Bank First Corp (BFC) FY 2023 MD&A

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

The following discussion and analysis of our consolidated financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes. Historical results of operations and the percentage relationships among any amounts included, and any trends that may appear, may not indicate trends in operations or results of operations for any future periods. We are a bank holding company and we conduct all of our material business operations through the Bank. As a result, the discussion and analysis above relates to activities primarily conducted at the Bank level.

We have made, and will continue to make, various forward-looking statements with respect to financial and business matters. Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forward-looking statements. For additional information regarding our cautionary disclosures, see the  “Cautionary Note Regarding Forward-Looking Statements” at the beginning of this Annual Report.

OVERVIEW

Bank First Corporation is a Wisconsin corporation that was organized primarily to serve as the holding company for Bank First, N.A. Bank First, N.A., which was incorporated in 1894, is a nationally-chartered bank headquartered in Manitowoc, Wisconsin. It is a member of the Federal Reserve, and is regulated by the OCC. Including its headquarters in Manitowoc, Wisconsin, the Bank has 26 banking locations in Brown, Columbia, Dane, Fond du Lac, Jefferson, Manitowoc, Monroe, Outagamie, Ozaukee, Shawano, Sheboygan, Waupaca, Waushara, and Winnebago counties in Wisconsin. The Bank offers loan, deposit and treasury management products at each of its banking locations.

As with most community banks, the Bank derives a significant portion of its income from interest received on loans and investments. The Bank’s primary source of funding is deposits, both interest-bearing and noninterest-bearing. In order to maximize the Bank’s net interest income, or the difference between the income on interest-earning assets and the expense of interest-bearing liabilities, the Bank must not only manage the volume of these balance sheet items, but also the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities. To account for credit risk inherent in all loans, the Bank maintains an allowance for credit losses (“ACL – Loans”) to absorb possible losses on existing loans that may become uncollectible. The Bank establishes and maintains this allowance by charging a provision for credit losses against operating earnings. Beyond its net interest income, the Bank further receives income through the net gain on sale of loans held for sale as well as servicing income which is retained on those sold loans. In order to maintain its operations and bank locations, the Bank incurs various operating expenses which are further described within the “Results of Operations” later in this section.

The Bank, through its 100% owned subsidiary TVG Holdings, Inc., holds a 40% ownership interest in Ansay & Associates, LLC, an insurance agency providing clients primarily located in Wisconsin with insurance and risk management solutions. The Bank owned 49.8% of UFS, LLC, which provides data processing solutions to over 60 banks in the Midwest, through October 1, 2023. On that date it sold 100% of its member interest in UFS to a third party. These unconsolidated subsidiary interests contribute noninterest income to the Bank through their underlying annual earnings.

As of December 31, 2023, the Company had total consolidated assets of $4.22 billion, total loans of $3.34 billion, total deposits of $3.43 billion and total stockholders’ equity of $619.8 million. The Company employs approximately 379 full-time equivalent employees and has an assets-to-FTE ratio of approximately $11.1 million. For more information, see the Company’s website at www.bankfirst.com.

Recent acquisitions

Hometown Bancorp, Ltd.

On February 10, 2023, the Company completed a merger with Hometown Bancorp, Ltd. ("Hometown"), a bank holding company headquartered in Fond du Lac, Wisconsin, pursuant to the merger agreement, dated as of July 25, 2022, by and between the Company and Hometown, whereby Hometown merged with and into the Company, and Hometown Bank,

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Hometown's wholly-owned banking subsidiary, merged with and into the Bank. Hometown's principal activity was the ownership and operation of Hometown Bank, a state-chartered banking institution that operated ten (10) branches in Wisconsin at the time of closing. The merger consideration totaled approximately $130.5 million.

Pursuant to the terms of the merger agreement, Hometown shareholders could elect to receive either 0.3962 of a share of the Company’s common stock or $29.16 in cash for each outstanding share of Hometown common stock, subject to a maximum of 30% cash consideration in total, with cash paid in lieu of any remaining fractional share. Company stock issued totaled 1,450,272 shares valued at approximately $115.1 million, with cash of $15.4 million comprising the remainder of merger consideration.

Denmark Bancshares, Inc.

On August 12, 2022, the Company completed a merger with Denmark Bancshares, Inc. (“Denmark”), a bank holding company headquartered in Denmark, Wisconsin, pursuant to the merger agreement, dated as of January 18, 2022 by and between the Company and Denmark, whereby Denmark merged with and into the Company, and Denmark State Bank, Denmark’s wholly-owned banking subsidiary, merged with and into the Bank. Denmark’s principal activity was the ownership and operation of Denmark State Bank, a state-chartered banking institution that operated seven (7) branches in Wisconsin at the time of closing. The merger consideration totaled approximately $128.8 million.

Pursuant to the terms of the merger agreement, Denmark shareholders could elect to receive either 0.5276 of a share of the Company’s common stock or $38.10 in cash for each outstanding share of Denmark common stock, subject to a maximum of 20% cash consideration in total, with cash paid in lieu of any remaining fractional share. Company stock issued totaled 1,579,530 shares valued at approximately $124.8 million, with cash of $4.0 million comprising the remainder of merger consideration.

The Company accounts for these transactions under the acquisition method of accounting, and thus, the financial position and results of operations of acquired institutions prior to the consummation date are not included in the accompanying consolidated financial statements. The acquisition method of accounting required assets purchased and liabilities assumed to be recorded at their respective fair values at the date of acquisition. The Company determines the fair value of core deposit intangibles, securities, premises and equipment, loans, other assets and liabilities, deposits and borrowings with the assistance of third-party valuations, appraisals, and third-party advisors. The estimated fair values are subject to refinement for up to one year after the consummation as additional information becomes available relative to the closing date fair values.

