Bankwell Financial Group, Inc. (BWFG) FY 2023 MD&A

Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

This section presents management’s perspective on our financial condition and results of operations. The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes contained elsewhere in this annual report. To the extent that this discussion describes prior performance, the descriptions relate only to the periods listed, which may not be indicative of future financial outcomes. In addition to historical information, this discussion contains forward looking statements that involve risks, uncertainties and assumptions that could cause results to differ materially from management’s expectations. Factors that could cause such differences are discussed in the sections titled “Cautionary Note Regarding Forward-Looking Statements” and “Risk Factors”. We assume no obligation to update any of these forward-looking statements.

General

Bankwell Financial Group, Inc. (the "Parent Corporation") is a bank holding company headquartered in New Canaan, Connecticut. The Parent Corporation offers a broad range of financial services through its banking subsidiary, Bankwell Bank (the "Bank" and, collectively with the Parent Corporation and the Parent Corporation's subsidiaries, "we", "our", "us", or the "Company").

The Bank is a Connecticut state chartered commercial bank, founded in 2002, whose deposits are insured under the Deposit Insurance Fund administered by the Federal Deposit Insurance Corporation (“FDIC”). The Bank provides a wide range of services to clients in our market, an area encompassing approximately a 100 mile radius around our branch network. In addition, the Bank pursues certain types of commercial lending opportunities outside our market, particularly where we have strong relationships. The Bank operates nine branches in New Canaan, Stamford, Fairfield, Westport, Darien, Norwalk, and Hamden, Connecticut.

The following discussion and analysis presents our results of operations and financial condition on a consolidated basis. However, because we conduct all of our material business operations through the Bank, the discussion and analysis relates to activities primarily conducted at the Bank.

We generate most of our revenue from interest on loans and investments and fee-based revenues. Our primary source of funding for our loans is deposits. Our largest expenses are interest on these deposits and salaries and related employee benefits. We measure our performance primarily through our net interest margin, efficiency ratio, ratio of ACL-Loans to total loans, return on average assets and return on average equity, among other metrics, while maintaining appropriate regulatory leverage and risk-based capital ratios.

Selected Financial Data

The following table sets forth selected consolidated financial data as of the dates and for the periods presented. The selected consolidated balance sheet data as of December 31, 2023 and 2022 and the selected consolidated statement of income data for the years ended December 31, 2023 and 2022 have been derived mainly from our audited consolidated financial statements and related notes that we have included elsewhere in this Annual Report. The selected consolidated balance sheet data as of December 31, 2021, 2020, and 2019 and the selected consolidated statement of income data for the years ended December 31, 2021, 2020, and 2019 has been derived mainly from audited consolidated financial statements that are not presented in this Annual Report.

The selected historical consolidated financial data as of any date and for any period are not necessarily indicative of the results that may be achieved as of any future date or for any future period. You should read the following selected statistical and financial data in conjunction with the more detailed information contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes that we have presented elsewhere in this Annual Report.

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Selected Financial Data

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(a)Excludes unvested restricted stock awards.

(b)This measure is not a measure recognized under Generally Accepted Accounting Principles ("GAAP") and is therefore considered to be a non-GAAP financial measure. See “Non-GAAP Financial Measures” for a description of this measure and a reconciliation of this measure to its most directly comparable GAAP measure.

(c)Calculated based on net income before preferred stock dividend.

(d)Calculated using the principal amounts outstanding on loans.

(e)Nonperforming assets consist of nonperforming loans and other real estate owned.

(f)The dividend payout ratio is the dividends per share divided by diluted earnings per share.

(g)Performance ratios for the year ended December 31, 2020 were negatively impacted by incremental COVID-19 pandemic related loan loss reserves and a $3.9 million one-time charge related to office consolidation, vendor contract termination and employee severance costs recognized in the fourth quarter of 2020.

NON-GAAP FINANCIAL MEASURES

We identify “efficiency ratio”, “tangible common equity ratio”, “tangible book value per share”, “total revenue” and “return on average common shareholders’ equity” as “non-GAAP financial measures.” In accordance with the SEC’s rules, we classify a financial measure as being a non-GAAP financial measure if that financial measure excludes or includes amounts, or is subject to adjustments that have the effect of excluding or including amounts, that are included or excluded, as the case may be, in the most directly comparable measure calculated and presented in accordance with generally accepted accounting principles as in effect from time to time in the United States in our statements of income, balance sheet or statements of cash flows. Non-GAAP financial measures do not include operating and other statistical measures or ratios or statistical measures calculated using exclusively either financial measures calculated in accordance with GAAP, operating measures or other measures that are not non-GAAP financial measures or both.

The non-GAAP financial measures that we discuss in this annual report should not be considered in isolation or as a substitute for the most directly comparable or other financial measures calculated in accordance with GAAP. Moreover, the manner in which we calculate the non-GAAP financial measures that we discuss in this annual report may differ from that of other companies reporting measures with similar names. You should understand how such other banking organizations calculate their financial measures similar or with names similar to the non-GAAP financial measures we have discussed in this annual report when comparing such non-GAAP financial measures.

Efficiency ratio is defined as non-interest expenses, less merger and acquisition related expenses, other real estate owned expenses and amortization of intangible assets, divided by our operating revenue, which is equal to net interest income plus non-interest income excluding gains and losses on sales of securities and gains and losses on other real estate owned. In our judgment, the adjustments made to operating revenue allow investors and analysts to better assess our operating expenses in relation to our core operating revenue by removing the volatility that is associated with certain one-time items and other discrete items that are unrelated to our core business.

Tangible common equity is defined as total shareholders’ equity, excluding preferred stock, less goodwill and other intangible assets. We believe that this measure is important to many investors in the marketplace who are interested in changes from period to period in common shareholders’ equity exclusive of changes in intangible assets. Goodwill, an intangible asset that is recorded in a purchase business combination, has the effect of increasing both common equity and assets while not increasing our tangible common equity or tangible assets.

Tangible common equity ratio is defined as the ratio of tangible common equity divided by total assets less goodwill and other intangible assets. We believe that this measure is important to many investors in the marketplace who are interested in relative changes from period to period in common equity and total assets, each exclusive of changes in intangible assets. We believe that the most directly comparable GAAP financial measure is total shareholders’ equity to total assets.

Tangible book value per share is defined as book value, excluding the impact of goodwill and other intangible assets, if any, divided by shares of our common stock outstanding, excluding unvested restricted stock awards.

Total revenue is defined as the sum of net interest income before provision of loan losses and noninterest income.

Return on average common shareholders’ equity is defined as net income attributable to common shareholders divided by total average shareholders’ equity less average preferred stock, if any.

The information provided below presents a reconciliation of each of our non-GAAP financial measures to the most directly comparable GAAP financial measure.

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Executive Overview

We are focused on being the banking provider of choice and to serve as an alternative to our larger competitors. We aim to do this through:

•Responsive, client-centric products and services and a community focus;

•Organic growth and strategic acquisitions when market opportunities present themselves;

•Utilization of efficient and scalable infrastructure; and

•Disciplined focus on risk management.

