Live Oak Bancshares, Inc. (LOB) FY 2022 MD&A

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

Overview

The following presents management’s discussion and analysis (“MD&A”) of the more significant factors that affected the Company's financial condition and results of operations for the year ended December 31, 2022 as compared to December 31, 2021. For a comparison of 2021 results to 2020 and other 2020 information not included herein, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under Part II, Item 7 of the 2021 Form 10-K filed with the SEC on February 24, 2022. This discussion should be read in conjunction with the financial statements and related notes included elsewhere in this Report on Form 10-K. Results of operations for the periods included in this review are not necessarily indicative of results to be obtained during any future period.

Dollar amounts in tables are stated in thousands, except for per share amounts.

Nature of Operations

Live Oak Bancshares, Inc. (collectively with its subsidiaries including Live Oak Banking Company, the “Company”) is a financial holding company and a bank holding company headquartered in Wilmington, North Carolina, incorporated under the laws of North Carolina in December 2008. The Company conducts business operations primarily through its commercial bank subsidiary, Live Oak Banking Company (the “Bank”). The Bank was incorporated in February 2008 as a North Carolina-chartered commercial bank. The Bank specializes in providing lending and deposit related services to small businesses nationwide. The Bank identifies and extends lending to credit-worthy borrowers both within specific industries, also called verticals, through expertise within those industries, and more broadly to select borrowers outside of those industries. A significant portion of the loans originated by the Bank are partially guaranteed by the U.S. Small Business Administration (“SBA”) under the 7(a) Loan program and the U.S. Department of Agriculture (“USDA”) Rural Energy for America Program (“REAP”), Water and Environmental Program (“WEP”), Business & Industry (“B&I”) and Community Facilities loan programs.

The Company’s wholly owned material subsidiaries are the Bank, Government Loan Solutions (“GLS”), Live Oak Grove, LLC (“Grove”), Live Oak Ventures, Inc. (“Live Oak Ventures”), and Canapi Advisors, LLC (“Canapi Advisors”). GLS is a management and technology consulting firm that advises and offers solutions and services to participants in the government guaranteed lending sector. GLS primarily provides services in connection with the settlement, accounting, and securitization processes for government guaranteed loans, including loans originated under the SBA 7(a) loan programs and USDA guaranteed loans. The Grove provides Company employees and business visitors an on-site restaurant location. Live Oak Ventures’ purpose is investing in businesses that align with the Company's strategic initiative to be a leader in financial technology. Canapi Advisors provides investment advisory services to a series of funds (the “Canapi Funds”) focused on providing venture capital to new and emerging financial technology companies.

The Bank’s wholly owned subsidiaries are Live Oak Number One, Inc., Live Oak Clean Energy Financing LLC (“LOCEF”), Live Oak Private Wealth, LLC (“Live Oak Private Wealth”) and Tiburon Land Holdings, LLC (“TLH”). Live Oak Number One, Inc. holds properties foreclosed on by the Bank. LOCEF provides financing to entities for renewable energy applications. Live Oak Private Wealth provides high-net-worth individuals and families with strategic wealth and investment management services. During the first quarter of 2022, Jolley Asset Management, LLC (“JAM”) was merged into Live Oak Private Wealth. JAM was previously a wholly owned subsidiary of Live Oak Private Wealth. TLH was formed in the third quarter of 2022 to hold land adjacent to the Bank's headquarters consisting of wetlands and other protected property for the use and enjoyment of the Bank's employees and customers.

The Company generates revenue primarily from net interest income and secondarily through origination and sale of government guaranteed loans. Income from the retention of loans is comprised principally of interest income. Income from the sale of loans is comprised of loan servicing revenue and revaluation of related servicing assets along with net gains on sales of loans. Offsetting these revenues are the cost of funding sources, provision for loan and lease credit losses, any costs related to foreclosed assets and other operating costs such as salaries and employee benefits, travel, professional services, advertising and marketing and tax expense. The Company also has less routinely generated gains and losses arising from its financial technology investments predominantly in its fintech segment, as discussed more fully later in this section under the caption “Results of Segment Operations.”

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Executive Summary

The table below sets forth selected consolidated financial data as of the dates or for the periods indicated.

(1)See "Non-GAAP Measures" presented at the conclusion of this Item 7 for more information and a reconciliation to the most closely related GAAP measure.

(2)Loans and leases at historical cost only (excludes loans measured at fair value).

(3)Annual net charge-offs as a percentage of annual average loans and leases held for investment.

(4)The year ended December 31, 2020 excludes one $6.1 million hotel loan classified as held for sale.

(5)Loans accounted for under the fair value option only (excludes loans and leases carried at historical cost).

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The following is a summary of the Company's financial highlights and events for 2022:

•Total assets were $9.86 billion at December 31, 2022 and $8.21 billion at December 31, 2021, a 20.0% increase. Asset growth was driven by significant deposit growth combined with gains from the sale of fintech investments, as discussed below, which was bolstered by substantial loan growth, investments and higher cash balances.

•Loans and leases held for sale and investment increased by $1.26 billion, or 19.0%. Excluding PPP loans, total loans and leases increased $1.51 billion, or 23.7%, to $7.89 billion at the end of 2022. Total loan originations in 2022 were $4.01 billion compared to $4.48 billion in 2021. Excluding PPP loans, total 2022 originations increased by $74.4 million, or 1.9%, compared to 2021.

•Total deposits increased by $1.77 billion, or 24.9%, to $8.88 billion at the end of 2022.

•Net income increased $9.2 million, or 5.5%, from $167.0 million, or $3.71 per diluted share, to $176.2 million, or $3.92 per diluted share, with key drivers of higher levels of reported net income outlined more fully in the opening to the section titled “Results of Operations.”

•In a year of significant Federal Reserve rate increases, net interest margin remained resilient at 3.87% for 2022 as compared to 3.86% for 2021, with net interest income increasing by $30.7 million, or 10.3%.

•Income from equity method and equity security investments increased $104.6 million. This increase was driven by equity method investment income of $149.2 million arising from gains related to the 2022 sales of the Company’s investments in Finxact, Inc. (“Finxact”) and Payrailz, LLC (“Payrailz”). Partially offsetting the increase in equity method income was a decrease in equity security investment gains related principally to the 2021 Greenlight Financial Technologies, Inc. (“Greenlight”) gain of $44.1 million.

•Net gains on sales of loans decreased $24.0 million, or 35.7%. This decrease was the result of weaker overall market conditions in 2022 making the sale of loans less profitable than retaining them for a longer period of time. The volume of guaranteed loans sold decreased $87.6 million, or 13.1%, in 2022 as compared to 2021 while the average net gain on loan sale premium decreased from 110% to 105% in the same comparative periods, respectively.

•The provision for loan and lease losses increased $25.7 million, largely the result of significant held for investment loan growth combined with charge-off experience impacts and changes in the macroeconomic outlook. Total nonperforming unguaranteed loans and leases as a percentage of total loans and leases held for investment decreased from 0.33% at the end of 2021 to 0.27% at the end of 2022. Net charge-offs as a percentage of average held for investment loans and leases carried at historical cost, for the years ended December 31, 2022 and 2021, were 0.14% and 0.08%, respectively.

•Salaries and employee benefits increased by $45.9 million, or 36.7%, during 2022. Excluding special bonus accruals for fintech investment gains in 2022 and 2021, as discussed above, the year-over-year increase was $39.4 million, or 32.6%. This increase was principally related to continued investment in human resources to support strategic and long term growth initiatives.

