LAKELAND FINANCIAL CORP (LKFN) FY 2021 MD&A

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

OVERVIEW

Net income in 2021 was $95.7 million, up 13.5% from $84.3 million in 2020. Net income for 2020 was 3.1% lower than $87.0 million in 2019.

Diluted net income per common share was $3.74 in 2021, $3.30 in 2020 and $3.38 in 2019. Return on average total assets was 1.56% in 2021 versus 1.55% in 2020 and 1.76% in 2019. Return on average total equity was 14.19% in 2021 versus 13.51% in 2020 and 15.47% in 2019. The dividend payout ratio, with respect to diluted earnings per share, was 36.36% in 2021, 36.36% in 2020 and 34.32% in 2019. The average equity to average assets ratio was 10.96% in 2021 compared to 11.51% in 2020 and 11.38% in 2019.

Net income in 2021 was positively impacted by a $15.1 million increase in net interest income and a $13.7 million decrease in provision for credit losses. Offsetting these positive impacts were a $13.1 million increase in noninterest expense and a $2.1 million decrease in noninterest income.

Net income in 2020 was $84.3 million, down 3.1% from $87.0 million in 2019 and up 4.9% from $80.4 million in 2018. Diluted net income per common share was $3.30 in 2020 and $3.38 in 2019. Return on average total assets was 1.55% in 2020 versus 1.76% in 2019. Return on average total equity was 13.51% in 2020 versus 15.47% in 2019. The dividend payout ratio, with respect to diluted earnings per share, was 36.36% in 2020 and 34.32% in 2019. The average equity to average assets ratio was 11.51% in 2020 compared to 11.38% in 2019.

Net income in 2020 was positively impacted by an $8.0 million, or 5.1% increase, in net interest income and an $1.8 million, or 4.1% increase, in noninterest income. Offsetting these positive impacts was an $11.5 million, or 356.6% increase, in the provision for credit losses and an $1.8 million, or 2.0%, increase in noninterest expense.

Total assets were $6.557 billion as of December 31, 2021 versus $5.830 billion as of December 31, 2020, an increase of $726.9 million or 12.5%. This increase was primarily due to a $663.7 million increase in available-for-sale investment securities and an increase in short-term investments of $455.9 million. The increase of investment securities reflects the deployment of $652 million in excess liquidity that resulted from deposit growth. Deposit growth was impacted by PPP and economic stimulus. Total average assets increased $729.0 million primarily due to a $434.4 million increase in available-for-sale investment securities and a $313.6 million increase in interest bearing deposits.

CRITICAL ACCOUNTING POLICIES

Certain of the Company’s accounting policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Some of the facts and circumstances which could affect these judgments include changes in interest rates, in the performance of the economy or in the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for credit losses.

Allowance for Credit Losses

The Company maintains an allowance for credit losses to provide for expected credit losses. Losses are charged against the allowance when management believes that the principal is uncollectible. Subsequent recoveries, if any, are credited to the allowance. Allocations of the allowance are made for specific loans and for pools of similar types of loans, although the entire allowance is available for any loan that, in management’s judgment, should be charged against the allowance. A provision for credit losses is taken based on management’s ongoing evaluation of the appropriate allowance balance. A formal evaluation of the adequacy of the credit loss allowance is conducted monthly. The ultimate recovery of all loans is susceptible to future market factors beyond the Company’s control.

The level of credit loss provision is influenced by growth in the overall loan portfolio, emerging market risk, emerging concentration risk, commercial loan focus and large credit concentration, new industry lending activity, general economic conditions and historical loss analysis. In addition, management gives consideration to changes in the facts and circumstances of watch list credits, which includes the security position of the borrower, in determining the appropriate level of the credit loss provision. Furthermore, management’s overall view on credit quality is a factor in the determination of the provision.

The determination of the appropriate allowance is inherently subjective, as it requires significant estimates by management. The Company has an established process to determine the adequacy of the allowance for credit losses that generally includes consideration of changes in the nature and volume of the loan portfolio and overall portfolio quality, along with current and forecasted economic conditions that may affect borrowers’ ability to repay. Consideration is not limited to

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these factors although they represent the most commonly cited factors. To determine the specific allocation levels for individual credits, management considers the current valuation of collateral and the amounts and timing of expected future cash flows as the primary measures. Management also considers trends in adversely classified loans based upon an ongoing review of those credits. With respect to pools of similar loans, an appropriate level of general allowance is determined by portfolio segment using a probability of default-loss given default (“PD/LGD”) model, subject to a floor. A default can be triggered by one of several different asset quality factors, including past due status, nonaccrual status, TDR status or if the loan has had a charge-off. This PD is then combined with a LGD derived from historical charge-off data to construct a default rate. This loss rate is then supplemented with adjustments for reasonable and supportable forecasts of relevant economic indicators, particularly the unemployment rate forecast from the Federal Open Market Committee’s Summary of Economic Projections, and other environmental factors based on the risks present for each portfolio segment. These environmental factors include consideration of the following: levels of, and trends in, delinquencies and nonperforming loans; trends in volume and terms of loans; changes in collateral strength; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedure, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. It is also possible that these factors could include social, political, economic, and terrorist events or activities. All of these factors are susceptible to change, which may be significant. As a result of this detailed process, the allowance results in two forms of allocations, specific and general. These two components represent the total allowance for credit losses deemed adequate to cover expected losses inherent in the loan portfolio.

Commercial loans are subject to a dual standardized grading process administered by the credit administration function. These grade assignments are performed independent of each other and a consensus is reached by credit administration and the loan review officer. Specific allowances are established in cases where management has identified significant conditions or circumstances related to an individual credit that indicate it should be evaluated on an individual basis. Considerations with respect to specific allocations for these individual credits include, but are not limited to, the following: (a) the sufficiency of the customer’s cash flow or net worth to repay the loan; (b) the adequacy of the discounted value of collateral relative to the loan balance; (c) whether the loan has been criticized in a regulatory examination; (d) whether the loan is nonperforming; (e) any other reasons the ultimate collectability of the loan may be in question; or (f) any unique loan characteristics that require special monitoring.

Allocations are also applied to categories of loans considered not to be individually analyzed, but for which the rate of loss is expected to be consistent with or greater than historical averages. Such allocations are based on past loss experience and information about specific borrower situations and estimated collateral values. These general pooled loan allocations are performed for portfolio segments of commercial and industrial; commercial real estate, multi-family, and construction; agri-business and agricultural; other commercial loans; and consumer 1-4 family mortgage and other consumer loans. General allocations of the allowance are determined by a historical loss rate based on the calculation of each pool’s probability of default-loss given default, subject to a floor. The length of the historical period for each pool is based on the average life of the pool. The historical loss rates are supplemented with consideration of economic conditions and portfolio trends.

Due to the imprecise nature of estimating the allowance for credit losses, the Company’s allowance for credit losses includes an unallocated component. The unallocated component of the allowance for credit losses incorporates the Company’s judgmental determination of potential expected losses that may not be fully reflected in other allocations, including factors such as the level of classified credits, economic uncertainties, industry trends impacting specific portfolio segments, broad portfolio quality trends, and trends in the composition of the Company’s large commercial loan portfolio and related large dollar exposures to individual borrowers. As a practical expedient, the Company has elected to state accrued interest separately from loan principal balances on the consolidated balance sheet. Additionally, when a loan is placed on non-accrual, interest payments are reversed through interest income.

For off balance sheet credit exposures outlined in the ASU at 326-20-30-11, it is the Company’s position that nearly all of the unfunded amounts on lines of credit are unconditionally cancellable, and therefore not subject to having a liability set up.

