HAWTHORN BANCSHARES, INC. (HWBK)

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation.

Pursuant to General Instruction G(2) to Form 10-K, the information required by this Item is incorporated herein by reference to the information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's 2024 Annual Report to Shareholders (included as Exhibit 13 hereto).

Forward-Looking Statements

This report, including information included or incorporated by reference in this report, contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, strategy, future performance and business of the Company and its subsidiaries, including, without limitation:

•statements that are not historical in nature, and

•statements preceded by, followed by or that include the words "believes," "expects," "may," "will," "should," "could," "anticipates," "estimates," "intends" or similar expressions.

Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

•competitive pressures among financial services companies may increase significantly,

•changes in the interest rate environment may reduce interest margins,

•general economic conditions, either nationally or in Missouri, may be less favorable than expected and may adversely affect the quality of the Company's loans and other assets,

•increases in non-performing assets in the Company's loan portfolios and adverse economic conditions may necessitate increases to the provisions for credit losses,

•costs or difficulties related to the integration of the business of the Company and its acquisition targets may be greater than expected,

•legislative, regulatory, or tax law changes may adversely affect the business in which the Company and its subsidiaries are engaged,

•credit and market risks relating to increasing inflation,

•economic or other disruptions caused by acts of terrorism, war or other conflicts, including the Russia-Ukraine conflict, and the Israel-Hamas conflict, natural disasters, such as hurricanes, wild fires, freezes, flooding and other man-made disasters, such as oil spills or power outages, health emergencies, epidemics or pandemics, climate changes or other catastrophic events,

•changes may occur in the securities markets,

•changes in the level and direction of loan delinquencies and write-offs and changes in estimates of the adequacy of the allowance for credit losses, and

•technological changes, including potential cyber-security incidents and other disruptions, or innovations to the financial services industry, including as a result of the increased telework environment.

We have described additional factors that could cause actual results to be materially different from those described in the forward-looking statements, which factors are identified in Item 1A of this report under the heading "Risk Factors." Other factors that we have not identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date such statement is made. Except as otherwise required by law, we undertake no obligation to publicly update or revise any forward-looking statement to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF

CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Crucial to the Company's community banking strategy is growth in its commercial banking services, retail mortgage lending and retail banking services. Through the branch network of its subsidiary bank, Hawthorn Bank (the "Bank"), the Company, with $1.9 billion in assets at December 31, 2023, provides a broad range of commercial and personal banking services. The Bank's specialties include commercial banking for small and mid-sized businesses, including equipment, operating, commercial real estate, Small Business Administration ("SBA") loans, and personal banking services including real estate mortgage lending, installment and consumer loans, certificates of deposit, individual retirement and other time deposit accounts, checking accounts, savings accounts, and money market accounts. Other financial services that the Company provides include trust services that include estate planning, investment and asset management services and a comprehensive suite of cash management services. The geographic areas in which the Company provides products and services include the Missouri communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, and the greater Kansas City metropolitan area.

The Company's primary source of revenue is net interest income derived primarily from lending and deposit taking activities. Much of the Company's business is commercial, commercial real estate development, and residential mortgage lending. The Company's income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancing activity.

The success of the Company's growth strategy depends primarily on the ability of its banking subsidiary to generate an increasing level of loans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-interest expenses relative to revenues generated. The Company's financial performance also depends, in part, on its ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success of the Company's growth strategy depends on its ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond its control.

The Company's subsidiary bank is a full-service bank that conducts general banking business, offering its customers checking and savings accounts, debit cards, certificates of deposit, safety deposit boxes and a wide range of lending services, including commercial and industrial loans, residential real estate loans, single payment personal loans, installment loans and credit card accounts. In addition, the Bank provides trust and brokerage services.

The deposit accounts of the Bank are insured by the Federal Deposit Insurance Corporation ("FDIC") to the extent provided by law. The operations of the Bank are supervised and regulated by the FDIC and the Missouri Division of Finance. Periodic examinations of the Bank are conducted by representatives of the FDIC and the Missouri Division of Finance. Such regulations, supervision and examinations are principally for the benefit of depositors, rather than for the benefit of shareholders. The Company is subject to supervision and examination by the Board of Governors of the Federal Reserve System.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The following accounting policies are considered most critical to the understanding of the Company's financial condition and results of operations. These critical accounting policies and estimates require management's most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experiences. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected. The impact and any associated risks related to the Company's critical accounting policies and estimates on its business operations are discussed throughout Management's Discussion and Analysis of Financial Condition and Results of Operations, where such policies affect the reported and expected financial results.

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Allowance for Credit Losses

Management has identified the accounting policy related to the allowance for credit losses ("ACL") as critical to the understanding of the Company's results of operations, since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change.

The Company’s ACL represents management’s best estimate of losses inherent in the portfolio. The policy is designed to maintain the allowance at a level sufficient to absorb reasonably estimated and probable losses within the portfolio. A mathematical calculation of an estimate is made to assist in determining the adequacy and reasonableness of management’s recorded ACL.

