss experience, current and forecasted economic conditions, an evaluation of qualitative factors, industry and peer bank loan quality indicators and other factors. See the discussion above under "Application of Critical Accounting Policies and Accounting Estimates" for more information. Management believes the allowance for credit losses atSeptember 30, 2022 to be adequate, but if forecasted economic conditions deteriorate beyond management's current expectations the allowance for credit losses may require an increase through additional provision for credit loss expense which would negatively impact earnings. 40
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Table of Contents Non-Interest Income Our non-interest income is composed of several components, some of which vary significantly between quarterly and annual periods. The following is a summary of our non-interest income for the three and nine months endedSeptember 30, 2022 and 2021 (in thousands): Three Months Ended September 30, Nine Months Ended September 30, $ Increase % Increase $ Increase % Increase 2022 2021
(Decrease) (Decrease) 2022 2021 (Decrease)
(Decrease)
Service charges on deposit accounts
292 17.36 %$ 5,470 $ 4,418 $ 1,052 23.81 % Brokerage income 1,919 1,586 333 21.00 5,348 4,665 683 14.64 Debit and credit card interchange income 3,259 3,012 247 8.20 9,870 8,894 976 10.97 Other fees and commissions 376 439 (63 ) (14.35 ) 1,144 1,064 80 7.52 Income on BOLI and annuity contracts 357 315 42 13.33 1,074 946 128 13.53 Gain (loss) on sale of loans (56 ) 2,275 (2,331 ) (102.46 ) 2,669 7,929 (5,260 ) (66.34 ) Mortgage servicing income 40 - 40 100.00 63 - 63 100.00 Gain (loss) on sale of securities (281 ) 28 (309 ) (1,103.57 ) (281 ) 28 (309 ) (1,103.57 ) Gain (loss) on sale of fixed assets 232 (6 ) 238 3,966.67 260 (29 ) 289
996.55
Loss on sale of other real estate - (4 ) 4 100.00 - (15 ) 15
100.00
Gain on sale of other assets - 1 (1 ) (100.00 ) 8 2 6 300.00 Other income 47 20 27 135.00 39 20 19 95.00 Total non-interest income$ 7,867 $ 9,348 $
(1,481 ) (15.84 %)$ 25,664 $ 27,922 $ (2,258 ) (8.09 %)
The decrease in non-interest income for the three and nine months
ended
The loss on sale of loans for the three months endedSeptember 30, 2022 resulted from the rise in interest rates in the mortgage market that negatively impacted the fair value of our interest rate lock commitments, loans held for sale as of the reporting date and loans that were sold during the three months endedSeptember 30, 2022 offset in part by gains in our mortgage hedging activities. The decrease in gain on sale of loans for the nine months endedSeptember 30, 2022 was due to the rising rate environment which contributed to weakened demand for purchase money mortgage loans and refinancing transactions that also negatively impacted the fair value of our the interest rate lock commitments, offset in part by mortgage hedging activities mentioned above. In addition, inflation has increased home prices which has contributed to a decrease in the volume of home purchases. The volume of mortgage loans originated for the nine months endedSeptember 30, 2022 was$94,149,000 compared to$167,429,000 for the nine months endedSeptember 30, 2021 . The mortgage industry expects volume to continue to decrease throughout the remainder of 2022. In anticipation of the slowing of mortgage origination volume due to the rising rate environment, the Company began to retain servicing rights on some of the loans it originates during the first quarter of 2022. We expect Encompass to contribute additional income through gain on sale of loans and operating fees paid to the Bank which should increase as the volume of mortgages made by Encompass increases. The loss on sale of securities was due to management's decision to sell these securities to provide additional liquidity. Management is evaluating the possibility of selling additional available-for-sale securities in the fourth quarter in an effort to restructure a portion of the securities portfolio into higher yielding securities in an effort to mitigate some of the pressure on the Company's net interest margin that would be experienced if rates continue to rise. Doing so would likely involve the sale of securities that are currently in a loss position which would trigger the Company recognizing those losses in the quarter where those securities are sold. The increase in service charges on deposit accounts for the three and nine months endedSeptember 30, 2022 primarily was due to an increase in service charges earned on overdraft fees and fees for paper statements. The increase in fees for paper statements resulted from an account conversion that placed new qualifications on certain account types.