Business Outlook

Below is a discussion of management’s current expectations regarding Company performance over the near-term based on market conditions, the regulatory environment and business strategies as of the time the Company filed this Report. Actual outcomes and results may differ materially from what is expressed or forecasted in these forward-looking statements. See “Important Note Regarding Forward-Looking Statements” in this Report for more information on forward-looking statements.

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The Company's results for 2022 demonstrated a continuation of solid growth momentum in building predictable long-term earnings, proactive credit risk management and continued investment into growth initiatives. In 2022, the Company recognized $149.2 million in cash gains from fintech investments and $95.9 million in additional capital to support future growth. Management continues to focus on building recurring revenue streams, promoting change within the financial technology industry, and building out selected existing verticals while adding new verticals to the Company's business model. Management anticipates that the Company's held-for-sale and held-for-investment loan portfolios will continue to grow as a result of healthy origination volumes and higher levels of loan retention that are intended to continue to promote long-term recurring revenue and profitability, including the continued pursuit of potential opportunities in conventional lending outside of SBA or other government guarantee programs.

Non-GAAP Financial Measures

Statements included in this management's discussion and analysis include non-GAAP financial measures and should be read along with the accompanying tables, which provide a reconciliation of non-GAAP financial measures to GAAP financial measures. The reconciliation of non-GAAP measures is presented at the conclusion of this Item 7.

Management believes that non-GAAP financial measures provide additional useful information that allows readers to evaluate the ongoing performance of the Company without regard to certain transactional activities. Non-GAAP financial measures should not be considered as an alternative to any measure of performance or financial condition as reported under GAAP, and investors should consider the Company's performance and financial condition as reported under GAAP and all other relevant information when assessing the performance or financial condition of the Company. Non-GAAP financial measures have limitations as analytical tools, and investors should not consider them in isolation or as a substitute for analysis of the Company's results or financial condition as reported under GAAP. Management’s non-GAAP measures are not necessarily comparable to similar named measures represented by other companies, as they may be calculated differently.

Results of Operations

The Company reported net income of $176.2 million, or $3.92 per diluted share, for 2022 compared to $167.0 million, or $3.71 per diluted share, for 2021.

This increase in net income was primarily attributable to the following items:

•Equity method investments income increased $146.0 million, due to a $120.8 million gain related to the Company’s sale of its investment in Finxact combined with a $28.4 million gain related to the Company’s sale of its investment in Payrailz in the second and third quarters of 2022, respectively;

•Increase in net interest income of $30.7 million, or 10.3%, largely from increases in volume for the held for investment loan and lease portfolio. The growth in net interest income was mitigated by rising average cost of funds outpacing the average yield on interest earning assets combined with growth in interest bearing liabilities.

•A decrease in income tax expense of $9.7 million, or 22.1%, primarily related to a higher level of tax credits in 2022.

Key factors partially offsetting the year-over-year increase in net income were:

•Decreased equity security investment gains of $41.4 million, largely due to the Company’s $44.1 million second quarter of 2021 fair value gain from its investment in Greenlight;

•Provision for loan and lease credit losses increased $25.7 million, or 169.2%, to $40.9 million for 2022, compared to $15.2 million for 2021. The level of provision expense in 2022 was primarily the result of loan growth, charge-off experience impacts, increased levels of loans classified as held for investment and changes in the macroeconomic outlook;

•Decreased net gains on sales of loans of $24.0 million, or 35.7%, principally the result of weaker overall market conditions in 2022;

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•An increase in noninterest expense of $83.2 million, or 36.0%, comprised principally of increased salaries and employee benefits up $45.9 million, or 36.7%, advertising and marketing expense up $5.5 million, or 110.8%, technology expense up $5.8 million, or 25.5%, contributions and donations up $4.1 million, or 177.2%; and increased impairment charges $13.0 million related to renewable energy tax credits.

Net Interest Income and Margin

Net interest income represents the difference between the income that the Company earns on interest-earning assets and the cost of interest-bearing liabilities. The Company’s net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates that the Company earns or pays on them, respectively. Net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as “volume changes.” It is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as “rate changes.” As a bank without a branch network, the Bank gathers deposits over the Internet and in the community in which it is headquartered. Due to the nature of a branchless bank and the relatively low overhead required for deposit gathering, the rates the Bank offers are generally above the industry average.

For 2022, net interest income increased $30.7 million, or 10.3%, to $327.5 million compared to $296.8 million for 2021. This increase was principally due to the significant growth in the held for investment loan and lease portfolio outpacing moderate growth in interest-bearing liabilities combined with an increase in average cost of funds which exceeded the increase in average yield on interest-earning assets. Excluding PPP loan impacts of $7.0 million, comprised of amortization of net deferred fees combined with a 1% annualized interest rate less the related interest expense from funding activity, net interest income increased by $75.1 million. Average interest-earning assets increased by $776.3 million, or 10.1%, to $8.46 billion for 2022, compared to $7.68 billion for 2021, while the yield on average interest-earning assets increased fifty-five basis points to 5.25%. The cost of funds on interest-bearing liabilities for 2022 increased sixty basis points to 1.47%, and the average balance of interest-bearing liabilities increased by $529.1 million, or 7.1%, over 2021. The increase in average interest-bearing liabilities was also largely driven by funding for significant loan originations and growth. This increase was muted by a $884.7 million reduction in average borrowings largely related to Paycheck Protection Program Liquidity Facility, or PPPLF, repayments in 2022. As indicated in the rate/volume table below, the overall increase discussed above is reflected in increased interest income of $83.2 million as compared to an increase in interest expense of $52.5 million for 2022 compared to 2021. For 2021 compared to 2022, net interest margin increased from 3.86% to 3.87%.

During 2022 and through February of 2023, the Federal Reserve increased the federal funds upper target rate by 425 basis points and 25 basis points, respectively, to 4.75%. In the Federal Reserve’s February 2023 press release it stated that it anticipates that ongoing increases to target range will be appropriate. In December 2022, the Federal Reserve released its most current federal funds target rate midpoint projections which implied an increase of the median Federal Funds rate to 5.1% by the end of 2023 and a decrease of approximately 100 basis points to 4.1% by the end of 2024. There can be no assurance that any further increases in the federal funds rate will occur, and if they do, the amount and timing of actual increases are subject to change. See Item 7A. Quantitative and Qualitative Disclosures About Market Risk for information about the Company’s sensitivity to interest rates.

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Average Balances and Yields. The following table presents information regarding average balances for assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets, the total dollar amount of interest expense on average interest-bearing liabilities, and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing the income or expense by the average balances for assets or liabilities, respectively, for the periods presented. Loan fees are included in interest income on loans.

(1)Average loan and lease balances include non-accruing loans and leases.

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Rate/Volume Analysis. The following table sets forth the effects of changing rates and volumes on net interest income. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior period volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior period rate). The total column represents the sum of the prior columns. For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionally based on the changes due to rate and the changes due to volume.

Provision for Loan and Lease Credit Losses

The provision for loan and lease credit losses represents the amount necessary to be charged against the current period’s earnings to maintain the allowance for credit losses (“ACL”) on loans and leases at a level that the Company believes is appropriate in relation to the estimated losses inherent in the loan and lease portfolio.