The Company’s methodology includes qualitative risk factors that allow management to adjust modeled historical losses and to address other limitations in the quantitative component that is based on modeled historical loss rates. Such risk factors are generally reviewed and updated quarterly, as appropriate, and are adjusted to reflect changes in national and local economic conditions, other external factors, the nature, volume and terms of loans in the portfolio, the volume and severity of past due loans, concentrations, trends in collateral values, the quality of the Company’s internal loan review department, lending management, and lending policies and procedures. At December 31, 2023, the ACL on loans included a qualitative adjustment of approximately $10.9 million.

The ending result of this process is a recorded consolidated ACL that represents management’s best estimate of the total modeled losses included in the portfolio considering available information from internal and external sources, relevant to assessing exposure to credit loss over the contractual term of the instrument. While management utilizes its best judgment and information available, the ultimate adequacy of the ACL is dependent upon a variety of factors beyond the Company’s control, including the performance of its portfolios, the economy, and changes in interest rates. As such, significant downturns in circumstances relating to instrument quality and economic conditions could result in a requirement for additional allowance. Likewise, an upturn in instrument quality and improved economic conditions may allow a reduction in the required allowance. In either instance, unanticipated changes could have a significant impact on the Company’s provision for credit losses and ACL reported in its Consolidated Income Statements and Consolidated Balance Sheets, respectively.

Further discussion of the methodology used in establishing the allowance and the impact of any associated risks related to these policies on the Company's business operations is provided in Note 1 to the Company's consolidated financial statements and is also discussed in the Lending and Credit Management section below.

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Executive Summary

The Company has prepared all of the consolidated financial information in this report in accordance with United States generally accepted accounting principles ("U.S. GAAP") and the rules of the SEC. In preparing the consolidated financial statements in accordance with U.S. GAAP, the Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.

1.Efficiency ratio is calculated as non-interest expense as a percentage of revenue. Total revenue is calculated as net interest income plus non-interest income.

2.Prior to adoption of ASU No 2016-13 on January 1, 2023, credit losses were estimated using the incurred loss approach.

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(1)Tier 1 leverage ratio is calculated by dividing Tier 1 capital by average total consolidated assets.

(2)Prior to adoption of ASU No 2016-13 on January 1, 2023, credit losses were estimated using the incurred loss approach.

Results of Operations Highlights

Consolidated net income decreased $19.8 million to $1.0 million, or $0.14 per diluted share, for the year ended December 31, 2023 compared to $20.8 million, or $2.94 per diluted share, for the year ended December 31, 2022. For the year ended December 31, 2023, the return on average assets (ROA) was 0.05%, the return on average stockholders' equity (ROE) was 0.76%, and the efficiency ratio was 78.5%.

Consolidated net income decreased $1.8 million to $20.8 million, or $2.94 per diluted share, for the year ended December 31, 2022 compared to $22.5 million, or $3.15 per diluted share, for the year ended December 31, 2021. For the year ended December 31, 2022, the return on average assets (ROA) was 1.16%, the return on average stockholders' equity (ROE) was 15.94%, and the efficiency ratio was 66.7%.

Net interest income was $59.1 million for the year ended December 31, 2023 compared to $58.8 million and $58.5 million for the years ended December 31, 2022 and 2021, respectively. The net interest margin was 3.29% for the year ended December 31, 2023 compared to 3.53% and 3.62% for the years ended December 31, 2022 and 2021, respectively.

Provision for (release of) credit losses For the year ended December 31, 2023, the Company recognized a provision for credit losses on loans and unfunded commitments of $2.3 million compared to a $0.9 million and $1.7 million release of provision expense for the years ended December 31, 2022 and 2021, respectively. The release of provision expense for 2022 and 2021 was driven in part from the release of specific reserves due to returning significant loan balances to accruing from non-accrual status or other collateral valuation adjustments.

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Non-interest income decreased $6.4 million, or 46.1%, for the year ended December 31, 2023 compared to the year ended December 31, 2022, and decreased $2.8 million, or 16.7%, for the year ended December 31, 2022 compared to the year ended December 31, 2021. These changes are discussed in greater detail below under Non-interest Income.

Non-interest expense increased $3.8 million, or 7.9%, for the year ended December 31, 2023 compared to the year ended December 31, 2022, and decreased $0.4 million, or 0.9%, for the year ended December 31, 2022 compared to the year ended December 31, 2021. These changes are discussed in greater detail below under Non-interest Expense.

Balance Sheet Highlights

Cash and cash equivalents – Cash and cash equivalents increased $9.7 million, or 11.6%, to $93.5 million as of December 31, 2023 compared to $83.7 million as of December 31, 2022, and decreased $76.2 million, or 47.6%, to $83.7 million as of December 31, 2022 compared to $159.9 million as of December 31, 2021. See the Liquidity Management section for further discussion.

Loans – Loans held for investment increased $17.9 million, or 1.2%, to $1.5 billion as of December 31, 2023 compared to December 31, 2022, and increased $219.1 million, or 16.8%, to $1.5 billion as of December 31, 2022 compared to $1.3 billion as of December 31, 2021.

Asset quality – Non-performing loans decreased $12.3 million to $6.4 million, or 0.42% of total loans, at December 31, 2023 compared to $18.7 million, or 1.23% of total loans, at December 31, 2022, and decreased $6.8 million to $18.7 million, or 1.23% of total loans, at December 31, 2022 compared to $25.5 million, or 1.96% of total loans, at December 31, 2021. The reduction in non-performing loans was primarily due to non-accrual loan relationships returning to accrual status in both 2023 and 2022.

