HANMI FINANCIAL CORP (HAFC) FY 2022 MD&A

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

This discussion presents management’s analysis of the financial condition and results of operations as of and for the years ended December 31, 2022, 2021 and 2020. This discussion should be read in conjunction with our Consolidated Financial Statements and the Notes related thereto presented elsewhere in this Report. See also “Cautionary Note Regarding Forward-Looking Statements.”

Critical Accounting Policies

We have established various accounting policies that govern the application of GAAP in the preparation of our Consolidated Financial Statements. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions to arrive at the carrying value of assets and liabilities and amounts reported for revenues and expenses. Our financial position and results of operations can be materially affected by these estimates and assumptions. Critical accounting policies are those policies that are most important to the determination of our financial condition and results of operations or that require management to make assumptions and estimates that are subjective or complex. Our significant accounting policies are discussed in the “Notes to Consolidated Financial Statements, Note 1 — Summary of Significant Accounting Policies.” Management believes that the following policy is critical.

Allowance for credit losses and Allowance for credit losses related to off-balance sheet items

Our allowance for credit losses methodologies incorporate a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for credit losses that management believes is appropriate at each reporting date. Quantitative factors include our historical loss experiences on loan pools segmented by type, and considers risk rating, delinquency and charge-off trends, collateral values, changes in nonperforming loans, and other factors.

We use qualitative factors to adjust the allowance calculation for risks not considered by the quantitative calculations. Qualitative factors considered in our methodologies include the general economic forecast in our markets, concentrations of credit, changes in lending management and staff, quality of the loan review system, and changes in interest rates.

The Company reviews baseline and alternative economic scenarios from Moody’s and quarterly projections of federal funds target rates from the Federal Open Market Committee (“FOMC”) for consideration as qualitative factors. Moody’s publishes a baseline forecast that represents the estimate of the most likely path for the United States economy through the current business cycle (50% probability that economic conditions will be worse and 50% probability that economic conditions will be better) as well as alternative scenarios to examine how different types of shocks will affect the future performance of the United States economy.

Certain quantitative and qualitative factors used to estimate credit losses and establish an allowance for credit losses are subject to uncertainty. The adequacy of our allowance for credit losses is sensitive to changes in current and forecasted economic conditions that may affect the ability of borrowers to make contractual payments as well as the value of the collateral securing such payments.

Although management believes it uses the best information necessary to establish the allowance for credit losses, future adjustments to the allowance for credit losses may be necessary and the Company’s results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations.

In addition, because future events affecting borrowers and collateral cannot be predicted without uncertainty, the existing allowance for credit losses may not be adequate or increases may be necessary should the quality of any loans deteriorate as a result of the factors discussed. Any material increase in the allowance for credit losses could adversely impact the Company's financial condition and results of operations.

See “— Allowance for Credit Losses”, “Financial Condition — Allowance for credit losses and Allowance for credit losses related to off-balance sheet items”, “Results of Operations — Credit Loss Expense” and “Notes to Consolidated Financial Statements, Note 1 — Summary of Significant Accounting Policies” for additional information on methodologies used to determine the allowance for credit losses and the allowance for credit losses related to off-balance sheet items.

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Allowance Attribution Analysis

The following are the key assumptions employed in the determination of the allowance for credit losses at December 31, 2022 and 2021:

Economic Factors

(1)
The Moody's Baseline scenario was used for the unemployment rate forecast for periods ended December 31, 2022 and 2021. We continue to use the unemployment rate forecast under the Baseline Scenario due to job market volatility and deterioration below expectations, with less impact to the lending environment compared to GDP growth and consumer sentiment forecasts.

(2)
The Moody's Alternative Scenario 3 was used for the GDP growth rate and consumer sentiment forecast for the period ended December 31, 2022. Effective Q2 2022, the Company elected to use Alternative Scenario 3 (mid-level downside/pessimistic scenario) for the GDP growth rate and consumer sentiment forecasts, given the elevation in inflation and rising rate environment.

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The potential effect from changes in key assumptions could affect the estimated allowance for credit losses at December 31, 2022. The following table illustrates the possible individual effects to the allowance for credit losses from changes in such assumptions:

Sensitivity Analysis

(1)
The following table provides additional details to the Baseline and Alternative Scenarios referred to above:

Executive Overview

For the years ended December 31, 2022, 2021 and 2020, net income was $101.4 million, $98.7 million and $42.2 million, respectively. The increase of $2.7 million, or 2.8%, in net income for the year ended December 31, 2022 as compared with the year ended December 31, 2021, was primarily attributable to an increase in net interest income of $42.6 million. Offsetting this increase were an increase in noninterest expense of $5.8 million, and a decrease in noninterest income of $6.3 million, as well as a $25.2 million reduction in the benefit from the year-ago credit loss recovery.

The increase of $56.5 million, or 133.9%, in net income for the year ended December 31, 2021 as compared with the year ended December 31, 2020, was primarily attributable to a decrease in credit loss expense of $69.9 million and a decrease in interest expense of $22.3 million. Partially offsetting these decreases were an increase in income tax expense of $19.5 million, and decreases in interest income on securities of $4.3 million and interest on loans receivable of $3.2 million.