Key Financial Measures

The primary measures we use to evaluate and manage our financial results are set forth in the tables below. Although we believe these measures are meaningful in evaluating our results and financial condition, they may not be directly comparable to similar measures used by other financial services companies and may not provide an appropriate basis to compare our results or financial condition to the results or financial condition of our competitors. The following tables set forth the key financial measures we use to evaluate the success of our business and our financial position and operating performance.

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(a)We derived the selected balance sheet measures as of December 31, 2023 and 2022 and the selected statement of income measures for the years ended December 31, 2023 and 2022 from our audited consolidated financial statements included elsewhere in this annual report. Average balances have been computed using daily averages. Our historical results may not be indicative of our results for any future period.

(b)Calculated using the principal amounts outstanding on loans.

(c)This measure is not a measure recognized under GAAP and is therefore considered to be a non-GAAP financial measure. See “Non-GAAP Financial Measures” for a description of this measure and a reconciliation of this measure to its most directly comparable GAAP measure.

(d)Excludes unvested restricted stock awards.

(e)Nonperforming assets consist of nonperforming loans and other real estate owned.

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Critical Accounting Policies and Estimates

The discussion and analysis of our results of operations and financial condition are based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires us to make significant estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from our current estimates, as a result of changing conditions and future events.

We believe that accounting estimates related to the measurement of the ACL-Loans, the valuation of derivative instruments, investment securities and deferred income taxes, and the evaluation of investment securities are particularly critical and susceptible to significant near-term change.

Allowance for Credit Losses-Loans ("ACL-Loans") and Allowance for Credit Losses-Unfunded commitments ("ACL-Unfunded commitments")

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (“ASC 326”), which requires the measurement of all expected credit losses for financial assets held at amortized cost to be based on historical experience, current condition, and reasonable and supportable forecasts. The Company adopted this guidance effective January 1, 2023 and recorded a cumulative effect adjustment that increased the allowance for credit losses for loans and loan commitments by $6.4 million, increased deferred tax assets by $1.5 million, and decreased retained earnings by $4.9 million, net of tax.

The ACL-Loans is measured on each loan’s amortized cost basis, excluding interest receivable, and is initially recognized upon origination or purchase of the loan, and subsequently remeasured on a recurring basis. The ACL-Loans is recognized as a contra-asset, and credit loss expense is recorded as a provision for loan losses in the consolidated statements of income. Loan losses are charged off against the ACL-Loans when management believes the loan is uncollectible. Subsequent recoveries, if any, are credited to the ACL-Loans. Loans are normally placed on nonaccrual status if it is probable that the Company will be unable to collect the full payment of principal and interest when due according to the contractual terms of the loan agreement, or the loan is past due for a period of 90 days or more unless the obligation is well-secured and is in the process of collection. The Company generally does not recognize an allowance for credit losses ("ACL") on accrued interest receivables, consistent with its policy to reverse interest income when interest is 90 days or more past due.

The Company also records an ACL-Unfunded commitments, which is based on the same assumptions as funded loans and also considers the probability of funding. The ACL is recognized as a liability, and credit loss expense is recorded as a provision for unfunded loan commitments within the provision for credit losses in the Consolidated statements of income.

For collectively evaluated loans and related unfunded commitments, the Company utilizes software provided by a third party, which includes various models for forecasting expected credit losses, to calculate its ACL. Management selected lifetime loss rate models, utilizing CRE, C&I, and Consumer specific models, to calculate the expected losses over the life of each loan based on exposure at default, loan attributes and reasonable, supportable economic forecasts. The models selected by the Company in its ACL calculation rely upon historical losses from a broad cross section of U.S. banks that also utilize the same third party for ACL calculations. Management reviewed the third party’s analysis of the banks included in the models as part of their model development dataset and determined the Company’s loan portfolio composition by property type, balance distribution by loan age, and delinquency status are similar, which supports the use of these loss rate models. The Company also noted the third party’s model development dataset has loan concentrations that are evenly distributed across the United States, while the Company’s portfolio is mainly concentrated in the Northeast. Based on the disparate regional concentration, management determined that a select group of peer banks is necessary to scale the loss rate models to produce an ACL that is more representative of the Company’s loan portfolio. This peer-based calibration, called a "peer scalar", utilizes the loss rates of a subset of peer banks to appropriately scale the initial model results. These peers have been selected by the Company given their similar characteristics, such as loan portfolio composition and location, to better align the models’ results to the Company’s expected losses.

Key assumptions used in the models include portfolio segmentation, risk rating, forecasted economic scenarios, the peer scalar, and the expected utilization of unfunded commitments, among others. Our loan portfolios are segmented by loan level attributes such as loan type, size, date of origination, and delinquency status to create homogenous loan pools. Pool level metrics are calculated, and loss rates are subsequently applied to the pools as the loans have similar characteristics.

To account for economic uncertainty, the Company incorporates multiple economic scenarios in determining the ACL. The scenarios include various projections based on variables such as Gross Domestic Product, interest rates, property price indices, and employment measures, among others. The scenarios are probability-weighted based on available information at the time the calculation is conducted. As part of our ongoing governance of ACL, scenario weightings and model parameters are reviewed periodically by management and are subject to change, as deemed appropriate.

The Company also considers qualitative adjustments to expected credit loss estimates for information not already captured in the quantitative loss estimation models. Qualitative factor adjustments may increase or decrease management’s estimate of expected credit losses. Qualitative loss factors are based on the Company’s judgment of market, changes in loan composition or concentrations, performance trends, regulatory changes, uncertainty of macroeconomic forecasts, and other asset specific risk characteristics.

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When loans do not share risk characteristics with other financial assets they are evaluated individually. Management applies its normal loan review procedures in making these judgments. Individually evaluated loans consist of loans with credit quality indicators which are substandard or doubtful. The Company also individually evaluates all insurance premium loans. While insurance premium loans are considered consumer loans, the third-party Consumer ACL model is designed for unsecured lending, whereas these loans are secured. To account for the fully secured structure of this type of loan, management determined each loan will be individually evaluated, regardless of the credit quality indicators. These loans are evaluated based upon their collateral, which primarily consists of cash, cash surrender value life insurance, and in some cases real estate. In determining the ACL-Loans for individually evaluated loans, the Company generally applies a discounted cash flow method for instruments that are individually assessed. For collateral dependent financial assets where the Company has determined that foreclosure of the collateral is probable and where the borrower is experiencing financial difficulty, the ACL is measured based on the difference between the fair value of the collateral and the amortized cost basis of the asset as of the measurement date. Fair value is generally calculated based on the value of the underlying collateral less an appraisal discount and the estimated cost to sell.

Loan modifications

In March 2022, the FASB issued ASU 2022-02, Financial Instruments – Credit Losses (ASU 326): Troubled Debt Restructurings and Vintage Disclosures. ASU 2022-02 eliminated the accounting guidance for TDRs by creditors while enhancing disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty. The Company adopted ASU 2022-02 effective January 1, 2023 and the impact was immaterial.