On January 1, 2023, the Company adopted ASU 2016-13, Financial Instruments - Credit Losses (Topic 326), which provides for the CECL credit loss model. The adoption of the standard resulted in an increase to the allowance for credit losses of $5.8 million and a liability for unfunded commitments totaling $1.3 million. These one-time cumulative adjustments resulted in a $5.6 million tax-effected decrease to retained earnings.

The allowance for credit losses to total loans was 1.54% at December 31, 2023, compared to the allowance for loan losses of 1.02% at December 31, 2022 and 1.30% at December 31, 2021. The Company's net charge-offs for the year ended December 31, 2023, were $0.3 million, or 0.02% of average loans compared to $0.4 million, or 0.03% of average loans for the year ended December 31, 2022, and net recoveries of $0.5 million, or 0.04% of average loans for the year ended December 31, 2021. See Lending and Credit Management below for further discussion.

Deposits – Total deposits decreased $61.2 million, or 3.8%, equal to $1.6 billion as of December 31, 2023 compared to December 31, 2022, and increased $115.3 million, or 7.6%, to $1.6 billion as of December 31, 2022 compared to $1.5 billion as of December 31, 2021.

Federal Home Loan Bank ("FHLB") advances and other borrowings – Total FHLB advances and other borrowings increased $9.0 million, or 9.2%, to $107.0 million as of December 31, 2023 compared to $98.0 million as of December 31, 2022, and increased $20.6 million, or 26.6%, to $98.0 million as of December 31, 2022 compared to $77.4 million as of December 31, 2021.

Capital – On January 1, 2023, the Company adopted Accounting Standard Update (ASU) 2016-13 and recorded a one-time cumulative effect adjustment to retained earnings totaling $5.6 million after-tax. Total shareholder’s equity was $136.1 million and the common equity to assets ratio was 7.26% at December 31, 2023 as compared to 6.62% and 8.13% at December 31, 2022 and December 31, 2021, respectively. Regulatory capital ratios remain “well-capitalized,” with a tier 1 leverage ratio of 10.29% and a total risk-based capital ratio of 13.99% at December 31, 2023.

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Average Balance Sheets

Net interest income is the largest source of revenue resulting from the Company's lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest-earning assets and interest-bearing liabilities. The following table presents average balance sheets, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the years ended December 31, 2023, 2022, and 2021, respectively. The average balances used in this table and other statistical data were calculated using average daily balances.

(1)Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21%, net of nondeductible interest expense for the years ended December 31, 2023, 2022 and 2021, respectively. Such adjustments totaled $1.1 million, $2.1 million and $1.8 million for the years ended December 31, 2023, 2022, and 2021, respectively.

(2)Non-accruing loans are included in the average amounts outstanding.

Rate and Volume Analysis

The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates for the years ended December 31, 2023 compared to December 31, 2022, and for the years ended December 31, 2022 compared to December 31, 2021. The change in interest due to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each.

(1)Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 21%, net of nondeductible interest expense for the years ended December 31, 2023, 2022 and 2021, respectively. Such adjustments totaled $1.1 million, $2.1 million and $1.8 million for the years ended December 31, 2023, 2022, and 2021, respectively.

(2)Non-accruing loans are included in the average amounts outstanding.

Financial results for the year ended December 31, 2023 compared to the year ended December 31, 2022 reflected a decrease in net interest income, on a fully taxable equivalent basis, of $0.7 million, or 1.1%, and financial results for the year ended December 31, 2022 compared to the year ended December 31, 2021 reflected an increase of $0.4 million, or 0.7%. Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) was 3.29% for the year ended December 31, 2023, compared to 3.53% and 3.62% for the years ended December 31, 2022 and 2021, respectively.

The decrease in net interest income and net interest margin for 2023 compared to 2022, resulted from higher interest expense on both deposits and borrowings. While interest income on a fully taxable equivalent basis increased $21.7 million for 2023 compared to 2022, interest expense increased $22.4 million for 2023 compared to 2022.

The increase in net interest income and decrease in net interest margin for 2022 compared to 2021 primarily resulted from higher interest income from growth in average loans of 9.7%, and a 4.1% increase in the investment portfolio, offset by higher interest expense for interest bearing liabilities and a reduction of fee income from loans under the SBA's Paycheck Protection Program.

Average interest-earning assets increased $105.3 million, or 6.1%, to $1.83 billion for the year ended December 31, 2023 compared to $1.72 billion for the year ended December 31, 2022, and average interest bearing liabilities increased $133.5 million, or 11.2%, to $1.33 billion for the year ended December 31, 2023 compared to $1.19 billion for the year ended December 31, 2022.

Average interest-earning assets increased $52.2 million, or 3.1%, to $1.72 billion for the year ended December 31, 2022 compared to $1.67 billion for the year ended December 31, 2021, and average interest bearing liabilities increased $50.7 million, or 4.4%, to $1.19 billion for the year ended December 31, 2022 compared to $1.14 billion for the year ended December 31, 2021.