For the years ended December 31, 2022, 2021 and 2020, our earnings per diluted share were $3.32, $3.22 and $1.38, respectively.

Additional significant financial highlights include:

•
Cash and due from banks decreased $256.5 million to $352.4 million as of December 31, 2022 from $609.0 million at December 31, 2021, primarily to fund an increase in loans and the redemption of subordinated debentures.

•
Loans receivable increased by $815.6 million, or 15.8%, to $5.97 billion as of December 31, 2022, compared with $5.15 billion as of December 31, 2021. The increase was primarily attributable to strong demand in residential and commercial real estate loans, commercial and industrial loans, and equipment financing loans.

•
Securities decreased $57.0 million to $853.8 million at December 31, 2022 from $910.8 million at December 31, 2021, primarily attributable to the impact of unrealized losses from rising interest rates.

•
Deposits were $6.17 billion at December 31, 2022 compared with $5.79 billion at December 31, 2021 as time deposits increased $969.0 million, while money market and savings deposits decreased $542.7 million.

•
Subordinated debentures and borrowings increased $126.9 million to $479.4 million at December 31, 2022 compared with $352.5 million at December 31, 2021, primarily attributable to the $212.5 million increase in borrowings, offset by the $87.3 million net redemption of the $100.0 million Fixed-to-Floating Subordinated Notes (“2027 Notes”) that were issued on March 21, 2017.

•
Cash dividends were $0.94 per share of common stock for the year ended December 31, 2022 compared with $0.54 and $0.52 per share of common stock for the years ended December 31, 2021 and 2020, respectively.

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Results of Operations

Net Interest Income

Our primary source of revenue is net interest income, which is the difference between interest and fees derived from earning assets, and interest paid on liabilities obtained to fund those assets. Our net interest income is affected by changes in the level and mix of interest-earning assets and interest-bearing liabilities, referred to as volume changes. Net interest income is also affected by changes in the yields earned on assets and rates paid on liabilities, referred to as rate changes. Interest rates charged on loans are affected principally by changes to market interest rates, the demand for such loans, the supply of money available for lending purposes, and other competitive factors. Those factors are, in turn, affected by general economic conditions and other factors beyond our control, such as federal economic policies, the general supply of money in the economy, legislative tax policies, governmental budgetary matters, and the actions of the Federal Reserve.

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The following table shows the average balances of assets, liabilities and stockholders’ equity; the amount of interest income, on a tax equivalent basis and interest expense; the average yield or rate for each category of interest-earning assets and interest-bearing liabilities; and the net interest spread and the net interest margin for the periods indicated. All average balances are daily average balances.

(1)
Loans receivable include loans held for sale and exclude the allowance for credit losses. Nonaccrual loans receivable are included in the average loans receivable balance.

(2)
Amounts calculated on a fully taxable equivalent basis using the current statutory federal tax rate of 21%.

(3)
Represents interest expense on deposits as a percentage of all interest-bearing and noninterest-bearing deposits.

(4)
Represents the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities.

(5)
Represents net interest income as a percentage of average interest-earning assets.

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The table below shows changes in interest income and interest expense and the amounts attributable to variations in interest rates and volumes for the periods indicated. The variances are primarily attributable to simultaneous volume and rate changes that have been allocated to the change due to volume and the change due to rate categories in proportion to the relationship of the absolute dollar amount attributable solely to the change in volume and to the change in rate.

(1)
Loans receivable include loans held for sale and exclude the allowance for credit losses. Nonaccrual loans receivable are included in the average loans receivable balance.

(2)
Amounts calculated on a fully equivalent basis using the current statutory federal tax rate of 21%.

2022 Compared to 2021

Interest income, on a taxable equivalent basis, increased $57.1 million, or 26.4%, to $273.8 million for the year ended December 31, 2022 from $216.7 million for the year ended December 31, 2021. Interest expense increased $14.5 million, or 67.2%, to $36.2 million for 2022, from $21.6 million in 2021. Net interest income, on a taxable equivalent basis, increased by $42.6 million, or 21.8%, to $237.6 million in 2022, from $195.1 million in 2021. The increase in net interest income was due to an increase in the average yield and average balance on average interest-earning assets, offset partially by increases in the rates paid on interest-bearing liabilities and borrowings. Average loans were 82.3% of average interest earning assets for 2022, an increase from 75.6% for 2021. The net interest spread and net interest margin, on a taxable equivalent basis, for the year ended December 31, 2022 were 3.02% and 3.50%, respectively, compared with 2.81% and 3.08%, respectively, for 2021.

The average balance of interest earning assets increased $458.7 million, or 7.2%, to $6.80 billion for the year ended December 31, 2022 from $6.34 billion for 2021. The increase in the average balance of interest-earning assets was due mainly to an $802.0 million increase in average loans, from $4.79 billion in 2021, to $5.60 billion in 2022. The average balance of securities increased $104.5 million, or 12.4%, to $949.9 million in 2022 from $845.4 million for 2021. The average balance of interest-bearing liabilities increased $28.8 million, or 0.8%, to $3.58 billion for 2022 compared to $3.55 billion in 2021. The increase in average interest-bearing liabilities resulted primarily from an increase in average time deposits in 2022.