Derivative Instrument Valuation

The Company enters into interest rate swap agreements as part of the Company’s interest rate risk management strategy. Management applies the hedge accounting provisions of Accounting Standards Codification (“ASC”) Topic 815, "Hedge Accounting, and formally documents at inception all relationships between hedging instruments and hedged items, as well as its risk management objectives and strategies for undertaking the various hedges. Additionally, the Company assesses whether the derivative used in its hedging transaction is expected to be and has been highly effective in offsetting changes in the fair value or cash flows of the hedged item. The Company discontinues hedge accounting when it is determined that a derivative is not expected to be or has ceased to be highly effective as a hedge, and then reflects changes in fair value of the derivative in earnings after termination of the hedge relationship.

The Company has interest rate swaps that qualify under ASC Topic 815, as cash flow hedges. Cash flow hedges are used to minimize the variability in cash flows of assets or liabilities, or forecasted transactions caused by fluctuations in the contractually specified interest rates, and are recorded at fair value in other assets within the consolidated balance sheet. Changes in the fair value of these cash flow hedges are initially recorded in accumulated other comprehensive income and subsequently reclassified into earnings when the forecasted transaction affects earnings.

The Company entered into one pay-fixed portfolio layer method fair value swap, designated as a hedging instrument, with a total notional amount of $150 million in the first quarter of 2023. The Company designated the fair value swap under the portfolio layer method. Under this method, the hedged item is designated as a hedged layer of a closed portfolio of financial loans that is anticipated to remain outstanding for the designated hedged period. Adjustments will be made to record the swap at fair value on the Consolidated Balance Sheets, with changes in fair value recognized in interest income. The carrying value of the fair value swap on the Consolidated Balance Sheets will also be adjusted through interest income, based on changes in fair value attributable to changes in the hedged risk.

The Company also has derivatives not designated as hedges. Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain loan clients. The Company executes interest rate swaps with commercial banking clients to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the client derivatives and the offsetting derivatives are recognized directly in earnings.

Investment Securities Valuation

Fair values of the Company’s investment securities are based on quoted market prices or dealer quotes, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. The Company’s private placement municipal housing authority bonds, classified as held to maturity, have no available quoted market price. The fair value for these securities is estimated using a discounted cash flow model. Due to the judgments and uncertainties involved in the estimation process, the estimates could result in materially different results under different assumptions and conditions.

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Allowance for Credit Losses - Securities ("ACL-Securities")

Effective January 1, 2023, pursuant to ASU No. 2016-13, each quarter the Company individually evaluates the available for sale debt securities and held to maturity securities for impairment credit losses. Available for sale securities include U.S. Treasuries, mortgage-backed securities, and corporate bonds. U.S. Treasuries and mortgaged-backed securities are guaranteed by the U.S. Government and as a result, management has a zero loss expectation. No ACL-Securities was recorded for these securities as of December 31, 2023. For the corporate bond portfolio, the Company developed a metric which includes each issuer’s current credit ratings and key financial performance metrics to assess the underlying performance of each issuer. The analysis of the issuers’ performance and the intent of the Company to retain these securities support the determination that there was no expected credit loss, and therefore, no ACL-Securities were recognized on the corporate bond portfolio as of December 31, 2023. Of our held to maturity securities portfolio, one security’s fair value was less than its amortized cost as of December 31, 2023. Since this is a highly rated state agency and municipal obligation, the Company's expectation of nonpayment of the amortized cost basis is zero. No allowance for ALC-Securities was recorded for this security as of December 31, 2023.

Deferred Income Taxes

In accordance with ASC Topic 740, “Income Taxes,” certain aspects of accounting for income taxes require significant management judgment, including assessing the realizability of Deferred Tax Assets (DTAs). Such judgments are subjective and involve estimates and assumptions about matters that are inherently uncertain. Should actual factors and conditions differ materially from those used by management, the actual realization of DTAs could differ materially from the amounts recorded in the Consolidated Financial Statements and the accompanying Notes thereto.

DTAs generally represent items for which a benefit has been recognized for financial accounting purposes that cannot be realized for tax purposes until a future period. The realization of DTAs depends upon future sources of taxable income. Valuation allowances are established for those DTAs determined not likely to be realized based on management’s judgment.

Earnings and Performance Overview

2023 Earnings Overview

Our net income for the year ended December 31, 2023 was $36.7 million, a decrease of $0.8 million, or 2.0%, compared to the year ended December 31, 2022. Diluted earnings per share was $4.67 for the year ended December 31, 2023, compared to diluted earnings per share of $4.79 for the year ended December 31, 2022. Our returns on average shareholders' equity and average assets for the year ended December 31, 2023, were 14.55% and 1.13%, respectively, compared to 16.72% and 1.44%, respectively for the year ended December 31, 2022.

Revenues (net interest income plus noninterest income) for the year ended December 31, 2023 were $99.3 million, versus $97.8 million for the year ended December 31, 2022. The increase in revenues for the year ended 2023 was primarily attributable to increases in the gain on sales of loans and servicing charges and fees. The increase was partially offset by a decrease in net interest income of $0.3 million.

Net income for the year ended December 31, 2023 was $36.7 million, versus $37.4 million for the year ended December 31, 2022. The decrease in net income for the year ended December 31, 2023 was due to an increase in noninterest expense partially offset by the aforementioned increase in revenues and a decrease in the provision for loan losses.

Net interest income for the year ended December 31, 2023 was $94.5 million, a decrease of $0.3 million compared to the year ended December 31, 2022. Our net interest margin decreased 80 basis points to 2.98% for the year ended December 31, 2023 compared to the year ended December 31, 2022. The decrease in the net interest margin was due to an increase in funding costs partially offset by an increase in yields on earning assets.

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Results of Operations

Net Interest Income

Net interest income is the difference between interest earned on loans and securities and interest paid on deposits and other borrowings, and is the primary source of our operating income. Net interest income is affected by the level of interest rates, changes in interest rates and changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Included in interest income are certain loan fees, such as deferred origination fees and late charges. We convert tax-exempt income to a Fully Taxed Equivalent (FTE) basis using the statutory federal income tax rate adjusted for applicable state income taxes net of the related federal tax benefit. The average balances are principally daily averages. Interest income on loans includes the effect of deferred loan fees and costs accounted for as yield adjustments. Premium amortization and discount accretion are included in the respective interest income and interest expense amounts.

FTE net interest income for the years ended December 31, 2023 and 2022 was $94.7 million and $94.9 million, respectively. FTE net interest income decreased primarily due to an increase in interest expense partially offset by an increase in interest income attributable to loan growth and higher overall loan yields.

FTE basis interest income for the year ended December 31, 2023 increased $70.3 million, or 59.5%, to $188.7 million compared to FTE basis interest income for the year ended December 31, 2022 due primarily to an increase in commercial real estate loans and commercial business loans. Average interest earning assets were $3.2 billion for the year ended December 31, 2023, increasing by $663.5 million, or 26.4%, from the year ended December 31, 2022. The average balance of total loans increased $599.6 million, or 27.9%. The total average balance of securities for the year ended December 31, 2023 increased by $11.2 million, or 9.4%, from the year ended December 31, 2022. The total yield in earnings assets increased to 5.86% at December 31, 2023, compared to 4.64% at December 31, 2022. The increase in yield was primarily driven by higher yields on loans, as well as higher yields on our cash balances as a result of the overall higher rate environment for 2023.