Total interest income (expressed on a fully taxable equivalent basis) increased to $93.1 million for the year ended December 31, 2023 compared to $71.3 million and $66.3 million for the years ended December 31, 2022 and 2021, respectively. The Company's rates earned on interest earning assets were 5.10% for the year ended December 31, 2023 compared to 4.14% and 3.97% for the years ended December 31, 2022 and 2021, respectively.

Interest income on loans held for investment increased to $84.5 million for the year ended December 31, 2023 compared to $63.4 million and $59.9 million for the years ended December 31, 2022 and 2021, respectively.

Average loans outstanding increased $138.6 million, or 9.9%, to $1.54 billion for the year ended December 31, 2023 compared to $1.41 billion for the year ended December 31, 2022. The average yield on loans receivable increased to 5.47% during the year ended December 31, 2023 compared to 4.51% for the year ended December 31, 2022. The increase in yield as of December 31, 2023 compared to the prior year is reflective of recent market conditions where most loan types have seen an increase in yield, consistent with recent increases in the prime rate. Contributing to the increase in yield was interest accreted into income on three loans returning to accruing status in 2023.

Average loans outstanding increased $124.1 million, or 9.7%, to $1.41 billion for the year ended December 31, 2022 compared to $1.28 billion for the year ended December 31, 2021. The average yield on loans receivable decreased to 4.51% during the year ended December 31, 2022 compared to 4.67% for the year ended December 31, 2021. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio.

Interest income on available-for-sale securities decreased to $6.7 million for the year ended December 31, 2023 compared to $7.2 million for the year ended December 31, 2022 and increased to $7.2 million for the year ended December 31, 2022 compared o $5.6 million for the year ended December 31, 2021.

Average securities decreased $28.4 million, or 10.4%, to $245.0 million for the year ended December 31, 2023 compared to $273.3 million for the year ended December 31, 2022. The average yield on securities increased to 2.74% for the year ended December 31, 2023 compared to 2.62% for the year ended December 31, 2022. The Company proactively elected a strategy to begin repositioning its balance sheet during the fourth quarter of 2023 by selling $83.7 million in book value of investment securities, with an average yield of 1.57%, which is expected to be accretive to earnings, net interest margin and return on assets in future periods.

Average securities increased $10.8 million, or 4.1%, to $273.3 million for the year ended December 31, 2022 compared to $262.5 million for the year ended December 31, 2021. The average yield on securities increased to 2.62% for the year ended December 31, 2022 compared to 2.15% for the year ended December 31, 2021. See the Liquidity Management section for further discussion.

Total interest expense was $32.9 million for the year ended December 31, 2023 compared to $10.5 million and $5.9 million for the years ended December 31, 2022 and 2021, respectively. The Company's rate paid on interest bearing

liabilities was 2.48% for the year ended December 31, 2023 compared to 0.88% and 0.52% for the years ended December 31, 2022 and 2021, respectively. See the Liquidity Management section for further discussion.

Interest expense on deposits was $25.8 million for the year ended December 31, 2023 compared to $7.1 million and $3.1 million for the years ended December 31, 2022 and 2021, respectively.

Average interest bearing deposits increased $104.9 million, or 9.9%, to $1.16 billion for the year ended December 31, 2023 compared to $1.06 billion for the year ended December 31, 2022. The average cost of deposits increased to 2.22% during the year ended December 31, 2023 compared to 0.68% for the year ended December 31, 2022.

Average interest bearing deposits increased $88.5 million, or 9.1%, to $1.06 billion for the year ended December 31, 2022 compared to $0.97 billion for the year ended December 31, 2021. The average cost of deposits increased to 0.68% during the year ended December 31, 2022 compared to 0.32% for the year ended December 31, 2021.

Interest expense on borrowings was $7.1 million for the year ended December 31, 2023 compared to $3.4 million and $2.8 million for the years ended December 31, 2022 and 2021, respectively.

Average borrowings were $167.0 million for the year ended December 31, 2023 compared to $138.3 million and $176.2 million for the years ended December 31, 2022 and 2021, respectively. The Company utilizes funding capacity with the FHLB to meet its short-term liquidity needs. The average cost of borrowings increased to 4.28% for the year ended December 31, 2023 compared to 2.45% and 1.57% for the years ended December 31, 2022, and 2021, respectively. The increase in cost of funds is from higher market interest rates. See the Liquidity Management section for further discussion.

Non-interest Income and Expense

Non-interest income for the years ended December 31, 2023, 2022, and 2021 was as follows:

*Total revenue is calculated as net interest income plus non-interest income.

NM = not meaningful

Total non-interest income decreased $6.4 million, or 46.1%, to $7.5 million for the year ended December 31, 2023 compared to the year ended December 31, 2022, and decreased $2.8 million, or 16.7%, to $14.0 million for the year ended December 31, 2022 compared to the year ended December 31, 2021.

Real estate servicing fees, net of the change in valuation of mortgage servicing rights ("MSRs") was $(0.6) million for the year ended December 31, 2023 compared to $1.0 million and $0.6 million for the years ended December 31, 2022 and 2021, respectively. In the fourth quarter of 2023, the Company recognized a $1.1 million mortgage servicing rights valuation write-down upon accepting a letter of intent to sell the Company's servicing portfolio during the first quarter of 2024. During 2022, mortgage rates and the discount rates used in the MSRs valuation increased as yields and risk increased contributing to increase in the valuation of MSRs in 2022 compared to 2021.