The average yield on interest-earning assets, on a taxable equivalent basis, increased 61 basis points to 4.03% in 2022 from 3.42% in 2021, due mainly to the increase in the yields on loans and securities. The average yield on loans increased to 4.61% for the year ended December 31, 2022 from 4.35% for 2021, primarily due to the continued increase in market interest rates in 2022. The average yield on securities, on a taxable equivalent basis, increased to 1.33% for 2022 from 0.75% for 2021. The average rate paid on interest-bearing liabilities increased by 40 basis points to 1.01% for 2022 from 0.61% for 2021. The increase reflected the higher cost of interest-bearing deposits, and an increase in the average rate on borrowings due to increases in market rates in 2022. The average rate paid on interest-bearing deposits increased from 0.36% in 2021, to 0.79% in 2022. The average rate on borrowings increased from 1.17% in 2021, to 1.61% in 2022. The average balance of subordinated debentures decreased from $154.4 million in 2021, to $149.9 million in 2022, and the average rate decreased by 12 basis points, resulting in a $0.4 million decrease in corporate interest expense.

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2021 Compared to 2020

Interest income, on a taxable equivalent basis, decreased $7.2 million, or 3.2%, to $216.7 million for the year ended December 31, 2021 from $223.9 million for the year ended December 31, 2020. Interest expense decreased $21.3 million or 49.7%, to $21.6 million for 2021 from $43.0 million in 2020. Net interest income, on a taxable equivalent basis, was $195.1 million and $180.9 million for 2021 and 2020, respectively. The increase in net interest income was primarily due to the decrease in interest expense on interest-bearing liabilities, partially offset by the decrease in interest income on interest-earning assets. Average loans were 75.6% of average interest earning assets for 2021, down from 82.6% for 2020. The net interest spread and net interest margin, on a taxable equivalent basis, for the year ended December 31, 2021 were 2.81% and 3.08%, respectively, compared with 2.75% and 3.19%, respectively, for 2020.

The average balance of loans increased $110.0 million, or 2.3%, to $4.79 billion for 2021 from $4.68 billion for 2020. The average balance of securities increased $181.7 million, or 27.4%, to $845.4 million in 2021 from $663.7 million for 2020. The average balance of interest earning assets increased $669.5 million, or 11.8%, to $6.34 billion for the year ended December 31, 2021 from $5.67 billion for 2020. The increase in the average balance of loans was due mainly to new loan production in real estate loans. The average balance of interest-bearing liabilities decreased $27.4 million, or 0.8%, to $3.55 billion for 2021 compared to $3.58 billion in 2020. The decrease in average interest-bearing liabilities resulted primarily from lower time deposits and borrowings, offset by increases in money market and savings accounts and subordinated debentures.

The average yield on loans decreased to 4.35% for the year ended December 31, 2021 from 4.52% for 2020, primarily due to the continued decrease in market interest rates in 2021, offset by the change in composition of the loan portfolio with a greater concentration of commercial real estate loans. The average yield on securities, on a taxable equivalent basis, decreased to 0.75% for 2021 from 1.59% for 2020, primarily attributable to the sale of securities during the second quarter of 2020 to take advantage of unrealized gains, the proceeds of which were reinvested into lower-yielding securities. The average yield on interest-earning assets, on a taxable equivalent basis, decreased 52 basis points to 3.42% in 2021 from 3.95% in 2020, due mainly to the decrease in the yields on the loan portfolio due to a decrease in market interest rates and the origination of $133.1 million of PPP loans at a rate of 1%. The average cost of interest-bearing liabilities decreased by 59 basis points to 0.61% for 2021 from 1.20% for 2020. The decrease was due to lower market interest rates and a shift away from time deposits to money market and savings deposits in the composition of the deposit accounts and lower borrowings, partially offset by an increase in subordinated debentures.

Credit Loss Expense

As a result of credit risks inherent in our lending business, we recognize an allowance for credit losses through charges to credit loss expense. These charges pertain not only to our outstanding loan portfolio, but also to off-balance sheet items, such as commitments to extend credit. Credit loss expense for our outstanding loan portfolio is recorded to the allowance for credit losses. The allowance for off-balance sheet items is included in accrued expenses and other liabilities and the allowance for uncollectible accrued interest receivable is included in accrued interest receivable.

2022 Compared to 2021

The credit loss expense for 2022 was $0.8 million, compared with a credit loss recovery of $24.4 million for 2021. The credit loss expense for 2022 was comprised of a $0.3 million provision for credit losses and a $0.5 million provision for off-balance sheet items. For the year ended December 31, 2021, the credit loss expense recovery was $24.4 million and was comprised of a $24.1 million negative provision for credit losses, and a $0.2 million negative provision for off-balance sheet items. Additionally, the credit loss expense recovery included a $1.7 million negative provision for accrued interest receivable for loans currently or previously modified under the CARES Act, offset by a $1.6 million SBA guarantee repair loss allowance.

2021 Compared to 2020

The credit loss expense recovery for 2021 was $24.4 million compared with a credit loss expense of $45.5 million for 2020. The credit loss expense recovery for 2021 was comprised of a $24.1 million negative provision for credit losses, a $0.2 million negative provision for off-balance sheet items and $1.7 million negative provision for accrued interest receivable for loans currently or previously modified under the CARES Act, offset by $1.6 from a SBA guarantee repair loss allowance. For the year ended December 31, 2020, credit loss expense was $45.5 million and included a $42.5 million provision for credit losses. Additionally, a $0.7 million provision for off-balance sheet items and a $2.3 million provision for losses on accrued interest receivable for loans currently or previously modified under the CARES Act was recorded as credit loss expense during 2020.