Interest expense for the year ended December 31, 2023 increased by $70.8 million, or 305.1%, compared to interest expense for the year ended December 31, 2022 due to an interest expense on deposits, resulting from an increase in rates paid on interest bearing deposits.

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Distribution of Assets, Liabilities and Stockholders’ Equity; Interest Rates and Interest Differential

The following table presents the average balances and yields earned on interest-earning assets and average balances and weighted average rates paid on our funding liabilities for the years ended December 31, 2023 and 2022.

(1)Average balances and yields for securities are based on amortized cost.

(2)The adjustment for securities and loans taxable equivalency was $207 thousand and $201 thousand, respectively, for the years ended December 31, 2023 and 2022. Tax exempt income was converted to a fully taxable equivalent basis at a 20 percent tax rate for 2023 and 2022.

(3)Net interest income as a percentage of total earning assets.

(4)Yields are calculated using the contractual day count convention for each respective product type.

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Effect of changes in interest rates and volume of average earning assets and average interest-bearing liabilities

The following table shows the extent to which changes in interest rates and changes in the volume of average earning assets and average interest-bearing liabilities have affected net interest income. For each category of earning assets and interest-bearing liabilities, information is provided relating to: changes in volume (changes in average balances multiplied by the prior year’s average interest rates); changes in rates (changes in average interest rates multiplied by the prior year’s average balances); and the total change. Changes attributable to both volume and rate have been allocated proportionately based on the relationship of the absolute dollar amount of change in each.

Provision for Loan Losses

The provision for loan losses is based on management’s periodic assessment of the adequacy of our ACL-Loans which, in turn, is based on such interrelated factors as the composition of our loan portfolio and its inherent risk characteristics, the level of nonperforming loans and net charge-offs, both current and historic, local economic and credit conditions, the direction of real estate values, and regulatory guidelines. The provision for loan losses is charged against earnings in order to maintain our ACL-Loans and reflects management’s best estimate of probable losses inherent in our loan portfolio at the balance sheet date.

The provision for loan losses for the year ended December 31, 2023 was $0.9 million compared to a $5.4 million provision for loan losses for the year ended December 31, 2022.

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Noninterest Income

Noninterest income is a component of our revenue and is comprised primarily of fees generated from loan and deposit relationships with our clients, fees generated from sales and referrals of loans, income earned on bank owned life insurance and gains on sales of investment securities. The following table compares noninterest income for the years ended December 31, 2023 and 2022.

Noninterest income increased by $1.8 million to $4.8 million for the year ended December 31, 2023, compared to the year ended December 31, 2022. The increase for the year ended December 31, 2023 was mainly driven by an increase in gains on SBA loan sales and service charges and fees.

Noninterest Expense

The following table compares noninterest expense for the years ended December 31, 2023 and 2022.

Noninterest expense increased by $6.0 million, or 14%, to $50.4 million for the year ended December 31, 2023 compared to the year ended December 31, 2022. The increase in noninterest expense was primarily driven by an increase in FDIC insurance expense and salaries and employee benefits expense.

FDIC insurance expense totaled $4.2 million for the year ended December 31, 2023, an increase of $2.5 million when compared to the same period in 2022. The higher FDIC insurance expense is attributed to the overall balance sheet growth and higher brokered deposit balances.

Salaries and employee benefits expense totaled $24.6 million for the year ended December 31, 2023, an increase of $2.4 million when compared to the same period in 2022. The increase in salaries and employee benefits expense mainly driven by lower loan originations which lowers the amount of origination expenses the Bank is able to defer.

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Income Taxes

Income tax expense for the years ended December 31, 2023 and 2022 totaled $11.4 million and $10.6 million, respectively. The effective tax rates for the years ended December 31, 2023 and 2022, were 23.7% and 22.0%, respectively.

Our net deferred tax asset at December 31, 2023 was $9.4 million, compared to $7.4 million at December 31, 2022.

On October 8, 2015, the Bank established a wholly-owned subsidiary, Bankwell Loan Servicing Group, Inc. (a Passive Investment Company “PIC”). The PIC was organized in accordance with Connecticut statutes to hold and manage certain loans that are collateralized by real estate. Income earned by the PIC is exempt from Connecticut income tax and any dividends paid by the PIC to the Bank are not taxable income for Connecticut income tax purposes. See Note 13 to our Consolidated Financial Statements for further information regarding income taxes.

Financial Condition

Summary

Assets totaled $3.2 billion at December 31, 2023, compared to assets of $3.3 billion at December 31, 2022. The increase in assets was primarily due to loan growth. Gross loans totaled $2.7 billion at December 31, 2023, an increase of $43.2 million or 1.6% compared to December 31, 2022. Deposits totaled $2.7 billion at December 31, 2023, compared to deposits of $2.8 billion at December 31, 2022.

Shareholders’ equity totaled $265.8 million as of December 31, 2023, an increase of $27.3 million compared to December 31, 2022, primarily a result of net income of $36.7 million for the year ended December 31, 2023 The increase was partially offset by the Day 1 CECL adoption impact of $4.9 million, dividends paid of $6.2 million, and a $1.5 million unfavorable impact to accumulated other comprehensive income. The unfavorable impact to accumulated other comprehensive income was driven by fair value marks related to hedge positions involving interest rate swaps of $2.4 million partially offset by fair value marks on the Company's available for sale investment securities portfolio of $0.9 million. The Company's interest rate swaps are used to hedge interest rate risk.

Loan Portfolio

We originate commercial real estate loans, construction loans, commercial business loans and consumer loans in our market. We also pursue certain types of commercial lending opportunities outside our market, particularly where we have strong business relationships. Our loan portfolio is the largest category of our earnings assets.

The following table compares the composition of our loan portfolio for the dates indicated:

Primary loan categories

Residential real estate.   Residential real estate loans decreased by $9.7 million, or 15.9%, at December 31, 2023 compared to December 31, 2022 and amounted to $50.9 million, representing 2% of total loans at December 31, 2023. In the fourth quarter of 2017, management made the strategic decision to cease originating residential mortgage loans.

Commercial real estate.   Commercial real estate loans were $1.9 billion and represented 72% of our total loan portfolio at December 31, 2023, a net increase of $26.4 million, or 1.4%, from December 31, 2022. Commercial real estate loans are secured by a variety of property types, including healthcare facilities, office buildings, retail facilities, commercial mixed use and multi-family dwellings.

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The following table compares the composition of our commercial real estate loan portfolio by non-owner occupied and owner occupied loans at December 31, 2023 and December 31, 2022:

(1) Excludes the positive fair value effect of the portfolio layer swap of $742 thousand for Commercial Real Estate at December 31, 2023.