Mortgage loan servicing fees earned on loans sold were $0.6 million for the year ended December 31, 2023 compared to $0.8 million and $0.8 million for the years ended December 31, 2022 and 2021, respectively. The Company was servicing

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$220.7 million of mortgage loans at December 31, 2023 compared to $240.5 million and $270.0 million at December 31, 2022 and 2021, respectively.

Gain on sales of mortgage loans was $2.6 million for the year ended December 31, 2023 compared to $2.7 million and $7.2 million for the years ended December 31, 2022 and 2021, respectively. The Company sold loans totaling $106.2 million for the year ended December 31, 2023 compared to $87.2 million and $206.6 million for the years ended December 31, 2022 and 2021, respectively.

(Losses) Gains on other real estate owned, net was $(4.4) million, for the year ended December 31, 2023 compared to $0.3 million and $(0.9) million for the years ended December 31, 2022 and 2021, respectively. During 2023 the Company recorded a $4.7 million valuation write-down primarily related to two foreclosed property relationships.

Investment Securities (Losses) Gains, Net

The following table presents the gross realized gains and losses from sales and calls of available-for-sale securities, as well as gains and losses on equity securities from fair value adjustments which have been recognized in earnings for the years ended December 31, 2023, 2022, and 2021:

The Company proactively elected a strategy to begin repositioning its balance sheet during the fourth quarter of 2023 by selling $83.7 million in book value of investment securities, with an average yield of 1.57%, for an after-tax realized loss of $9.1 million.

Non-interest expense for the years ended December 31, 2023, 2022, and 2021 was as follows:

*Efficiency ratio is calculated as non-interest expense as a percentage of total revenue. Total revenue is calculated as net interest income plus non-interest income.

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Total non-interest expense increased $3.8 million, or 7.9%, to $52.4 million for the year ended December 31, 2023 compared to the year ended December 31, 2022, and decreased $0.4 million, or 0.9%, to $48.5 million for the year ended December 31, 2022 compared to the year ended December 31, 2021.

Salaries increased $2.7 million, or 12.9%, to $23.3 million for the year ended December 31, 2023 compared to the year ended December 31, 2022, and decreased $0.1 million, or 0.5%, to $20.6 million for the year ended December 31, 2022 compared to the year ended December 31, 2021. The increase for the year ended December 31, 2023 over the year ended December 31, 2022 was primarily due to the payment of severance due to the reduction in 35 full-time employees during the fourth quarter of 2023, payroll accruals, and annual merit increases. The decrease for the year ended December 31, 2022 over the year ended December 31, 2021 was primarily due to decreases in incentive pay and deferred loan costs related to loan volume.

Employee benefits decreased $0.7 million, or 11.6%, to $5.7 million for the year ended December 31, 2023 compared to the year ended December 31, 2022, and decreased $0.5 million, or 7.1%, to $6.4 million for the year ended December 31, 2022 compared to the year ended December 31, 2021. The decrease for the year ended December 31, 2023 over the year ended December 31, 2022 was primarily due to a decrease in 401(k) plan contributions and pension cost due to lower annual discount rate assumptions compared to the prior year's annual assumptions. The decrease for the year ended December 31, 2022 over the year ended December 31, 2021 was primarily due to a decrease in 401(k) plan contributions, medical premiums, and pension cost due to lower annual discount rate assumptions compared to the prior year's annual assumptions.

Legal, examination, and professional fees increased $0.9 million, or 53.9%, to $2.5 million for the year ended December 31, 2023 compared to the year ended December 31, 2022, and decreased $1.4 million, or 46.1%, to $1.6 million for the year ended December 31, 2022 compared to the year ended December 31, 2021. The changes for 2023 over 2022 primarily related to a write off of consulting fees related to a digital account opening project that was canceled during the fourth quarter of 2023. The changes for 2022 over 2021 was related to $1.5 million in legal fees accrued for as of December 31, 2021 for a lawsuit that was resolved in January 2022.

Loan expense increased $0.4 million, or 63.4%, to $0.9 million for the year ended December 31, 2023 compared to the year ended December 31, 2022, and decreased $0.2 million, or 30.0%, to $0.6 million for the year ended December 31, 2022 compared to the year ended December 31, 2021. The changes for 2023 over 2022 was primarily due to the recognition of an adjustment to an unearned dealers reserve related to prior years' activity in the first quarter of 2023.

Income Taxes (Benefit)

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were (121.5)% for the year ended December 31, 2023 compared to 17.3% and 20.2% for the years ended December 31, 2022 and 2021, respectively.

The decrease in the effective tax rate for the year ended December 31, 2023 compared to the year ended December 31, 2022 was primarily attributable to the decrease in earnings, increase in tax-exempt income, and the benefit recorded pertaining to a historical tax credit. The increase in the effective tax rate for the year ended December 31, 2022 compared to the year ended December 31, 2021 was primarily attributable to an increase in earnings and an increase in state taxes attributed to elevated earnings. The effective tax rate for each of the years ended December 31, 2023, 2022, and 2021, respectively, is lower than the U.S. federal statutory rate of 21% primarily due to tax-free income.