The allowance is inherently uncertain as it represents the Company’s expectation of the future collectability of loans in its portfolio; actual collections may be greater than or less than expectations. Actual collections may be impacted by wider economic conditions such as changes in the competitive environment or in the levels of business investment or consumer spending, or by the quality of borrowers’ management teams and the success of their strategy execution. Borrowers’ ability to repay may also change due to the effects of government monetary or fiscal policy, which could affect the level of demand for borrowers’ products or services.

The Company’s allowance for credit losses is subject to changes in the inputs to the model, including the following: the numbers of delinquent loans, nonaccrual loans, troubled debt restructuring, or charge offs; the levels of charge offs and recoveries; projected unemployment rates and other economic indicators; the Company’s collateral position on adversely classified loans; or management’s qualitative judgment of the implication of trends in its loan portfolio or in the broader economy.

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RESULTS OF OPERATIONS

Overview

In 2021 and 2020, the Company continued to grow loans and deposits organically, in its geographic footprint of northern Indiana and in central Indiana in the Indianapolis market. In addition, during 2021 and 2020 the Company was an active participant in the PPP. The Company had 51 branches as of December 31, 2021. The Company’s profitability has been positively impacted by growth in loans and deposits and a reduction in provision for credit losses. In addition, asset quality has remained stable. The core banking contributions to noninterest income of loan, wealth management, and merchant card interchange fee income increased in 2021. Overall, expense growth has reflected our continued investment in people, technology and our branch infrastructure. The outlook for 2022 includes plans for continued organic loan growth and expanding our lending radius, a disciplined credit philosophy, continued investment in the Company in the form of staff additions, continued expansion in our geographic footprint, and continued investments in customer-facing technology and cybersecurity risk management tools.

Selected income statement information for the years ended December 31, 2021, 2020 and 2019 is presented in the following table.

(1)Noninterest expense/Net interest income plus Noninterest income.

(2)Non-GAAP financial measure. Calculated by subtracting intangible assets, net of deferred tax, from total assets and total equity. Management believes this is an important measure because it is useful for planning and forecasting purposes. See reconciliation on the next page.

(3)Non-GAAP financial measure. Calculated by subtracting the impact PPP loans had on average earnings assets, loan interest income, average interest bearing liabilities, and interest expense. Management believes this is an important measure because it provide for better comparability to prior periods, given the expectation that PPP represents a limited governmental intervention in the lending market, designed to support small businesses through the pandemic, its low fixed interest rate of 1.0% and because the accretion of net loan fee income can be accelerated upon borrower forgiveness and repayment by the SBA. Management is actively monitoring net interest margin on a fully tax equivalent basis with and without PPP loan impact for the duration of this program. See reconciliation on the next page.

(4)Non-GAAP financial measure. Pretax pre-provision earnings is calculated by adding net interest income to noninterest income and subtracting noninterest expense. Management believes this is an important measure because it may enable investors to identify the trends in the Company's earnings exclusive of the effects of tax and provision expense, which may vary significantly from period to period. See reconciliation on the next page.

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The Company believes that providing non-GAAP financial measures provides investors with information useful to understanding the company's financial performance. A reconciliation of these non-GAAP financial measures is provided below (dollars in thousands, except per share data).

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The impact of the Paycheck Protection Program on Net Interest Margin FTE is provided below (dollars in thousands).

Net Income

Net income was $95.7 million in 2021, an increase of $11.4 million, or 13.5%, versus net income of $84.3 million in 2020. The increase in net income from 2020 to 2021 was primarily due to an increase in net interest income of $15.1 million, or 9.3%, and a decrease in the provision for credit losses of $13.7 million, or 92.7%. Noninterest expense increased $13.1 million, or 14.3%, and noninterest income decreased $2.1 million, or 4.5%. Net interest income for 2021 included $14.9 million in PPP interest and fee income compared to $12.8 million for 2020. The decrease in provision expense for 2021 was driven by improved economic conditions, which were supported by government stimulus programs and accommodative FOMC monetary policy.

Net income was $84.3 million in 2020, a decrease of $2.7 million, or 3.1%, versus net income of $87.0 million in 2019. The decrease in net income from 2019 to 2020 was primarily due to an increase in the provision for credit losses of $11.5 million, or 356.6%, as well as an increase of $1.8 million, or 2.0%, in noninterest expense. Net interest income increased $8.0 million, or 5.1%, and noninterest income increased $1.8 million, or 4.1%. Net interest income for 2020 included $12.8 million in PPP interest and fee income. The increase in provision for credit losses was driven by the potential negative impact to the Company's borrowers due to the economic impact of the COVID-19 pandemic.

Net Interest Income

The following table presents a three-year average balance sheet and, for each major asset and liability category, its related interest income and yield or its expense and rate for the years ended December 31, 2021, 2020 and 2019.

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THREE YEAR AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS

(1)Loan fees are included as taxable loan interest income. Net loan fees attributable to PPP loans were $12.5 million and $9.0 million for the years ended December 31, 2021 and 2020, respectively. All other loan fees were immaterial in relation to total taxable loan interest income for the periods presented.

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(2)Nonaccrual loans are included in the average balance of taxable loans.

(3)Tax exempt income was converted to a fully taxable equivalent basis at a 21 percent tax rate. The tax equivalent rate for tax exempt loans and tax exempt securities acquired after January 1, 1983 included the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) adjustment applicable to nondeductible interest expenses. Taxable equivalent basis adjustments were $3.6 million, $2.4 million and $2.1 million for the years ended December 31, 2021, 2020 and 2019, respectively.

The following table shows fluctuations in net interest income attributable to changes in the average balances of assets and liabilities and the yields earned or rates paid for the years ended December 31.

NET INTEREST INCOME – RATE/VOLUME ANALYSIS (fully tax equivalent basis, dollars in thousands)

(1)The earning assets and interest bearing liabilities used to calculate interest differentials are based on average daily balances for 2021, 2020 and 2019. The changes in net interest income are created by changes in interest rates and changes in the volumes of loans, investments, deposits and borrowings. In the table above, changes attributable to volume are computed using the change in volume from the prior year multiplied by the previous year’s rate, and changes attributable to rate are computed using the change in rate from the prior year multiplied by the previous year’s volume. The change in interest or expense due to both rate and volume has been allocated between factors in proportion to the relationship of the absolute dollar amounts of the change in each.

(2)Tax exempt income was converted to a fully taxable equivalent basis at a 21 percent tax rate. The tax equivalent rate for tax exempt loans and tax exempt securities acquired after January 1, 1983 included the TEFRA adjustment applicable to nondeductible interest expense.

Net interest income increased by $15.1 million to $178.1 million in 2021 compared to 2020, primarily due to a $721.8 million, or 13.9%, increase in average earning assets, driven by a $434.4 million increase in average available-for-sale investment securities and a $313.6 million increase in interest bearing deposits. The yield on average earning assets decreased 44 basis points to 3.33% in 2021 from 3.77% in 2020. The net interest margin decreased to 3.07% in 2021 versus 3.19% in 2020, driven by continued margin compression and excess liquidity on the Company's balance sheet. The net interest margin decreased to 3.19% in 2020 versus 3.38% in 2019, driven by the Federal Reserve Bank decreasing the target Federal Funds

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Rate by 225 basis points since the second half of 2019, inclusive of two emergency cuts during March 2020, in response to the economic challenges from the COVID-19 pandemic.