Construction.   Construction loans were $183.4 million at December 31 2023, an increase of $28.2 million, or 18.2%, from December 31, 2022. Commercial construction loans consist of commercial development projects, such as apartment buildings and condominiums, as well as office buildings, retail and other income producing properties and land loans.

Commercial business.   Commercial business loans were $500.6 million and represented 18.4% of our total loan portfolio at December 31, 2023, a net decrease of $19.9 million, or 3.8%, from December 31, 2022. Commercial business loans primarily provide working capital, equipment financing, financing for leasehold improvements and financing for expansion and are generally secured by assignments of corporate assets, real estate and personal guarantees of the business owners.

Consumer loans. Consumer loans were $36.0 million and represented 1.3% of our total loan portfolio as of December 31, 2023, an increase of $18.1 million, or 100.7%. We do not expect our consumer loans to become a material component of our loan portfolio, as we do not engage in any material amount of consumer lending. This portfolio segment includes loans to finance insurance premiums secured by the cash surrender value of life insurance and marketable securities, overdraft lines of credit, and unsecured personal loans to high net worth individuals.

Current environment

We evaluate the appropriateness of our underwriting standards in response to changes in national and regional economic conditions, including such matters as market interest rates, energy prices, trends in real estate values, and employment levels. Based on our assessment of these matters, underwriting standards and credit monitoring activities are enhanced from time to time in response to changes in these conditions. In response to the economic environment in 2023, the Company:

•increased and expanded its monitoring of our entire loan portfolio, with added focus on our commercial real estate loan portfolio,

•added resources in the Portfolio Management Department;

•expanded reporting to Directors' Loan Committee and the Board of Directors which includes:

◦upcoming commercial real estate maturity schedule, including loan to value, debt service coverage ratio, occupancy, and commentary on expected refinance or payoff status, maturity by property type and owner occupied or non-owner-occupied status;

◦individual loan level detail of the performance on our residential care portfolio and our insurance agency portfolio.

•expanded the scope of our third-party loan review from 60% of the loan portfolio to include all new and renewed loans originated since September 2022, all residential care loans, all commercial real estate loans secured by office properties where the loan balance is greater than one million dollars, and all loans with addresses in New York City; and

•enhanced our covenant tracking and reporting to the Directors Loan Committee.

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The following table compares the composition of our commercial real estate loan portfolio by property type, and collateral location as of December 31, 2023:

(1) Excludes the positive fair value effect of the portfolio layer swap of $742 thousand for Commercial Real Estate at December 31, 2023.

(2) Primarily consists of skilled nursing and assisted living facilities.

(3) Includes Special use, self storage, and land.

During 2023, we conducted a detailed review of every general office loan in our portfolio. As of December 31, 2023, the Bank had $193.0 million of loans collateralized by offices, which represented 7.1% of the total loan portfolio. Most of the properties in this portfolio are in suburban locations, including all the New York State properties, which are all located in Westchester County. 96.9% of this portfolio was pass rated, and there were two relationships totaling $6.0 million on nonaccrual status. We also performed an additional review of our multifamily exposure. As of December 31, 2023, we had $257.5 million of loans collateralized by multifamily properties, which represented 9.5% of the total loan portfolio. 100% of the portfolio is pass rated. These properties are all located in Connecticut, New York, or New Jersey, with the majority in suburban locations. Nine properties totaling $52.3 million, with an average balance of $5.8 million, are in New York City.

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The following table presents an analysis of the commercial real estate portfolio's loan to value at origination and by property type as of December 31, 2023.

(1) Excludes the positive fair value effect of the portfolio layer swap of $742 thousand for Commercial Real Estate at December 31, 2023.

(2) Primarily consists of skilled nursing and assisted living facilities.

The following table presents an analysis of the maturity of our commercial real estate, commercial construction and commercial business loan portfolios as of December 31, 2023.

(1) Excludes the positive fair value effect of the portfolio layer swap of $742 thousand for Commercial Real Estate and $179 thousand for Commercial Business.

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The following table presents an analysis of the interest rate sensitivity of our commercial real estate, commercial construction and commercial business loan portfolios due after one year as of December 31, 2023.

Asset Quality

We actively manage asset quality through our underwriting practices and collection operations. Our Board of Directors monitors credit risk management. The Directors' Loan Committee ("DLC") has primary oversight responsibility for the credit-granting function including approval authority for credit-granting policies, review of management’s credit-granting activities and approval of large exposure credit requests, as well as loan review and problem loan management and resolution. The committee reports the results of its respective oversight functions to our Board of Directors. In addition, our Board of Directors receives information concerning asset quality measurements and trends on a monthly basis. While we continue to adhere to prudent underwriting standards, our loan portfolio is not immune to potential negative consequences as a result of general economic weakness, such as a prolonged downturn in the real estate market on a national scale. Decreases in real estate values could adversely affect the value of property used as collateral for loans. In addition, adverse changes in the economy could have a negative effect on the ability of borrowers to make scheduled loan payments, which would likely have an adverse impact on earnings.

The Company has established credit policies applicable to each type of lending activity in which it engages. The Company evaluates the creditworthiness of each client and extends credit of up to 80% of the market value of the collateral, depending on the borrower's creditworthiness and the type of collateral. The borrower’s ability to service the debt is monitored on an ongoing basis. Real estate is the primary form of collateral. Other important forms of collateral are business assets, time deposits and marketable securities. While collateral provides assurance as a secondary source of repayment, the Company ordinarily requires the primary source of repayment for commercial loans, to be based on the borrower’s ability to generate continuing cash flows. In the fourth quarter of 2017 management made the strategic decision to cease originating residential mortgage loans. In the third quarter of 2019, the Company stopped offering home equity loans or lines of credit. The Company’s policy for residential lending generally required that the amount of the loan may not exceed 80% of the original appraised value of the property. In certain situations, the amount may have exceeded 80% LTV either with private mortgage insurance being required for that portion of the residential loan in excess of 80% of the appraised value of the property or where secondary financing is provided by a housing authority program second mortgage, a community’s low/moderate income housing program, or a religious or civic organization.

Credit risk management involves a partnership between our relationship managers and our credit approval, portfolio management, credit administration and collections staff. Disciplined underwriting, portfolio monitoring and early problem recognition are important aspects of maintaining our high credit quality standards and low levels of nonperforming assets since our inception in 2002.

Acquired Loans.   Loans acquired in acquisitions are initially recorded at fair value with no carryover of the related allowance for credit losses. Acquired loans that have evidence of deterioration in credit quality since origination and for which it is probable, at acquisition, that all contractually required payments will not be collected are initially recorded at fair value without recording an ACL-Loans. The fair value of the loans is determined using market participant assumptions to estimate the amount and timing of principal and interest cash flows initially expected to be collected on the loans and discounting those cash flows at an appropriate market rate of interest.