Losses inherent in loan relationships are mitigated if a portion of the loan is guaranteed by the SBA or USDA. Typical SBA 7(a) and USDA guarantees range from 50% to 90% depending on loan size and type, which serve to reduce the risk profile of these loans. The Company believes that its focus on compliance with regulations and guidance from the SBA and USDA are key factors to managing this risk.

For 2022, the provision for loan and lease credit losses was $40.9 million compared to $15.2 million in 2021, an increase of $25.7 million. The 2022 increase in provision was primarily the result of loan growth, charge-off experience impacts, increased levels of loans classified as held for investment and changes in the macroeconomic outlook.

Loans and leases held for investment at historical cost were $6.85 billion as of December 31, 2022, an increase of $1.97 billion, or 40.5%, compared to December 31, 2021. Excluding PPP loans and net unearned fees on those loans, the balance in loans and leases held for investment at historical cost was $6.84 billion at December 31, 2022, an increase of $2.22 billion, or 48.2%, over December 31, 2021.

Net charge-offs for loans and leases carried at historical cost were $8.0 million, or 0.14% of average loans and leases held for investment, carried at historical cost, for 2022, compared to net charge-offs of $3.9 million, or 0.08%, for 2021, an increase of $4.0 million, or 102.5%. The increase in net charge-offs for 2022 was anticipated following the expiration of government subsidies and the return to expected losses consistent with pre-Covid historical experience. Net charge-offs are a key element of historical experience in the Company's estimation of the allowance for credit losses on loans and leases.

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In addition, nonperforming loans and leases not guaranteed by the SBA or USDA, excluding $6.7 million and $4.8 million accounted for under the fair value option at December 31, 2022 and 2021, respectively, totaled $18.8 million, which was 0.27% of the held for investment loan and lease portfolio carried at historical cost at December 31, 2022, compared to $16.0 million, or 0.33% of loans and leases held for investment carried at historical cost at December 31, 2021. Nonperforming loans and leases carried at historical cost which are not guaranteed by the SBA or USDA were 0.27% and 0.35% of the historical cost portion of the held for investment loan and lease portfolio, excluding PPP loans, at December 31, 2022 and 2021, respectively.

Noninterest Income

Noninterest income is principally comprised of net gains from the sale of SBA and USDA-guaranteed loans along with servicing revenue and related revaluation of the servicing asset. Revenue from the sale of loans depends upon the volume, maturity structure and rates of underlying loans as well as the pricing and availability of funds in the secondary markets prevailing in the period between completed loan funding and closing of sale. In addition, the loan servicing revaluation is significantly impacted by changes in market rates and other underlying assumptions such as prepayment speeds and default rates. Net gain (loss) on loans accounted for under the fair value option is also significantly impacted by changes in market rates, prepayment speeds and inherent credit risk. Other less consistent elements of noninterest income include gains and losses on investments.

The following table shows the components of noninterest income and the dollar and percentage changes for the periods presented.

Years ended December 31, 2022 vs. 2021

For 2022, noninterest income increased by $77.8 million, or 48.6%, compared to 2021. The increase from the prior year is primarily the result of an increase in equity method investment income of $146.0 million, due to a $120.8 million gain related to the Company’s sale of its investment in Finxact combined with a $28.4 million gain related to the Company’s sale of its investment in Payrailz in the second and third quarters of 2022, respectively. Partially offsetting this increase is decreased equity security investment gains, largely due to the Company’s $44.1 million second quarter 2021 fair value gain from its investment in Greenlight combined with decreased net gains on sales of loans of $24.0 million and higher losses on loan servicing asset revaluation of $4.9 million.

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The tables below reflect loan and lease production, sales of guaranteed loans and the aggregate balance in guaranteed loans sold that are being serviced. These components are key drivers of the Company's noninterest income.

(1)This represents the outstanding principal balance of guaranteed loans serviced, as of the last day of the applicable period, which have been sold into the secondary market.

Changes in various components of noninterest income are discussed in more detail below.

Loan Servicing Asset Revaluation: The Company revalues its serviced loan portfolio at least quarterly. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as adequate compensation for servicing, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. For 2022, there was a negative loan servicing revaluation adjustment of $16.6 million compared to $11.7 million for 2021, an increase in expense of $4.9 million, or 41.4%. The decrease in the valuation of the servicing asset was principally due to negative market conditions in 2022.

In consideration of the sensitivity of servicing rights as discussed above and in Note 5 to the accompanying audited consolidated financial statements, the following table is provided to reflect the effect on fair value as of December 31, 2022 due to hypothetical changes in yield curve rates.

Net Gains on Sales of Loans: For 2022, net gains on sales of loans decreased $24.0 million, or 35.7%, compared to 2021. The volume of guaranteed loans sold decreased $87.6 million, or 13.1%, to $580.9 million from $668.5 million in 2021. The average net gain on loan sale premium decreased from 110% to 105% in 2021 and 2022, respectively. The decrease in net gains on sales of loans was principally the result of lower loan sales volume combined with negative market conditions beginning to materialize in 2022, as discussed above. Accordingly, these market trends influenced the Company's appetite for loan sales during periods of weaker premiums in the current year.

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Net Gain (Loss) on Loans Accounted for Under the Fair Value Option: For 2022, the net gain on loans accounted for under the fair value option decreased $3.2 million, or 75.4%, compared to 2021. The carrying amount of loans accounted for under the fair value option at December 31, 2022 and 2021 was $494.5 million (all classified as held for investment) and $670.5 million ($25.3 million classified as held for sale and $645.2 million classified as held for investment), respectively, a decrease of $176.1 million, or 26.3%. The lower net gain on loans accounted for under the fair value option during 2022 was principally the result of the earlier discussed negative market conditions combined with the continued amortization of the underlying loan portfolio.

Noninterest Expense

Noninterest expense comprises all operating costs of the Company, such as employee-related costs, travel, professional services, advertising and marketing expenses, exclusive of interest and income tax expense.

The following table shows the components of noninterest expense and the related dollar and percentage changes for the periods presented.

Total noninterest expense for 2022 increased $83.2 million, or 36.0%, compared to 2021. The increase in noninterest expense was predominately driven by the following items.

Salaries and employee benefits: Total personnel expense for 2022 increased by $45.9 million, or 36.7%, compared to 2021. The increase in salaries and employee benefits was principally related to continued investment in human resources to support strategic and growth initiatives. Additional bonus accruals of $7.5 million and $3.0 million were included in both the second and third quarters of 2022 related to the earlier discussed Finxact and Payrailz gains, respectively, while the second quarter of 2021 included an additional $4.0 million bonus accrual, related to the earlier mentioned Greenlight gain. Total full-time equivalent employees increased from 794 at December 31, 2021 to 970 at December 31, 2022. Salaries and employee benefits expense included $20.3 million of stock-based compensation for 2022, compared to $16.9 million for 2021. Expenses related to the employee stock purchase program, stock grants, stock option compensation and restricted stock expense are all considered stock-based compensation.

Travel expense: Travel expense increased $2.7 million, or 46.3%. Travel expenses increased primarily to support the growth in loan origination volume and customer base as travel restrictions have eased combined with inflationary impacts on travel related costs.

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Professional services expense: Professional services expense decreased $3.4 million, or 22.5%, compared to 2021. The decrease compared to the prior period was largely driven by lower legal fees.

Advertising and marketing expense: Advertising and marketing expense increased $5.5 million, or 110.8%, compared to 2021. Increases were largely driven by as a continued investment in the Company’s lending and deposit market growth.