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Noninterest Income

The following table sets forth the various components of noninterest income for the years indicated:

2022 Compared to 2021

For the year ended December 31, 2022 noninterest income was $34.2 million, a decrease of $6.3 million, or 15.5%, compared with $40.5 million in 2021. The decrease was primarily due to a $7.8 million decrease in the gain on sale of SBA loans. The volume of SBA loans sold for the full year 2022 declined to $156.1 million from $261.8 million for the full year 2021. 2021 SBA loan sales included $132.7 million of second-draw PPP loans sold for gains of $3.0 million.

2021 Compared to 2020

For the year ended December 31, 2021 noninterest income was $40.5 million, a decrease of $2.6 million, or 6.1%, compared with $43.1 million in 2020. The decrease was primarily attributable to a net loss of $0.5 million on the sale of securities for the year ended December 31, 2021 compared with $15.7 million of gains in 2020, partially offset by increases from a gain on the sale of SBA loans of $12.0 million and service charges on deposit accounts of $2.6 million.

Noninterest Expense

The following table sets forth various components of noninterest expense for the years indicated:

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2022 Compared to 2021

For the year ended December 31, 2022, noninterest expense was $130.3 million, an increase of $5.8 million, or 4.7%, compared with $124.5 million for 2021. The increase in noninterest expense was mainly due to a $3.6 million, or 4.9% increase in salaries and benefits, a $1.8 million increase in other operating expenses, a $1.1 million increase in data processing expenses and a $1.0 million increase in advertising and promotion, offset partially by a $1.4 million decrease in occupancy and equipment. The increase in salaries and benefits was due to salary increases and increases in employees, as a result of increased staffing added to support the growth in loans and deposits. The number of full-time equivalent employees increased to 624 as of December 31, 2022, from 590 as of December 31, 2021. The increase in other operating expenses was due mainly to an increase in loan related expenses as a result of increased loan volume and a $0.4 million servicing asset valuation adjustment. The increase in data processing was due to increased processing costs related to higher volumes. The increase in advertising and promotion was due to services added during 2022. The decrease in occupancy and equipment was due primarily to a $1.5 million reversal of estimated property taxes in 2022.

2021 Compared to 2020

For the year ended December 31, 2021, noninterest expense was $124.5 million, an increase of $5.4 million, or 4.5%, compared with $119.1 million for 2020. The increase was due primarily to an increase in salaries and benefits of $5.6 million, stemming from increased compensation on higher loan production, offset partially by a decrease of $1.2 million in professional fees.

Income Tax Expense

For the years ended December 31, 2022, 2021 and 2020, income tax expense was $39.3 million, $36.8 million and $17.3 million, respectively. The effective tax rate for the years ended December 31, 2022, 2021 and 2020 was 27.9%, 27.2% and 29.1%, respectively. The higher effective tax rate for 2022 compared with 2021 was due mainly to a lower reduction in the deferred tax asset valuation allowance required for state net operating loss carryforwards and state tax credits. The lower effective tax rate for 2021 compared with 2020 was due mainly to a reduction in the deferred tax asset valuation allowance required for state net operating loss carryforwards and state tax credits in 2021.

Income taxes are discussed in more detail in “Notes to Consolidated Financial Statements, Note 1 — Summary of Significant Accounting Policies” and “Note 11 — Income Taxes” presented elsewhere herein.

Financial Condition

Securities Portfolio

As of December 31, 2022, our securities portfolio was composed of mortgage-backed securities, collateralized mortgage obligations, debt securities issued by U.S. government agencies and sponsored agencies and tax-exempt municipal bonds. Most of the securities carried fixed interest rates. Other than holdings of U.S. government and agency securities, there were no securities of any one issuer exceeding 10% of stockholders’ equity as of December 31, 2022, 2021 and 2020.

As of December 31, 2022, securities available for sale decreased $57.0 million, or 6.3%, to $853.8 million from $910.8 million as of December 31, 2021. The decrease was primarily attributable to the impact of unrealized losses from rising interest rates in 2022.

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The following table summarizes the contractual maturity schedule for securities, at amortized cost, and their cost-weighted average yield, which is calculated using amortized cost as the weight, as of December 31, 2022:

Loan Portfolio

As of December 31, 2022, 2021 and 2020, loans receivable (excluding loans held for sale), net of deferred loan costs, discounts and allowance for credit losses, were $5.90 billion, $5.08 billion and $4.79 billion, respectively, representing an increase of $816.6 million or 16.1% in 2022 and an increase of $289.2 million, or 6.0% in 2021. The $816.6 million increase in loans for 2022 was primarily attributable to higher new loan production, mainly in real estate and commercial and industrial loans.

During the year ended December 31, 2022, total loan originations consisted of $723.7 million of commercial real estate loans, $420.5 million of commercial and industrial loans, $420.2 million of residential/consumer loans, $342.1 million of equipment financing agreements, and $208.6 million of SBA loans, offset by $1.30 billion of payoffs and other net reductions.