The increase in debit and credit card interchange income for the three and
nine months ended
The increase in brokerage income for the three and nine months endedSeptember 30, 2022 was primarily due to an increase in the opening of new investment accounts during the last twelve months. In addition, the increase in interest rates has increased customers' interest in opportunities to capitalize on products and services provided.
The gain on sale of fixed assets was attributable to the sale of a lot which was originally purchased for a future branch location.
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Table of Contents Non-Interest Expense Non-interest expense consists primarily of employee costs, occupancy expenses, furniture and equipment expenses, advertising and public relations expenses, data processing expenses, ATM and interchange expenses, director's fees, audit, legal and consulting fees, and other operating expenses. The following is a summary of our non-interest expense for the three and nine months endedSeptember 30, 2022 and 2021 (in thousands): Three Months Ended September 30, Nine Months Ended September 30, $ Increase % Increase $ Increase % Increase 2022 2021 (Decrease) (Decrease) 2022 2021 (Decrease) (Decrease) Salaries and employee benefits$ 14,443 $ 13,456 $ 987 7.34 %$ 43,353 $ 40,778 $ 2,575 6.31 % Occupancy expenses, net 1,422 1,436 (14 ) (0.97 ) 4,167 4,067 100 2.46 Advertising & public relations expense 886 736 150 20.38 2,233 1,830 403
22.02
Furniture and equipment expense 838 846 (8 ) (0.95 ) 2,547 2,508 39 1.56 Data processing expense 1,908 1,509 399 26.44 5,533 4,419 1,114 25.21 ATM & interchange expense 1,363 1,218 145 11.90 3,806 3,522 284 8.06 Directors' fees 146 179 (33 ) (18.44 ) 447 463 (16 ) (3.46 ) Audit, legal & consulting expenses 217 323 (106 ) (32.82 ) 635 684 (49 ) (7.16 ) Provision expense (benefit) for credit losses on unfunded commitments (515 ) 84 (599 ) (713.10 ) (298 ) 221 (519 ) (234.84 ) Other operating expenses 3,040 2,904 136 4.68 8,789 8,673 116
1.34
Total non-interest expense$ 23,748 $ 22,691 $ 1,057 4.66 %$ 71,212 $ 67,165 $ 4,047 6.03 % The increase in non-interest expense for the three and nine months endedSeptember 30, 2022 when compared to the comparable periods in 2021 is primarily attributable to an increase in salaries and employee benefits, an increase in data processing expense, an increase in advertising expense, and an increase in ATM & interchange expense for the nine months endedSeptember 30, 2022 , partially offset by a decrease in provision for credit losses on unfunded commitments. Salaries and employee benefits increased for the three and nine months endedSeptember 30, 2022 primarily due to an increase in the number of employees necessary to support the Company's growth in operations and branch count as well as an increase in incentives and temporary salaries, offset by a decrease in commission salaries. The increase in occupancy expense for the nine months endedSeptember 30, 2022 is primarily attributable to an increase in lease expense due to an increase in leased branches, an increase in depreciation expense resulting from the opening of a new branch, and an increase in utilities due to an increase in cost of energy, offset by a decrease in building maintenance and repairs due to the elimination of COVID-19 related cleaning expenses as well as parking lot repairs that occurred in 2021. The Company anticipates that salaries and employee benefits expense and occupancy expense will continue to increase as the Company's operations and facilities continue to grow and competition to retain and attract associates is becoming more intense. Data processing expense increased for the three and nine months endedSeptember 30, 2022 primarily due to an increase in computer maintenance, computer license expense, and call center expense. The computer maintenance and license expenses included movement of in-house systems to cloud servers, additional investments in digital banking solutions, and an increase in information security expenses. The increase in call center expense resulted from an increase in call volume due to the call center extending their operating hours. The Company anticipates that data processing expenses will continue to increase as the Company's operations grow and the focus by the Company on the acceleration of digital product offerings increases. Advertising and public relations expense increased for the three and nine months endedSeptember 30, 2022 partially due to the opening of a new branch which included targeted marketing efforts to drive traffic and awareness for the new location, as well as additional targeted marketing efforts to help increase market share in our growth areas. We also saw an increase in expenses related to the return of in-person events, both bank hosted and those hosted by our community partners, as COVID-19 restrictions continued to loosen. The Company was also the sole sponsor for aHabitat for Humanity home build.