CRITICAL ACCOUNTING POLICIES AND ACCOUNTING ESTIMATES

The accounting and reporting policies of the Company conform to GAAP in the United States and general practices within the financial institution industry. To prepare financial statements in conformity with GAAP, management makes estimates, assumptions and judgments based on available information. These estimates, assumptions and judgments are based on information available as of the date of the financial statements and, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statement. In particular, management has identified several accounting policies that, due to the estimates, assumptions and judgments inherent in those policies, are critical in understanding our financial statements.

The following is a discussion of the critical accounting policies and significant estimates that require us to make complex and subjective judgments. Additional information about these policies can be found in Note 1 of our consolidated financial statements as of December 31, 2023, included elsewhere in this Annual Report on Form 10-K.

Business Combinations, Core Deposit Intangible and Acquired Loans. We account for business combinations under the acquisition method of accounting in accordance with Accounting Standards Codification (ASC) 805, Business Combinations (ASC 805). We recognize the full fair value of the assets acquired and liabilities assumed and immediately expense transaction costs. Fair values are subject to refinement for up to one year after the closing date of an acquisition as information relative to closing date fair values becomes available. Results of operations of the acquired business are included in the statement of income from the effective date of the acquisition.

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The primary identifiable intangible asset we typically record in connection with a whole bank or branch acquisition is the value of the core deposit intangible which represents the estimated value of the long-term deposit relationships acquired in the transaction. Determining the amount of identifiable intangible assets and their average lives involves multiple assumptions and estimates and is typically determined by performing a discounted cash flow analysis, which involves a combination of any or all of the following assumptions: customer attrition/runoff, alternative funding costs, deposit servicing costs, and discount rates.

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Further, the valuation of acquired loans involves significant estimates and assumptions based on information available as of the acquisition date. Loans acquired in a business combination are evaluated either individually or in pools of loans with similar characteristics; including consideration of a credit component. A number of factors are considered in determining the estimated fair value of purchased loans including, among other things, the remaining life of the acquired loans, estimated prepayments, estimated loss ratios, estimated value of the underlying collateral, estimated holding periods, contractual interest rates compared to market interest rates, and net present value of cash flows expected to be received.

Allowance for Credit Losses — Loans. The ACL – Loans represents management’s estimate of expected credit losses in the Company’s loan portfolio at the balance sheet date. The Company estimates the ACL – Loans based on the amortized cost basis of the underlying loan using a current expected credit loss methodology (“CECL”). To estimate the amount of ACL-Loans, the Company considers historical loss rates and other qualitative adjustments, as well as a forward-looking component that considers reasonable and supportable forecasts over the expected life of each loan. The Company’s ACL - Loans is calculated using collectively evaluated and individually evaluated loans.  This evaluation is inherently subjective as it requires material estimates that are susceptible to significant change including the amounts and timing of future cash flows expected to be received on loans.

Deferred Tax Assets. Deferred tax assets (“DTA”) and liabilities are determined using the liability method. DTAs and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities and the current enacted tax rates which will be in effect when these differences are expected to reverse. Provision (benefit) for deferred taxes is the result of changes in the DTAs and liabilities. Deferred taxes are reviewed quarterly and are reduced by a valuation allowance if, based upon the information available, it is more likely than not that some or all of the DTAs will not be realized.

Recent Accounting Pronouncements. For a discussion of recent accounting pronouncements, see “Note 1 – Summary of Significant Accounting Policies" of the Notes to the Consolidated Financial Statements in Item 8 of this report on Form 10-K for further discussion.

RESULTS OF OPERATIONS

The following discussion and analysis presents the more significant factors that affected our financial condition as of December 31, 2023 and 2022 and results of operations for each of the years then ended. Refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K filed with the SEC on March 10, 2023 for a discussion and analysis of the more significant factors that affected periods prior to 2022.

General.  Net income increased $29.3 million, or 64.8%, to $74.5 million for the year ended December 31, 2023, from $45.2 million for the year ended December 31, 2022. During 2023, as a result of the acquisition of Hometown during February 2023 and the impact of the acquisition of Denmark impacting the full year of 2023 compared to less than five months of 2022, the Company experienced increased net interest income, a higher provision for credit losses, an increase in service charge and loan servicing income, and a significant increase in many noninterest expense areas. Also during 2023 the Company sold 100% of its member interest in UFS, LLC, creating a pre-tax gain on sale of $38.9 million. Finally, the Company sold its available for sale US Treasury securities during 2023, creating a pre-tax loss on sale of $7.9 million.

Net Interest Income.  The management of interest income and expense is fundamental to our financial performance. Net interest income, the difference between interest income and interest expense, is the largest component of the Company’s total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets). We seek to maximize net interest income without exposing the Company to an

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excessive level of interest rate risk through our asset and liability policies. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest-bearing assets and liabilities. Our net interest margin can also be adversely impacted by the reversal of interest on nonaccrual loans and the reinvestment of loan payoffs into lower yielding investment securities and other short-term investments.

Net interest income after provision for credit losses increased by $26.9 million to $128.8 million for the year ended December 31, 2023, from $101.9 million for the year ended December 31, 2022. Interest income on loans increased by $61.9 million, or 57.8%, from 2022 to 2023. Total average interest-earning assets increased to $3.66 billion for the year ended December 31, 2023 from $3.09 billion for the year ended December 31, 2022. The Bank’s net interest margin increased twenty-eight basis points to 3.69% for the year ended December 31, 2023, up from 3.41% for the year ended December 31, 2022.