The table below shows the maturity distribution of outstanding loans (before the allowance for credit losses) as of December 31, 2022. In addition, the table shows the distribution of such loans between those with floating or variable interest rates and those with fixed or predetermined interest rates.

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The table below shows the maturity distribution of outstanding loans with fixed or predetermined interest rates due after one year, as of December 31, 2022.

The table below shows the maturity distribution of outstanding loans with floating or variable interest rates (including hybrids) due after one year, as of December 31, 2022.

As of December 31, 2022, the loan portfolio included the following concentrations of loans to one type of industry that were greater than 10% of loans receivable:

Loan Quality Indicators

Delinquent loans (defined as 30 to 89 days past due and still accruing) were $7.5 million, $5.9 million and $9.5 million as of December 31, 2022, 2021 and 2020, respectively, representing an increase of $1.6 million, or 27.4%, in 2022 and a decrease of $3.6 million or 37.9%, in 2021.

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Activity in criticized loans was as follows for the periods indicated:

Special mention loans decreased $16.3 million, or 17.1%, to $79.0 million at December 31, 2022 compared with $95.3 million as of December 31, 2021. The decrease was mainly due to payoffs and paydowns of $23.6 million and upgrades to pass of $69.9 million, primarily related to nine commercial real estate hotel loans. Offsetting the decrease were by downgrades from pass of $64.6 million. These downgrades included a $46.8 million loan relationship identified during the third quarter of 2022. The loan relationship is comprised of a $25.0 million asset-based line of credit (of which $24.1 million was outstanding at December 31, 2022), a $13.4 million commercial real estate loan and a $9.3 million commercial term loan. We continue to work actively with the borrower’s new management and its parent company to ensure satisfactory performance under the loan agreements.

Classified loans decreased $14.4 million, or 23.8%, to $46.2 million at December 31, 2022, from $60.6 million at December 31, 2021. The decrease in classified loans was primarily attributable to various payoffs, paydowns and upgrades of $26.7 million, offset by various downgrades of $12.3 million.

Nonperforming Assets

Nonperforming loans consist of loans on nonaccrual status and loans 90 days or more past due and still accruing interest. Nonperforming assets consist of nonperforming loans and OREO. Loans are placed on nonaccrual status when, in the opinion of management, the full timely collection of principal or interest is in doubt. Generally, the accrual of interest is discontinued when principal or interest payments become more than 90 days past due, unless management believes the loan is adequately collateralized and in the process of collection. However, in certain instances, we may place a particular loan on nonaccrual status earlier, depending upon the individual circumstances surrounding the delinquency of the loan. When a loan is placed on nonaccrual status, previously accrued but unpaid interest is reversed against current income. Subsequent collections of cash are applied as principal reductions when received, except when the ultimate collectability of principal is probable, in which case interest payments are credited to income. Nonaccrual loans may be restored to accrual status when principal and interest become current and full repayment is expected, which generally occurs after sustained payment of six months. Interest income is recognized on the accrual basis for impaired loans not meeting the criteria for nonaccrual. OREO consists of properties acquired by foreclosure or similar means or are vacant bank properties for which their usage for operations has ceased and management intends to offer for sale.

Except for nonperforming loans discussed below, management is not aware of any loans as of December 31, 2022 for which known credit problems of the borrower would cause serious doubts as to the ability of such borrowers to comply with their present loan repayment terms, or any known events that would result in the loan being designated as nonperforming at some future date.

Nonaccrual loans were $9.8 million and $13.4 million as of December 31, 2022 and 2021, respectively, representing a decrease of $3.5 million, or 26.3%, in 2022 and a decrease of $69.7 million, or 83.9%, in 2021. The decrease in nonaccrual loans for 2022 was primarily due to the payoffs, paydowns, note sales, or upgrades of $17.3 million. At December 31, 2022 and 2021, $4.0 million and $4.7 million, respectively, of nonaccrual loans were adversely affected by the COVID-19 pandemic. As of December 31, 2022 and 2021, all loans 90 days or more past due were classified as nonaccrual.

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The $9.8 million of nonperforming loans as of December 31, 2022 had individually evaluated allowances of $3.3 million, compared to $13.4 million of nonperforming loans with individually evaluated allowances of $2.8 million as of December 31, 2021. The allowance for collateral-dependent loans is calculated as the difference between the outstanding loan balance and the value of the collateral as determined by recent appraisals less estimated costs to sell. The allowance for collateral-dependent loans varies based on the collateral coverage of the loan at the time of designation as nonperforming. We continue to monitor the collateral coverage on these loans on a quarterly basis, based on recent appraisals, and adjust the allowance accordingly.

As of December 31, 2022, OREO consisted of one property with a carrying value of $0.1 million. As of December 31, 2021, there was one property with a carrying value of $0.7 million in OREO.

Individually Evaluated Loans

The Company reviews all loans on an individual basis when they do not share similar risk characteristics with loan pools. Individually evaluated loans are measured for expected credit losses based on the present value of expected cash flows discounted at the effective interest rate, the observable market price, or the fair value of collateral. The allowance for collateral-dependent loans is calculated as the difference between the outstanding loan balance and the value of the collateral as determined by recent appraisals, less estimated costs to sell. The allowance for collateral-dependent loans varies based on the collateral coverage of the loan at the time of the designation as nonperforming.