Technology expense: Technology expense increased $5.8 million, or 25.5%, compared to 2021. This increase was primarily related to enhanced investments in the Company’s technology resources.

Renewable energy tax credit investment impairment: The Company recognized $16.1 million in impairment charges related to new renewable energy tax credit investment transactions in 2022 as compared to $3.1 million in 2021. Investments of this type generate a return primarily through the realization of income tax credits and other benefits; accordingly, impairment of the investment amount is generally recognized in conjunction with the realization of related tax benefits. These investments generated federal investment tax credits in 2022 and 2021 of $16.4 million and $3.4 million, respectively, which are included in the Company’s effective tax rates.

Contributions and donations: For 2022, contributions and donations expense increased $4.1 million, or 177.2%, compared to 2021. This increase was related to a special charitable donation during the second quarter of 2022 of $5.0 million made in connection with the earlier discussed Finxact gain.

Income Tax Expense

Income tax expense and related effective tax rate in 2022 was $34.1 million and 16.2% compared to $43.8 million and 20.8% in 2021. The lower effective tax rate of 16.2% for 2022 was principally due to higher levels of tax credits related to renewable energy tax credit transactions, as discussed above.

Results of Segment Operations

The Company’s operations are managed along two primary operating segments: Banking and Fintech. A description of each segment and the methodologies used to measure financial performance is described in Note 16. Segments in the accompanying notes to the consolidated financial statements. Net income (loss) by operating segment is presented below:

Banking

Net income decreased $73.7 million, or 50.6%, compared to 2021. Key factors influencing this decrease are discussed below.

The provision for loan and lease credit losses for 2022, increased $25.7 million, or 169.2%, over 2021. See the analysis of provision for loan and lease credit losses included in the above section captioned “Provision for Loan and Lease Credit Losses” as it is entirely related to the Banking segment.

Noninterest income decreased $33.8 million, or 29.6%, over 2021. The decrease was principally driven by a decrease in net gains on sales of loans combined with an increase of losses in loan servicing asset revaluation and decrease in net gain arising from loans accounted for under the fair value option. See the analysis of these categories of noninterest income included in the above section captioned “Noninterest Income” for additional discussion.

Noninterest expense increased $81.1 million, or 37.6%, compared to 2021. See the analysis of these categories of noninterest expense included in the above section captioned “Noninterest Expense” for additional discussion.

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Partially offsetting the above elements which reduced income was an increase in net interest income of $31.1 million, or 10.4%, and lower income tax expense of $35.8 million, compared to 2021. See the analysis of net interest income included in the above section captioned “Net Interest Income and Margin,” as it is predominantly related to the Banking segment. The decrease in income tax expense relative to the Bank is primarily the result of a lower level of pretax income combined with higher levels of investment tax credits related to renewable energy investment transactions.

Fintech

Net income increased by $82.0 million over 2021. The increase was principally due to equity method investment gains of $28.4 million and $120.8 million from the sale of Payrailz and Finxact, respectively. This increase was partially offset by decreased equity security investment gains of $41.4 million, largely a result of the 2021 gain of $44.1 million arising from the Company’s investment in Greenlight.

Income tax expense increased $25.7 million, compared to 2021. This increase is a product of the above discussed increase in Fintech segment income.

Discussion and Analysis of Financial Condition

Total assets at December 31, 2022 were $9.86 billion, an increase of $1.64 billion, or 20.0%, compared to total assets of $8.21 billion at December 31, 2021. The growth in total assets was principally driven by the following:

•Cash and cash equivalents, comprised of cash and due from banks and federal funds sold, combined with investment securities available-for-sale was $1.43 billion at December 31, 2022, an increase of $321.6 million, or 29.0%, compared to $1.11 billion at December 31, 2021. This increase was primarily due to proceeds arising from the Payrailz and Finxact sales combined with growing deposit levels.

•Growth in total loans and leases held for investment and held for sale of $1.26 billion resulting from strong origination activity in 2022 and holding loans available for sale for longer periods of time before sale, as discussed more fully below. Total originations during 2022 were $4.00 billion.

Loans held for sale decreased $561.9 million, or 50.3%, during 2022, from $1.12 billion at December 31, 2021, to $554.6 million at December 31, 2022. This decrease was primarily the result of a $754.7 million transfer of loans, including $696.6 million in guaranteed loans, from held for sale to held for investment in the third quarter of 2022. This transfer was largely due to the impact of market conditions in a rising rate environment influencing management's intent and ability to hold these loans for the foreseeable future. See “Results of Operations” discussion of “Net Gains on Sales of Loans” for additional information influencing managements intent to hold more loans for investment.

Loans and leases held for investment increased $1.82 billion, or 33.0%, during 2022, from $5.52 billion at December 31, 2021, to $7.34 billion at December 31, 2022. The increase was primarily the result of the above-mentioned loan originations in 2022 combined with increased levels of loans retained as held for investment. Excluding PPP loans, total loans and leases held for investment increased $2.07 billion, or 39.4%, during 2022. All PPP loans are classified as held for investment and were $12.9 million at December 31, 2022.

Total deposits were $8.88 billion at December 31, 2022, an increase of $1.77 billion, or 24.9%, from $7.11 billion at December 31, 2021. The increase in deposits was largely driven by significant loan origination efforts.

Borrowings decreased to $83.2 million at December 31, 2022 from $318.3 million at December 31, 2021. This decrease was related principally to net curtailments of borrowings through the PPPLF which was paid off in the third quarter of 2022. These PPPLF borrowings are used to help fund PPP loans.

Shareholders’ equity at December 31, 2022 was $811.0 million as compared to $715.1 million at December 31, 2021. The book value per share was $18.41 at December 31, 2022 compared to $16.39 at December 31, 2021. Average equity to average assets was 9.0% for the year ended December 31, 2022 compared to 7.9% for the year ended December 31, 2021. The increase in shareholders’ equity for 2022 was principally the result of $176.2 million in net income and stock-based compensation expense of $20.3 million, partially offset by other comprehensive loss associated with negative market impacts on the Company’s available-for-sale investment portfolio of $94.2 million.

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Loans Held for Sale & Serviced Portfolio

Any loan or portion of a loan that the Company has the intent and ability to sell is classified as held for sale. The average age of the held for sale portfolio as of December 31, 2022 was 12.1 months from origination date. Approximately 14.8% of the current held for sale portfolio is older than two years. The majority of held for sale loans over one year old are composed of construction loans. Construction loans typically have extended build out periods that inherently result in longer lead times between origination and the ultimate sale date. Approximately 34.7% of the held for sale portfolio is aged between one and two years.

As of December 31, 2022 and 2021, the cumulative total outstanding balance of loans sold since May 2007 totaled $3.48 billion and $3.30 billion, respectively. The Company generally continues to service loans after the date of sale. As of December 31, 2022 and 2021, the total outstanding balance of loans and leases, including those serviced for others, was $11.38 billion and $9.96 billion, respectively.

Loan and Lease Maturity

As of December 31, 2022, $9.06 billion, or 79.6%, of the total outstanding balance of loans and leases, including those at fair value and those serviced for others, were variable rate loans that adjust at specified dates based on the prime lending rate or other variable indices. As of December 31, 2022, $4.82 billion, or 42.3%, of total outstanding balance of loans and leases, including those at fair value and those serviced for others, were variable rate loans that adjust on either a calendar monthly or calendar quarterly basis using the prime lending rate or other variable indices.