Interest Income.  Total interest income increased $65.9 million, or 56.6%, to $182.5 million for the year ended December 31, 2023, up from $116.5 million for the year ended December 31, 2022. This increase was driven by an increase in average rates earned on interest-earning assets, rising from 3.82% during 2022 to 5.03% during 2023, and a $565.4 million increase in average interest-earning assets during 2023 when compared to 2022. Most of the growth in average interest-earning assets was the result of the acquisitions of Denmark and Hometown.

Interest Expense.  Interest expense increased $36.6 million, or 293.6%, to $49.0 million for the year ended December 31, 2023, up from $12.4 million for the year ended December 31, 2022. The increase was driven by a combination of increases in the average rates paid on interest-bearing liabilities, rising from 0.60% during 2022 to 2.04% during 2023, and a $311.0 million increase in average interest-bearing liabilities. Once again, most of the growth in average interest-bearing liabilities was the result of the acquisitions of Denmark and Hometown.

Interest expense on interest-bearing deposits increased by $32.1 million to $42.4 million for the year ended December 31, 2023, from $10.3 million for the year ended December 31, 2022. This increase was due to a higher interest rate environment driving an increase in average rates paid on interest-bearing deposits, rising from 0.54% during 2022 to 1.84% during 2023, and growth of $398.9 million year-over-year  in average interest-bearing deposits.

Provision for Credit Losses.  Credit risk is inherent in the business of making loans. We establish an allowance for credit losses through charges to earnings, which are shown in the statements of income as the provision for credit losses. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for credit losses is determined by conducting a quarterly evaluation of the adequacy of our allowance for credit losses and charging the shortfall or excess, if any, to the current quarter’s expense. This has the effect of creating variability in the amount and frequency of charges to earnings. The provision for credit losses and level of allowance for each period are dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in our market area. The determination of the amount is complex and involves a high degree of judgment and subjectivity.

We recorded a provision for credit losses of $4.7 million for the year ended December 31, 2023, compared to $2.2 million for the year ended December 31, 2022. The increased provision for credit losses during 2023 was primarily result of ASU 2016-13, which was adopted at the beginning of 2023, requiring a provision to be recorded related to loans acquired from Hometown. Metrics regarding the credit quality of the Bank’s loan portfolio continue to show very little in terms of credit stress during 2023. The ACL-Loans was $43.6 million, or 1.30% of total loans, at December 31, 2023 compared to $22.7 million, or 0.78% of total loans at December 31, 2022. The increased ACL - Loans coverage was also the result of adopting ASU 2016-13 as of January 1, 2023.

Noninterest Income.  Noninterest income is an important component of our total revenues. A significant portion of our noninterest income has historically been associated with service charges and income from the Bank’s unconsolidated subsidiaries, Ansay and UFS. Other typical sources of noninterest income include loan servicing fees and gains on sales of mortgage loans.

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Noninterest income increased by $38.4 million, or 195.0% to $58.1 million for 2023, up from $19.7 million during 2022. The primary driver of the increase in noninterest income was the aforementioned $38.9 million pre-tax gain on sale of UFS during 2023. This sale also led to a decrease in the income provided by UFS during 2023 as this revenue stream no longer existed during the final quarter. The continued slowdown in the retail mortgage lending market during 2023 led to a $0.7 million decline in gains on sales of mortgage loans to the secondary market year-over-year. While this slowdown continued from 2022, the positive impact it had on the valuation of the Company’s mortgage servicing rights (“MSR”) was less significant during 2023, leading to only $0.4 million in positive valuation adjustments to MSRs in 2023 compared to $2.9 million in 2022. Finally, income from service charges and loan servicing saw a significant increase year-over-year as a result of added scale from the acquisitions of Denmark and Hometown. The major components of our noninterest income are listed in the table below:

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Noninterest Expense.  Noninterest expense increased $26.2 million to $88.1 million for the year ended December 31, 2023, up from $62.0 million for the year ended December 31, 2022. One driver of this increase in noninterest expense was the aforementioned sale of a significant number of available for sale securities during 2023, resulting in a $7.9 million pre-tax loss during 2023. These securities had an average yield of 1.36%. Proceeds of these sales were reinvested in a combination of short and long-term investments with an average yield of 4.98%. Personnel expense increased $7.2 million, or 21.7%,  data processing expense increased $1.7 million, or 26.7%, postage, stationary and supplies expense increased $0.3 million, or 40.6%, charitable contributions expense increased by $0.2 million, or 31.5%, advertising expense increased $0.1 million, or 19.9%, and other noninterest expense increased $2.7 million, or 42.1%, all primarily as a result of the added scale from the Denmark and Hometown acquisitions. Outside service fees decreased $0.4 million, or 5.6%, primarily as a result of nearly all legal and professional fees related to the Denmark acquisition and many of these same fees related to the Hometown acquisition occurring during 2022. Amortization of intangibles increased by $4.0 million, or 172.8%, as the acquisitions of Denmark and Hometown created core deposit intangibles of $15.1 million and $16.5 million, respectively, which began amortizing on the date those transactions closed. These acquisitions also resulted in several former bank branches of those institutions becoming other real estate owned, leading to the significant losses on sales and valuations of these buildings during 2023.The major components of our noninterest expense are listed in the table below:

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Income Tax Expense.  We recorded a provision for income taxes of $24.3 million for the year ended December 31, 2023, compared to $14.4 million for the year ended December 31, 2022, reflecting effective tax rates of 24.6% and  24.2%, respectively. The income tax expense related to the gain on sale of UFS offset the impact of legislation passed as part of the 2023 Wisconsin state budget which exempts interest and fees earned on certain commercial loans of $5 million or less made to borrowers who reside or are located in the state of Wisconsin. The expected future reduction in the Bank’s effective tax rate as a result of this legislation resulted in a valuation allowance on our deferred tax assets totaling $2.5 million, adding to income tax expense for 2023.