Under the accounting model for acquired loans, the excess of cash flows expected to be collected over the carrying amount of the loans, referred to as the “accretable yield”, is accreted into interest income over the life of the loans. Accordingly, acquired loans are not subject to classification as nonaccrual in the same manner as originated loans. Rather, acquired loans are considered to be accruing loans because their interest income relates to the accretable yield recognized and not to contractual interest payments. The excess of the loans' contractually required payments over the cash flows expected to be collected is the nonaccretable difference. As such, charge-offs on acquired loans are first applied to the nonaccretable difference and then to any ACL-Loans recognized subsequent to the acquisition. A decrease in expected cash flows in subsequent periods may indicate that the loan pool is a credit loss, which would require the establishment of an ACL-Loans by a charge to the provision for loan losses.

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Nonperforming Assets.   Nonperforming assets include nonaccrual loans and property acquired through foreclosures or repossession. The following table presents nonperforming assets and additional asset quality data for the dates indicated:

Total nonaccrual loans were $49.2 million as of December 31, 2023. Nonperforming assets as a percentage of total assets was 1.53% at December 31, 2023, when compared to 0.51% at December 31, 2022. The ACL-Loans at December 31, 2023 was $27.9 million, representing 1.03% of total loans.

Nonaccrual Loans. Loans greater than 90 days past due are generally put on nonaccrual status. Loans are also placed on nonaccrual status when, in the opinion of management, full collection of principal and interest is doubtful. Interest previously accrued, but uncollected, is reversed against current period income. Subsequent payments are recognized on a cash basis or principal recapture basis depending on a number of factors including probability of collection and if a credit loss is identified. A nonaccrual loan is restored to accrual status when it is no longer delinquent and collectability of interest and principal is no longer in doubt. At December 31, 2023 and 2022, there were no commitments to lend additional funds to any borrower on nonaccrual status.

Past Due Loans. When a loan is 15 days past due, the Company sends the borrower a late notice. The Company attempts to contact the borrower by phone if the delinquency is not corrected promptly after the notice has been sent. When the loan is 30 days past due, the Company mails the borrower a letter reminding the borrower of the delinquency, and attempts to contact the borrower personally to determine the reason for the delinquency and ensure the borrower understands the terms of the loan. If necessary, after the 90th day of delinquency, the Company may take other appropriate legal action. A summary report of all loans 30 days or more past due is provided to the Board of Directors of the Company periodically. Loans greater than 90 days past due are generally put on nonaccrual status. A nonaccrual loan is restored to accrual status when it is no longer delinquent and collectability of interest and principal is no longer in doubt. A loan is considered to be no longer delinquent when timely payments are made for a period of at least six months (one year for loans providing for quarterly or semi-annual payments) by the borrower in accordance with the contractual terms.

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The following table presents past due loans as of December 31, 2023 and 2022:

Total past due loans totaled $21.3 million and represented 0.78% of total loans as of December 31, 2023, increasing $5.2 million from December 31, 2022.

Modifications.   Loans are considered restructured when the borrower is experiencing financial difficulties and the Bank has granted concessions to a borrower due to the borrower’s financial condition that we otherwise would not have considered. These concessions may include modifications of the terms of the debt such as reduction of the stated interest rate other than normal market rate adjustments, extension of maturity dates, or reduction of principal balance or accrued interest. The decision to restructure a loan, rather than aggressively enforcing the collection of the loan, may benefit us by increasing the ultimate probability of collection.

Restructured loans are classified as accruing or nonaccruing based on management’s assessment of the collectability of the loan. Loans which are already on nonaccrual status at the time of the restructuring generally remain on nonaccrual status for approximately six months before management considers such loans for return to accruing status. Accruing restructured loans are placed into nonaccrual status if and when the borrower fails to comply with the restructured terms and management deems it unlikely that the borrower will return to a status of compliance in the near term. There were no nonaccrual loans modified during the year ended December 31, 2023. There were seven nonaccrual loans modified totaling $2.5 million during the year ended December 31, 2022.

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The following table presents information on modified loans:

As of December 31, 2023 and 2022, loans classified as modified totaled $16.4 million and $22.2 million, respectively.

Potential Problem Loans.   We classify certain loans as “special mention”, “substandard”, or “doubtful”, based on criteria consistent with guidelines provided by our banking regulators. Potential problem loans represent loans that are currently performing, but for which known information about possible credit problems of the related borrowers causes management to have doubts as to the ability of such borrowers to comply with the present loan repayment terms and which may result in disclosure of such loans as nonperforming at some time in the future. We cannot predict the extent to which economic conditions or other factors may impact borrowers and the potential problem loans. Accordingly, there can be no assurance that other loans will not become 90 days or more past due, be placed on nonaccrual, become restructured, or require increased allowance coverage and provision for loan losses. Potential problem loans are assessed for loss exposure using the methods described in Note 5 to our Consolidated Financial Statements under the caption “Credit Quality Indicators”.

We expect the levels of nonperforming assets and potential problem loans to fluctuate in response to changing economic and market conditions, and the relative sizes of the respective loan portfolios, along with our degree of success in resolving problem assets. We take a proactive approach with respect to the identification and resolution of problem loans.

Allowance for Credit Losses - Loans ("ACL-Loans")

Our Board of Directors has adopted an Allowance for Credit Losses policy designed to provide management with a methodology for determining and documenting the allowance for credit losses for each reporting period. We evaluate the adequacy of the ACL-Loans at least quarterly, and in determining our ACL-Loans, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of our ACL-Loans is based on internally assigned risk classifications of loans, the Bank’s and peer banks’ historical loss experience, changes in the nature of the loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates. See additional discussion regarding our Allowance for Credit Losses-Loans ("ACL-Loans") and Allowance for Credit Losses-Unfunded commitments ("ACL-Unfunded commitments") under the caption "Critical Accounting Policies and Estimates."

Our general practice is to identify problem credits early and recognize full or partial charge-offs as promptly as practicable when it is determined that it is probable that the loan will not be repaid according to its original contractual terms, including principal and interest. Full or partial charge-offs on collateral dependent loans are recognized when the collateral is deemed to be insufficient to support the carrying value of the loan. We do not recognize a recovery when an updated appraisal indicates a subsequent increase in value of the collateral.

Our charge-off policies, which comply with standards established by our banking regulators, are consistently applied from period to period. Charge-offs are recorded on a monthly basis, as incurred. Partially charged-off loans continue to be evaluated on a monthly basis and additional charge-offs or loan loss provisions may be recorded on the remaining loan balance based on the same criteria.

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The following table presents the activity in our ACL-Loans and related ratios for the dates indicated:

At December 31, 2023, our ACL-Loans was $27.9 million and represented 1.03% of total loans, compared to $22.4 million, or 0.84% of total loans at December 31, 2022. The increase relates to the CECL transition adjustment to retained earnings. The increase in the ACL-Loans provision for credit losses was primarily driven by forward looking CECL macroeconomic factors.

The carrying amount of total individually evaluated loans at December 31, 2023 was $105.0 million. This compares to a carrying amount of $42.8 million for total individually evaluated loans at December 31, 2022. The amount of ACL-Loans related to individually evaluated loans was $1.0 million and $0.9 million, respectively, at December 31, 2023 and 2022.