ATM and interchange expense increased for the three and nine months ended
Provision for credit losses on unfunded commitments decreased for the three and
nine months ended
The efficiency ratio is a common and comparable KPI used in the banking industry. The Company uses this metric to monitor how effective management is at using our internal resources. It is calculated by dividing our non-interest expense by our net interest income plus non-interest income. Our efficiency ratio for the three months endedSeptember 30, 2022 and 2021 was 51.63% and 56.41%, respectively. Our efficiency ratio for the nine months endedSeptember 30, 2022 and 2021 was 54.78% and 58.49%, respectively. The improvement in the efficiency ratio for the three and nine months endedSeptember 30, 2022 was due to increased levels of interest income, partially offset by a decrease in the gain on sale of loans due to the rising rate environment. Income Taxes The Company's income tax expense was$12,037,000 for the nine months endedSeptember 30, 2022 , an increase of$1,016,000 over the comparable period in 2021. Income tax expense was$4,523,000 for the quarter endedSeptember 30, 2022 , an increase of$460,000 over the same period in 2021. The percentage of income tax expense to net income before taxes was 22.83% and 23.63% for the nine months endedSeptember 30, 2022 and 2021, respectively, and 22.95% and 23.34% for the quarters endedSeptember 30, 2022 and 2021, respectively. Our effective tax rate represents our blended federal and state rate of 26.14% affected by the impact of anticipated favorable permanent differences between our book and taxable income such as bank-owned life insurance, income earned on tax-exempt securities and loans, and certain federal and state tax credits. 42
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Table of Contents Financial Condition Balance Sheet Summary The Company's total assets increased$140,790,000 , or 3.53%, to$4,130,386,000 atSeptember 30, 2022 from$3,989,596,000 atDecember 31, 2021 . Total assets increased$19,245,000 , or 0.47%, atSeptember 30, 2022 fromJune 30, 2022 . Loans, net of allowance for credit losses, totaled$2,953,745,000 atSeptember 30, 2022 , a 20.84% increase compared to$2,444,282,000 atDecember 31, 2021 , and a 7.92% increase compared to$2,737,002,000 atJune 30, 2022 . In 2021, management targeted owner-occupied commercial real estate, residential real estate lending and consumer lending as areas of focus on growing our loan portfolio. In 2022, management is targeting owner-occupied commercial real estate, residential real estate lending and small business lending as areas of focus. The following details the loans of the Company atSeptember 30, 2022 andDecember 31, 2021 : September 30, 2022 December 31, 2021 Balance $ Balance % Increase Increase Balance % of Portfolio Balance % of Portfolio (Decrease) (Decrease) Residential 1-4 family real estate$ 812,433 27.03 %$ 689,579 27.63 %$ 122,854 17.82 % Commercial and multi-family real estate 993,647 33.07 908,673 36.41 84,974 9.35 Construction, land development and farmland 853,326 28.39 612,659 24.55 240,667 39.28 Commercial, industrial and agricultural 124,115 4.13 118,155 4.73 5,960 5.04 1-4 family equity lines of credit 142,043 4.73 92,229 3.69 49,814 54.01 Consumer and other 79,720 2.65 74,643 2.99 5,077 6.80 Total loans before net deferred loan fees$ 3,005,284 100.00 %$ 2,495,938 100.00 %$ 509,346 20.41 % Overall, the Bank's loan demand and related new loan production has continued to be strong, though loan demand weakened in the third quarter of 2022 when compared to the second quarter of 2022. The net loan growth of 20.84% fromDecember 31, 2021 , reflects the strong production, partially offset by several large loan payoffs. The demand is supported by the continued population growth and corporate relocations in the Bank's primary market areas, the opening of new branches, and increased marketing efforts. The increase in residential 1-4 family real estate loans is attributable to the Bank being able to grow its residential portfolio through marketing efforts directed at those building houses, and the developing investor sector of 1-4 family. The increase in construction, land development and farmland loans, commercial and multi-family real estate, and 1-4 family equity lines of credit is primarily attributable to the addition of several large loan relationships. Although the Company has continued to grow loans in 2022, the Company expects to experience a decline in demand for loans as interest rates continue to rise and the economy worsens, including as a result of persistent high inflation. Because construction loans remain a meaningful portion of our portfolio, the Bank has implemented an additional layer of monitoring as it seeks to avoid advancing funds that exceed the present value of the collateral securing the loan. The responsibility for monitoring percentage of completion and distribution of funds tied to these completion percentages is now monitored and administered by aCredit Administration Department independent of the lending function. The Bank continues to seek to diversify its real estate portfolio as it seeks to lessen concentrations in any one type of loan.