Growth in the commercial loan portfolio accounted for most of the growth in loans. Management believes that the growth in the loan portfolio, excluding the PPP loan program, will likely continue in a measured and prudent fashion as a result of our continued strategic focus on commercial and industrial lending, as well as commercial real estate lending. Average total loans were flat at $4.421 billion at December 31, 2021 compared to $4.424 billion at December 31, 2020. Average total loans, excluding PPP loans, were $4.183 billion at December 31, 2021 and represented growth of $135.5 million, or 3.3%, during 2021. Loan growth, excluding PPP loans, was slower in 2021 and 2020 as compared to prior years due to excess liquidity on our customers' balance sheets and a slowdown in demand for manufacturing and industrial loans. The utilization of commercial lines of credit has dropped in 2021 and 2020, due to softened loan demand, to 42% at December 31, 2021 from 43% at December 31, 2020 and 46% at December 31, 2019. However, available lines of credit have increased by a record $557 million to $4.101 billion at December 31, 2021 compared to $3.544 billion at December 31, 2020. Management believes that tepid loan demand has impacted the decrease in commercial line utilization and believes its organic growth strategy of continued expansion in its current geographic footprint and in Indianapolis will provide continued loan growth opportunities.

During 2021 a reduction in average loans of $3.4 million, growth in average available-for-sale investment securities of $434.4 million and growth in average short-term investments and interest bearing deposits of $290.8 million was funded through an increase in deposits. Average demand deposits increased $361.3 million in 2021 and average interest bearing deposit accounts increased $345.4 million. The increase in deposits for 2021 resulted from excess liquidity on our customers’ balance sheets resulting from a combination of PPP and economic stimulus. As a result of this excess liquidity on the Company's balance sheet, management deployed $652 million into the available-for-sale investment securities portfolio during 2021.

Provision for Credit Losses

On December 27, 2020, President Trump signed into law the Consolidated Appropriations Act, 2021. This law extended relief for troubled debt restructurings and provided the opportunity to further delay CECL adoption originally provided under the CARES Act. The Company elected to defer adoption of CECL until January 1, 2021. Prior to this, provision expense was recorded under the incurred loss methodology. The day one impact of the adoption was an increase in the allowance for credit losses of $9.1 million, with an offset, net of taxes, to beginning stockholders' equity.

The Company recorded a provision for credit losses of $1.1 million in 2021 compared to $14.8 million in 2020 and $3.2 million in 2019. The lower provision in 2021 was driven by improvement in the financial condition and outlook of the Company's borrowers. The Company’s allowance for credit losses as of December 31, 2021 was $67.8 million compared to $61.4 million as of December 31, 2020 and $50.7 million as of December 31, 2019. The allowance for credit losses represented 1.58% of total loans as of December 31, 2021 versus 1.32% at December 31, 2020 and 1.25% at December 31, 2019. CECL adoption included a one-time increase to the allowance for credit losses of $9.1 million. The company’s credit loss reserve to total loans, excluding PPP loans, was 1.59% at December 31, 2021 compared to 1.45% at December 31, 2020 and 1.25% at December 31, 2019. PPP loans are guaranteed by the United States SBA and have not been allocated for within the allowance for credit losses. Net charge-offs of $3.8 million, or 0.09% of average loans, and net charge-offs of $4.0 million, or 0.09% of average loans, were recorded in 2021 and 2020, respectively. The charge offs for 2021 and 2020 resulted primarily from a single commercial credit each year. Management believes the charge offs were one-off instances and are not reflective of deteriorating trends in the loan portfolio. The Company’s management continues to monitor the adequacy of the provision based on loan levels, asset quality, economic conditions including the impact of the COVID-19 pandemic and other factors that may influence the assessment of the collectability of loans.

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Noninterest Income

The following table presents changes in the components of noninterest income for the years ended December 31.

Noninterest income was $44.7 million in 2021 versus $46.8 million in 2020, a decrease of $2.1 million, or 4.5%. The decrease was primarily driven by a $4.1 million decrease in interest rate swap fees generated from commercial lending transactions, as well as a $2.5 million decrease in mortgage banking income. Demand for interest rate swap arrangements decreased in 2021. The carrying value of mortgage servicing rights was negatively impacted by increased prepayment speeds, resulting from the low interest rate environment. Offsetting these decreases were an increase in loan service fees of $1.8 million, an increases in wealth advisory and investment brokerage fees of $1.6 million, an increase in merchant and interchange fees of $615,000, and an increase in service charges on deposit accounts of $498,000. The increases in fee income were driven by growth in fee-based businesses including from the wealth advisory group, merchant services, debit card interchange and institutional services areas due to higher transaction volumes and increased economic activity.

Noninterest income was $46.8 million in 2020 versus $45.0 million in 2019, an increase of $1.8 million, or 4.1% higher. The increase was primarily driven by a record $3.4 million increase in interest rate swap fees generated from commercial lending transactions, as well as a $2.3 million increase in mortgage banking income. Noninterest income was also positively impacted by increase in wealth advisory fees due to continued growth of client relationships. Offsetting these increases was a decrease in service charges on deposit accounts driven primarily by lower treasury management fees as well as reduced levels of overdraft fee income.

Noninterest Expense

The following table presents changes in the components of noninterest expense for the years ended December 31.

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Noninterest expense increased by $13.1 million, or 14.3%, to $104.3 million for the year ended December 31, 2021 as compared to $91.2 million for 2020. Salaries and employee benefits increased by $8.5 million due primarily to increased performace-based compensation, increased salaries and increased health insurance expense. Additionally, increased legal fees and costs associated with the digital platform conversion to LCB Digital contributed to an overall increase of $1.8 million in professional fees. Corporate and business development expenses increased as the 2021 economy re-opened, and client events and contributions increased in 2021.

Noninterest expense was $91.2 million in 2020 versus $89.4 million in 2019, an increase of $1.8 million, or 2.0%. Data processing fees increased $1.5 million in 2020 primarily due to the Company's continued investment in customer focused, technology-based solutions and ongoing cybersecurity and data management enhancements. FDIC insurance and other regulatory fees increased $1.1 million due to the expiration of insurance assessment credits and growth of the balance sheet. Professional fees increased by $670,000 primarily due to higher legal expenses, increased fees to accounting firms and professional fees for innovative project implementations. Salaries and employee benefits increased primarily due to an increase in staffing at revenue producing and risk management areas as well as higher health insurance expenses. Offsetting these increases were decreases in corporate and business development as the COVID-19 pandemic forced the cancellation and postponement of events, in-person trainings and face-to-face customer and prospect meetings due to COVID-19 safety protocols. The Company spent approximately $640,000 since the pandemic began on personal protective equipment, protective barriers and enhanced social distancing measures for the safety of bank customers and employees.

As previously disclosed, in the third quarter of 2019, the Bank discovered potentially fraudulent activity by a former treasury management client involving multiple banks. The former client subsequently filed several related bankruptcy cases, captioned In re Interlogic Outsourcing, Inc., et al., which are pending in the United States Bankruptcy Court for the Western District of Michigan. On April 27, 2021, the bankruptcy court entered an order approving an amended plan of liquidation, which was filed by the former client, other debtors and bankruptcy plan proponents, and approving the consolidation of the assets in the aforementioned cases under the Khan IOI Consolidated Estate Trust. On August 9, 2021, the liquidating trustee for the bankruptcy estates filed a complaint against the Bank and the Company, and has agreed to stay prosecution of the action through March 31, 2022. The action is focused on a series of business transactions among the client, related entities, and the Bank, which the liquidating trustee alleges are voidable under applicable federal bankruptcy and state law. The complaint also addresses treatment of the Bank’s claims filed in the bankruptcy cases. Based on current information, we have determined that a material loss is neither probable nor estimable at this time, and the Bank and the Company intend to vigorously defend themselves against all allegations asserted in the complaint.