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The following table presents the allocation of the ACL-Loans, the ACL-Loans percentage, and the related loan segments to total loans percentage:

The allocation of the ACL-Loans at December 31, 2023 reflects our assessment of credit risk and probable loss within each portfolio. We believe that the level of the ACL-Loans at December 31, 2023 is appropriate to cover probable losses.

Investment Securities

We manage our investment securities portfolio to provide a readily available source of liquidity for balance sheet management, to generate interest income and to implement interest rate risk management strategies. Investments are designated as either marketable equity, available for sale, held to maturity or trading securities at the time of purchase. We do not currently maintain a portfolio of trading securities. Investment securities available for sale may be sold in response to changes in market conditions, prepayment risk, rate fluctuations, liquidity, or capital requirements. Investment securities available for sale are reported at fair value, with any unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity, net of tax, until realized. Investment securities held to maturity are reported at amortized cost. Marketable equity securities are reported at fair value, with any changes in fair value recognized in earnings.

The amortized cost and fair value of investment securities as of the dates indicated are presented in the following table:

At December 31, 2023, the carrying value of our investment securities portfolio totaled $127.6 million and represented 4% of total assets, compared to $121.6 million and 4% of total assets at December 31, 2022. The increase of $6.0 million primarily reflects purchases of treasury bonds. We purchase investment grade securities with a focus on liquidity, earnings and duration exposure.

The net unrealized losses on our investment portfolio at December 31, 2023 was $7.5 million and included $0.8 million of gross unrealized gains. The net unrealized loss position on our investment portfolio at December 31, 2022 was $9.2 million and included $0.3 million of gross unrealized gains.

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The following tables summarize the amortized cost and weighted average yield of securities in our investment securities portfolio as of December 31, 2023 and 2022, based on remaining period to contractual maturity. Information for mortgage-backed securities is based on the final contractual maturity dates without considering repayments and prepayments.

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Bank Owned Life Insurance ("BOLI")

BOLI amounted to $51.4 million as of December 31, 2023. The purchase of life insurance policies results in an income-earning asset on our consolidated balance sheet that provides monthly tax-free income to us. We expect to benefit from the BOLI contracts as a result of the tax-free growth in cash surrender value and death benefits that are expected to be generated over time. BOLI is included in our Consolidated Balance Sheets at its cash surrender value. Increases in the cash surrender value are reported as a component of noninterest income in our Consolidated Statements of Income.

Deposit Activities and Other Sources of Funds

Our sources of funds include deposits, including brokered deposits, FHLB borrowings, subordinated debt and proceeds from the sales, maturities and payments of loans and investment securities.

Total deposits represented 85% of our total assets at December 31, 2023. While scheduled loan and securities repayments are relatively stable sources of funds, loan and securities prepayments and deposit inflows are influenced by prevailing interest rates and local economic conditions and are inherently uncertain.

Deposits

We offer a wide variety of deposit products and rates to consumer and business clients consistent with FDIC regulations. Our executive management team meets regularly to determine pricing and marketing initiatives. In addition to being an important source of funding for us, deposits also provide an ongoing stream of fee revenue.

We participate in the Certificate of Deposit Account Registry Service ("CDARS") and Insured Cash Sweep Service ("ICS") programs. We use CDARS and ICS to place client funds into certificate of deposit accounts and money market accounts, respectively, into other participating banks. These transactions occur in amounts that are less than FDIC insurance limits to ensure that deposit clients are eligible for FDIC insurance on the full amount of their deposits. Reciprocal amounts of deposits are received from other participating banks that do the same with their client deposits, and, we also execute one-way buy transactions. CDARS one-way and ICS one-way buy transactions are considered to be brokered deposits for bank regulatory purposes.

Time deposits may also be generated through the use of a listing service. We subscribe to a listing service, accessible to financial institutions, in which we may advertise our time deposit rates. Interested financial institutions then contact us directly to acquire a time certificate of deposit. There is no third party brokerage service involved in this transaction.

The following table sets forth the composition of our deposits for the dates indicated:

Total deposits were $2.7 billion at December 31, 2023, a decrease of $64.1 million, or 2%, from December 31, 2022.

Brokered certificates of deposits ("Brokered CDs") totaled $860.5 million and $976.5 million at December 31, 2023 and December 31, 2022, respectively. Brokered money market accounts totaled $91.4 million and $41.8 million at December 31, 2023 and 2022, respectively. There were no certificates of deposits from national listing services, one-way buy CDARS or one-way buy ICS at December 31, 2023 or December 31, 2022. Brokered deposits are comprised of Brokered CDs, brokered money market accounts, one-way buy CDARS, and one-way buy ICS.

As of December 31, 2023, our FDIC insured deposits were $1,945.9 million, or 71% of total deposits. Additionally, $110.0 million of deposits are insured by standby letters of credit with the Federal Home Loan Bank of Boston, or 4% of total deposits.

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At December 31, 2023 and 2022, time deposits, including CDARS and Brokered CDs, with a denomination of $100 thousand or more totaled $1.2 billion and $1.2 billion, respectively, maturing during the periods indicated in the table below:

Federal Home Loan Bank Advances and Other Borrowings

The Bank is a member of the FHLB, which is part of a twelve district Federal Home Loan Bank System. Members are required to own capital stock of the FHLB, and borrowings are collateralized by qualifying assets not otherwise pledged. The maximum amount of credit that the FHLB will extend varies from time to time, depending on its policies and the amount of qualifying collateral the member can pledge. The Bank had satisfied its collateral requirement at December 31, 2023.

We utilize advances from the FHLB as part of our overall funding strategy, to meet short-term liquidity needs and to manage interest rate risk arising from the difference in asset and liability maturities. Total FHLB advances were $90.0 million at December 31, 2023 and $90.0 million at December 31, 2022.

The Bank has additional borrowing capacity at the FHLB up to a certain percentage of the value of qualified collateral. In accordance with agreements with the FHLB, the qualified collateral must be free and clear of liens, pledges and encumbrances. At December 31, 2023, the Bank had pledged $927.1 million of eligible loans as collateral to support borrowing capacity at the FHLB of Boston. As of December 31, 2023, the Bank had immediate availability to borrow an additional $344.4 million based on qualified collateral.

Advances from the FHLB include short-term advances with original maturity dates of one year or less. The following table sets forth certain information concerning short-term FHLB advances as of and for the periods indicated:

(1) $50 million of the Company's FHLB borrowings are subject to longer term interest rate swap agreements and the weighted average rate reflects the "all-in" swap rate under these long interest rate term swap agreements.

On October 14, 2021, the Company completed a private placement of a $35.0 million fixed-to-floating rate subordinated note (the “2021 Note”) to an institutional accredited investor. The Company used the net proceeds to repay the outstanding balance of subordinated debt issued in 2015 and for general corporate purposes.

The 2021 Note bears interest at a fixed rate of 3.25% per year until October 14, 2026. Thereafter, the interest rate will reset quarterly at a variable rate equal to the then current three-month term SOFR plus 233 basis points. The 2021 Note has a stated maturity of October 15, 2031 and is non-callable for five years. Beginning October 15, 2026, the Company may redeem the 2021 Note, in whole or in part, at its option. The 2021 Note is not redeemable at the option of the holder. The 2021 Note has been structured to qualify for the Company as Tier 2 capital under regulatory guidelines.