For a detailed discussion regarding our allowance for credit losses, see "Provision for Credit Losses and Allowance for Credit Losses" above.
Securities decreased$58,433,000 , or 6.51%, to$839,152,000 atSeptember 30, 2022 from$897,585,000 atDecember 31, 2021 , and decreased$76,955,000 , or 8.40%, fromJune 30, 2022 primarily due to an increase in interest rates that caused the fair market value of our securities portfolio to decline, partially offset by the purchase of new securities. The average yield, excluding tax equivalent adjustment, of the securities portfolio atSeptember 30, 2022 was 1.99% with a weighted average life of 8.17 years, as compared to an average yield of 1.59% and a weighted average life of 8.17 years atDecember 31, 2021 . The weighted average lives on mortgage-backed securities reflect the repayment rate used for book value calculations. Premises and equipment decreased$2,772,000, or 4.41%, fromDecember 31, 2021 toSeptember 30, 2022 . The primary reason for the decrease was due to current year depreciation of$3,346,000 and the sale of a property which was originally purchased for a new branch location. This was partially offset by an increase in leasehold improvements and an increase in furniture, fixtures and equipment from the opening of a new branch, the remodel of five branches, as well as an increase in equipment that was primarily attributable to the purchase of new debit card printers for several branches and security cameras, an increase in computer hardware and software, and the purchase of a company vehicle. The increase in deposits in the first nine months of 2022, which is described below, was outpaced by loan growth during the period, causing interest bearing deposits with other financial institutions to decrease. Interest bearing deposits with other financial institutions decreased to$78,713,000 atSeptember 30, 2022 from$400,940,000 atDecember 31, 2021 . Total liabilities increased by 5.93% to$3,787,823,000 atSeptember 30, 2022 compared to$3,575,879,000 atDecember 31, 2021 . Total liabilities increased$40,131,000 , or 1.07%, atSeptember 30, 2022 from the quarter endedJune 30, 2022 . The increase in total liabilities sinceDecember 31, 2021 was composed of a$190,585,000 , or 5.36% increase in total deposits and a$21,359,000 , or 102.65%, increase in accrued interest and other liabilities. The increase in total deposits sinceDecember 31, 2021 was primarily attributable to growth in market share which resulted in the opening of new deposit accounts. The increase in accrued interest and other liabilities sinceDecember 31, 2021 was attributable to an increase in reserve for unfunded commitments due to the adoption of CECL onJanuary 1, 2022 , which resulted in an adjustment to the opening balance of the reserve for unfunded commitments of$6,195,000 . This increase was also attributable to an increase in escrow payable, an increase in finance lease payable due to the opening of a branch inJanuary 2022 , and an increase in employee bonus payable, partially offset by a decrease in reserve for income taxes. We expect to see a slight downward trend in deposit balances as inflation has caused consumers to spend more money and as consumers seek to move deposits from liquid funds to other higher earning investments. 43
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Table of Contents Non-Performing Assets Non-performing loans, which included nonaccrual loans and loans 90 days past due, atSeptember 30, 2022 totaled$541,000 , an increase from$389,000 atDecember 31, 2021 . The increase in non-performing loans during the nine months endedSeptember 30, 2022 of$152,000 is due primarily to the addition of three residential 1-4 family real estate loan relationships, one 1-4 family equity line of credit relationship, and one consumer loan relationship that were not 90 days past due atDecember 31, 2021 , partially offset by three residential 1-4 family real estate loan relationships that are no longer 90 days past due. Management believes that it is probable that it will incur losses on its non-performing loans but believes that these losses should not exceed the amount in the allowance for credit losses already allocated to these loans, unless there is unanticipated deterioration of local real estate values. The net non-performing asset ratio (NPA) is used as a measure of the overall quality of the Company's assets. Our NPA ratio is calculated by taking the total of our loans greater than 90 days past due and accruing interest, nonaccrual loans, non-performing