At December 31, 2022, 81.6%, or $6.44 billion, of the combined held for sale and held for investment loan and lease portfolio, including those at fair value, were composed of variable rate loans.

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At December 31, 2022, $1.87 billion, or 25.5%, of loans held for investment, including those at fair value, matures in less than five years. Loans and leases maturing in greater than five years total $5.48 billion of the total $7.35 billion. The variable rate portion of the total held for investment loans and leases, excluding PPP loans, is 80.4%, which reflects the Company’s strategy to minimize interest rate risk through the use of variable rate products.

(1)Excludes net deferred (fees) costs

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Asset Quality

Management considers asset quality to be of primary importance. A formal loan review function, independent of loan origination, is used to identify and monitor problem loans. This function reports directly to the Audit & Risk Committee of the Board of Directors.

Nonperforming Assets

The Bank places loans and leases on nonaccrual status when they become 90 days past due as to principal or interest payments, or prior to that if management has determined based upon current information available to them that the timely collection of principal or interest is not probable. When a loan or lease is placed on nonaccrual status, any interest previously accrued as income but not actually collected is reversed and recorded as a reduction of loan or lease interest and fee income. Typically, collections of interest and principal received on a nonaccrual loan or lease are applied to the outstanding principal as determined at the time of collection of the loan or lease.

Troubled debt restructurings (“TDRs”) occur when, because of economic or legal reasons pertaining to the debtor’s financial difficulties, debtors are granted concessions that would not otherwise be considered. Such concessions would include, but are not limited to, the transfer of assets or the issuance of equity interests by the debtor to satisfy all or part of the debt, modification of the terms of debt or the substitution or addition of debtor(s).

Nonperforming assets and TDRs, excluding loans measured at fair value, at December 31, 2022 were $134.9 million, which represented a $54.7 million, or 68.2%, increase from December 31, 2021. These nonperforming assets, at December 31, 2022 were comprised of $73.4 million in nonaccrual loans and leases. At December 31, 2022, there were no foreclosed assets. Of the $134.9 million of nonperforming assets and TDRs, $75.1 million carried an SBA guarantee, leaving an unguaranteed exposure of $59.8 million in total nonperforming assets and TDRs at December 31, 2022. This represents an increase of $22.8 million, or 61.7%, from an unguaranteed exposure of $37.0 million at December 31, 2021.

The following table provides information with respect to nonperforming assets and troubled debt restructurings, excluding loans measured at fair value, at the dates indicated.

(1)Excludes loans measured at fair value.

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(1)Excludes loans measured at fair value.

Total nonperforming assets and troubled debt restructurings, including loans measured at fair value, at December 31, 2022 were $208.3 million, which represented a $54.8 million, or 35.7%, increase from December 31, 2021. These nonperforming assets, at December 31, 2022 were comprised of $120.4 million in nonaccrual loans and leases. Of the $208.3 million of nonperforming assets and TDRs, $134.1 million carried an SBA guarantee, leaving an unguaranteed exposure of $74.2 million in total nonperforming assets and TDRs at December 31, 2022. This represents an increase of $21.7 million, or 41.4%, from an unguaranteed exposure of $52.5 million at December 31, 2021.

See the below discussion related to the change in potential problem and impaired loans and leases for management’s overall observations regarding the change in total nonperforming loans and leases.

As a percentage of the Bank’s total capital, nonperforming loans and leases, excluding loans measured at fair value, represented 9.0% at December 31, 2022, compared to 6.0% at December 31, 2021. Adjusting the ratio to include only the unguaranteed portion of nonperforming loans and leases at historical cost to reflect management’s belief that the greater magnitude of risk resides in this portion, the ratio at both December 31, 2022 and December 31, 2021 was 2.3%.

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As of December 31, 2022, and December 31, 2021, potential problem (also referred to as criticized) and classified loans and leases, excluding loans measured at fair value, totaled $424.7 million and $372.7 million, respectively. The following is a discussion of these loans and leases. Risk Grades 5 through 8 represent the spectrum of criticized and classified loans and leases. For a complete description of the risk grading system, see “Credit Quality Indicators” in Note 3 to the notes to consolidated financial statements. At December 31, 2022, the portion of criticized and classified loans and leases guaranteed by the SBA or USDA totaled $195.8 million and total portfolio unguaranteed exposure risk was $228.9 million, or 5.5% of total held for investment unguaranteed exposure carried at historical cost. This compares to the December 31, 2021 portion of criticized and classified loans and leases guaranteed by the SBA or USDA which totaled $197.2 million and total portfolio unguaranteed exposure risk was $175.5 million, or 6.3% of total held for investment unguaranteed exposure carried at historical cost. As of December 31, 2022, loans and leases carried at historical cost within the following verticals comprise the largest portion of the total potential problem and classified loans and leases: Wine and Craft Beverage at 11.5%, General Lending at 10.3%, Senior Housing at 10.2%, Sponsor Finance at 7.8%, Healthcare at 6.4%, Hotels at 5.9%, Fitness Centers at 5.1%, Agriculture at 4.5% and Senior Care at 4.0%. As of December 31, 2021, loans and leases carried at historical cost within the following verticals comprise the largest portion of the total potential problem and classified loans and leases: Educational Services at 16.1%, Wine and Craft Beverage at 13.7%, Hotels at 11.8%, Entertainment Centers at 10.4%, Healthcare at 9.0%, Fitness Centers at 5.3%, Self-Storage at 4.8%, Agriculture at 4.5% and Veterinary at 4.4%. Of the above listed verticals, Senior Housing and Sponsor Finance is within the Company’s Specialty Lending division while Hotels are within the Energy & Infrastructure division, the remainder of the above listed verticals are within the Small Business Banking division. The majority of the $52.0 million increase in potential problem and classified loans and leases in 2022 was comprised of several relationships that did not have a government guarantee, largely related to some of the more recently matured verticals. The Company believes that its underwriting and credit quality standards have remained high and continues to consider changing economic conditions in a rising interest rate environment.

Loans and leases that experience insignificant payment delays and payment shortfalls are generally not individually evaluated for the purpose of estimating the allowance for credit losses. The Bank generally considers an “insignificant period of time” from payment delays to be a period of 90 days or less. The Bank would consider a modification for a customer experiencing what is expected to be a short-term event that has temporarily impacted cash flow. This could be due, among other reasons, to illness, weather, impact from a one-time expense, slower than expected start-up, construction issues or other short-term issues. Credit personnel will review the request to determine if the customer is stressed and how the event has impacted the ability of the customer to repay the loan or lease long term. At December 31, 2022, the Company had a total of $10.2 million in modified unguaranteed loans and leases on payment deferral with $346 thousand in accrued interest.

Management endeavors to be proactive in its approach to identify and resolve problem loans and leases and is focused on working with the borrowers and guarantors of these loans and leases to provide loan and lease modifications when warranted. Management implements a proactive approach to identifying and classifying loans and leases as special mention (also referred to as criticized), Risk Grade 5. At December 31, 2022, and December 31, 2021, Risk Grade 5 loans and leases, excluding loans measured at fair value, totaled $286.5 million and $267.4 million, respectively. The increase in Risk Grade 5 loans and leases, exclusive of loans measured at fair value, during 2022 was principally confined to five verticals: Senior Housing ($43.4 million or 227.2%), General Lending ($20.5 million or 107.1%), Sponsor Finance ($13.8 million or 72.3%), Broadband ($12.4 million or 64.7%) and Community Facilities ($8.9 million or 46.8%). Partially offsetting the above increases were decreases in Risk Grade 5 loans principally concentrated in four verticals: Educational Services ($46.9 million or 245.5%), Hotels ($16.4 million or 85.9%), Entertainment Centers ($14.6 million or 76.5%) and Bioenergy ($9.4 million or 49.4%). The increase in criticized loans in 2022 was related to a small number of loans within mature verticals. Of the above listed verticals, Senior Housing and Sponsor Finance is within the Company’s Specialty Lending division while Community Facilities, Hotels and Bioenergy are within the Energy & Infrastructure division, the remainder of the above listed verticals are within the Small Business Banking division.