Individually evaluated loans were $9.8 million, $13.4 million and $91.0 million as of December 31, 2022, 2021 and 2020, respectively, representing a decrease of $3.5 million, or 26.3%, for 2022, and a decrease of $77.6 million, or 85.3%, for 2021. Specific allowance allocations associated with individually evaluated loans increased $0.5 million to $3.3 million as of December 31, 2022, compared with $2.8 million as of December 31, 2021.

For the year ended December 31, 2022, monthly payments for one loan were restructured, with a net carrying value of $92,000 at the time of modification, which was subsequently classified as a TDR. For the year ended December 31, 2021, no loans were restructured and subsequently classified as TDRs. Temporary payment structure modifications included, but were not limited to, extending the maturity date, reducing the amount of principal and/or interest due monthly, and/or allowing for interest only monthly payments for six months or less.

At December 31, 2022, the Company assessed accruing TDRs along with performing and accruing loans on a collective basis. As of December 31, 2022, TDRs on accrual status were $1.2 million, all of which were temporary interest rate and payment reductions or extensions of maturity, and a $10,000 allowance relating to these loans was included in the allowance for credit losses. As of December 31, 2021, there were no outstanding accruing TDRs.

As of December 31, 2022 and 2021, TDRs on nonaccrual status were $0.4 million and $2.9 million, respectively, and a $6,000 and $4,000 allowance relating to these loans, respectively, was included in the allowance for credit losses.

As of December 31, 2020, TDRs on accrual status were $7.9 million, all of which were temporary interest rate and payment reductions or extensions of maturity, and a $5,000 allowance relating to these loans, was included in the allowance for credit losses. As of December 31, 2020, TDRs on nonaccrual status were $17.1 million, and a $12,000 allowance relating to these loans, respectively, was included in the allowance for credit losses.

Allowance for credit losses and Allowance for credit losses related to off-balance sheet items

The Company’s estimate of the allowance for credit losses at December 31, 2022 reflects losses expected over the remaining contractual life of the assets based on historical, current, and forward-looking information. The contractual term does not consider extensions, renewals or modifications unless the Company has identified an expected troubled debt restructuring.

Management selected three loss methodologies for the collective allowance estimation. At December 31, 2022, the Company used the discounted cash flow (“DCF”) method to estimate allowances for credit losses for the commercial and industrial loan portfolio, the Probability of Default/Loss Given Default (“PD/LGD”) method for the commercial property, construction and residential property portfolios, and the Weighted Average Remaining Maturity (“WARM”) method to estimate expected credit losses for equipment financing agreements (lease receivables portfolio). Loans that do not share similar risk characteristics are individually evaluated for allowances.

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For all loan pools utilizing the DCF method, the Company determined that four quarters represented a reasonable and supportable forecast period and reverted to a historical loss rate over twelve quarters on a straight-line basis. For each of these loan segments, the Company applied an annualized historical PD/LGD using all available historical periods. Since reasonable and supportable forecasts of economic conditions are imbedded directly into the DCF model, qualitative adjustments are considered but were minimal.

For loan pools utilizing the PD/LGD method, the Company used historical periods that included an economic downturn to derive historical losses for better alignment in the estimation of expected losses under the PD/LGD method. The Company relied on Frye-Jacobs modeled LGD rates for loan segments with no historical losses. In addition, for those loans granted a loan modification due to COVID-19, the Company used the annualized PD/LGD as of March 31, 2020 to reflect the moratorium on TDRs under Section 4013 of the CARES Act. The PD/LGD method incorporates a forecast into loss estimates using a qualitative adjustment.

The Company used the WARM method to estimate expected credit losses for the equipment financing agreements portfolio. The Company applied an expected loss ratio based on internal historical losses adjusted as appropriate for qualitative factors.

For the year ended December 31, 2022, the Company relied on the economic projections from Moody’s to inform its loss driver forecasts over the four-quarter forecast period. For all loan pools, the Company utilizes and forecasts the national unemployment rate as the primary loss driver.

To adjust the historical and forecast periods to current conditions, the Company applies various qualitative factors derived from market, industry or business specific data, changes in the underlying portfolio composition, trends relating to credit quality, delinquency, nonperforming and adversely rated equipment financing agreements, and reasonable and supportable forecasts of economic conditions.

The allowance for credit losses was $71.5 million at December 31, 2022 compared with $72.6 million at December 31, 2021. The allowance attributed to loans individually evaluated was $3.3 million at December 31, 2022 compared with $2.8 million at December 31, 2021. The allowance attributed to loans collectively evaluated was $68.2 million at December 31, 2022, compared with $69.8 million at December 31, 2021. This decrease principally reflected the reduction of required reserves due to upgrades on loans previously adversely affected by the pandemic, offset partially by increased loan production, during the year ended December 31, 2022.