Future noninterest expense may continue to be impacted due to the COVID-19 pandemic. For example, continued economic reopening and growth may impact balance sheet growth and resulting revenue growth which could increase the amount the Company pays in incentive-based compensation. In addition, prolonged supply chain disruptions, labor availability shortages and increased infection rates due to COVID-19 variants could halt the economic recovery and resulting elevated provision expense which may reduce net income and diluted earnings per share, a key performance metric that impacts incentive-based compensation targets.

Income Taxes

The Company recognized income tax expense in 2021 of $21.7 million, compared to $19.5 million in 2020 and $20.3 million in 2019. The effective tax rate in 2021 was 18.5% compared to 18.8% in 2020, and 18.9% in 2019. For a detailed analysis of the Company’s income taxes see Note 13 – Income Taxes.

CERTAIN STATISTICAL DISCLOSURES BY BANK HOLDING COMPANIES

We are required to provide certain statistical disclosures as a bank holding company under the SEC's Industry Guide 3. The following table provides certain of those disclosures.

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Return on average assets is computed by dividing net income by average assets for each indicated fiscal year. Average assets is computed by adding total assets as of each date during the indicated fiscal year and dividing by the number of days in the fiscal year.

Return on average total equity is computed by dividing net income by average equity for each indicated fiscal year. Average equity is computed by adding the total equity attributable to the Company as of each date during the indicated fiscal year and dividing by the number of days in the fiscal year.

Average equity to average assets is computed by dividing average equity by average assets for each indicated fiscal year, as calculated in accordance with the previous explanation.

Dividend payout ratio is computed by dividing dividends declared per common share by earnings per diluted common share for each indicated fiscal year.

Refer to the "Financial Condition - Loan Portfolio", "Financial Condition - Sources of Funds" and "Risk Management - Loan Portfolio" sections of this MD&A and to the Notes to Consolidated Financial Statements of this Form 10-K for the other required disclosures.

FINANCIAL CONDITION

Overview

Total assets of the Company were $6.557 billion as of December 31, 2021, an increase of $726.9 million, or 12.5%, when compared to $5.830 billion as of December 31, 2020. Total loans, excluding PPP loans, increased by $24.5 million, or 0.6%, as of December 31, 2021 from $4.237 billion at December 31, 2020. Total loans outstanding decreased by $361.3 million, or 7.8%, to $4.288 billion at December 31, 2021 from $4.649 billion at December 31, 2020. PPP loans outstanding were $26.2 million as of December 31, 2021, compared to $412.0 million at December 31, 2020. The company received PPP forgiveness proceeds and borrowers' repayment of $709.5 million from the SBA for loans since the program's inception. Cash and cash equivalents increased by $433.3 million and available-for-sale securities increased by $663.7 million. Funding for the investment securities portfolio and organic loan growth came from a $698.6 million increase in total deposits as well as a $54.1 million increase in retained earnings, offset by an $10.5 million decrease in total borrowings.

Uses of Funds

Investment Portfolio

At year end 2021, 2020 and 2019, there were no holdings of securities of any one issuer, other than the U.S. government, government agencies and government sponsored agencies, in an amount greater than 10% of stockholders’ equity. See Note 2 – Securities for more information on these investments.

Purchases of securities available-for-sale totaled $835.0 million in 2021, $216.5 million in 2020 and $129.5 million in 2019. Growth of the investment portfolio during the past three years serves to provide liquidity for the Company and provide longer duration as an offset to the short duration of the loan portfolio. The Company deployed $652 million in excess liquidity into the investment securities portfolio during 2021 and $100 million in 2020 in order to preserve net interest income in the current rate and economic environment. Investment securities represented 21% of total assets on December 31, 2021 compared to 13% on December 31, 2020 and 12% on December 31, 2019. Management expects the investment portfolio as a percent of total assets to normalize once core loan growth demand increases and investment security repayments are deployed into loan growth. Securities sales totaled $14.0 million in 2021, $8.0 million in 2020 and $57.1 million in 2019. Paydowns from prepayments and scheduled payments of $113.1 million, $90.4 million and $53.0 million were received in 2021, 2020 and 2019, and the amortization of premiums, net of the accretion of discounts, was $5.0 million, $4.0 million and $3.9 million, respectively. Maturities and calls of securities totaled $24.7 million, $7.6 million and $14.8 million in 2021, 2020 and 2019, respectively. No provision for allowance for credit loss was recorded in connection with the investment securities portfolio in 2021, and no other-than-temporary impairment was recognized in 2020 or 2019. The investment portfolio is managed to provide for an appropriate balance between liquidity, credit risk and investment return and to limit the Company’s exposure to risk to an acceptable level. The longer duration of the investment security portfolio serves to balance the shorter duration of the loan portfolio.

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The weighted average yields and maturity distribution for the securities portfolio at December 31, 2021, were as follows:

The Company does not trade or invest in or sponsor certain unregistered investment companies defined as hedge funds and private equity funds in the Volcker Rule.

Real Estate Mortgage Loans Held For Sale

Real estate mortgages held for sale decreased by $3.7 million to $7.5 million at December 31, 2021 from $11.2 million at December 31, 2020 as a result of reduced mortgage refinancing demand compared to refinancing activity during 2020. This asset category is subject to a high degree of variability depending on, among other things, recent mortgage loan rates and the timing of loan sales into the secondary market. The Company generally sells almost all of the mortgage loans it originates in the secondary market. Proceeds from sales totaled $126.4 million in 2021, $114.2 million in 2020 and $64.8 million in 2019.

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Loan Portfolio

The loan portfolio by class as of December 31, 2021, 2020 and 2019 was as follows:

The ratio of loans to total loans by portfolio segment as of December 31, 2021, 2020 and 2019 was as follows:

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In 2021, net loan balances decreased by $367.7 million to $4.220 billion, which excludes approximately $119.4 million in loans originated for sale. PPP loans of $26.2 million are included in non-working capital loans of commercial and industrial loans at December 31, 2021. In 2020, net loan balances increased by $572.6 million to $4.588 billion, which excludes approximately $117.6 million in loans originated for sale. PPP loans of $412.0 million were included in non-working capital loans of commercial and industrial loans at December 31, 2020. In 2019, net loan balances increased by $148.9 million to $4.015 billion, which excludes approximately $66.0 million in loans originated for sale.

The mix of loan types within the Company’s portfolio continued a trend toward a higher percentage of the total loan portfolio being in commercial loans. This higher percentage of commercial loans to the total portfolio was a result of the Company’s long standing strategic plan that is focused on organic expansion and growth in commercial loans. Commercial and industrial loans together with owner occupied commercial real estate loans represent 49.6% and 52.4% of total loans as of December 31, 2021 and 2020, respectively. The owner-occupied commercial real estate loans tend to represent the real estate holding of our commercial and industrial loan customers. Another significant loan segment are loans to the agri-business sector. During 2021, the Bank ranked as the third largest agricultural lender in the State of Indiana.

The residential construction and land development loans class included construction loans totaling $3.3 million and $7.2 million as of December 31, 2021 and 2020. Declines in consumer loans during 2021 resulted from paydowns due to borrower excess liquidity generated from mortgage refinancing activity and government stimulus programs. The Bank generally sells conforming mortgage loans which it originates on the secondary market. These loans generally represent mortgage loans that are made to clients with long-term or substantial relationships with the Bank on terms consistent with secondary market requirements. The loan classifications are based on the nature of the loans as of the loan origination date. There were no foreign loans included in the loan portfolio for the periods presented.