On August 19, 2022, the Company entered into a Subordinated Note Purchase Agreement with certain qualified institutional buyers, pursuant to which the Company issued and sold 6.0% fixed-to-floating rate subordinated notes due 2032 (the “2022 Notes”) in the aggregate principal amount of $35.0 million. The Company used the net proceeds from the sale of the 2022 Notes for general corporate purposes.

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The 2022 Notes bear interest at a fixed rate of 6.0% per year until August 31, 2027. Thereafter, the interest rate will reset quarterly at a variable rate equal to the then current three-month term SOFR plus 326 basis points. The 2022 Notes have a stated maturity of September 1, 2032 and are non-callable for five years. Beginning August 19, 2027, the Company may redeem the 2022 Notes, in whole or in part, at its option. The 2022 Notes are not subject to redemption at the option of the holder. The 2022 Notes have been structured to qualify for the Company as Tier 2 capital under regulatory guidelines.

Derivative Instruments

The Company uses interest rate swap instruments to fix the interest rate on short-term FHLB borrowings or brokered deposits, all of which are designated as cash flow hedges. The hedge strategy converts the rate of interest on short-term rolling FHLB advances or brokered deposits to long-term fixed interest rates, thereby protecting the Bank from interest rate variability in the contractually specified interest rates.

The Company entered into one pay-fixed portfolio layer method fair value swap, designated as a hedging instrument, with a total notional amount of $150 million in the first quarter of 2023. The Company designated the fair value swap under the portfolio layer method. Under this method, the hedged item is designated as a hedged layer of a closed portfolio of financial loans that is anticipated to remain outstanding for the designated hedged period.

Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain loan clients. The Company executes interest rate swaps with commercial banking clients to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the client derivatives and the offsetting derivatives are recognized directly in earnings. Information about derivative instruments at December 31, 2023 and 2022 was as follows:

(1) Represents interest rate swaps with commercial banking clients, which are offset by derivatives with a third party.

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(1) Represents interest rate swaps with commercial banking clients, which are offset by derivatives with a third party.

Liquidity and Capital Resources

Liquidity Management

Liquidity is defined as the ability to generate sufficient cash flows to meet all present and future funding requirements at reasonable costs. Our primary source of liquidity is deposits. While our generally preferred funding strategy is to attract and retain low cost deposits, our ability to do so is affected by competitive interest rates and terms in the marketplace. Other sources of funding include discretionary use of purchased liabilities (e.g., FHLB term advances and other borrowings), cash flows from our investment securities portfolios, loan sales, loan repayments and earnings. Investment securities designated as available for sale may also be sold in response to short-term or long-term liquidity needs.

The Bank’s liquidity position is monitored daily by management. The Asset Liability Committee, or ALCO, establishes guidelines to ensure maintenance of prudent levels of liquidity. ALCO reports to the Company’s Board of Directors.

The Bank has a detailed liquidity funding policy and a contingency funding plan that provide for the prompt and comprehensive response to unexpected demands for liquidity. We employ a stress testing methodology to estimate needs for contingent funding that could result from unexpected outflows of funds in excess of “business as usual” cash flows. The Bank has established unsecured borrowing capacity with the Pacific Coast Bank (PCBB), Atlantic Community Bankers Bank (ACBB), and Zion’s Bank and also maintains additional collateralized borrowing capacity with the Federal Reserve Bank of New York ("FRBNY") and the FHLB in excess of levels used in the ordinary course of business. Our sources of liquidity include cash, unpledged investment securities, borrowings from the FRBNY, FHLB, lines of credit from PCBB, ACBB, and Zion's Bank, the brokered deposit market and national CD listing services.

Capital Resources

Shareholders’ equity totaled $265.8 million as of December 31, 2023, an increase of $27.3 million compared to December 31, 2022, primarily a result of (i) net income of $36.7 million for the year ended December 31, 2023. The increase was partially offset by the Day 1 CECL adoption of $4.9 million, dividends paid of $6.2 million, and a $1.5 million unfavorable impact to accumulated other comprehensive income. The unfavorable impact to accumulated other comprehensive income was driven by fair value marks related to hedge positions involving interest rate swaps of $2.4 million partially offset by fair value marks on the Company's available for sale investment securities portfolio of $0.9 million. The Company's interest rate swaps are used to hedge interest rate risk. As of December 31, 2023, the tangible common equity ratio and tangible book value per share were 8.19% and $34.50, respectively.

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. At December 31, 2023, the Bank met all capital adequacy requirements to which it was subject and exceeded the regulatory minimum capital levels to be considered well-capitalized under the regulatory framework. At December 31, 2023, the Bank’s ratio of total common equity

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tier 1 capital to risk-weighted assets was 11.30%, total capital to risk-weighted assets was 12.32%, Tier 1 capital to risk-weighted assets was 11.30% and Tier 1 capital to average assets was 9.81%.

Under the current guidelines, banking organizations must have a minimum total risk-based capital ratio of 8.0%, a minimum Tier 1 risk-based capital ratio of 6.0%, a minimum common equity Tier 1 risk-based capital ratio of 4.5%, and a minimum leverage ratio of 4.0% in order to be "adequately capitalized." In addition to these requirements, banking organizations must maintain a capital conservation buffer consisting of common Tier 1 equity in an amount above the minimum risk-based capital requirements for “adequately capitalized” institutions equal to 2.5% of total risk-weighted assets, resulting in a requirement for the Company and the Bank to effectively maintain common equity Tier 1, Tier 1 and total capital ratios of 7.0%, 8.5% and 10.5%, respectively. The Company and the Bank must maintain the capital conservation buffer to avoid restrictions on the ability to pay dividends, pay discretionary bonuses, or to engage in share repurchases.

Contractual Obligations

The following table summarizes our contractual obligations to make future payments as of December 31, 2023. Payments for borrowings do not include interest. Payments related to leases are based on actual payments specified in the underlying contracts.

Off-Balance Sheet Arrangements

In the normal course of business, we are a party to financial instruments with off-balance sheet risk to meet the financing needs of our clients. These financial instruments include commitments to extend credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the financial statements. The contractual amounts of these instruments reflect the extent of involvement we have in particular classes of financial instruments.

We enter into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of the Bank’s commitments to extend credit are contingent upon clients maintaining specific credit standards at the time of loan funding. The Bank minimizes its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures.

Commitments to extend credit totaled $333.5 million and $561.0 million, respectively at December 31, 2023 and 2022. The following table summarizes our commitments to extend credit as of the dates indicated. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements. In addition, borrowers may be required to meet certain performance requirements to continue to draw on these commitments. We manage our liquidity in light of the aggregate amounts of commitments to extend credit and outstanding standby letters of credit in effect from time to time to ensure that we will have adequate sources of liquidity to fund such commitments and honor drafts under such letters of credit.

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As of December 31, 2023

As of December 31, 2022