TDRs and other real estate owned and dividing that sum by our total assets outstanding. Our NPA ratio for the periods endedSeptember 30, 2022 andDecember 31, 2021 was 0.02% and 0.01%, respectively. Other loans may be classified as collateral dependent when the current net worth and financial capacity of the borrower or of the collateral pledged, if any, is viewed as inadequate and it is probable that the Company will be unable to collect the scheduled payments of principal and interest due under the contractual terms of the loan agreement. Such loans generally have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt, and if such deficiencies are not corrected, there is a probability that the Company will sustain some loss. In such cases, interest income continues to accrue as long as the loan does not meet the Company's criteria for nonaccrual status. Collateral dependent loans are measured at the fair value of the collateral less estimated selling costs. If the measure of the collateral dependent loan is less than the recorded investment in the loan, the Company shall recognize impairment by creating a valuation allowance with a corresponding charge to the provision for credit losses or by adjusting an existing valuation allowance for the collateral dependent loan with a corresponding charge or credit to the provision for credit losses. AtSeptember 30, 2022 the Company had a recorded investment in collateral dependent loans totaling$643,000 , down from a recorded investment in impaired loans totaling$668,000 atDecember 31, 2021 . The decrease during the nine months endedSeptember 30, 2022 as compared toDecember 31, 2021 is primarily due to the paydown of three collateral dependent relationships. The allowance for credit losses related to collateral dependent loans was measured based upon the estimated fair value of related collateral. Loans are charged-off in the month when the determination is made that the loan is uncollectible. Net charge-offs for the nine months endedSeptember 30, 2022 were$548,000 as compared to$240,000 in net charge-offs for the same period in 2021. The increase in net charge-offs during the nine months endedSeptember 30, 2022 as compared to the same time period in 2021 was primarily attributable to an increase in net charge-offs for overdraft accounts. Overall, the Bank has experienced minimal charge-offs during 2022. It is expected that charge-offs will be modest for the remainder of 2022; however, a deterioration in local economic conditions may negatively impact charge-offs in the future. AtSeptember 30, 2022 , our internally classified loans decreased$2,012,000 , or 26.18%, to$5,674,000 from$7,686,000 atDecember 31, 2021 primarily due to the payoff of three internally classified loan relationships. Classified loan balances have remained relatively consistent due to the stable markets in which we operate; however, if short-term rates continue to rise and economic conditions worsen, our classified loan balances could increase. Loans are listed as classified when information obtained about possible credit problems of the borrower has prompted management to question the ability of the borrower to comply with the repayment terms of the loan agreement. 44
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Table of Contents
Liquidity and Asset Management
The Company's management seeks to maximize net interest income by managing the Company's assets and liabilities within appropriate constraints on capital, liquidity and interest rate risk. Liquidity is the ability to maintain sufficient cash levels necessary to fund operations, meet the requirements of depositors and borrowers, and fund attractive investment opportunities. Higher levels of liquidity, like those we built up in response to the COVID-19 pandemic, bear corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets and higher interest expense involved in extending liability maturities. Liquid assets include cash, due from banks, interest bearing deposits in other financial institutions and unpledged investment securities that will mature within one year. The Company's primary source of liquidity is a stable core deposit base. In addition, Federal funds purchased, FHLB advances, and brokered deposits provide a secondary source. These sources of liquidity are generally short-term in nature and are used to fund asset growth and meet other short-term liquidity needs. Liquidity needs can also be met from loan payments and investment security sales or maturities. AtSeptember 30, 2022 , the Company's liquid assets totaled$582.5 million down from$985.9 million atDecember 31, 2021 , though a portion of these liquid assets include available-for-sale securities that are in an unrealized loss position. If the Company was required to sell any of these securities while they are in an unrealized loss position the Company would be required to