Repricing opportunities of the loan portfolio occur either according to predetermined float rate indices, adjustable rate schedules included in the related loan agreements or upon maturity of each principal payment. The following table indicates the scheduled maturities of the loan portfolio as of December 31, 2021:

At maturity, credits are reviewed and, if renewed, are renewed at rates and conditions that prevail at the time of maturity.

Based upon the table above, all loans due after one year which have a predetermined interest rate and loans due after one year which have floating or adjustable interest rates as of December 31, 2021 amounted to $1.241 billion and $1.824 billion, respectively.

Paycheck Protection Program

During 2020 and the first half of 2021, the Bank funded PPP loans totaling $735.6 million for its customers through the PPP programs. In addition, the Bank processed forgiveness applications for PPP loans representing 97% of loans originated. As of December 31, 2021, PPP loans outstanding, net of deferred fees, totaled $26.2 million; $3.8 million from PPP round one and $22.3 million from PPP round two. As of December 31, 2021, the SBA has approved forgiveness of, or borrowers repaid, $709.5 million in PPP loans; $566.7 million for PPP loans originated during round one and $142.8 million for PPP loans originated during round two. As of December 31, 2021, the Bank had submitted additional PPP forgiveness applications on behalf of customers in the amount of $8.3 million that were awaiting SBA approval.

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Bank Owned Life Insurance

Bank owned life insurance increased by $2.4 million to $97.7 million at December 31, 2021 and by $11.4 million to $95.2 million at December 31, 2020 from $83.8 million at December 31, 2019. The increase during 2021 was primarily due to investment returns on the life insurance policies of pre-existing life insurance policies. The increase during 2020 was primarily due to the purchase of additional life insurance policies on officers of the Bank. Bank owned life insurance provides investment income from the securities the life insurance is invested in and offsets benefit plan expenses for participants covered by insurance.

Sources of Funds

The average daily deposits and borrowings together with the average rates paid on those deposits and borrowings for the years ended December 31, 2021, 2020 and 2019 are summarized in the following table:

Time deposits as of December 31, 2021 will mature as follows:

Deposits

Total deposits increased by $698.6 million to $5.735 billion, comparing December 31, 2021 to December 31, 2020. The increase in deposits consisted of growth of $703.6 million in core deposit combined with a decrease of $5.0 million in brokered deposits. Total deposit growth was led by an increase of $321.9 million, or 16.6%, in commercial deposits. In addition, retail deposits increased by $259.5 million, or 13.5%, while public funds deposits increased by $122.2 million, or 10.5%. PPP loan proceeds to borrowers and government stimulus to consumers impacted the increase in deposit during 2021 as loan proceeds and stimulus payments were deposited into customer checking and savings accounts at the Bank. Proceeds from the sale of customer businesses also contributed to the increase of deposits during 2021.

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Total deposits increased by $903.0 million to $5.037 billion, comparing December 31, 2020 to December 31, 2019. The growth in deposits consisted of $1.002 billion in core deposit growth offset by a decrease of $98.5 million in brokered deposits. Total deposit growth was led by an increase of $664.3 million, or 52.1%, in commercial deposits. In addition, retail deposits increased by $301.9 million, or 18.7%, while public funds deposits increased by $35.3 million, or 3.1%. The growth in deposits in 2020 resulted from increased deposit balances from new and existing customers, as well as a decreased utilization of brokered deposits. Deposit growth was impacted by excess liquidity on customer balance sheets resulting from PPP loans, due to both economic stimulus payments made to retail customers and an increase in savings rates. Core deposit growth enabled the Company to reduce reliance on wholesale funding during 2020 and 2021.

As previously noted, 22% of the Company’s deposit base is attributable to public fund entities which primarily represent customers in the Company’s geographic footprint. A majority of public fund balances represent customers with operating accounts at the Bank. A shift in funding away from public fund deposits could require the Company to execute alternative funding plans under the Contingency Funding Plan discussed in further detail under “Liquidity Risk” below. The following table presents total deposits by portfolio segment as of December 31, 2021, 2020 and 2019:

FHLB Advances and Other Borrowings

During 2021, average total short-term borrowings decreased by $33.9 million to $408,000, primarily due to lower short-term FHLB borrowings and lower usage of the Company's holding company line of credit. Ending balances of short-term and miscellaneous borrowings decreased $10.5 million during 2021 to $0. The decrease was due to the payoff of the Company's holding company line of credit which was used in connection with its share repurchase activity during 2020. The holding company's line repayment was funded by a dividend from the Bank. There was no share repurchase activity during 2021.

Short-term FHLB borrowings are used to fund short-term balance sheet growth due to the flexible nature of the financial instrument and allow the Company to prudently fund commercial or retail loans when opportunities are presented. Average total long-term borrowings increased by $12.7 million to $75.0 million, due to a $75.0 million long-term FHLB borrowing taken in 2020 that was outstanding for all of 2021.

During 2020, average total short-term borrowings decreased by $27.0 million to $34.3 million, primarily due to the payoff of outstanding short-term FHLB borrowings. During 2020, the Company utilized $10.5 million of the holding company's $30.0 million revolving line of credit in connection with its share repurchase activity. Average total long-term borrowings increased by $31.5 million to $62.3 million, primarily due to a $75.0 million long-term FHLB borrowing offset by the repayment of the Company's subordinated debentures in December 2019.

Capital

The Company believes that a strong, appropriately managed capital position is critical to support continued growth of loans and earnings. Capital is used primarily to fund continued organic loan growth and to support dividends to shareholders. The Company had a total risk-based capital ratio of 15.4%, a Tier I risk-based capital ratio of 14.1% and a common Tier 1 risk-based capital ratio of 14.1% as of December 31, 2021. These ratios met or exceeded the Federal Reserve Bank’s “well-capitalized” minimums of 10.0%, 8.0% and 6.5%, respectively. The Company also had a Tier 1 leverage ratio of 10.7% and a tangible equity ratio of 10.7%. See Note 16 – Capital Requirements for more information.

The ability to maintain these ratios is a function of the balance between net income and a prudent dividend policy. Total stockholders’ equity increased by 7.3% to $704.9 million as of December 31, 2021 from $657.2 million as of December 31, 2020. The Company earned $95.7 million in 2021 and $84.3 million in 2020. The Company declared cash dividends of $1.36 per share in 2021, which decreased equity by $34.7 million. The Company declared cash dividends of $1.20 per share in 2020, which decreased equity by $30.6 million. The change in accumulated other comprehensive income in 2021

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was due to changes in the fair values of available-for-sale securities and the defined benefit pension which decreased equity by $11.7 million in 2021 compared to an increase of $15.7 million in 2020. The impact to equity due to other comprehensive income (loss) is not included in regulatory capital. In addition, during March of 2020 the Company repurchased 289,101 shares of its common stock for $10.0 million.

RISK MANAGEMENT

Overview

The Company, with the oversight of the Corporate Risk Committee of the Board, has developed a company-wide risk management program intended to help identify, manage and mitigate the various business risks the Company is exposed to. Following is a discussion addressing the risks identified as most significant to the Company – Credit, Liquidity, Interest Rate and Market Risk. Item 7A. includes additional discussion about market risk.

Credit Risk

Credit risk represents the risk of loss arising from an obligor’s inability or failure to meet contractual payment or performance terms. Our primary credit risks result from lending and to a lesser extent, investment activities.