NET INTEREST MARGIN

Net interest income represents the difference between interest earned, primarily on loans and investments, and interest paid on funding sources, primarily deposits and borrowings. Interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate paid on total interest-bearing liabilities. Net interest margin is the amount of net interest income, on a fully taxable-equivalent basis, expressed as a percentage of average interest-earning assets. The average rate earned on earning assets is the amount of annualized taxable equivalent interest income expressed as a percentage of average earning assets. The average rate paid on interest-bearing liabilities is equal to annualized interest expense as a percentage of average interest-bearing liabilities.

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The following tables set forth the distribution of our average assets, liabilities and shareholders’ equity, and average rates earned or paid on a fully taxable equivalent basis for each of the periods indicated:

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Rate/Volume Analysis

The following tables describe the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volumes (changes in average balance multiplied by prior year average rate) and (ii) changes attributable to changes in rate (change in average interest rate multiplied by prior year average balance), while (iii) changes attributable to the combined impact of volumes and rates have been allocated proportionately to separate volume and rate categories.

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CHANGES IN FINANCIAL CONDITION

Total Assets.  Total assets increased $561.4 million, or 15.3%, to $4.22 billion at December 31, 2023 from $3.66 billion at December 31, 2022. The primary driver of this increase, as with most of the categories below, was our acquisition of Hometown, consisting of $615.1 million in assets, during 2023.

Cash and Cash Equivalents.  Cash and cash equivalents increased by $128.1 million, or 107.3%, to $247.5 million at December 31, 2023 from $119.4 million at December 31, 2022.

Investment Securities.  The carrying value of total investment securities decreased by $104.2 million to $245.5 million at December 31, 2023 from $349.7 million at December 31, 2022. This decrease was the result of sales of available for sale securities during 2023 as well as maturities of securities for which we chose to retain the funds in cash and cash equivalents rather than reinvest in securities.

Loans.  Net loans increased by $428.1 million, or 14.9%, to $3.30 billion at December 31, 2023 from $2.87 billion at December 31, 2022.

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Bank-Owned Life Insurance.  At December 31, 2023, our investment in bank-owned life insurance was $61.3 million, an increase of $15.2 million from $46.1 million at December 31, 2022.

Deposits.  Deposits increased $372.7 million, or 12.2%, to $3.43 billion at December 31, 2023 from $3.06 billion at December 31, 2022.

Borrowings.  At December 31, 2023 and 2022, borrowings consisted of advances from the FHLB of Chicago, subordinated debt to other banks and a junior subordinated debenture related to the Hometown Bancorp, Ltd. Capital Trust I. FHLB borrowings totaled $35.3 million and $1.9 million at December 31, 2023 and 2022, respectively. Subordinated debt decreased from $23.5 million at December 31, 2022 to $12.0 million at December 31, 2023. The junior subordinated debenture, which resulted from the acquisition of Hometown, totaled $4.1 million at December 31, 2023.

Stockholders’ Equity.  Total stockholders’ equity increased $166.7 million, or 36.8%, to $619.8 million at December 31, 2023 from $453.1 million at December 31, 2022.

LOANS

Our lending activities are conducted principally in Wisconsin. The Bank makes commercial and industrial loans, commercial real estate loans, construction and development loans, residential real estate loans, and a variety of consumer loans and other loans. Much of the loans made by the Bank are secured by real estate collateral. The Bank’s commercial business loans are primarily made based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower, with liquidation of the underlying real estate collateral typically being viewed as the primary source of repayment in the event of borrower default. Although commercial business loans are also often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment. Repayment of the Bank’s residential loans are generally dependent on the health of the employment market in the borrowers’ geographic areas and that of the general economy with liquidation of the underlying real estate collateral being typically viewed as the primary source of repayment in the event of borrower default.

Our loan portfolio is our most significant earning asset, comprising 79.3%, 79.1% and 76.1% of our total assets as of December 31, 2023, 2022 and 2021, respectively. Our strategy is to grow our loan portfolio by originating quality commercial and consumer loans that comply with our credit policies and that produce revenues consistent with our financial objectives. We believe our loan portfolio is well-balanced, which provides us with the opportunity to grow while monitoring our loan concentrations.

Total loans increased $449.0 million, or 15.5%, to $3.34 billion as of December 31, 2023 as compared to $2.89 billion as of December 31, 2022. Our loan growth during the year ended December 31, 2023 has been comprised of a decrease of $4.5 million, or 0.9%, in commercial and industrial loans, an increase of $301.1 million, or 21.5%, in commercial real estate loans, an increase of $1.1 million, or 0.6%, in construction and development loans, an increase of $149.1 million, or 20.2%, in residential 1-4 family loans and an increase of $2.2 million, or 3.5%, in consumer and other loans.