The table below presents the allowance for credit losses by portfolio segment as a percentage of the total allowance for credit losses and loans by portfolio segment as a percentage of the aggregate investment of loans receivable for the periods presented:

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The following table sets forth certain information regarding certain ratios related to our allowance for credit losses for the periods presented:

The allowance for credit losses was $71.5 million, $72.6 million and $90.4 million, respectively, as of December 31, 2022, 2021 and 2020, representing a decrease of $1.0 million, or 1.4%, in 2022 and a decrease of $17.8 million, or 19.7%, in 2021. The allowance for credit losses as a percentage of loans decreased to 1.20% as of December 31, 2022 from 1.41% as of December 31, 2021. The decrease in the allowance for credit losses was mainly due to the decline in the allowance attributed to loans collectively evaluated resulting from improvements in macroeconomic conditions and assumptions, offset partially by increased loan production.

The allowance for off-balance sheet exposure, as of December 31, 2022, 2021 and 2020, was $3.1 million, $2.6 million and $2.8 million, respectively, representing an increase of $0.5 million, or 20.4%, in 2022, and a decrease of $0.2 million, or 7.4%, in 2021. The Bank closely monitors the borrower’s repayment capabilities, while funding existing commitments to ensure losses are minimized. Based on management’s evaluation and analysis of portfolio credit quality and prevailing economic conditions, we believe these allowances were adequate for losses inherent in the loan portfolio and off-balance sheet exposure as of December 31, 2022.

The following table presents a summary of net charge-offs (recoveries) for the loan portfolio:

For the year ended December 31, 2022, gross charge-offs were $4.7 million, a decrease of $1.7 million, or 25.9%, from $6.4 million in 2021, and gross recoveries were $3.3 million, a decrease of $9.3 million, or 73.5%, from $12.7 million in 2021. Net loan charge-offs were $1.4 million, or 0.02% of average loans, compared with net loan recoveries of $6.3 million, or 0.13% of average loans and net loan charge-offs of $30.9 million or 0.66% of average loans, respectively, for the years ended December 31, 2022, 2021 and 2020.

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Deposits

The following table shows the composition of deposits by type as of the dates indicated:

Total deposits were $6.17 billion, $5.79 billion and $5.28 billion as of December 31, 2022, 2021 and 2020, respectively, representing an increase of $381.8 million, or 6.6%, in 2022, and an increase of $511.3 million, or 9.7%, in 2021. The increase in total deposits for 2022 was primarily attributable to an increase of $969.0 million in time deposits, offset by a decrease of $542.7 million in money market and savings accounts. The changes in the deposit composition from 2021 to 2022 were primarily due to the increase in deposit rates.

The average balance of deposits for the years ended December 31, 2022, 2021 and 2020 were $5.95 billion, $5.56 billion and $4.95 billion, respectively. The average balance of deposits increased 7.0%, 12.4% and 5.4% in 2022, 2021 and 2020, respectively.

As of December 31, 2022, the aggregate amount of uninsured deposits (deposits in amounts greater than $250,000, which is the maximum amount for federal deposit insurance) was $2.65 billion. The aggregate amount of our uninsured time deposits was $498.0 million. In addition, other uninsured deposits, such as demand deposits and money market and savings deposits was $2.15 billion.

Borrowings and Subordinated Debentures

Borrowings mostly take the form of advances from the FHLB. At December 31, 2022, advances from the FHLB were $350.0 million, an increase of $212.5 million from $137.5 million at December 31, 2021. The increase in borrowings in 2022 compared to 2021 was primarily to fund new loan production. At December 31, 2022, the Bank had $100.0 million in term advances and $250.0 million in overnight advances from the FHLB. All FHLB advances were term advances at December 31, 2021.

The following is a summary of FHLB advances with contractual maturities greater than 12 months:

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The following is financial data pertaining to FHLB advances:

Subordinated debentures were $129.4 million as of December 31, 2022 and $215.0 million as of December 31, 2021. The decrease was due primarily to the $87.3 million redemption of the 2027 Notes on March 30, 2022. Subordinated debentures were comprised of fixed-to-floating subordinated notes of $108.2 million and $194.2 million as of December 31, 2022 and 2021, respectively, and junior subordinated deferrable interest debentures of $21.2 million and $20.8 million as of December 31, 2022 and 2021, respectively. See “Note 10 - Subordinated Debentures” to the consolidated financial statements for more details.

Interest Rate Risk Management

The spread between interest income on interest-earning assets and interest expense on interest-bearing liabilities is the principal component of net interest income, and interest rate changes substantially affect our financial performance. We emphasize capital protection through stable earnings rather than maximizing yield. In order to achieve stable earnings, we prudently manage our assets and liabilities and closely monitor the percentage changes in net interest income and equity value in relation to limits established within our guidelines.

The Company performs simulation modeling to estimate the potential effects of interest rate changes. The following table summarizes as of December 31, 2022, one of the stress simulations performed to forecast the impact of changing interest rates on net interest income and the value of interest-earning assets and interest-bearing liabilities reflected on our balance sheet (i.e., an instantaneous parallel shift in the yield curve of the magnitude indicated below). This sensitivity analysis is compared to policy limits, which specify the maximum tolerance level for net interest income exposure over a 1- to 12-month and a 13- to 24-month horizon, given the basis point adjustment in interest rates reflected below.

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The estimated sensitivity does not necessarily represent our forecast, and the results may not be indicative of actual changes to our net interest income. These estimates are based upon a number of assumptions, including the timing and magnitude of interest rate changes, prepayments on loans receivable and securities, pricing strategies on loans receivable and deposits, and replacement of asset and liability cash flows.