Investment Portfolio

The Company’s investment portfolio consists of U.S. treasuries, government agencies and municipal bonds subject to an investment security policy that is approved annually by the Board. During 2021, purchases in the securities portfolio consisted of primarily municipal bonds, agency securities and mortgage-backed securities. As of December 31, 2021, the Company’s investment in U.S government sponsored mortgage-backed securities represented approximately 35% of total securities consisting of Collateralized Mortgage Obligations, Commercial Mortgage-Backed Securities and mortgage pools issued by Ginnie Mae, Fannie Mae and Freddie Mac. Ginnie Mae, Fannie Mae and Freddie Mac securities are each guaranteed by their respective agencies as to principal and interest. All mortgage securities purchased by the Company in 2021 were within risk tolerances for price, prepayment, extension and original life risk characteristics contained in the Company’s investment policy. As of December 31, 2021, all mortgage-backed securities were performing in a manner consistent with management’s expectations at time of purchase. Municipal securities represent 55% of total securities as of December 31, 2021 and were rated investment grade at the time of purchase and continue to be rated investment grade. The Company uses analytics provided by its third party portfolio advisor to evaluate and monitor credit risk for all investments on a quarterly basis. Based upon these analytics as of December 31, 2021, the securities in the available-for-sale portfolio had approximately a 4.6 year effective duration. The analysis indicated a negative 16.06% change in market value in the event of a 300 basis point upward, instantaneous rate shock and an approximate positive 3.90% change in market value in the event of a 100 basis point downward, instantaneous rate shock.

Loan Portfolio

The Company has a relatively high percentage of commercial and commercial real estate loans extended to businesses with a broad range of revenue and within a wide variety of industries. Traditionally, this type of lending may have more credit risk than other types of lending because of the size and diversity of the credits. The Company manages this risk by utilizing conservative credit structures, by adjusting its pricing to the perceived risk of each individual credit and by diversifying the portfolio by customer, product, industry and market area and by obtaining personal loan guarantees.

There were no loan concentrations within industries, which exceeded ten percent of total loans, except commercial real estate and manufacturing. Commercial real estate was $1.955 billion, or 45.6%, of total loans and manufacturing was $438.8 million, or 10.2%, of total loans at December 31, 2021. The owner occupied commercial real estate portfolio generally represents the financing of factories and operational facilities for the Bank's commercial and industrial borrowers. The Company’s in-house lending limit was raised from $30.0 million to $40.0 million during 2020. Manufacturing loans are included in the commercial and industrial loans total and are well diversified by industry. Agri-business and agricultural loans represent 10.4% of total loans as of December 31, 2021 and are not concentrated to any agricultural sector. Nearly all of the Bank’s commercial, industrial, agricultural real estate mortgage, real estate construction mortgage and consumer loans are made within its geographic market areas and to diverse industries.

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The following is a summary of nonperforming loans as of December 31, 2021 and 2020.

(1)Includes nonaccrual troubled debt restructured loans.

Nonperforming assets of the Company include nonperforming loans (as indicated above), nonaccrual investments and other real estate owned and repossessions, the total of which amounted to $15.3 million and $12.4 million at December 31, 2021 and 2020, respectively. Nonperforming loans increased by $3.0 million during 2021, due primarily to the downgrade of one commercial loan relationship. The relationship is a shared national credit participation of $5.2 million to a commercial borrower that operates grain elevators and handles feed processing and merchandising of agriculture products. Loans to this borrower are secured by a blanket lien on all assets, including buildings, inventory, accounts receivable and equipment. This loan is current on interest and principal payments through December 2021. As of December 31, 2021, management believed that there were no significant foreseeable losses relating to nonperforming assets, except as discussed below.

Loans for which the borrower appears to be unable or unwilling to repay its debt in full or on time and the collateral is insufficient to cover all principal and accrued interest, will be reclassified as nonperforming loans to the extent they are unsecured, on or before the date when the loan becomes 90 days delinquent, with the exception of small dollar other consumer loans which are not placed on nonaccrual status since these loans are charged-off when they have been delinquent from 90 to

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180 days, and when the related collateral, if any, is not sufficient to offset the indebtedness. When a loan is classified as a nonaccrual loan, interest on the loan is no longer accrued, all unpaid accrued interest is reversed and interest income is subsequently recorded only to the extent cash payments are received. Accrual status is resumed when all contractually due payments are brought current and future payments are reasonably assured.

A loan is individually analyzed when full payment under the original loan terms is not expected. Reserves are evaluated in total for smaller-balance loans of similar nature not in nonaccrual or troubled debt restructured status such as residential mortgage, consumer, and credit card loans, and on an individual loan basis for other loans. If a loan is individually analyzed, a portion of the allowance may be allocated so that the loan is reported, net, at the present value of estimated future cash flow or at the fair value of collateral if repayment is expected solely from the collateral.

Total nonperforming loans were $15.1 million, or 0.35% of total loans, at year end 2021 versus $12.1 million, or 0.26% of total loans, at year end 2020. There were 34 loans totaling $25.6 million classified as individually analyzed as of December 31, 2021 versus 39 loans totaling $20.2 million at the end of 2020. The increase in individually analyzed loans during 2021 resulted primarily from the downgrade of one commercial loan relationship. The relationship is a shared national credit participation of $5.2 million to a commercial borrower that operates grain elevators and handles feed processing and merchandising of agriculture products. Loans to this borrower are secured by a blanket lien on all assets, including buildings, inventory, accounts receivable and equipment. This loan is current on interest and principal payments through December 2021.

Loans renegotiated as troubled debt restructurings are those loans for which either the contractual interest rate has been reduced below market rates and/or other concessions to market terms are granted to the borrower because of a deterioration in the financial condition of the borrower which results in the inability of the borrower to meet the terms of the loan.

As of December 31, 2021, there were 27 loans totaling $11.3 million renegotiated as troubled debt restructurings of which $217,000 were modified in 2021. Of these loans, $6.2 million were included in nonaccrual loans in the previous table and the remaining $5.1 million were performing under their modified terms. As of December 31, 2020, there were 31 loans totaling $11.7 million renegotiated as troubled debt restructurings of which $5.5 million were modified in 2020. Of these loans, $6.5 million were included in nonaccrual loans in the previous table and the remaining $5.2 million were performing under their modified terms. The Company has no commitments to lend additional funds to any of the borrowers.

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The following is a summary of the credit loss experience for the years ended December 31, 2021, 2020 and 2019.

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The following is a summary of the allocation for credit losses as of December 31, 2021 and 2020.

At December 31, 2021, the allowance for credit losses was 1.58% of total loans outstanding, versus 1.32% of total loans outstanding at December 31, 2020 under the incurred loss model. The allowance for credit losses was 1.59% of total loans outstanding, excluding PPP loans of $26.2 million, as of December 31, 2021 versus 1.45% of total loans outstanding, excluding PPP loans of $412.0 million, as of December 31, 2020. This reflects a more comparable ratio to prior periods, as PPP loans are fully guaranteed by the SBA and have not been allocated for within the allowance for credit losses calculation. Management believes the allowance for credit losses is at a level commensurate with the overall risk exposure of the loan portfolio. However, if economic conditions fail to recover or continue to deteriorate due to the COVID-19 pandemic or the current economic environment, certain borrowers may experience difficulty and the level of nonperforming loans, charge-offs and delinquencies could rise and require increases in the allowance for credit losses. The process of identifying expected credit losses is a subjective process. Therefore, the Company maintains a general allowance to cover expected credit losses within the entire portfolio. The methodology management uses to determine the adequacy of the credit loss reserve includes the considerations below.