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The following table presents the balance and associated percentage of each major category in our loan portfolio at December 31, 2023, 2022, and 2021:

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Our directors and officers and their affiliates are customers of, and have other transactions with, the Bank in the normal course of business. All loans and commitments included in such transactions were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and do not involve more than normal risk of collection or present other unfavorable features. At December 31, 2023 and December 31, 2022, total loans outstanding to such directors and officers and their affiliates were $63.9 million and $70.2 million, respectively. During the year ended December 31, 2023, $24.5 million of additions and $30.8 million of repayments were made to these loans, compared to $46.5 million of additions and $49.8 million of repayments during the year ended December 31, 2022. At December 31, 2023 and December 31, 2022, all of the loans to directors and officers were performing according to their original terms.

Loan segments

Changes in the principal segments of our loan portfolio are discussed below. Descriptions of and risks related to these segments can be found in the consolidated financial statements and footnotes presented elsewhere in this report.

Commercial and Industrial (C&I).  Our C&I portfolio totaled $487.9 million and $492.5 million at December 31, 2023 and 2022, respectively, and represented 15% and 17% of our total loans, respectively. C&I loans decreased 0.9% during 2023, as a result of exiting a few nonperforming borrowers and borrowers from acquired institutions that did not fit the Bank’s lending philosophy. C&I loans increased 34.5% during 2022 primarily as a result of loans acquired from Denmark during 2022, slightly offset by significant levels of PPP loans being forgiven during the year.

Commercial Real Estate (CRE).  Our CRE loan portfolio totaled $1.70 billion and $1.40 billion at December 31, 2023 and 2022, respectively, and represented 51% and 48% of our total loans, respectively. Our CRE loans increased 21.5% during 2023, primarily as a result of loans acquired from Hometown during 2023. Our CRE loans increased 25.8% during 2022, primarily as a result of loans acquired from Denmark during 2022.

Construction and Development (C&D).  Our C&D loan portfolio totaled $200.8 million and $199.7 million at December 31, 2023 and 2022, respectively, and represented 6% and 7% of our total loans, respectively. C&D loans increased 0.6% during 2023, as a result of management making a strategic decision to limit growth in this area. C&D loans increased 50.8% during 2022, primarily as a result of loans acquired from Denmark during 2022.

Residential 1-4 Family. Our residential 1-4 family loan portfolio totaled $888.6 million and $739.5 million at December 31, 2023 and 2022, respectively, and represented 27% and 25% of our total loans, respectively. Residential 1-4 family loans increased 20.2% during 2023, primarily as a result of loans acquired from Hometown during 2023. Residential 1-4 family loans increased 29.3% during 2022, primarily as a result of loans acquired from Denmark during 2022.

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We do not offer reverse mortgages nor do we offer loans that provide for negative amortization of principal, such as “Option ARM” loans, where the borrower can pay less than the interest owed on his loan, resulting in an increased principal balance during the life of the loan. We also do not offer “subprime loans” (loans that are made with low down payments to borrowers with weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, bankruptcies, or borrowers with questionable repayment capacity as evidenced by low credit scores or high debt-burden ratios) or Alt-A loans (defined as loans having less than full documentation).

Residential real estate loans are originated both for sale to the secondary market as well as for retention in the Bank’s loan portfolio. The decision to sell a loan to the secondary market or retain within the portfolio is determined based on a variety of factors including but not limited to our asset/liability position, the current interest rate environment, and customer preference. Servicing rights are retained on all loans sold to the secondary market.

We were servicing mortgage loans sold to others without recourse of approximately $1.18 billion and $866.9 million at December 31, 2023 and 2022, respectively.

Loans sold with the retention of servicing assets result in the capitalization of servicing rights. Loan servicing rights are subsequently amortized as an offset to other income over the estimated period of servicing. The net balance of capitalized servicing rights amounted to $13.7 million and $9.6 million at December 31, 2023 and 2022, respectively.

Consumer Loans.  Our consumer loan portfolio totaled $51.0 million and $45.0 million at December 31, 2023 and 2022, respectively, and represented 1% and 2% of our total loans, respectively. Consumer loans include secured and unsecured loans, lines of credit and personal installment loans. Our consumer loans increased by 13.3% and 39.9% during 2023 and 2022, respectively.

Other Loans.  Our other loans totaled $15.0 million and $18.8 million at December 31, 2023 and 2022, respectively, and are immaterial to the overall loan portfolio. The other loans category consists primarily of overdrawn depository accounts, loans utilized to purchase or carry securities and loans to nonprofit organizations.

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Loan Portfolio Maturities.

The following tables summarize the dollar amount of loans maturing in our portfolio based on their loan type, fixed or variable rate of interest, and contractual terms to maturity at December 31, 2023. The tables do not include any estimate of prepayments, which can significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below. Demand loans, loans having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less.

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NONPERFORMING ASSETS

In order to operate with a sound risk profile, we focus on originating loans that we believe to be of high quality. We have established loan approval policies and procedures to assist us in maintaining the overall quality of our loan portfolio. When delinquencies in our loans exist, we rigorously monitor the levels of such delinquencies for any negative or adverse trends. From time to time, we may modify loans to extend the term or make other concessions to help a borrower with a deteriorating financial condition stay current on their loan and to avoid foreclosure. We generally do not forgive principal or interest on loans or modify the interest rates on loans to rates that are below market rates. Furthermore, we are committed to collecting on all of our loans and, as a result, at times have lower net charge-offs compared to many of our peer banks. We believe that our commitment to collecting on all of our loans results in higher loan recoveries.

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Our nonperforming assets consist of nonperforming loans and foreclosed real estate. Nonperforming loans are those on which the accrual of interest has stopped, as well as loans that are contractually 90 days past due on which interest continues to accrue. The composition of our nonperforming assets is as follows:

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At December 31, 2023, 2022 and 2021, loans individually evaluated had specific reserves of $4,245,000, $8,000 and $964,000, respectively. Levels of specific reserves are dependent on the specific underlying impaired loans at any given time. Management has evaluated the aforementioned loans and other loans classified as nonperforming and believes that all nonperforming loans have been adequately reserved for in the allowance for credit losses at December 31, 2023.