Lending and Credit Management

Interest earned on the loan portfolio is a primary source of interest income for the Company. Loans held for investment represented 80.8% of total assets as of December 31, 2023 compared to 78.3% as of December 31, 2022.

Lending activities are conducted pursuant to an established loan policy approved by the Bank's Board of Directors. The Bank's credit review process is overseen by market loan committees with established loan approval limits. In addition, a senior loan committee reviews all credit relationships in aggregate over an established dollar amount. The senior loan committee meets weekly and is comprised of senior managers of the Bank.

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Major classifications within the Company’s held-for-investment loan portfolio as of the dates indicated are as follows:

The Company extends credit to its local community market through traditional real estate mortgage products. The Company does not participate in credit extensions to sub-prime residential real estate markets. The Company does not lend funds for the type of transactions defined as “highly leveraged” by bank regulatory authorities or for foreign loans. Additionally, the Company does not have any concentrations of loans exceeding 10% of total loans that are not otherwise disclosed in the loan portfolio composition table. The Company does not have any interest-earning assets that would have been included in non-accrual, past due, or restructured loans if such assets were loans.

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The contractual maturities of loan categories at December 31, 2023 and the composition of those loans between fixed rate and floating rate loans are as follows:

The Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers but are not funded until the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. For the year ended December 31, 2023, the Company sold approximately $106.2 million of loans to investors compared to $87.2 million and $206.6 million for the years ended December 31, 2022 and 2021, respectively. At December 31, 2023, the Company was servicing approximately $220.7 million of loans sold to the secondary market compared to $240.5 million at December 31, 2022, and $270.0 million at December 31, 2021.

Risk Elements of the Loan Portfolio

Management, internal loan review and the senior loan committee formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Loans in excess of $2.0 million in the aggregate and all adversely classified credits identified by management are reviewed by the senior loan committee. In addition, all other loans are reviewed on a risk weighted selection process. The senior loan committee reviews and reports to the Board of Directors, at scheduled meetings: past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management will evaluate individual loans for expected credit losses when those loans do not share similar risk characteristics with loans evaluated using a collective (pooled) basis. Management follows the guidance provided in the Financial Accounting Standards Board's (FASB) Accounting Standards

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Codification (ASC) Topic 326-20-30-2. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is individually analyzed and in conjunction with current economic conditions and loss experience, reserves are estimated as further discussed below.

Loans not individually evaluated are aggregated and collectively analyzed. Under ASC 326-20-30-2 and ASC 326-20-55-5, the Company should aggregate financial assets based on similar risk characteristics. Management determined that segmenting loans not individually analyzed by the federal call report codes represents the most prudent way to consolidate loans by their associated risk qualities.

General reserves are recorded for collectively analyzed loans using a consistent methodology. Two different models are used for calculating the general reserve. The Discounted Cash Flow model considers quantitative peer group historic loss experience, forecasts over the estimated life of the loan pools, industry data, and qualitative or environmental factors, such as: lending policies and procedures; economic conditions; the nature, volume and terms of the portfolio; lending staff and management; past due loans; the loan review system; collateral values; concentrations of credit; and external factors. The Remaining Life model applies a long-term average loss rate calculated using peer data that is adjusted for qualitative or environmental factors such as those previously noted. The model used depends on the loan portfolio segment. Management believes, but there can be no assurance, that these procedures keep management informed of potential problem loans.

Non-Performing Assets

The following table summarizes non-performing assets:

(a)Non-performing loans include loans 90 days past due and accruing, non-accrual loans, and 90 days past due.

(b)Non-performing assets include non-performing loans and other real estate owned and repossessed assets.

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Total non-performing assets were $8.2 million, or 0.53% of total loans, at December 31, 2023 compared to $27.5 million, or 1.81% of total loans, at December 31, 2022.

Total non-accrual loans at December 31, 2023 decreased $12.4 million to $6.3 million compared to $18.7 million at December 31, 2022. The decrease in non-accrual loans was primarily due to three large commercial real-estate non-accrual loan relationships returning to accrual status.

Loans past due 90 days and still accruing interest at December 31, 2023, were $119,387 compared to $1,248 at December 31, 2022. Other real estate owned and repossessed assets at December 31, 2023 were $1.7 million compared to $8.8 million at December 31, 2022. During the year ended December 31, 2023, $0.1 million of non-accrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets compared to $0.2 million for the year ended December 31, 2022.

Provision and Allowance for Credit Losses on Loans and Liability for Unfunded Commitments

Allowance for Credit Losses

On January 1, 2023, the Company adopted ASU 2016-13, Financial Instruments - Credit Losses (Topic 326), which provides for the CECL credit loss model. The adoption of the standard resulted in an increase to the allowance for credit losses of $5.8 million and a liability for unfunded commitments totaling $1.3 million. These one-time cumulative adjustments resulted in a $5.6 million tax-effected decrease to retained earnings.

The following table is a summary of the allocation of the allowance for credit losses:

The allowance for credit losses was $23.7 million, or 1.54%, of loans outstanding at December 31, 2023 compared to $15.6 million, or 1.02%, of loans outstanding at December 31, 2022. The ratio of the allowance for credit losses to non-performing loans was 370.25% at December 31, 2023, compared to 83.35% at December 31, 2022.