Loans are charged against the allowance for credit losses when management believes that the principal is uncollectible. Subsequent recoveries, if any, are credited to the allowance. The allowance is an amount that management believes will be adequate for expected credit losses relating to specifically identified loans based on an evaluation of the loans by management, as well as other expected credit losses inherent in the loan portfolio. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current and forecasted economic conditions that may affect the borrower’s ability to repay. Management also considers trends in adversely classified loans based upon a monthly review of those credits. An appropriate level of qualitative and environmental allowance is determined after considering the following factors: changes in the nature and volume of the loan portfolio, overall portfolio quality, changes in collateral strength and current economic conditions that may affect the borrowers’ ability to repay. Consideration is not limited to these factors although they represent the most commonly cited factors. Federal regulations require insured institutions to classify their own assets on a regular basis. The regulations provide for three categories of classified loans: Substandard, Doubtful and Loss. The regulations also contain a Special Mention category. Special Mention is defined as loans that do not currently expose an insured institution to a sufficient degree of risk to warrant classification as Substandard, Doubtful or Loss but do possess credit deficiencies or potential weaknesses deserving management’s close attention. The Company’s policy is to establish a specific allowance for credit losses for any assets where management has identified conditions or circumstances that indicate an asset is nonperforming. If an asset or portion thereof is classified as loss, the Company’s policy is to either establish specific allocations for credit losses in the amount of 100% of the portion of the asset classified loss or charge-off such amount.

At December 31, 2021, on the basis of management’s review of the loan portfolio, the Company had 81 credits totaling $234.5 million on the classified loan list versus 96 credits totaling $286.1 million on December 31, 2020. These amounts represent outstanding balances, excluding deferred fees and costs. The decrease in classified loans during 2021 reflects the improved economic outlook some of the Company’s borrowers are experiencing, particularly in the hotel and entertainment industries as the economy continues to reopen. As of December 31, 2021, the Company had $176.6 million of assets classified as Special Mention, $57.9 million classified as Substandard, $0 classified as Doubtful and $0 classified as Loss as compared to $251.9 million, $34.3 million, $0 and $0, respectively, at December 31, 2020. The balances reported in Note 4 – Allowance for Credit Losses and Credit Quality include deferred fees and costs.

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Included in the classified loan amounts for December 31, 2021 above were the following troubled debt restructured loans: 13 mortgage loans totaling $1.2 million with total allocations of $209,000 and 7 commercial loans totaling $3.9 million with total allocations of $1.6 million. Included in the classified loan amounts for December 31, 2020 above were the following troubled debt restructured loans: 12 mortgage loans totaling $1.1 million with total allocations of $220,000, and 12 commercial loans totaling $8.9 million with total allocations of $4.1 million.

In accordance with Section 4013 of the CARES Act, loan deferrals granted to customers that resulted from the impact of COVID-19 and who were not past due at the time of deferral were not considered trouble debt restructurings as of December 31, 2021. This provision expired January 1, 2022 under the Consolidated Appropriations Act, 2021. At the time of the expiration of the provision, one retail borrower in the amount of $11,000 had a COVID-19 related deferral and was not considered to be a troubled debt restructuring.

Allowance estimates are developed by management taking into account actual loss experience, subject to a floor, adjusted for current economic conditions and a reasonably supportable forecast period. The Company has regular discussions regarding this methodology with regulatory authorities. Allowance estimates are considered a prudent measurement of the risk in the Company's loan portfolio based upon loan segment. In accordance with CECL accounting guidance, the allowance is based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the reported amounts. For a more thorough discussion of the allowance for credit losses methodology see the Critical Accounting Policies section of this Item 2.

The allowance for credit losses increased 10.4%, or $6.4 million, from $61.4 million at December 31, 2020 to $67.8 million at December 31, 2021 due to the day one impact of the adoption of CECL which increased the allowance for credit losses by $9.1 million. Pooled loan allocations increased $8.9 million from $50.2 million at December 31, 2020 to $58.7 million at December 31, 2021. The unallocated component of the allowance for credit losses was $450,000 at December 31, 2021, which decreased from $3.1 million reported at December 31, 2020, and decreased primarily due to changes in methodology as a result of the adoption of the CECL standard. The unallocated component of the allowance for credit losses incorporates the Company’s judgmental determination of expected losses that may not be fully reflected in other allocations, including factors such as the level of classified credits, economic uncertainties, industry trends impacting specific portfolio segments, broad portfolio quality trends and trends in the composition of the Company’s large commercial loan portfolio and related large dollar exposures to individual borrowers.

The Company has experienced growth in total loans, excluding PPP loans, over the last several years with organic growth exclusive of PPP loans of $24.5 million, or 0.6%, from December 31, 2020 to December 31, 2021. The concentration of this loan growth was in the commercial loan portfolio, which can result in overall asset quality being influenced by a small number of credits. Management has historically considered growth and portfolio composition when determining credit loss allocations. Management believes that it is prudent to continue to provide for credit losses in a manner consistent with its historical approach due to the loan growth described above and current economic conditions.

Watch list loans were $51.7 million lower at $234.5 million as of December 31, 2021, compared to $286.1 million at December 31, 2020. Watch list loans represent 5.47% of total loans at December 31, 2021 compared to 6.15% at December 31, 2020. Watch list loans excluding PPP loans, were 5.50% of total loans at December 31, 2021 compared to 6.75% at December 31, 2020. This reflects a more comparable ratio to prior periods, as PPP loans are fully guaranteed by the SBA and have not been allocated for within the allowance for credit losses calculation. The reduction in watchlist loans resulted primarily from upgrades of $62.3 million and payoffs of $2.4 million. The Company's continued growth strategy promotes diversification among industries as well as continued focus on the enforcement of a disciplined credit culture and a conservative portion in loan work-out situations.

Liquidity Risk

Liquidity risk arises from the possibility that the Company may not be able to satisfy current or future financial commitments or may become unduly reliant on alternative funding sources. Liquidity is monitored and closely managed by the ALCO Committee.

Management maintains a liquidity position that it believes will adequately provide funding for loan demand and deposit run- off that may occur in the normal course of business. The liquidity structure is expressly detailed in the Company’s Contingency Funding Plan, which is discussed below. The Company relies on a number of different sources in order to meet these potential liquidity demands. The primary sources are increases in deposit accounts and cash flows from loan payments and the securities portfolio. The cash flow from the securities portfolio is expected to provide approximately $143.2 million of potential contingent funding in 2022.

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During 2021, the Company experienced excess levels of liquidity as a result of strong core deposit growth. Management expects the excess liquidity to dissipate over time as depositors utilize the excess funds.

The Company has approval of $3.218 billion in secondary funding sources available as of December 31, 2021, of which $85.0 million was utilized. The Company had $350.0 million of availability in federal funds lines with eleven correspondent banks, none of which was drawn on as of December 31, 2021. The Company has Board approval to borrow up to $800.0 million at the FHLB, but, given the Company’s current collateral structure and outstanding borrowings as of December 31, 2021, the Company could have only borrowed up to $227.8 million under this authority based on utilization of $75.0 million of advances at December 31, 2021. The Company also has additional collateral that could be pledged to the FHLB of $544.9 million as of December 31, 2021 to generate additional liquidity. Further, the Company had available capacity at the Federal Reserve Bank of Chicago of up to $616.5 million given its current collateral structure at the Federal Reserve Bank discount window program and the terms of these facilities at December 31, 2021, with no balances outstanding at December 31, 2021. The Company also has established relationships in the brokered time deposit and brokered money market sectors, as well as the IntraFi Network CD Option One-Way Buy program, to access these funds when desired with settlement of funds in one to two weeks’ time. Additionally, the Bank has entered agreements with IntraFi Network relative to their Insured Cash Sweep One-Way Buy program. As of December 31, 2021, the total amount available to the Bank via this program was $100.0 million, of which $10.0 million was drawn on. The Bank is also a member of the American Financial Exchange (AFX) where overnight fed funds purchased can be obtained from other banks on the exchange that have approved the Bank for an unsecured, overnight line. These funds are only available if the approving banks have an ‘offer’ out to sell that day. As of December 31, 2021, the total amount approved for the Bank via AFX banks was $319.0 million and none was outstanding at year end.