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Nonaccrual Loans

Loans are typically placed on nonaccrual status when any payment of principal and/or interest is 90 days or more past due, unless the collateral is sufficient to cover both principal and interest and the loan is in the process of collection. Loans are also placed on nonaccrual status when management believes, after considering economic and business conditions, that the principal or interest will not be collectible in the normal course of business. We monitor closely the performance of our loan portfolio. In addition to the monitoring and review of loan performance internally, we have also contracted with an independent organization to review our commercial and retail loan portfolios. The status of delinquent loans, as well as situations identified as potential problems, is reviewed on a regular basis by senior management.

ALLOWANCE FOR CREDIT LOSSES - LOANS

The Company assesses the adequacy of its ACL - Loans at the end of each calendar quarter. The level of ACL - Loans is based on the Company’s evaluation of historical default and loss experience, current and projected economic conditions, asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect the borrowers’ ability to repay a loan, the estimated value of any underlying collateral, composition of the loan portfolio and other relevant factors. The ACL - Loans is increased by a provision for credit losses, which is charged to expense, when the analysis shows that an increase is warranted. The ACL – Loans is reduced by charge-offs, net of recoveries, when they occur. The ACL is believed adequate to absorb all expected future losses to be recognized over the contractual life of the loans in the portfolio.

For further details on the Company’s ACL – Loans, refer to the footnotes presented along with the consolidated financial statements elsewhere in this report.

At December 31, 2023, the ACL - Loans was $43.6 million (representing 1.30% of period end loans). The Company adopted CECL as of January 1, 2023, which increased the ACL - Loans by $11.0 million. In addition, the ACL - Loans increased due to the acquisition of Hometown, which required a $3.6 million provision for credit losses on non-Purchase Credit Deteriorated (“PCD”) loans and a $5.5 million reserve related to PCD loans. The reserve related to PCD loans was recorded as an adjustment to the acquisition date fair values on these loans and was not included in the provision for credit losses. Net charge-offs remain negligible.

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The following table summarizes the changes in our ACL - Loans for the years indicated:

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The level of charge-offs depends on many factors, including the national and regional economy. Cyclical lagging factors may result in charge-offs being higher than historical levels. The dollar amount of the ACL - Loans increased primarily as a result of loan growth and changes in the portfolio composition. Although the allowance is allocated between categories, the entire allowance is available to absorb losses attributable to all loan categories. Management believes that the ACL - Loans is adequate.

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The following table summarizes an allocation of the ACL - Loans and the related percentage of loans outstanding in each category for the periods below.

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SOURCES OF FUNDS

General.   Deposits traditionally have been our primary source of funds for our investment and lending activities. We continue to focus on growing core deposits through our relationship driven banking philosophy and community-focused marketing programs. We also borrow from the FHLB of Chicago to supplement cash needs, to lengthen the maturities of liabilities for interest rate risk management purposes and to manage our cost of funds. Our additional sources of funds are scheduled payments and prepayments of principal and interest on loans and investment securities and fee income and proceeds from the sales of loans and securities.

Deposits.  Our current deposit products include non-interest bearing and interest-bearing checking accounts, savings accounts, money market accounts, and certificate of deposits. As of December 31, 2023, deposit liabilities accounted for approximately 81.3% of our total liabilities and equity. We accept deposits primarily from customers in the communities in which our branches and offices are located, as well as from small businesses and other customers throughout our lending area. We rely on our competitive pricing and products, quality customer service, and convenient locations and hours to attract and retain deposits. Deposit rates and terms are based primarily on current business strategies, market interest rates, liquidity requirements and our deposit growth goals.

Total deposits were $3.43 billion and $3.06 billion as of December 31, 2023 and 2022, respectively. Noninterest-bearing deposits at December 31, 2023 and 2022 were $1.05 billion and $934.1 million, respectively, while interest-bearing deposits were $2.38 billion and $2.13 billion at December 31, 2023 and 2022, respectively.

At December 31, 2023, we had a total of $582.0 million in certificates of deposit, including $0.7 million of brokered deposits, of which $0.7 million had remaining maturities of one year or less. Based on historical experience and our current pricing strategy, we believe we will retain a large portion of these accounts upon maturity.

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The following tables set forth the average balances of our deposits for the periods indicated:

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The following table provides information on maturities of certificates of deposits which exceed FDIC insurance limits of $250,000 as of December 31, 2023:

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Borrowings

Deposits and investment securities for sale are the primary source of funds for our lending activities and general business purposes. However, we may also obtain advances from the FHLB, purchase federal funds and engage in overnight borrowing from the Federal Reserve, correspondent banks, or enter into repurchase agreements.

Securities sold under repurchase agreements

The Company has securities sold under repurchase agreements which have contractual maturities up to one year from the transaction date with variable and fixed rate terms. The agreements to repurchase require that the Company (seller) repurchase identical securities as those that are sold. The securities underlying the agreements are under the Company’s control.

The following table summarizes securities sold under repurchase agreements, and the weighted average interest rates paid:

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Lines of credit and other borrowings

The Company’s other borrowings have historically consisted primarily of short-term FHLB of Chicago advances collateralized by a blanket pledge agreement on the Company’s FHLB capital stock and retail and commercial loans held in the Company’s portfolio. There were $35.3 million and $1.9 million of advances outstanding from the FHLB at December 31, 2023 and 2022, respectively. See Note 14 “Notes Payable” of the Notes to Consolidated Financial Statements under Part II, Item 8 for additional disclosures.