recognize the loss on those securities through the income statement when they are sold. Additionally, as ofSeptember 30, 2022 , the Company had available approximately$123.8 million in unused federal funds lines of credit with regional banks and, subject to certain restrictions and collateral requirements, approximately$482.4 million of borrowing capacity with theFederal Home Loan Bank of Cincinnati to meet short term funding needs. The Company maintains a formal asset and liability management process to quantify, monitor and control interest rate risk and to assist management as management seeks to maintain stability in net interest margin under varying interest rate environments. The Company accomplishes this process through the development and implementation of lending, funding and pricing strategies designed to maximize net interest income under varying interest rate environments subject to specific liquidity and interest rate risk guidelines and competitive market conditions. Analysis of rate sensitivity and rate gap analysis are the primary tools used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Included in the analysis are cash flows and maturities of financial instruments held for purposes other than trading, changes in market conditions, loan volumes and pricing and deposit volume and mix. These assumptions are inherently uncertain, and, as a result, net interest income cannot be precisely estimated nor can the impact of higher or lower interest rates on net interest income be precisely predicted. Actual results will differ due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management's strategies, among other factors. The Company also uses simulation modeling to evaluate both the level of interest rate sensitivity as well as potential balance sheet strategies. The Company's Asset Liability Committee meets quarterly to analyze the interest rate shock simulation. The interest rate shock simulation model is based on a number of assumptions. These assumptions include, but are not limited to, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment and replacement of asset and liability cash flows and balance sheet management strategies. We model instantaneous change in interest rates using a growth in the balance sheet as well as a flat balance sheet to understand the impact to earnings and capital. Based on the Company's IRR simulation, the Company had a neutral interest-rate risk position as ofSeptember 30, 2022 . The Company's net interest margin and earnings could be negatively impacted if short-term rates continue to rise and competitive pressures in the Company's market areas force the Company to increase deposit rates faster than it is able to increase yields on loans. As discussed elsewhere herein, the Bank anticipates that its net interest margin is likely to contract during the remainder of 2022 because of the Company's current balance sheet position and the rising rate environment we are currently experiencing and expect to continue in the near term. The Company also uses Economic Value of Equity ("EVE") sensitivity analysis to understand the impact of changes in interest rates on long-term cash flows, income and capital. EVE is calculated by discounting the cash flows for all balance sheet instruments under different interest rate scenarios. The EVE is a longer term view of interest rate risk because it measures the present value of the future cash flows. Presented below is the estimated impact on the Bank's net interest income and EVE as ofSeptember 30, 2022 , assuming an immediate shift in interest rates: % Change from Base Case for
Immediate Parallel Changes in Rates
-300 BP -200 BP -100 BP +100 BP +200 BP +300 BP
Net interest income (9.91 )% (5.73 )% (2.33 )% (1.17 )% (2.50 )% (4.03 )%
EVE (18.20 )% (8.18 )% (2.31 )% (0.97 )% (2.66 )% (4.83 )%
While an instantaneous and severe shift in interest rates was used in this
analysis to provide an estimate of exposure under these scenarios, we believe
that a gradual shift in interest rates would have a more modest impact. Further,
the earnings simulation model does not take into account factors such as future
balance sheet growth, changes in product mix, changes in yield curve
relationships, and changing product spreads that could mitigate any potential
adverse impact of changes in interest rates. Moreover, since EVE measures the
discounted present value of cash flows over the estimated lives of instruments,
the change in EVE does not directly correlate to the degree that earnings would
be impacted over a shorter time horizon (i.e., the current year). Further, EVE
does not take into account factors such as future balance sheet growth, changes
in product mix, changes in yield curve relationships, hedging strategies that we
may institute, and changing product spreads that could mitigate any potential
adverse impact of changes in interest rates.