Provision for (Release of) Credit Losses / Loan Losses

The Company recognized a provision for credit losses of $2.3 million for the year ended December 31, 2023 compared to a $0.9 million and $1.7 million release of provision for loan losses for the years ended December 31, 2022 and 2021, respectively. The increase in the provision in the fourth quarter of 2023 resulted from a $1.3 million increase in a specific

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reserve resulting from the downgrade of one commercial loan relationship. The release of provision expense for 2022 was driven in part from the release of specific reserves totaling $2.8 million in the first quarter of 2022 due to returning significant commercial real-estate loan balances to accruing from non-accrual status or other collateral valuation adjustments.

The following table is a summary of net charge-offs to average loans:

Net Loan Charge-offs

The Company's net loan charge-offs were $0.3 million, or 0.02% of average loans, for the year ended December 31, 2023 compared to net charge-offs of $0.4 million, or 0.03% of average loans, for the year ended December 31, 2022.

Loans Held For Sale

The Company designates certain long-term fixed rate personal real estate loans as held for sale. These loans are initially measured at fair value under the fair value option election with subsequent changes in fair value recognized in mortgage banking income. The loans are primarily sold to Freddie Mac, Fannie Mae, and PennyMac and other various secondary market investors. At December 31, 2023, the carrying amount of these loans was $3.9 million compared to $0.6 million at December 31, 2022.

Investment Portfolio

The Company's investment portfolio consists of securities classified as available-for-sale, equity or other. Available-for-sale debt securities, the largest component, are carried at estimated fair value. Unrealized holding gains and losses from available-for-sale securities are excluded from earnings and reported, net of applicable taxes, as a separate component of stockholders' equity until realized.

The Company does not engage in trading activities and, accordingly, does not have any debt or equity securities classified as trading securities. Historically, the Company's practice was to purchase and hold debt instruments until maturity unless special circumstances existed. However, since the investment portfolio's major function is to provide liquidity and to balance the Company's interest rate sensitivity position, all debt securities are now classified as available-for-sale.

At December 31, 2023, the investment portfolio classified as available-for-sale represented 10.1% of total consolidated assets. Future levels of investment securities can be expected to vary depending upon liquidity and interest sensitivity needs as well as other factors.

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Available- for-Sale Securities

The following table presents the composition of the investment portfolio and related fair value by major category:

(a)Certain hybrid instruments possessing characteristics typically associated with debt obligations.

As of December 31, 2023, the expected maturity and tax-equivalent yield in the investment portfolio was as follows:

(1)Rates on obligations of states and political subdivisions have been adjusted to fully taxable equivalent rates using the statutory federal income tax rate of 21%.

(2)Mortgage-backed securities have been included using historic repayment speeds. Repayment speeds were determined from actual portfolio experience during the 12 months ended December 31, 2023 calculated separately for each mortgage-backed security. These repayment speeds are not necessarily indicative of future repayment speeds and are subject to change based on changing mortgage interest rates. The tax equivalent yield is calculated on amortized cost using a level yield method and a 21% tax rate.

At December 31, 2023, $13.3 million of debt securities classified as available-for-sale in the table above had variable rate provisions with adjustment periods ranging from one week to twelve months.

Other Investment Securities

Other investment securities include equity securities with readily determinable fair values and other investments securities that do not have readily determinable fair values. Investments in FHLB stock, and Midwest Independent BankersBank ("MIB") stock, that do not have readily determinable fair values, are required for membership in those organizations.

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Liquidity and Capital Resources

Liquidity Management

The role of liquidity management is to ensure funds are available to meet depositors' withdrawal demands and borrowers' credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity to meet the demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from external sources, principally depositors. Due to the nature of services offered by the Company, management prefers to focus on transaction accounts and full service relationships with customers.

The Company's Asset/Liability Committee, primarily made up of senior management, has direct oversight responsibility for the Company's liquidity position and profile. A combination of daily, weekly, and monthly reports provided to management detail the following: internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, available pricing and market access to the financial markets for capital, and exposure to contingent draws on the Company's liquidity.

The Company has a number of sources of funds to meet liquidity needs on a daily basis. The Company's most liquid assets are comprised of available-for-sale investment securities, federal funds sold, and excess reserves held at the Federal Reserve Bank.

Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available-for-sale investment portfolio was $188.7 million at December 31, 2023 and included an unrealized net loss of $27.2 million. The portfolio includes projected maturities and mortgage-backed securities pay-downs of approximately $2.1 million over the next 12 months, which offer resources to meet either new loan demand or reductions in the Company's deposit base.

The Company pledges portions of its investment securities portfolio as collateral to secure public fund deposits, federal funds purchase lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes required by law. The Company's unpledged securities in the available-for-sale portfolio totaled approximately $99.5 million and $139.2 million at December 31, 2023 and 2022, respectively.

Total investment securities pledged for these purposes were as follows:

Liquidity is available from the Company's base of core customer deposits, defined as demand, interest checking, savings, money market deposit accounts, and time deposits less than $250,000, less all brokered deposits under $250,000. Such deposits totaled $1.5 billion and represented 93.1% of the Company's total deposits at December 31, 2023, compared to $1.5 billion and 91.7% of the Company's total deposits at December 31, 2022. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships.