The total loans pledged as collateral were $1.49 billion and $1.15 billion at December 31, 2023 and 2022, respectively.

The Company maintains a $7.5 million line of credit with a commercial bank, which was entered into on May 15, 2022. There were no outstanding balances on this note at December 31, 2023 or 2022. Any future borrowings will require monthly payments of interest at a variable rate, and will be due in full on May 15, 2024.

During September 2017, the Company entered into subordinated note agreements with three separate commercial banks under which it borrowed $11.5 million. These notes were all issued with 10-year maturities, carried interest at a variable rate payable quarterly, were callable on or after the sixth anniversary of the issuance dates, and qualified for Tier 2 capital for regulatory purposes. These notes were repaid in full during October 2023.

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On July 22, 2020, the Company entered into subordinated note agreements with two separate commercial banks. The Company had through December 31, 2020, to borrow funds up to a maximum availability of $6.0 million under each agreement, or $12.0 million total. These notes were issued with 10-year maturities, carry interest at a fixed rate of 5.0% through June 30, 2025, and at a variable rate thereafter, payable quarterly. These notes are callable on or after January 1, 2026 and qualify for Tier 2 capital for regulatory purposes. The Company had outstanding balances of $6.0 million under these agreements at December 31, 2023 and 2022.

During August 2022, the Company entered into subordinated note agreements with an individual. The Company had outstanding balances of $6.0 million under these agreements as of December 31, 2023 and 2022. These notes were issued with 10-year maturities, carry interest at a fixed rate of 5.25% through August 6, 2027, and at a variable rate thereafter, payable quarterly. These notes are callable on or after August 6, 2027 and qualify for Tier 2 capital for regulatory purposes. The individual associated with these subordinated note agreements is not a related party of the Company.

As a result of the acquisition of Hometown during February 2023, the Company acquired all of the common securities of Hometown’s wholly-owned subsidiaries, Hometown Bancorp, Ltd. Capital Trust I (“Trust I”) and Hometown Bancorp, Ltd. Capital Trust II (“Trust II”). The Company also assumed adjustable rate junior subordinated debentures issued to these trusts. The junior subordinated debentures issued to Trust I and Trust II totaled $4.1 million and $8.2 million, respectively, carried interest at floating rates resetting on each quarterly payment date, and were due on January 7, 2034 and December 15, 2036, respectively. Applicable discounts originally totaling $1.5 million were recorded to carry the assumed debentures at their then estimated fair value and were being accreted to interest expense over the remaining life of the debentures. Both junior subordinated debentures were redeemable by the Company, subject to prior approval by the Federal Reserve Bank, on any quarterly payment date. The junior subordinated debentures represented the sole asset of Trust I and Trust II. The trusts were not included in the Company’s consolidated financial statements. The net effect of all agreements assumed with respect to Trust I and Trust II is that the Company, through payments on its debentures, was liable for the distributions and other payments required on the trusts’ preferred securities. Trust I and Trust II also provided the Company with $12.0 million in Tier 1 capital for regulatory capital purposes. The Company redeemed the junior subordinated debenture related to Trust II during December 2023, resulting in Trust II’s dissolution. The Company redeemed the junior subordinated debenture related to Trust I on January 8, 2024, resulting in Trust I’s dissolution. As a result of the redemption of the junior subordinated debenture related to Trust II and notification of the Company’s intent to redeem the junior subordinated debenture of Trust I prior to December 31, 2023, the Company amortized the remaining original fair value discounts into interest expense during 2023.

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INVESTMENT SECURITIES

Our securities portfolio consists of securities available for sale and securities held to maturity. Securities are classified as held to maturity or available for sale at the time of purchase. Obligations of states and political subdivisions and mortgage-backed securities, all of which are issued by U.S. government agencies or U.S. government-sponsored enterprises, make up the largest components of the securities portfolio. We manage our investment portfolio to provide an adequate level of liquidity as well as to maintain neutral interest rate-sensitive positions, while earning an adequate level of investment income without taking undue or excessive risk.

Securities available for sale consist of U.S. Treasury securities, obligations of states and political subdivision, agency mortgage-backed securities, corporate notes, and certificates of deposits. Securities classified as available for sale, which management has the intent and ability to hold for an indefinite period of time, but not necessarily to maturity, are carried at fair value, with unrealized gains and losses, net of related deferred income taxes, included in stockholders’ equity as a separate component of other comprehensive income. The fair value of securities available for sale totaled $142.2 million and included gross unrealized gains of $86,000 and gross unrealized losses of $12.2 million at December 31, 2023. At December 31, 2022, the fair value of securities available for sale totaled $304.6 million and included gross unrealized gains of $0.5 million and gross unrealized losses of $21.8 million.

Securities classified as held to maturity consist of U.S. Treasury securities and obligations of states and political subdivisions. These securities, which management has the intent and ability to hold to maturity, are reported at amortized cost. Securities held to maturity as of December 31, 2023 and 2022, are carried at their amortized cost of $103.3 million and $45.1 million, respectively.

The Company recognized a net loss on sale of investment securities of $7.9 million during the year ended December 31, 2023. The Company did not sell any securities in 2022.