At December 31, 2022, approximately 91.4% of loans and leases classified as Risk Grade 5 are performing with no relationships having payments past due more than 30 days. While the level of nonperforming assets fluctuates in response to changing economic and market conditions, in light of the relative size and composition of the loan and lease portfolio and management’s degree of success in resolving problem assets, management believes that a proactive approach to early identification and intervention is critical to successfully managing a small business loan portfolio. As government payment assistance began to expire toward the end of 2020, borrowers with continuing difficulties arising from the pandemic were provided additional relief through payment deferrals. At December 31, 2022, the Company had $14.8 million in unguaranteed loans on SBA payment assistance. Management monitors these borrowers closely and has observed financial conditions continuing to improve.

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Allowance for Credit Losses on Loans and Leases

The ACL of $63.6 million at December 31, 2021, increased by $33.0 million, or 51.9%, to $96.6 million at December 31, 2022. The ACL as a percentage of loans and leases held for investment at historical cost amounted to 1.4% and 1.3% at December 31, 2022 and 2021, respectively. The increase in the ACL during 2022 was primarily due to significant loan growth, charge-off experience impacts, increased levels of loans classified as held for investment and changes in the macroeconomic outlook, as addressed more fully in the above section captioned “Provision for Loan and Lease Credit Losses” in “Results of Operations.”

Actual past due held for investment loans and leases, inclusive of loans measured at fair value, have increased by $24.2 million since December 31, 2021. Total loans and leases 90 or more days past due increased $7.3 million, or 14.8%, compared to December 31, 2021. This increase was comprised of a $4.2 million decrease in unguaranteed exposure combined with an offsetting $11.5 million increase in the guaranteed portion of past due loans compared to December 31, 2021. At December 31, 2022 and December 31, 2021, total held for investment unguaranteed loans and leases past due as a percentage of total held for investment unguaranteed loans and leases, inclusive of loans measured at fair value, was 0.7% and 0.6%, respectively. Total unguaranteed loans and leases past due were comprised of $21.2 million carried at historical cost, an increase of $4.6 million, and $9.6 million measured at fair value, an increase of $4.5 million, as of December 31, 2022 compared to December 31, 2021. The 2022 increase in past dues was largely related to sixteen loans spread across seven mature verticals. Management continues to actively monitor and work to improve asset quality. Management believes the ACL of $96.6 million at December 31, 2022 is appropriate in light of the risk inherent in the loan and lease portfolio. Management’s judgments are based on numerous assumptions about current and expected events that it believes to be reasonable, but which may or may not be valid. Accordingly, no assurance can be given that management’s ongoing evaluation of the loan and lease portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the ACL, thus adversely affecting the Company’s operating results. Additional information on the ACL is presented in Note 5. Loans and Leases Held for Investment and Credit Quality of the condensed consolidated financial statements in this Report.

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The following table sets forth the breakdown of the allowance for credit losses on loans and leases carried at historical cost by category at the dates indicated.

(1)Excludes loans measured at fair value.

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Analysis of Loan and Lease Loss Experience. The following table sets forth an analysis of net charge-offs for loans and leases carried at historical cost to average total loans and leases, carried at historical cost, by category for the years indicated.

(1)Excludes loans measured at fair value.

Investment Securities

Investment securities totaled $1.01 billion at December 31, 2022, an increase of $108.7 million, or 12.0%, compared to $906.1 million at December 31, 2021. The increase in the investment portfolio for 2022 was to support earnings through additional yield compared to cash alternatives, continue to provide a contingent funding source, and act as a mechanism to manage the Company’s interest rate risk. This also included purchases of $367.5 million in mortgage-backed securities, including $49.0 million for purposes of complying with the Community Reinvestment Act, and purchases of $23.2 million in collateralized mortgage obligations to increase yield and duration.

The investment securities portfolio consists entirely of available-for-sale securities. The Company purchases securities for the investment securities portfolio to manage interest rate risk, ensure a stable source of liquidity and to provide a steady source of income in excess of cost of funds.

At December 31, 2022, the modified duration of the overall available-for-sale securities portfolio was approximately 6.8 years.

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The following table sets forth the stated maturities and weighted average yields of investment securities at December 31, 2022. Certain mortgage related securities have adjustable interest rates and will reprice annually within the various maturity ranges. These repricing schedules are not reflected in the tables below.

At December 31, 2022, the Company had 98.3% of its total investment securities portfolio in mortgage-backed securities, compared with 98.2% at December 31, 2021. The Company has continued to purchase mortgage-backed securities in order to obtain a favorable yield versus cash alternatives while still maintaining a low risk profile within the investment portfolio.

Deposits

The following table sets forth the composition of deposits.

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Deposits increased to $8.88 billion at December 31, 2022 from $7.11 billion at December 31, 2021, an increase of $1.77 billion, or 24.9%. This increase was primarily due to the growth of the Company’s customer base in the savings and time deposit products, enhanced by a nationwide marketing campaign with attractive rates and additional wholesale funding, to support the significant loan growth in 2022. Noninterest-bearing deposits increased $104.8 million, or 117.4%, during 2022, and interest-bearing deposits increased $1.67 billion, or 23.8%, during the same period.

At December 31, 2022, the aggregate balance of uninsured time deposit accounts totaled $39.1 million. At December 31, 2022, 81.8% of uninsured time deposit accounts were scheduled to mature within one year. The maturity profile of uninsured time deposits at December 31, 2022 is as follows:

Borrowings

Total borrowings decreased $235.1 million at December 31, 2022 from December 31, 2021 as a result of the following:

In March 2021, the Company entered into a 60-month term loan agreement of $50.0 million with a third party correspondent bank. The loan accrues interest at a fixed rate of 2.95% with a monthly payment sufficient to fully amortize the loan, with all remaining unpaid principal and interest due at maturity on March 30, 2026. The Company paid the Lender a non-refundable $325 thousand loan origination fee upon signing of the Note that is presented as a direct deduction from the carrying amount of the loan and will be amortized into interest expense over the life of the loan.

In April 2020, the Company entered into the Federal Reserve Bank's PPPLF. Under the PPPLF, advances must be secured by pledges of loans to small businesses originated by the Company under the U.S. Small Business Administration's 7(a) loan program titled the Paycheck Protection Program. The PPPLF accrues interest at thirty-five basis points and matures at various dates equal to the maturity date of the PPPLF collateral pledged to secure the advance, and will be accelerated on and to the extent of any 7(a) loan forgiveness reimbursement by the SBA for any PPPLF collateral or the date of purchase by the SBA from the borrower of any PPPLF collateral. On the maturity date of each advance, the Company repays the advance plus accrued interest. This borrowing was paid in full at September 30, 2022.