Interest rate risk (sensitivity) management focuses on the earnings risk associated with changing interest rates. Management seeks to maintain profitability in both immediate and long-term earnings through funds management/interest rate risk management. The Company's rate sensitivity position has an important impact on earnings. Senior management of the Company analyzes the rate sensitivity position quarterly. Management focuses on the spread between the Company's cost of funds and interest yields generated primarily through loans and investments.
The Company's securities portfolio consists of earning assets that provide interest income. Securities classified as available-for-sale include securities intended to be used as part of the Company's asset/liability strategy and/or securities that may be sold in response to changes in interest rate, prepayment risk, or the need to fund loan demand. AtSeptember 30, 2022 , securities totaling appro ximately$34,609,000 mature or will be subject to rate adjustments within the next twelve months. A secondary source of liquidity is the Company's loan portfolio. AtSeptember 30, 2022 , loans totaling appr oximately$943,397,000 either will become du e or will be subject to rate adjustments within twelve months from that date. As for liabilities, atSeptember 30, 2022 , certificates of deposit of$250,000 or greater totaling approxi mately$100,644,000 will beco me due or reprice during the next twelve months. Historically, there has been no significant reduction in immediately withdrawable accounts such as negotiable order of withdrawal accounts, money market demand accounts, demand deposit accounts and regular savings accounts. Management anticipates that there will be no significant withdrawals from these accounts in the future. Management believes that with present maturities, borrowing capacity with theFederal Home Loan Bank of Cincinnati and the efforts of management in its asset/liability management program, liquidity will not pose a problem in the near term future. 45
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Off Balance Sheet Arrangements
AtSeptember 30, 2022 , we had unfunded loan commitments outstanding of$1,274,381,000 and outstanding standby letters of credit of$79,404,000 . Because these commitments generally have fixed expiration dates and many will expire without being drawn upon, the total commitment level does not necessarily represent future cash requirements. If needed to fund these outstanding commitments, the Bank has the ability to liquidate federal funds sold or securities available-for-sale or on a short-term basis to borrow and purchase federal funds from other financial institutions. Additionally, the Bank could sell participations in these or other loans to correspondent banks. As mentioned above, the Bank has been able to fund its ongoing liquidity needs through its stable core deposit base, loan payments, investment security maturities and short-term borrowings.
Capital Position and Dividends
AtSeptember 30, 2022 , total stockholders' equity was$342,563,000 , or 8.29% of total assets, which compares with$413,717,000 , or 10.37% of total assets, atDecember 31, 2021 . The dollar decrease in stockholders' equity during the nine months endedSeptember 30, 2022 is the result of the net effect of a$108,888,000 unrealized loss on investment securities (described elsewhere in this report) net of applicable income tax benefit of$38,525,000 , cash dividends declared of$20,878,000 , net of$16,117,000 reinvested under the Company's dividend reinvestment plan,$586,000 related to stock option compensation,$1,011,000 related to the cumulative effect of change in accounting principle for the adoption of CECL, the Company's net income of$40,702,000 and proceeds from the issuance of common stock related to exercise of stock options of$164,000 . Also included was$5,000 of net loss related to minority interest and$37,000 in non-controlling contributions related to Encompass. 46
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