The following tables set forth the composition and maturities of investment securities as of December 31, 2023 and December 31, 2022. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

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LIQUIDITY AND CAPITAL RESOURCES

Liquidity.    Liquidity is defined as the Company’s ability to generate adequate cash to meet its needs for day-to-day operations and material long and short-term commitments. Liquidity is the risk of potential loss if we were unable to meet our funding requirements at a reasonable cost. We are expected to maintain adequate liquidity at the Bank to meet the cash flow requirements of customers who may be either depositors wishing to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. Our asset and liability management policy is intended to cause the Bank to maintain adequate liquidity and, therefore, enhance our ability to raise funds to support asset growth, meet deposit withdrawals and lending needs, maintain reserve requirements and otherwise sustain our operations.

We continuously monitor our liquidity position to ensure that assets and liabilities are managed in a manner that will meet all of our short-term and long-term cash requirements. We manage our liquidity based on demand and specific events and uncertainties to meet current and future financial obligations of a short-term nature. We also monitor our liquidity requirements in light of interest rate trends, changes in the economy and the scheduled maturity and interest rate sensitivity of the investment and loan portfolios and deposits. Our objective in managing liquidity is to respond to the needs of depositors and borrowers as well as to increase earnings enhancement opportunities in a changing marketplace.

Our liquidity is maintained through investment portfolio, deposits, borrowings from the FHLB, and lines available from correspondent banks. Our highest priority is placed on growing noninterest bearing deposits through strong community involvement in the markets that we serve. Borrowings and brokered deposits are considered short-term supplements to our overall liquidity but are not intended to be relied upon for long-term needs. We believe that our present position is adequate to meet our current and future liquidity needs, and management knows of no trend or event that will have a material impact on the Company’s ability to maintain liquidity at satisfactory levels. Management further believes that our present position is adequate to assure that securities classified as held to maturity will not need to be sold prior to maturity.

Capital Adequacy.  Total shareholders’ equity was $619.8 million at December 31, 2023, compared to $453.1 million at December 31, 2022. Our total shareholders’ equity increased during 2023 and 2022 as a result of our profitability, reduced by dividends paid and common share repurchases. Growth in shareholders’ equity was further stimulated by the acquisitions of Hometown during 2023 and Denmark during 2022.

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Our capital management consists of providing adequate equity to support our current and future operations. We are subject to various regulatory capital requirements administered by state and federal banking agencies, including the Federal Reserve and the OCC. Failure to meet minimum capital requirements may prompt certain actions by regulators that, if undertaken, could have a direct material adverse effect on our financial condition and results of operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank and Company must meet specific capital guidelines that involve quantitative measure of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and the classifications are also subject to qualitative judgment by the regulator in regards to risk weighting and other factors. See “Business—Supervision and Regulation—Capital Requirements.”

The following table reflects capital ratios computed pursuant to the regulatory capital rules as applicable to the Company and the Bank. As a result of the Economic Growth Act, the Company is no longer required to comply with its risk-based capital rules. For more information, see “Business—Supervision and Regulation—Capital Requirements.”

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As previously mentioned, the Company carried $12.0 million of subordinated debt and $4.0 million of junior subordinated debt as of December 31, 2023 and $23.5 million of subordinated debt as of December 31, 2022, which is included in total capital for the Company in the tables above.

FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK

We are party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments primarily include commitments to originate and sell loans, standby and direct pay letters of credit, unused lines of credit and unadvanced portions of construction and development loans. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in these particular classes of financial instruments.

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Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for loan commitments, standby and direct pay letters of credit and unadvanced portions of construction and development loans is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

Off-Balance Sheet Arrangements.

Our significant off-balance-sheet arrangements consist of the following:

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Off-balance sheet arrangement means any transaction, agreement or other contractual arrangement to which an entity unconsolidated with the registrant is a party, under which the registrant has (1) any obligation under a guarantee contract, (2) retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement, (3) any obligation, including a contingent obligation, under a contract that would be accounted for as a derivative instrument, or (4) any obligation, including a contingent obligation, arising out of a variable interest.

Loan commitments are made to accommodate the financial needs of our customers. Standby and direct pay letters of credit commit us to make payments on behalf of customers when certain specified future events occur. Both arrangements have credit risk essentially the same as that involved in extending loans to clients and are subject to our normal credit policies. Collateral (e.g., securities, receivables, inventory, equipment, etc.) is obtained based on management’s credit assessment of the customer.

Loan commitments and standby and direct pay letters of credit do not necessarily represent our future cash requirements because while the borrower has the ability to draw upon these commitments at any time, these commitments occasionally expire without being drawn upon. Our off-balance sheet arrangements as of December 31, 2023 were as follows:

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We closely monitor the amount of our remaining future commitments to borrowers in light of prevailing economic conditions and adjust these commitments as necessary. We will continue this process as new commitments are entered into or existing commitments are renewed.

Effects of Inflation

The effect of inflation on a financial institution differs significantly from the effect on an industrial company. While a financial institution’s operating expenses, particularly salary and employee benefits, are affected by general inflation, the asset and liability structure of a financial institution consists largely of monetary items. Monetary items, such as cash, investments, loans, deposits and other borrowings, are those assets and liabilities which are or will be converted into a fixed number of dollars regardless of changes in prices. As a result, changes in interest rates have a more significant impact on a financial institution’s performance than does general inflation. For additional information regarding interest rates and changes in net interest income see “Quantitative and Qualitative Disclosures about Market Risk—Interest Rate Sensitivity.” Inflation may have impacts on the Bank’s customers, on businesses and consumers and their ability or willingness to invest, save or

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spend, and perhaps on their ability to repay loans. As such, there would likely be impacts on the general appetite of banking products and the credit health of the Bank’s customer base.