In September 2020, the Company renewed a $50.0 million revolving line of credit originally issued in 2017 with a third party correspondent bank. Subsequently on October 20, 2021, the Company renewed and increased the revolving line of credit from $50.0 million to $100.0 million and increased the term from 12 months to 36 months. The line of credit is unsecured and accrues interest at 30-day SOFR plus 1.25%, with an interest rate cap of 4.25% and an interest rate floor of 2.75%.  Payments are interest only with all principal and accrued interest due at maturity on October 10, 2025. The terms of this loan require the Company to maintain minimum capital and debt service coverage ratios. The Company paid the Lender a non-refundable $750 thousand loan origination fee upon signing of the Note that will be amortized into interest expense over the life of the loan. The Company made an advance of $8.0 million on December 20, 2021 and $12.0 million on March 16, 2022. The Company paid down this balance in full on May 20, 2022 and there is $100.0 million of available credit remaining at December 31, 2022.

On December 30, 2022, the Company made an advance of $50.0 million on an overnight Fed Funds line of credit that is unsecured with an interest rate of 4.65% with $50.0 million of available credit remaining at December 31, 2022.

Liquidity Management

Liquidity management refers to the ability to meet day-to-day cash flow requirements based primarily on activity in loan and deposit accounts of the Company’s customers. Liquidity is immediately available from four major sources: (a) cash on hand and on deposit at other banks; (b) the outstanding balance of federal funds sold; (c) the market value of unpledged investment securities; and (d) availability under lines of credit, FHLB advances, and the Federal Reserve Discount Window. A primary tool in the Company’s liquidity management process is the utilization of a Volatile Liability Coverage Ratio (“VLCR”) model to stress outflows in various scenarios with targeted days of liquidity coverage. The VLCR model output is then used by management to ensure adequate liquidity sources are available during those future periods. At December 31, 2022, the total amount of these four liquidity source items was $4.01 billion, or 40.7% of total assets, a decrease of 0.9% of total assets from $3.42 billion, or 41.6% of total assets, at December 31, 2021.

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Loans and other assets are funded primarily by loan sales, wholesale deposits and core deposits. To date, an increasing retail deposit base and a stable amount of brokered deposits have been adequate to meet loan obligations, while maintaining the desired level of immediate liquidity. The Company maintains an investment securities portfolio that is available for both immediate and secondary contingent liquidity purposes, whether via pledging to the Federal Home Loan Bank or through liquidation. Additionally, the Company maintains a guaranteed loan portfolio that is also a contingent liquidity source, whether via pledging to the Federal Reserve Discount Window or through liquidation.

At December 31, 2022, none of the investment securities portfolio was pledged to secure public deposits or pledged to retail repurchase agreements, leaving $1.01 billion available to be pledged as collateral.

Contractual Obligations

The Company has entered into significant fixed and determinable contractual obligations for future payments. See the accompanying notes to the consolidated financial statements for expected timing of payments as of December 31, 2022. These include operating leases (Note 4. Leases), time deposits with stated maturity dates (Note 7. Deposits) and borrowings (Note 8. Borrowings).

Off-Balance Sheet Arrangements

In the normal course of operations, the Company engages in a variety of financial transactions that, in accordance with GAAP, are not recorded in the consolidated financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customers’ requests for funding and take the form of commitments to extend credit and standby letters of credit. In 2022, the Company also entered into airplane purchase agreement commitments. For more information, see Note 11. Commitments and Contingencies in the accompanying notes to the consolidated financial statements.

Asset/Liability Management and Interest Rate Sensitivity

One of the primary objectives of asset/liability management is to maximize the net interest margin while minimizing the earnings risk associated with changes in interest rates. One method used to manage interest rate sensitivity is to measure, over various time periods, the interest rate sensitivity positions, or gaps. This method, however, addresses only the magnitude of timing differences and does not address earnings or market value. Therefore, management uses an earnings simulation model to prepare, on a regular basis, earnings projections based on a range of interest rate scenarios to more accurately measure interest rate risk. For more information, see Item 7A of this Report.

Capital

The maintenance of appropriate levels of capital is a management priority and is monitored on a regular basis. The Company’s principal goals related to the maintenance of capital are to provide adequate capital to support the Company’s risk profile consistent with the risk appetite approved by the Board of Directors; provide financial flexibility to support future growth and client needs; comply with relevant laws, regulations, and supervisory guidance; achieve optimal credit ratings for the Company and its subsidiaries; and provide a competitive return to shareholders. Management regularly monitors the capital position of the Company on both a consolidated and Bank level basis. In this regard, management’s goal is to maintain capital at levels that are in excess of the regulatory “well capitalized” levels. Risk-based capital ratios, which include Tier 1 Capital, Total Capital and Common Equity Tier 1 Capital, are calculated based on regulatory guidance related to the measurement of capital and risk-weighted assets.

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Capital amounts and ratios as of December 31, 2022, 2021 and 2020 are presented in the table below.

(1)Prompt corrective action provisions are not applicable at the bank holding company level.

Critical Accounting Policies and Estimates

The preparation of consolidated financial statements in accordance with GAAP requires the Company to make estimates and judgments that affect reported amounts of assets, liabilities, income and expenses and related disclosure of contingent assets and liabilities. The Company bases estimates on historical experience and on various other assumptions that are believed to be reasonable under current circumstances, results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily available from other sources. Estimates are evaluated on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.

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The Company’s accounting policies, including those for the Company’s critical accounting estimates are described in detail in Note 1. Organization and Summary of Significant Accounting Policies in the consolidated financial statements and are an integral part of the Company’s consolidated financial statements. A thorough understanding of these accounting policies is essential when reviewing the Company’s reported results of operations and financial position. The Company’s most critical accounting estimates are listed below. These estimates require the Company to make difficult, subjective or complex judgments about matters that are inherently uncertain.

Allowance for credit losses (ACL)

The Company’s policy is to maintain the ACL at a level to absorb expected credit losses. The loan and lease portfolio is periodically reviewed by management to identify trends and to measure asset quality. Accounting policies related to the ACL on financial instruments including loans and off-balance-sheet credit exposures are considered to be critical as these policies involve considerable subjective judgment and estimation by the Company. The ACL is a valuation account that is deducted from the amortized cost basis of loans and leases to present a net amount expected to be collected over the life of the asset.

The Company’s ACL on loans and leases is estimated using relevant information, from internal and external sources, relating to past events, current conditions, and reasonable and supportable forecasts, and measured on a pooled basis where loans with similar risk characteristics (such as industry and type of collateral) are collectively evaluated for impairment. The ACL is computed using a discounted cash flow (“DCF”) methodology that utilizes inputs and assumptions that require significant judgement. The most significant assumptions used are: 1) economic forecast assumptions, 2) prepayment assumptions, and 3) application of qualitative factors, the most significant of which is related to the loan risk grading process. Sensitivities to these three areas are disclosed below to demonstrate how a change in economic forecast, prepayment assumptions and risk grades may impact the ACL. The below sensitivities only consider each variable individually in isolation as compared to the reported total of the ACL and factor in no correlated impacts to other inputs or factors of the ACL model.

Economic forecast

Probability of default (“PD”) and loss given default (“LGD”) rates within the DCF model are adjusted for national unemployment rates during the reasonable and supportable forecast period. The Company has determined that a reasonable and supportable forecast period is four quarters with loss rates reverting back to a historical loss rate over the subsequent four quarters on a straight-line basis.