The key assumptions, based upon loans receivable, securities and deposits, are as follows:

Capital Resources and Liquidity

Capital Resources

Historically, our primary source of capital has been the retention of operating earnings. In order to ensure adequate levels of capital, management periodically assesses projected sources and uses of capital in conjunction with projected increases in assets and levels of risk. Management considers, among other things, earnings generated from operations, and access to capital from financial markets through the issuance of additional securities, including common stock or notes, to meet our capital needs.

In response to the uncertainty surrounding the COVID-19 pandemic, the Board reduced the quarterly cash dividends paid on common stock beginning in the second quarter of 2020. Due to the continued stabilization of Company results and financial condition, the Board authorized an increase in the quarterly cash dividend to $0.12 per share for the second quarter of 2021 from $0.10 per share for the first quarter of 2021. As the effects of the pandemic continued to subside and the Company’s results and financial condition improved, the Board again increased the dividend to $0.20 per share for the fourth quarter of 2021, to $0.22 per share for the first and second quarters of 2022 and to $0.25 per share for the third and fourth quarters of 2022. The Board will continue to re-evaluate the level of quarterly dividends in subsequent quarters.

The Company’s ability to pay dividends to shareholders depends in part upon dividends it receives from the Bank. California law restricts the amount available for cash dividends to the lesser of a bank’s retained earnings or net income for its last three fiscal years (less any distributions to shareholders made during such period). Where the above test is not met, cash dividends may still be paid, with the prior approval of the DFPI, in an amount not exceeding the greatest of: (1) retained earnings of the bank; (2) net income of the bank for its last fiscal year; or (3) the net income of the bank for its current fiscal year. As of January 1, 2023, after giving effect to the 2023 first quarter dividend declared by the Company, the Bank has the ability to pay $166.1 million of dividends without the prior approval of the Commissioner of the DFPI.

At December 31, 2022, the Bank’s total risk-based capital ratio of 13.86%, Tier 1 risk-based capital ratio of 12.85%, common equity Tier 1 capital ratio of 12.85%, and Tier 1 leverage capital ratio of 11.07%, placed the Bank in the “well capitalized” category, which is defined as institutions with total risk-based capital ratio equal to or greater than 10.00%, Tier 1 risk-based capital ratio equal to or greater than 8.00%, common equity Tier 1 capital ratio of 6.50%, and Tier 1 leverage capital ratio equal to or greater than 5.00%.

At December 31, 2022, the Company’s total risk-based capital ratio, Tier 1 risk-based capital ratio, common equity Tier 1 capital ratio and Tier 1 leverage capital ratio were 14.49%, 11.71%, 11.37%, and 10.07%, respectively, all of which exceeded all of the Company’s regulatory capital ratio requirements.

For a discussion of recently implemented changes to the capital adequacy framework prompted by Basel III and the Dodd-Frank Act, see “Note 13 — Regulatory Matters” of Notes to Consolidated Financial Statements in this Report.

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Liquidity

The Bank has Contingency Funding Plans (“CFPs”) designed to ensure that liquidity sources are sufficient to meet its ongoing obligations and commitments, particularly in the event of a liquidity contraction. The CFPs are designed to examine and quantify its liquidity under various “stress” scenarios. Furthermore, the CFPs provide a framework for management and other critical personnel to follow in the event of a liquidity contraction or in anticipation of such an event. The CFPs address authority for activation and decision making, liquidity options and the responsibilities of key departments in the event of a liquidity contraction.

For a discussion of our liquidity position, see “Note 22 - Liquidity” of Notes to Consolidated Financial Statements in this Report.

Off-Balance Sheet Arrangements

For a discussion of off-balance sheet arrangements, see “Note 19 — Off-Balance Sheet Commitments” of Notes to Consolidated Financial Statements and “Item 1. Business — Off-Balance Sheet Commitments” in this Report.

Recently Issued Accounting Standards Not Yet Effective

Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, On March 12, 2020, the FASB issued ASU 2020-04 to ease the potential burden in accounting for reference rate reform. The amendments in ASU 2020-04 are elective and apply to all entities that have contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued due to reference rate reform.

The new guidance provided several optional expedients that reduce costs and complexity of accounting for reference rate reform, including measures to simplify or modify accounting issues resulting from reference rate reform for contract modifications, hedges, and debt securities.

The amendments are effective for all entities from the beginning of an interim period that includes the issuance date of ASU 2020-04. An entity may elect to apply the amendments prospectively through December 31, 2022.

The adoption of this standard is not expected to have a material effect on the Company’s operating results or financial condition.

ASU 2022-02, Troubled Debt Restructurings and Vintage Disclosures (Topic 326): The FASB amended the accounting and disclosure requirements for expected credit losses by removing the recognition and measurement guidance on TDRs and enhancing disclosures pertaining to certain loan refinancings and restructurings by creditors made to borrowers experiencing financial difficulty. Additionally, this standard requires disclosure of current-period gross write-offs by year of origination for financing receivables.

The standard becomes effective for the Company for the interim and annual periods beginning on January 1, 2023. Early adoption is permitted.

The Company is in the process of evaluating the standard and its effect on the Company’s financial condition, results of operations, cash flows, and financial statement disclosures.