The Company had all of its securities in the available-for-sale portfolio at December 31, 2021, allowing the Company maximum flexibility to sell securities to meet funding demands. Management believes the majority of the securities in the available- for-sale portfolio are of high quality and marketable. Approximately 45% of this portfolio is comprised of U.S. government agency securities or mortgage-backed securities directly or indirectly backed by the U.S. government. In addition, the Company has historically sold the majority of its originated mortgage loans on the secondary market to reduce interest rate risk and to create an additional source of funding.

The Company has a formalized Contingency Funding Plan (“CFP”). The Board and management recognize the importance of liquidity during times of normal operations and in times of stress. The CFP was developed to ensure that the multiple liquidity sources available to the Company are readily available. The CFP specifically considers liquidity at the Bank and the Company level. The CFP identifies the potential funding sources at the Bank level, which includes the FHLB, the Federal Reserve Bank, brokered deposits, one-way buy products via the IntraFi Network (CD Option and ICS) and Fed Funds. The CFP also addresses the Bank’s ability to liquidate its securities portfolio. The CFP funding sources at the holding company level include a holding company committed line of credit, as well as the ability to transfer securities from the investment subsidiary of the Bank to the Company. The Company’s committed line of credit has availability up to $30.0 million, of which $0 was drawn upon as of December 31, 2021.

Further, the CFP identifies CFP team members and expressly details their respective roles. Potential risk scenarios are identified and the plan includes multiple scenarios, including short-term and long-term funding crisis situations. Under the long-term funding crisis, two additional scenarios are identified: a moderate risk scenario and a highly stressed scenario. The CFP details the responsibilities and the actions to be taken by the CFP team under each scenario. Quarterly reports to management and the Board under the CFP include an early warning indicator matrix and pro forma cash flows for the various scenarios.

The following table discloses information on the maturity of the Company’s contractual long-term obligations as of December 31, 2021.

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During the normal course of business, the Company becomes a party to financial instruments with off-balance sheet risk in order to meet the financing needs of its customers. These financial instruments include commitments to make loans and open-ended revolving lines of credit. The Company follows the same credit policy (including requiring collateral, if deemed appropriate) to make such commitments as it follows for those loans that are recorded in its financial statements.

The Company’s exposure to credit losses in the event of nonperformance is represented by the contractual amount of the commitments. Management does not expect any significant losses as a result of these commitments. Off-balance sheet transactions are more fully discussed in Note 18 – Commitments, Off-Balance Sheet Risks and Contingencies.

The following table discloses information on the maturity of the Company’s commitments.

Interest Rate Risk

Interest rate risk is the risk that the estimated fair value of the Company’s assets, liabilities and derivative financial instruments will decline as a result of changes in interest rates or financial market volatility, or that net income will be significantly reduced by interest rate changes.

Interest rate risk represents the Company’s primary market risk exposure. The Company does not have material exposure to foreign currency exchange risk and does not maintain a trading portfolio. The Corporate Risk Committee of the Board annually reviews and approves the ALCO policy and the Derivatives and Hedging policy used to manage interest rate risk. These policies set guidelines for balance sheet structure, which are designed to protect the Company from the impact that interest rate changes could have on net income, but it does not necessarily indicate the effect on future net interest income. Given the Company’s mix of interest bearing liabilities and interest bearing assets on December 31, 2021 and using changes in the interest rate environment over a one-year period, the net interest margin could be expected to decline in a falling interest rate environment and increase in a rising interest rate environment. Earnings can also be affected by the monetary and fiscal policies of the U.S. Government and its agencies, particularly the Federal Reserve Board.

During the entirety of 2021 the Federal Reserve Board’s Federal Open Market Committee (“FOMC”) kept the target federal funds rate at a range of 0% to .25%. There has been no movement in the target federal funds rate since March 2020. The Committee announced and implemented in late 2021 the beginning of their bond taper process relative to their purchases of treasury and mortgage-backed securities; this tapering is now expected to conclude in early 2022. The FOMC statement released for the meeting in December 2021 was relatively positive with the Fed suggesting the economy continues to strengthen and characterized the labor markets as solid, while they did also note that risks to the economic outlook remain including from new variants of the COVID-19 virus. The updated economic projections released at the December meeting project three quarter point rates increases in 2022, another three in 2023 and two more in 2024. Additionally, the longer run Fed median forecast for the federal funds rate was left unchanged at 2.50%. The combined result of the decrease in the yield on earning assets offset by a decrease in the cost of funding earning assets led to decrease in the net interest margin from 3.19% for 2020 to 3.07% for 2021 given the Company’s asset sensitive balance sheet. The Company’s yield on earning assets decreased 44 basis points during 2021 as assets repriced at lower rates due to the low rate environment and competitive markets for commercial loan pricing and excess liquidity was deployed into the investment portfolio. The commercial loan portfolio represents 90% of the total loan portfolio. Approximately 69% of the commercial loan portfolio are variable rate loans which are primarily indexed to 30 day LIBOR, Prime and FHLB indices. The rate paid on deposit accounts and purchased funds decreased 35 basis points for 2021 mainly due to time deposit repricing and decreased rates paid on public fund accounts, including transactional accounts and time deposit accounts, as these accounts are typically more sensitive to interest rates. The realized decrease in the rate paid on deposit accounts and purchased funds was benefited by an increase in the average balance of non-interest bearing demand deposit accounts for 2021 verses 2020, which was largely influenced by PPP Round 2 loan proceeds deposited into borrower checking and savings accounts at the Bank, as well as an overall increase in the savings rate and continued economic stimulus payments.

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Future changes in the net interest margin will be dependent upon multiple factors including further actions by the FOMC during 2022 in response to the continued COVID-19 pandemic, inflation, economic conditions and geopolitical concerns, the results of any of the administration’s changes to economic policy and laws, competitive pressures in the various markets served, and changes in the structure of the balance sheet as a result of changes in customer demands for products and services. In general, we expect loans to reprice quicker than deposits in a rising and falling rate environment as quantified in the sensitivity to market rates table in Item 7A.

The effects of price changes and inflation can vary substantially for most financial institutions. While management believes that inflation affects the growth of total assets, it believes that it is difficult to assess the overall impact. Management believes this to be the case due to the fact that generally neither the timing nor the magnitude of the inflationary changes in the consumer price index (“CPI”) coincides with changes in interest rates. The price of one or more of the components of the CPI may fluctuate considerably and thereby influence the overall CPI without having a corresponding effect on interest rates or upon the cost of those goods and services normally purchased by the Company. In years of high inflation and high interest rates, intermediate and long-term interest rates tend to increase, thereby adversely impacting the market values of investment securities, mortgage loans and other long-term fixed rate loans. In addition, higher short-term interest rates caused by inflation tend to increase the cost of funds. In other years, the reverse situation may occur.