The ACL is highly sensitive to the unemployment economic forecast used. Due to the high level of uncertainty regarding significant assumptions, the Company often evaluates various economic scenarios from authoritative industry sources to assess variability of economic outlooks. At December 31, 2022, the Company utilized economic assumptions that management believed were the most likely to occur during the duration of the forecast period which had current unemployment levels remaining relatively stable during the one-year forecast period. Selecting a different forecast in the current environment could result in a significantly different ACL. The following table summarizes the impact of more severe unemployment forecast scenarios if they had been selected at December 31, 2022.

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If facts and circumstances supported the Company’s utilization of more severe unemployment scenario other impacts to the model would also be factored in which could result in a materially different estimate than that provided above.

Prepayment assumptions

Expected losses are calculated as the product of PD, LGD, and exposure at default (“EAD”). Expected losses are then discounted using the loan or leases effective interest rate, adjusted for estimated prepayments. Changes to the prepayment assumptions used would result in a different estimated ACL. To illustrate, if the weighted average prepayment assumption were decreased by 25%, the ACL as of December 31, 2022 would increase by approximately $5.4 million or 5.6%.

Loan risk grade - qualitative adjustments

Historical loss information is adjusted for differences in current risk characteristics that are not considered within the quantitative modeling process of the ACL but are relevant in assessing the expected credit losses. These qualitative adjustments include risk grades, delinquency levels, pool age, portfolio mix & growth rates and the status of servicing efforts that may be impacted by natural disasters or health pandemics. As indicated above, the loan risk grading process generally has the most significant impact on the ACL. Accordingly, the Company’s internal risk rating system and resulting loss estimates are highly dependent on the accuracy for the risk rating assigned to each loan and lease. The inherent imprecision in the risk rating system resulting from inaccuracy in assigning and/or entering risk ratings in the loan accounting system is monitored by the Company’s internal and external asset quality review functions. Changes to internal risk ratings, would result in a different estimated allowance for credit losses. To illustrate, if all loans in the Company’s five largest industry verticals ($1.7 billion or 40.9% of unguaranteed held for investment loans not accounted for under the fair value option) were adjusted down by one risk grade (e.g., RG 4 to RG 5) across all pools, the ACL as of December 31, 2022 would increase by approximately $10.0 million, or 10.4%.

Other Considerations

While management utilizes its best judgment and information available, the ultimate adequacy of our ACL is dependent upon a variety of factors beyond our control, including the performance of our portfolios, the economy, changes in interest rates and the view of the regulatory authorities toward classification of assets. See Note 1. Organization and Summary of Significant Accounting Policies and Note 3. Loans and Leases Held for Investment and Credit Quality in the notes to consolidated financial statements for further details of the factors considered by the Company in estimating the necessary level of the ACL.

Valuation of loans accounted for under the fair value option

Loans accounted for under the fair value option involve estimation for credit risk, market liquidity, and economic condition impacts using factors that are beyond management’s control.

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Credit risk

The credit element of the loan fair value mark is estimated using the same DCF model discussed above relative to ACL calculations with key inputs requiring significant judgement and assumptions being: 1) selection of economic forecast, 2) prepayment assumptions, and 3) application of qualitative factors, the most significant of which is related to the loan risk grading process.

Economic forecast

To illustrate, absent any other changes in the model, if the Company selected the severe, moderate, or mild scenarios as described above, the credit mark for fair value loans at December 31, 2022 would have increased by approximately $2.3 million or 17.1%, $1.1 million or 8.3%, and $409 thousand or 3.0%, respectively. If facts and circumstances supported the Company’s utilization of more severe unemployment scenario other impacts to the model would also be factored in which could result in a materially different estimated than that provided above.

Prepayment assumptions

Expected losses are calculated as the product of PD, LGD, and exposure at default (“EAD”). Expected losses are then discounted using the loan or leases effective interest rate, adjusted for estimated prepayments. Changes to the prepayment assumptions used would result in a different estimated fair value mark. To illustrate, if the weighted average prepayment assumption were decreased by 25%, the fair value mark as of December 31, 2022 would increase by approximately $829 thousand, or 6.0%.

Loan risk grade - qualitative adjustments

To illustrate, if all loans in the Company’s five largest industry verticals ($103.0 million or 23.1% of unguaranteed held for investment loans accounted for under the fair value option) were adjusted down by one risk grade (e.g., RG 4 to RG 5) across all pools, the fair value mark as of December 31, 2022 would increase by $602 thousand, or 4.4%.

Market risk

Market liquidity and economic condition adjustments are estimated using the sale prices of similar loans based on yield, term and asset size. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

Other Considerations

See Note 10. Fair Value of Financial Instruments in the notes to consolidated financial statements for further details of the factors considered by management in estimating the fair value of loans. In the first quarter of 2021, the Company chose not to elect the fair value for all retained participating interests arising from new government guaranteed loan sales.

Valuation of servicing assets

The fair value of servicing assets is based on market prices for comparable servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as adequate compensation for servicing, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses, with the prepayment speed being one of the most sensitive assumptions. Changes to these assumptions can have a material impact on the valuation of the servicing assets.

Yield curve rates are considered a significant assumption in the valuation of servicing rights and an analysis of sensitivity is reflected in the section captioned “Noninterest Income” elsewhere in this discussion. See also Note 5. Servicing Assets in the notes to consolidated financial statements for further details of the factors considered by the Company in estimating the fair value servicing assets.

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Non-GAAP Measures

Some of the financial measures included in our selected historical consolidated financial data and elsewhere in this Report are not measures of financial performance recognized by GAAP. These non-GAAP financial measures are: “tangible shareholders’ equity;” “tangible assets;” “tangible shareholders’ equity to tangible assets;” “tangible book value per share;” and “efficiency ratio.” Management uses these non-GAAP financial measures in its analysis of the Company’s performance.

•“Tangible shareholders’ equity” is total shareholders’ equity less goodwill and other intangible assets. Management has not considered loan servicing rights as an intangible asset for purposes of this calculation.

•“Tangible assets” is total assets less goodwill and other intangible assets. Management has not considered loan servicing rights as an intangible asset for purposes of this calculation.

•“Tangible shareholders’ equity to tangible assets” is defined as the ratio of shareholders’ equity less goodwill and other intangible assets, divided by total assets less goodwill and other intangible assets. Management believes this measure is important because it shows relative changes from period to period in equity and total assets, each exclusive of changes in intangible assets. Management has not considered loan servicing rights as an intangible asset for purposes of this calculation.

•“Tangible book value per share” is defined as total equity reduced by goodwill and other intangible assets divided by total common shares outstanding. Management believes this measure is important because it shows changes from period to period in book value per share exclusive of changes in intangible assets. Management has not considered loan servicing rights as an intangible asset for purposes of this calculation.

•“Efficiency ratio” is defined as total noninterest expense divided by the sum of net interest income and noninterest income. Management believes this measure is important as an indicator of productivity because it shows the amount of noninterest expense that was required to generate a dollar of revenue. While the efficiency ratio is a measure of productivity, its value reflects the unique attributes of the “high-touch business model” the Company employs.

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The Company believes these non-GAAP financial measures provide useful information to management and investors that is supplementary to the financial condition, results of operations and cash flows computed in accordance with GAAP; however, the Company acknowledges that non-GAAP financial measures have a number of limitations. As such, you should not view these measures as a substitute for results determined in accordance with GAAP, and they are not necessarily comparable to non-GAAP financial measures that other companies use. The following table provides a reconciliation of these non-GAAP financial measures to the most closely related GAAP measure.

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