Core deposits at December 31, 2023 and 2022 were as follows:

Maturities of uninsured time deposits with balances over $250,000 as of December 31, 2023 were as follows:

Estimated uninsured deposits totaled $387.1 million, including $108.1 million of certificates of deposit, at December 31, 2023, compared to $420.3 million, including $94.9 million of certificates of deposit, at December 31, 2022. The Company had brokered deposits totaling $0.2 million and $40.1 million at December 31, 2023 and 2022, respectively.

Included in the uninsured deposits at December 31, 2023 and December 31, 2022 are public fund deposits greater than $250,000, which are collateralized by the Company totaling $137.7 million and $111.6 million, respectively. The estimated uninsured and uncollateralized deposits ratio to total deposits at December 31, 2023 and December 31, 2022 was 15% and 19%, respectively.

Other components of liquidity are the level of borrowings from third party sources and the availability of future credit. The Company's outside borrowings are comprised of securities sold under agreements to repurchase, FHLB advances, and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of December 31, 2023, under agreements with these unaffiliated banks, the Bank may borrow up to $35.0 million in federal funds on an unsecured basis and $8.6 million on a secured basis. There were no federal funds purchased outstanding at December 31, 2023. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company's investment portfolio. The Company elected to discontinue the repurchase agreement product during 2023 and customers were moved to reciprocal deposit products within the Company's deposit mix. The Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window; although no such borrowings were outstanding at December 31, 2023.

As a member of the FHLB, the Bank has access to credit products of the FHLB. As of December 31, 2023, the Bank had $107.0 million in outstanding borrowings with the FHLB. In addition, the Company has $49.5 million at December 31, 2023 in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts.

Borrowings outstanding at December 31, 2023 and 2022 were as follows:

The Company pledges certain assets, including loans and investment securities to the Federal Reserve Bank, FHLB, and other correspondent banks as security to establish lines of credit and borrow from these entities. Based on the type and value of collateral pledged, the Company may draw advances against this collateral.

The following table reflects the advance equivalent of the assets pledged, borrowings, and letters of credit outstanding, in addition to the estimated future funding capacity available to the Company.

At December 31, 2023, loans of $708.3 million were pledged to the FHLB as collateral for borrowings and letters of credit. At December 31, 2023, investments with a market value of $9.0 million were pledged to secure federal funds purchase lines and borrowing capacity at the Federal Reserve Bank.

Sources and Uses of Funds

Cash and cash equivalents were $93.5 million at December 31, 2023 compared to $83.7 million at December 31, 2022. The $9.7 million increase resulted from changes in the various cash flows produced by operating, investing, and financing activities of the Company, as shown in the accompanying consolidated statement of cash flows for the year ended December 31, 2023. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $17.6 million for the year ended December 31, 2023.

Investing activities, consisting mainly of purchases, sales and maturities of available-for-sale securities, and changes in the level of the loan portfolio, provided total cash of $54.2 million. The cash inflow primarily consisted of $74.5 million from sales of securities and $24.4 million from maturities and calls of securities, respectively. This was partially offset by a $29.5 million purchase of securities and a net increase in loans held for investment of $18.3 million. The Company proactively elected a strategy to begin repositioning its balance sheet during the fourth quarter of 2023 by selling $83.7 million in book value of investment securities, with an average yield of 1.57%, for an after-tax realized loss of $9.1 million. This is expected to be accretive to earnings, net interest margin and return on assets in future periods.

Financing activities used cash of $62.1 million, resulting primarily from a $128.4 million decrease in demand and interest-bearing transaction accounts. This was partially offset by a $67.1 million increase in time deposits. The Company utilized funding capacity with the FHLB by drawing advances of $346.8 million and repaying $337.8 million to meet its short-term liquidity needs during the year.

In the normal course of business, the Company enters into certain forms of off-balance-sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company's various risk management processes. Management considers both on-balance sheet and off-balance-sheet transactions in its evaluation of

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the Company's liquidity. The Company had $406.0 million in unused loan commitments and standby letters of credit as of December 31, 2023. Although the Company's current liquidity sources are adequate to fund this commitment level, many of the unused commitments are expected to expire or be partially used, and does not necessarily represent future cash requirements.

The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company's ongoing liquidity needs primarily include funding its operating expenses and paying cash dividends to its shareholders. The Company paid cash dividends to its common shareholders totaling approximately $4.6 million and $4.2 million for the years ended December 31, 2023 and 2022, respectively. A large portion of the Company's liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid $9.0 million and $10.5 million in dividends to the Company during the years ended December 31, 2023 and 2022, respectively. At December 31, 2023 and 2022, the Company had cash and cash equivalents totaling $6.8 million and $2.5 million, respectively.

Capital Management

The Company is subject to various regulatory capital requirements administered by federal and state banking agencies. Under the Basel III Capital Rules, at December 31, 2023, the Company met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions, as shown in the following table as of December 31, for the years indicated:

Commitments, Contractual Obligations, and Off-Balance-Sheet Arrangements

The required payments of time deposits and other borrowed money, not including interest, at December 31, 2023 are as follows: