MERCANTILE BANK CORP (MBWM) FY 2022 MD&A

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

The following discussion and other portions of this Annual Report contain forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates, and projections about the financial services industry, the economy, and our company. Words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “is likely,” “plans,” “projects,” “indicates,” “strategy,” “future,” “likely,” “may,” “should,” “will,” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“Future Factors”) that are difficult to predict with regard to timing, extent, likelihood, and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. We undertake no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events (whether anticipated or unanticipated), or otherwise.

Future Factors include, among others, adverse changes in interest rates and interest rate relationships; increasing rates of inflation and slower growth rates; significant declines in the value of commercial real estate; market volatility; demand for products and services; climate impacts; labor markets; the degree of competition by traditional and non-traditional financial services companies; changes in banking regulation or actions by bank regulators; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; potential cyber-attacks, information security breaches, and other criminal activities; litigation liabilities; governmental and regulatory policy changes; the outcomes of existing or future contingencies; trends in customer behavior as well as their ability to repay loans; changes in local real estate values; damage to our reputation resulting from adverse publicity, regulatory actions, litigation, operational failures, and the failure to meet client expectations and other facts; changes in the method of determining Libor and the phase-out of Libor; changes in the national and local economies, including the ongoing disruption to supply chain and financial markets caused by the Coronavirus Pandemic and unstable political and economic environments; and risk factors described in our annual report on Form 10-K for the year ended December 31, 2022. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement.

Discussions of 2020 items and year-to-year comparisons between 2021 and 2020 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2021.

CRITICAL ACCOUNTING ESTIMATES

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“Management’s Discussion and Analysis”) is based on Mercantile Bank Corporation’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Our critical accounting estimates are highly dependent upon subjective or complex judgments and assumptions, and changes in such may have a significant impact on the financial statements, just as actual results may differ. We have reviewed the application of our critical accounting estimates with the Audit Committee of our Board of Directors.

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Allowance For Credit Losses (“allowance”): The allowance is maintained at a level we believe is adequate to absorb estimated credit losses identified and inherent in the loan portfolio. Our evaluation of the adequacy of the allowance is an estimate based on past loan loss experience, the nature and volume of the loan portfolio, information about specific borrower situations and estimated collateral values, guidance from bank regulatory agencies, and assessments of the impact of current and anticipated economic conditions on the loan portfolio. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off. Credit losses are charged against the allowance when we believe the uncollectibility of a loan is likely. The balance of the allowance represents our best estimate, but significant downturns in circumstances relating to loan quality or economic conditions could result in a requirement for an increased allowance in the future. Likewise, an upturn in loan quality or improved economic conditions may result in a decline in the required allowance in the future. In either instance, unanticipated changes could have a significant impact on the allowance and operating results. The allowance is increased through a provision charged to operating expense. Uncollectible loans are charged-off through the allowance, while recoveries of loans previously charged-off are added to the allowance.

In June 2016, the FASB issued ASU No. 2016-13, Measurement of Credit Losses on Financial Instruments. This ASU (as subsequently amended by ASU 2018-19) significantly changed how entities measure credit losses for most financial assets and certain other instruments that are not measured at fair value through net income. This standard replaced the “incurred loss” approach with an “expected loss” model. Referred to as the current expected credit loss (“CECL”) model, this standard applies to financial assets subject to credit losses and measured at amortized cost, and certain off-balance sheet credit exposures. The standard also expanded disclosure requirements regarding an entity’s assumptions, models, and methods for estimating the allowance. In addition, entities need to disclose the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by the year of origination. This ASU was effective for interim and annual reporting periods beginning after December 15, 2019.

Financial institutions were not required to comply with the CECL methodology requirements from the enactment date of the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) until the earlier of the end of the President’s declaration of a National Emergency or December 31, 2020. The Consolidated Appropriations Act, 2021, that was enacted in December 2020, provided for a further extension of the required CECL adoption date to January 1, 2022. An economic forecast is a key component of the CECL methodology. As we continued to experience an unprecedented economic environment whereby a sizable portion of the economy had been significantly impacted by government-imposed activity limitations and similar reactions by businesses and individuals, substantial government stimulus was provided to businesses, individuals and state and local governments and financial institutions offered businesses and individuals payment relief options, economic forecasts were regularly revised with no economic forecast consensus. Given the high degree of uncertainty surrounding economic forecasting, we elected to postpone the adoption of CECL until January 1, 2022, and continued to use our incurred loan loss reserve model as permitted through December 31, 2021.

We adopted CECL effective January 1, 2022 using the modified retrospective method for all financial assets measured at amortized cost and off-balance sheet credit exposures. Results for reporting periods beginning after January 1, 2022 are presented under CECL while prior period amounts continue to be reported in accordance with the incurred loss accounting standards. The transition adjustment of the CECL adoption included a decrease in the allowance of $0.4 million, and a $0.3 million increase to the retained earnings account to reflect the cumulative effect of adopting CECL on our Consolidated Balance Sheet, with the $0.1 million tax impact portion being recorded as part of the deferred tax asset in other assets on our Consolidated Balance Sheet.

See Note 1 – Significant Accounting Policies in the Notes to our Consolidated Financial Statements in this Form 10-K for additional information on our estimation process and methodology related to the allowance. See also Note 3 – Loans and Allowance for Credit Losses in the Notes to our Consolidated Financial Statements in this Form 10-K for further information regarding our loan portfolio and allowance.

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Mortgage Servicing Rights: Mortgage servicing rights are recognized as assets based on the allocated fair value of retained servicing rights on loans sold. Servicing rights are carried at the lower of amortized cost or fair value and are expensed in proportion to, and over the period of, estimated net servicing income. We utilize a discounted cash flow model to determine the value of our servicing rights. The valuation model utilizes mortgage loan prepayment speeds, the remaining life of the mortgage loan pool, delinquency rates, our cost to service loans, and other factors to determine the cash flow that we will receive from servicing each grouping of loans. These cash flows are then discounted based on current interest rate assumptions to arrive at the fair value of the right to service those loans. Impairment is evaluated quarterly based on the fair value of the servicing rights, using groupings of the underlying loans classified by interest rates. Any impairment of a grouping is reported as a valuation allowance.

Goodwill: Accounting rules require us to determine the fair value of all the assets and liabilities of an acquired entity, and to record their fair value on the date of acquisition. We employ a variety of means in determining fair value, including the use of discounted cash flow analysis, market comparisons and projected future revenue streams. For those items for which we conclude that we have the appropriate expertise to determine fair value, we may choose to use our own calculation of fair value. In other cases, where the fair value is not readily determined, consultation with outside parties is used to determine fair value. Once valuations have been determined, the net difference between the price paid for the acquired entity and the fair value of the balance sheet is recorded as goodwill. Goodwill is assessed at least annually for impairment, with any such impairment recognized in the period identified. A more frequent assessment is performed if there are material changes in the market place or within the organizational structure.

INTRODUCTION

This Management’s Discussion and Analysis should be read in conjunction with the consolidated financial statements contained in this Annual Report. This discussion provides information about the consolidated financial condition and results of operations of Mercantile Bank Corporation and its consolidated subsidiary, Mercantile Bank (“our bank”), and Mercantile Insurance Center, Inc. (“our insurance company”), a subsidiary of our bank. Unless the text clearly suggests otherwise, references to “us,” “we,” “our,” or “the company” include Mercantile Bank Corporation and its wholly-owned subsidiaries referred to above.

CORONAVIRUS PANDEMIC

Although virtually all related restrictions have been terminated, impacts remain across national and global economies due to the pandemic of coronavirus disease 2019 (“Covid-19”) caused by severe acute respiratory syndrome coronavirus 2 (the “Coronavirus Pandemic”). Overall, the Coronavirus Pandemic has caused a sustained global economic slowdown of varying durations across different industries, and it is possible that it could still cause a global recession as a result of deteriorating economic and political conditions such as increased unemployment, decreased capital spending, declines in consumer confidence, and economic slowdowns. This uncertainty is heightened in certain geographic areas due to continued surges in Covid-19 cases, and governments at all levels continue to react to changes in circumstances, including vaccine hesitancy, booster shot efficacy, supply chain disruptions and inflationary pressures. For example, although many health and safety restrictions have been lifted and vaccine distribution has increased, certain adverse consequences of the Coronavirus Pandemic continue to impact the macroeconomic environment and may persist for some time, including labor shortages and disruptions of global supply chains, particularly in China and other parts of Asia. In addition, this uncertainty is further heightened by the possibility that new and highly infectious variants and subvariants of Covid-19 might arise which are more severe, more transmissible, and capable of evading vaccinations, booster shots and prior immunity.

The Coronavirus Pandemic has had a significant impact on our financial condition and operating results since its onset in March, 2020. Federal government stimulus programs resulted in a massive increase to the money supply, providing significant inflationary pressures that the Federal Reserve’s Federal Open Market Committee (“FOMC”) has been attempting to manage through substantial increases in the federal funds rate since March, 2022. In addition, we experienced significant growth in liquidity as federal government stimulus monies were deposited by program recipients, providing for sizable impacts to our operating performance as well as our capital and liquidity positions during 2022 and 2021.

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The following section summarizes the primary Covid-19 related measures that directly impacted us and our customers.

We continue to monitor the situation, including cases of sickness within our workforce, and will take action to adjust office attendance policies as circumstances warrant in order to protect the health and safety of employees, contractors, and others who visit our offices. However, if the Coronavirus Pandemic worsens and shutdown orders are issued in the future, our ability to operate could be adversely impacted, depending on the language of such orders. The extent to which the Coronavirus Pandemic continues to impact us will depend on future developments, which are highly uncertain and cannot be predicted.

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CLIMATE CHANGE

Increased public and investor concern about climate change will likely continue to (1) generate more regional and/or national requirements to reduce greenhouse gas emissions; (2) increase energy efficiency and reduce carbon pollution; and (3) cause a shift to cleaner and more sustainable sources of energy which may be more expensive than using fossil fuels as an energy source. The potential impact of climate changes on our operations and the needs of our customers remains uncertain. Scientists have proposed that the impacts of climate change could include changes in rainfall patterns, water shortages, changes to the water levels of lakes and other bodies of water, changing storm patterns and intensities, and changing temperature levels. These changes could be severe and vary by geographic location. Climate change may also affect the occurrence of certain natural events, the incidence and severity of which are inherently unpredictable. We could also face indirect financial risks passed through the supply chain that could result in higher prices for resources, such as energy. Additionally, climate change may adversely impact the demand, prices, and availability of property and casualty insurance that insures our loan collateral. Due to significant economic variability associated with potential future changing climate conditions, we are unable to predict the impact climate change will have on us.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE MATTERS

There has been an increased focus from regulators and stakeholders on environmental, social, and governance (“ESG”) matters, including greenhouse gas emissions, sustainability, and climate-related risks; diversity, equity and inclusion; responsible sourcing and supply chain; human rights and social responsibility; and corporate governance and oversight. Given our commitment to ESG matters, we actively manage these issues and have established and publicly announced certain goals, commitments, and targets which we may refine or even expand further in the future. These goals, commitments, and targets reflect our current plans and aspirations and are not guarantees that we will be able to achieve them. Evolving stakeholder expectations and our efforts and ability to manage these issues, provide updates on them, and accomplish our goals, commitments, and targets present numerous operational, regulatory, reputational, financial, legal, and other risks, any of which may be outside of our control or could have a material adverse impact on our business, including on our reputation and stock price. Further, there is uncertainty around the accounting standards and climate-related disclosures associated with emerging laws and reporting requirements and the related costs to comply with the emerging regulations. Our failure or perceived failure to achieve our ESG goals, maintain ESG practices, or comply with emerging ESG regulations that meet evolving regulatory or stakeholder expectations could harm our reputation, adversely impact our ability to attract and retain customers and talent, and expose us to increased scrutiny from the investment community and regulatory authorities. Our reputation also may be harmed by the perception that our stakeholders have about our action or inaction on ESG-related issues.

Our ESG Committee supports our ongoing commitment to environmental, health and safety, corporate social responsibility, corporate governance, sustainability, and other public policy matters relevant to our organization. The ESG Committee is a cross-functional management committee, led by the Chief Risk Officer, that assists us in: (1) setting general strategies relating to ESG matters; (2) developing, implementing, and monitoring initiatives and polices based on those strategies; (3) recommending communications with employees, investors, and shareholders with respect to ESG matters; and (4) monitoring and assessing developments relating to, and improving our understanding of, ESG matters. The committee met four times during 2022. Highlights for 2022 included the enhancement of our online financial wellness tools, the rollout of the MercStart Fresh deposit program, the development of a diverse vendor database for employee use, and the creation of a Vendor and Supplier Code of Conduct. The Vendor and Supplier Code of Conduct, along with our Environmental Policy, Diversity, Equity and Inclusion Policy, Human Rights Policy, and Supplier Diversity Program Policy, are reviewed and approved by our Board of Directors at least annually. These polices are available on our website, along with an application for diverse suppliers. Also during 2022, we moved Board of Director oversight of ESG matters from the Audit Committee to the Governance Committee.

FINANCIAL OVERVIEW

We recorded net income of $61.1 million, or $3.85 per basic and diluted share, for 2022, compared with net income of $59.0 million, or $3.69 per basic and diluted share, for 2021. Higher net interest income, stemming from an improved net interest margin and ongoing strong loan growth, combined with continued strength in asset quality metrics and ongoing increases in treasury management fee income, more than offset a significant decline in residential mortgage banking revenue as industry-wide originations come off of the record levels of 2020 and 2021 which were driven by low residential mortgage rates and resulting refinancing activity. Our earnings performance in 2021 also benefited from negative provisions to the allowance.

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Commercial loans increased $181 million during 2022, reflecting the combined growth of commercial loans and activity under the PPP. Core commercial loans (commercial loans excluding PPP loans) increased $221 million, or almost 8%, during 2022, while PPP loans declined $39.2 million. Core commercial and industrial loans increased $86.9 million, owner-occupied commercial real estate (“CRE”) loans grew $73.4 million, multi-family and residential rental property loans increased $35.4 million, vacant land, land development, and residential construction loans increased $18.6 million, and nonowner-occupied CRE loans grew $6.3 million. As a percentage of total core commercial loans, commercial and industrial loans and owner-occupied CRE loans combined equaled 58.2% at December 31, 2022, compared to 57.1% at year-end 2021. The new commercial loan pipeline remains strong, and at December 31, 2022, we had $197 million in unfunded loan commitments on commercial construction and development loans that are in the construction phase.

Residential mortgage loans, excluding home equity lines of credit, increased $275 million during 2022, representing a growth rate of approximately 62%. With the increase in residential mortgage loan interest rates during 2022, we witnessed a shift in borrowers primarily selecting adjustable rate residential mortgage loans compared to fixed rate residential mortgage loans in the prior two years. Generally, we sell fixed rate residential mortgage loans to third-party investors, while we maintain adjustable rate residential mortgage loans on our balance sheet. During 2022, approximately 35% of our residential mortgage loan production was comprised of longer-term fixed rate loans, compared to about 68% during 2021. The shift in product mix impacts the timing of revenue recognition; it takes an estimated 24 months for the amount of net interest income earned on a residential mortgage loan that is retained on our balance sheet to approximate the amount of immediately recorded gain on sale of a residential mortgage loan that has been sold to a third-party investor.

The overall quality of our loan portfolio remains strong, with nonperforming loans equaling 0.20% of total loans as of December 31, 2022. Accruing loans past due 30 to 89 days remain very low, and we had no foreclosed properties throughout 2022. Gross loan charge-offs totaled $0.3 million during 2022, while recoveries of prior period loan charge-offs totaled $1.0 million, providing for net loan recoveries of $0.7 million, or 0.02% of average total loans, for the year.

We recorded a credit loss provision expense of $6.6 million during 2022, compared to a negative provision expense of $4.3 million during 2021. The provision expense recorded during 2022 was necessitated by the net increase in required reserve levels stemming from changes to several environmental factors that largely reflected enhanced inherent risk within the commercial loan and residential mortgage loan portfolios, loan growth, and increased specific reserves for certain distressed loan relationships. A higher reserve for residential mortgage loans reflecting slower principal prepayment rates, and the resulting extended average life of the portfolio also impacted provision expense in 2022. The negative provision expense recorded during 2021 primarily reflected reduced allowance allocations attributed to improvement in both current and forecasted economic conditions and net loan recoveries, which more than offset required allowance allocations necessitated by strong loan growth.

Interest-earning deposits, primarily consisting of funds deposited at the Federal Reserve Bank of Chicago, are used to manage daily liquidity needs and interest rate risk sensitivity. During 2022, the average balance of these funds equaled $445 million, or 9.3% of average earning assets, compared to $671 million, or 14.9% of average earning assets, during 2021. Typically, we maintain our interest-earning deposits at approximately $75 million, or about 2% of average earning assets. The elevated levels during 2022 and 2021 primarily reflected increased local deposits stemming from Covid-19-related federal government stimulus programs and reduced business and consumer investing and spending. The excess level of interest-earning deposits had a negative impact on our net interest margin. The level of interest-earning deposits was on a declining trend throughout 2022, as excess monies were used to fund loan growth as well as brokered deposit and Federal Home Loan Bank of Indianapolis (“FHLBI”) advance maturities. We also experienced a net decline in local deposit balances throughout 2022. Our deposit balance at the Federal Reserve Bank of Chicago equaled $29.4 million as of December 31, 2022.

Total deposits decreased $370 million during 2022, and totaled $3.71 billion at December 31, 2022. Local deposits declined $346 million, and out-of-area deposits decreased $23.9 million. A large portion of the decline in local deposits was comprised of a single customer’s anticipated withdrawal of funds that had been deposited in late 2021 from the sale of a business; excluding the withdrawal of these monies, local deposits were down approximately $150 million in 2022. Sizable withdrawals by other customers to fund bonus and tax payments, especially during the latter part of the fourth quarter, and public unit withdrawals primarily reflecting transfers into high-yielding accounts at other banks and nonbanks, also contributed to the decrease in local deposits.

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Net interest income increased $34.2 million during 2022 compared to 2021. Interest income was up $38.3 million, while interest expense increased $4.1 million. Interest income on loans increased significantly during 2022 due to a rapidly increasing interest rate environment and loan growth. Our yield on loans was 3.87% during the first quarter of 2022, growing to 5.49% during the fourth quarter of 2022, and equaling 4.50% for all of 2022. Our yield on loans during 2021 was 4.06%, which had been significantly positively impacted by PPP net fee income accretion. We also recorded growth in interest income on securities, reflecting portfolio growth as we deployed a portion of our excess liquid funds position and the higher interest rate environment. The higher interest rate environment also provided for increased interest income on our interest-earning deposits. Interest expense on deposits increased a relatively low $0.9 million in 2022, in large part reflecting generally steady deposit rates in a rapidly increasing interest rate environment during most of 2022. Interest expense on other borrowed money increased $4.2 million during 2022, reflecting interest costs associated with the $90.0 million in subordinated notes issued between December 2021 and January 2022, and higher interest rates on our floating rate subordinated debentures.

Noninterest income was $32.1 million during 2022, compared to $56.2 million during 2021. The decline mainly resulted from a $21.3 million reduction in mortgage banking income, reflecting the aforementioned increase in residential mortgage loan interest rates and corresponding substantial reduction in refinancing activity. We also recorded a $3.4 million decline in interest rate swap income, as the higher interest rate environment resulted in less transactions. We continued to record meaningful increased fee income in our treasury management products and services, with service charges on deposit and sweep accounts, credit and debit card fees, and payroll services growing $0.9 million, $0.7 million and $0.4 million, respectively.

Noninterest expense was $108 million during 2022, compared to $111 million during 2021. Excluding contributions to The Mercantile Bank Foundation, noninterest expense totaled $106 million and $107 million in 2022 and 2021, respectively. Aggregate salary and benefit costs declined $1.3 million in 2022, in large part reflecting lower residential mortgage lender commissions, reduced stock-based compensation costs, and higher residential mortgage loan deferred costs, which more than offset higher salary costs stemming from annual merit increases, market adjustments, and higher bonus accruals.

FINANCIAL CONDITION

Our total assets decreased $385 million during 2022, and totaled $4.87 billion as of December 31, 2022. Total loans increased $463 million and securities available for sale were up $10.2 million, while interest-earning deposits declined $881 million. Total deposits decreased $370 million and FHLBI advances were down $65.8 million, while net proceeds from the issuance of subordinated notes totaled $14.6 million. In large part, the excess funds maintained with the Federal Reserve Bank of Chicago at year-end 2021 were used to fund loan growth, deposit withdrawals, and FHLBI advance maturities during 2022.

Earning Assets

Average earning assets equaled 94.3% of average total assets during 2022, compared to 93.9% during 2021. The loan portfolio continued to comprise a majority of earning assets, followed by securities and interest-earning deposits. Average total loans equaled 77.8% of average earning assets during 2022, compared to 73.7% in 2021, while average securities and interest-earning deposits comprised 12.9% and 9.3% of average earning assets during 2022 and 11.4% and 14.9% of average earning assets during 2021, respectively.

Our loan portfolio has historically been primarily comprised of commercial loans. Commercial loans increased $181 million during 2022, reflecting the combined net growth of core commercial loans and net activity under the PPP. Core commercial loans increased $221 million, or almost 8%, during 2022, while PPP loans declined $39.2 million. Core commercial and industrial loans increased $86.9 million, owner-occupied CRE loans grew $73.4 million, multi-family and residential rental property loans increased $35.4 million, vacant land, land development, and residential construction loans increased $18.6 million, and nonowner-occupied CRE loans grew $6.3 million. As a percentage of total core commercial loans, commercial and industrial loans and owner-occupied CRE loans combined equaled 58.2% at December 31, 2022, compared to 57.1% at year-end 2021. The new commercial loan pipeline remains strong, and at December 31, 2022, we had $197 million in unfunded loan commitments on commercial construction and development loans that are in the construction phase. We believe our commercial loan portfolio remains well diversified.

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As of December 31, 2022, availability on commercial construction and development loans that are in the construction phase totaled $197 million, with most of the funds expected to be drawn over the next 12 to 18 months. Our current pipeline reports indicate continued strong commercial loan funding opportunities in future periods, including $330 million in new lending commitments, a majority of which we expect to be accepted and funded over the next 12 to 18 months. Our commercial lenders also report additional opportunities they are currently discussing with existing borrowers and potential new customers. We remain committed to prudent underwriting standards that provide for an appropriate yield and risk relationship, as well as concentration limits we have established within our commercial loan portfolio. Usage of existing commercial lines of credit was relatively stable during 2022 at approximately 42%, compared to about 36% during the latter half of 2020 and all of 2021, and our historical average of about 47% prior to the Coronavirus Pandemic.

Residential mortgage loans totaled $755 million, or 19.3% of total loans, at December 31, 2022, compared to $443 million, or 12.8% of total loans, as of December 31, 2021. Residential mortgage loans, excluding home equity lines of credit, increased $275 million during 2022, representing a growth rate of approximately 62%. We originated $614 million in residential mortgage loans during 2022, compared to $952 million in 2021, a reduction of about 36%. The decline primarily reflected an increase in residential mortgage loan interest rates throughout 2022, resulting in a substantial reduction of refinancing activity. Production associated with refinancing activity totaled $134 million in 2022, compared to $458 million in 2021. With the increase in residential mortgage loan rates, we also witnessed a shift in borrowers primarily selecting adjustable rate residential mortgage loans compared to fixed rate residential mortgage loans in 2021. Generally, we sell fixed rate residential mortgage loans to third-party investors, while we maintain adjustable rate residential mortgage loans on our balance sheet. During 2022, approximately 35% of our residential mortgage loan production was comprised of longer-term fixed rate loans, compared to about 68% during 2021. The shift in product mix impacts the timing of revenue recognition; it takes an estimated 24 months for the amount of net interest income earned on a residential mortgage loan that is retained on our balance sheet to approximate the amount of immediately recorded gain on sale of a residential mortgage loan that has been sold to a third-party investor.

Other consumer-related loans increased $4.9 million during 2022, and at December 31, 2022 totaled $29.8 million, or 0.7% of total loans. As of December 31, 2021, the other consumer-related loan portfolio comprised 0.7% of total loans. We expect this loan portfolio segment to remain relatively steady in dollar amount but decline as a percent of total loans in future periods as commercial loans and residential mortgage loan portfolios grow.

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The following table summarizes our loan portfolio:

(*) For December 31, 2022, December 31, 2021, and December 31, 2020, includes $0.9 million, $40.1 million, and $365 million in loans originated under the Paycheck Protection Program, respectively.

(**) In conjunction with the adoption of the CECL methodology effective January 1, 2022, home equity lines of credit were reclassified to 1-4 family mortgage loans from consumer loans. Home equity lines of credit totaled $37.4 million, $29.5 million, $32.6 million, $37.7 million, and $41.6 million as of December 31, 2022, December 31, 2021, December 31, 2020, December 31, 2019, and December 31, 2018, respectively.

The following table presents total loans outstanding as of December 31, 2022, according to scheduled repayments of principal on fixed rate loans and repricing frequency on variable rate loans. Floating rate commercial loans that are currently at interest rate floors are treated as fixed rate loans and are reflected using maturity date and not repricing frequency.

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Our credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to provide effective loan portfolio administration. The credit policies and procedures are meant to minimize the risk and uncertainties inherent in lending. In following these policies and procedures, we must rely on estimates, appraisals and evaluations of loans and the possibility that changes in these items could occur quickly because of changing economic conditions or other factors. Identified problem loans, which exhibit characteristics (financial or otherwise) that could cause the loans to become nonperforming or require restructuring in the future, are included on the internal loan watch list. Senior management and the Board of Directors review this list regularly. Market value estimates of collateral on nonperforming loans, as well as on foreclosed and repossessed assets, are reviewed periodically. We have a process in place to monitor whether value estimates at each quarter-end are reflective of current market conditions. Our credit policies establish criteria for obtaining appraisals and determining internal value estimates. We may also adjust outside and internal valuations based on identifiable trends within our markets, such as recent sales of similar properties or assets, listing prices, and offers received. In addition, we may discount certain appraised and internal value estimates to address distressed market conditions.

Nonaccrual loans totaled $7.7 million, or 0.2% of total loans, as of December 31, 2022, compared to $2.3 million, or 0.1% of total loans, as of December 31, 2021. Nonperforming assets, comprised of nonaccrual loans, loans past due 90 days or more and accruing interest and foreclosed properties, totaled $7.7 million (0.2% of total assets) as of December 31, 2022, compared to $2.5 million (0.1% of total assets) as of December 31, 2021. The volume of nonperforming assets has remained under 0.3% of total assets since year-end 2015, and has averaged 0.1% over the past four years. Given the low level of nonperforming loans and accruing loans 30 to 89 days delinquent, combined with what we believe are strong credit administration practices, we are pleased with the overall quality of the loan portfolio.

The following tables provide a breakdown of nonperforming assets by property type:

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The following tables provide a reconciliation of nonperforming assets:

During 2022, loan charge-offs totaled $0.3 million, while recoveries of prior period loan charge-offs equaled $1.0 million, providing for net loan recoveries of $0.7 million, or 0.02% of average total loans. During 2021, loan charge-offs totaled $1.0 million, while recoveries of prior period loan charge-offs equaled $2.7 million, providing for net loan recoveries of $1.7 million, or 0.05% of average total loans. We continue our collection efforts on charged-off loans, and we expect to record recoveries in future periods; however, given the nature of these efforts, it is not practical to forecast the dollar amount and timing of the recoveries.

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The following table illustrates the breakdown of the allowance for credit losses by loan type (dollars in thousands) and of the total loan portfolio (in percentages). For the years 2019 and 2018, presented loan and allowance data are reflective of only originated loans and the allowance for originated loans. We terminated the application of purchase accounting associated with our merger with Firstbank effective January 1, 2020.

The following table depicts the ratio of our allowance to nonperforming loans:

We adopted CECL effective January 1, 2022 using the modified retrospective method for all financial assets measured at amortized cost and off-balance sheet credit exposures. Results for reporting periods beginning after January 1, 2022 are presented under CECL while prior period amounts continue to be reported in accordance with the incurred loss accounting standards. The transition adjustment of the CECL adoption included a decrease in the allowance of $0.4 million, which included a $0.3 million increase to the retained earnings account to reflect the cumulative effect of adopting CECL on our Consolidated Balance Sheet, with the $0.1 million tax impact portion being recorded as part of the deferred tax asset in other assets on our Consolidated Balance Sheet.

The allowance for loan loss accounting in effect at December 31, 2021 and all prior periods was based on our estimate of probable incurred loan losses as of the reporting date (“incurred loss” methodology). Under the CECL methodology, our allowance is based on the total amount of credit losses that are expected over the remaining life of the loan portfolio. Our estimate of credit losses under CECL is determined using a complex model that relies on historical loss information, reasonable and supportable economic forecasts, and various qualitative factors.

The primary risk elements with respect to commercial loans are the financial condition of the borrower, the sufficiency of collateral, and timeliness of scheduled payments. We have a policy of requesting and reviewing periodic financial statements from commercial loan customers, and we have a disciplined and formalized review of the existence of collateral and its value. The primary risk element with respect to each residential mortgage loan and consumer loan is the timeliness of scheduled payments. We have a reporting system that monitors past due loans and have adopted policies to pursue creditors’ rights in order to preserve our collateral position.

See Note 1 - Significant Accounting Policies in this Form 10-K for further detailed descriptions of our estimation process and methodology related to the allowance. See also Note 3 - Loans and Allowance for Credit Losses in this Form 10-K for further information regarding our loan portfolio and allowance.

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The allowance equaled $42.2 million, or 1.08% of total loans, and over 500% of nonperforming loans, as of December 31, 2022. As of December 31, 2022, the allowance was comprised of $39.6 million in general reserves relating to performing loans and $2.6 million in specific reserves on other loans, primarily nonperforming loans. Troubled debt restructurings totaled $11.6 million at December 31, 2022, consisting of $6.1 million that are on nonaccrual status and $5.5 million that are on accrual status. The latter are not included in our nonperforming loan totals. Loans with an aggregate carrying value of $0.4 million as of December 31, 2022 had been subject to previous partial charge-offs aggregating $0.3 million over the past several years. As of December 31, 2022, there were no specific reserves allocated to loans that had been subject to a previous partial charge-off.

The following table provides a breakdown of our loans categorized as troubled debt restructurings:

Although we believe the allowance is adequate to absorb loan losses in our originated loan portfolio as they arise, there can be no assurance that we will not sustain loan losses in any given period that could be substantial in relation to, or greater than, the size of the allowance.

Securities available for sale increased $10.2 million during 2022, totaling $603 million as of December 31, 2022. Purchases of U.S. Government agency bonds totaled $54.5 million during 2022, while purchases of U.S. Government agency guaranteed mortgage-backed securities totaled $2.1 million. There were no U.S. Government agency bond maturities or calls during 2022, while principal paydowns on U.S. Government agency guaranteed mortgage-backed securities totaled $5.8 million. Purchases of municipal bonds totaled $50.4 million during 2022; proceeds from matured and called municipal bonds totaled $12.1 million. At December 31, 2022, the portfolio was primarily comprised of U.S. Government agency bonds (65%), municipal bonds (30%), and U.S. Government agency guaranteed mortgage-backed securities (5%). All of our securities are currently designated as available for sale and are therefore stated at fair value. The fair value of securities designated as available for sale at December 31, 2022 totaled $603 million, including a net unrealized loss of $82.7 million. After we considered whether the securities were issued by the federal government or its agencies and whether downgrades by bond rating agencies had occurred, we determined that the unrealized losses were due to changing interest rate environments. As we do not intend to sell our debt securities before recovery of their cost basis, and we believe it is more likely than not that we will not be required to sell our debt securities before recovery of the cost basis, no unrealized losses are deemed to be other-than-temporary. We maintain the securities portfolio at levels to provide adequate pledging and secondary liquidity for our daily operations. In addition, the securities portfolio serves a primary interest rate risk management function. We expect upcoming purchases to generally consist of municipal bonds, with the securities portfolio maintained at about 12% of total assets.

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The following table reflects the composition of the securities portfolio:

Market values on our U.S. Government agency bonds, mortgage-backed securities issued or guaranteed by U.S. Government agencies, and municipal bonds are generally determined on a monthly basis with the assistance of a third party vendor. Evaluated pricing models that vary by type of security and incorporate available market data are utilized. Standard inputs include issuer and type of security, benchmark yields, reported trades, broker/dealer quotes, and issuer spreads. The market value of certain non-rated securities issued by relatively small municipalities generally located within our markets is estimated at carrying value. We believe our valuation methodology provides for a reasonable estimation of market value, and that it is consistent with the requirements of accounting guidelines.

FHLBI stock totaled $17.7 million as of December 31, 2022, compared to $18.0 million as of December 31, 2021. The reduction reflects the FHLBI’s repurchase of excess stock. Our investment in FHLBI stock is necessary to engage in their advance and other financing programs. We have regularly received quarterly cash dividends, and we expect a cash dividend will continue to be paid in future quarterly periods.

The following table shows by class of maturities as of December 31, 2022 the amounts and weighted average yields (on a fully taxable-equivalent basis) of investment securities:

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Interest-earning deposits, primarily consisting of funds deposited at the Federal Reserve Bank of Chicago, are used to manage daily liquidity needs and interest rate risk sensitivity. During 2022, the average balance of these funds equaled $445 million, or 9.3% of average earning assets, compared to $671 million, or 14.9% of average earning assets, during 2021. Typically, we maintain our interest-earning deposits at approximately $75 million, or about 2% of average earning assets. The elevated levels during 2022 and 2021 primarily reflected increased local deposits stemming from Covid-19-related federal government stimulus programs and reduced business and consumer investing and spending. The excess level of interest-earning deposits had a negative impact on our net interest margin. The level of interest-earning deposits was on a declining trend throughout 2022, as excess monies were used to fund loan growth as well as brokered deposit and FHLBI advance maturities. We also experienced a net decline in local deposit balances throughout 2022. Our deposit balance at the Federal Reserve Bank of Chicago equaled $29.4 million as of December 31, 2022.

Non-Earning Assets

Cash and due from bank balances averaged 1.5% of total assets during 2022, similar to the average level during 2021, and no significant changes are expected in future periods. Net premises and equipment equaled $51.5 million at December 31, 2022, representing a decrease of $5.8 million during 2022. The decline primarily reflected the sale of a branch facility located in Lansing, Michigan as part of a branch relocation project whereby we are moving our operations to a leased facility that better aligns with our operations in the greater Lansing area and provides for lower operating costs, along with depreciation expense. We had no foreclosed or repossessed assets as of December 31, 2022, unchanged from December 31, 2021.

Other assets equaled $95.0 million at December 31, 2022, reflecting an increase of $40.7 million during 2022. The increase is primarily associated with $21.1 million of growth in the fair value of interest rates swaps and a $16.6 million increase in a deferred tax benefit related to unrealized losses on available for sale securities.

Source of Funds

Total deposits decreased $370 million during 2022, totaling $3.71 billion as of December 31, 2022. Local deposits declined $346 million and out-of-area deposits decreased $23.9 million. We had no out-of-area deposits as of December 31, 2022, compared to $23.9 million, or 0.6% of total deposits, as of December 31, 2021. FHLBI advances decreased $65.7 million during 2022, totaling $308 million as of December 31, 2022.

Noninterest-bearing checking accounts declined $73.2 million during 2022, in large part during the fourth quarter due primarily from commercial customers withdrawing funds for the payment of taxes and bonuses. Interest-bearing checking accounts increased $36.2 million, while savings deposits declined $12.7 million. Money market deposit accounts decreased $263 million during 2022, primarily reflecting a single customer’s anticipated withdrawal of funds that had been deposited in late 2021 from the sale of a business. Local time deposits decreased $33.3 million during 2022. The $23.9 million reduction in out-of-area time deposits during 2022 reflects maturities that were not replaced as the funds were no longer needed.

Total local deposits had increased an aggregate $1.50 billion during 2020 and 2021. Noninterest-bearing checking accounts grew $753 million during this time period, while interest-bearing checking accounts and money market deposit accounts were up $206 million and $531 million, respectively. The increases in these transactional deposit products largely reflected federal government stimulus programs, especially the PPP, as well as lower business investing and spending. Deposit growth associated with new commercial lending relationships was also notable. Savings deposits were up $125 million, primarily reflecting the impact of federal government stimulus programs and lower consumer investing and spending.

Securities sold under agreements to repurchase (“sweep accounts”) decreased $3.1 million during 2022, totaling $194 million as of December 31, 2022. The aggregate balance of this funding type can be subject to relatively large daily fluctuations given the nature of the customers utilizing this product and the sizable balances that many of the customers maintain. The average balance of sweep accounts equaled $200 million during 2022, with a high balance of $236 million and a low balance of $173 million. Our sweep account program entails transferring collected funds from certain business noninterest-bearing checking accounts to overnight interest-bearing repurchase agreements. Such repurchase agreements are not deposit accounts and are not afforded federal deposit insurance. All of our repurchase agreements are accounted for as secured borrowings.

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FHLBI advances declined $65.7 million during 2022, totaling $308 million as of December 31, 2022. Advance maturities aggregating $94.0 million were not replaced as the funds were no longer needed, while advances totaling $28.3 million were obtained to match-fund fixed rate longer term commercial lending relationships. FHLBI advances are primarily used to assist in funding loan demand, as well as playing an integral role in our interest rate risk management program. FHLBI advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on certain commercial real estate property loans, and substantially all other assets of our bank under a blanket lien arrangement. Our borrowing line of credit at year-end 2022 totaled $1.03 billion, with remaining availability based on collateral of $713 million.

On December 15, 2021, we entered into Subordinated Note Purchase Agreements with certain institutional accredited investors pursuant to which we issued and sold $75.0 million in aggregate principal amount of its 3.25% fixed-to-floating rate subordinated notes (“Notes”). The Notes have a stated maturity of January 30, 2032, are redeemable by us at our option, in whole or in part, on or after January 30, 2027 on any interest payment date at a redemption price of 100% of the principal amount of the Notes being redeemed. The Notes are not subject to redemption at the option of the holder. The Notes will bear interest at a fixed rate of 3.25% per year until January 29, 2027. Commencing on January 30, 2027 and through the stated maturity date of January 30, 2032, the interest rate will reset quarterly at a variable rate equal to the then-current Three-Month Term SOFR plus 212 basis points. On December 15, 2021, we injected $70.0 million of the issuance proceeds to our bank as an increase to equity capital.

On January 14, 2022, we issued an additional $15.0 million of its Notes to certain institutional accredited investors, reflecting an expansion of the $75.0 million issuance completed on December 15, 2021. The additional $15.0 million issuance was completed on the same terms as the prior offering and under the existing indenture. On January 14, 2022, we injected $15.0 million of the issuance proceeds to our bank as an increase to equity capital.

Shareholders’ equity declined $15.2 million during 2022, totaling $441 million as of December 31, 2022. Positively impacting shareholders’ equity was net income of $61.1 million, while negatively affecting shareholders’ equity were cash dividends on our common stock totaling $19.6 million. Activity relating to the issuance and sale of common stock through various stock-based compensation programs and our dividend reinvestment plan positively impacted shareholders’ equity by a total of $4.7 million. Negatively impacting shareholders’ equity during 2022 was a $61.6 million increase in the after-tax net unrealized loss on available for sale securities.

RESULTS OF OPERATIONS

FOR THE YEARS ENDED DECEMBER 31, 2022 and 2021

Summary

We recorded net income of $61.1 million, or $3.85 per basic and diluted share, for 2022, compared to net income of $59.0 million, or $3.69 per basic and diluted share, for 2021. Diluted earnings per share increased $0.16, or 4.3%, during 2022 compared to 2021.

The higher level of net income during 2022 compared to 2021 reflected improved net interest income and lower noninterest expense, which more than offset decreased noninterest income and an increased provision for credit losses. The increase in net interest income resulted from a higher net interest margin and earning asset growth. Overhead costs declined in 2022 primarily due to reduced contributions to The Mercantile Bank Foundation and compensation-related costs. The reduction in noninterest income during 2022 mainly reflected decreased mortgage banking income and interest rate swap income, which outweighed increases in treasury management fee income. The provision expense recorded during 2022 was necessitated by the net increase in required reserve levels stemming from changes to several environmental factors that largely reflected enhanced inherent risk within the commercial loan and residential mortgage loan portfolios, loan growth, and increased specific reserves for certain distressed loan relationships. A higher reserve for residential mortgage loans reflecting slower principal prepayment rates and the associated extended average life of the portfolio also impacted provision expense during 2022. A negative loan loss provision expense was recorded in 2021, primarily reflecting reduced allocations attributable to improvement in both current and forecasted economic conditions and a net loan recovery.

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Net Interest Income

Net interest income, the difference between revenue generated from earning assets and the interest cost of funding those assets, is our primary source of earnings. Interest income (adjusted for tax-exempt income) and interest expense totaled $182 million and $23.6 million, respectively, during 2022, providing for net interest income of $158 million. During 2021, interest income and interest expense equaled $144 million and $19.4 million, respectively, providing for net interest income of $124 million. In comparing 2022 with 2021, interest income increased 26.7%, interest expense was up 21.4%, and net interest income increased 27.5%. The level of net interest income is primarily a function of asset size, as the weighted average interest rate received on earning assets is greater than the weighted average interest cost of funding sources; however, factors such as types and levels of assets and liabilities, the interest rate environment, interest rate risk, asset quality, liquidity, and customer behavior also impact net interest income as well as the net interest margin.

The $34.2 million increase in net interest income in 2022 compared to 2021 resulted from an improved net interest margin and a higher level of average earning assets. During 2022, the net interest margin equaled 3.33%, up from 2.76% during 2021 due to a higher yield on average earning assets, which more than offset an increase in the cost of funds. The increased yield on average earning assets mainly resulted from a higher yield on loans and a change in earning asset mix, reflecting a decrease in low-yielding interest-earning deposits. The increased yield on loans primarily resulted from higher interest rates on variable-rate commercial loans stemming from the FOMC significantly raising the targeted federal funds rate in an effort to curb elevated inflation levels. The FOMC increased the targeted federal funds rate by 425 basis points during the period of March 2022 through December 2022. As of December 31, 2022, approximately 65% of the commercial loan portfolio consisted of variable-rate loans. Higher yields on other interest-earning assets and securities, reflecting the increased interest rate environment, also contributed to the improved yield on earning assets. During 2022, earning assets averaged $4.77 billion, representing an increase of $256 million, or 5.7%, from the $4.51 billion average during 2021. Average loans increased $382 million, average interest-earning deposits were down $226 million, and average securities were up $99.9 million. The cost of funds increased from 0.43% in 2021 to 0.50% in 2022 mainly due to higher costs of non-time deposits and trust preferred securities, reflecting the increased interest rate environment, and the issuance of subordinated notes totaling $90 million in December of 2021 and January of 2022. Subordinated note issuance proceeds of $85.0 million were injected into Mercantile Bank as an increase to equity capital to support expected loan growth.

A significant volume of excess on-balance sheet liquidity, which initially surfaced in the second quarter of 2020 in large part due to government stimulus programs related to the Covid-19 environment, negatively impacted the yield on average earning assets by 24 basis points and 46 basis points during 2022 and 2021, respectively, and the net interest margin by 19 basis points and 39 basis points during the respective periods. The excess funds, consisting almost entirely of low-yielding deposits with the Federal Reserve Bank of Chicago, were mainly a product of local deposit growth and PPP loan forgiveness activities.

The following table depicts the average balance, interest earned and paid, and weighted average rate of our assets, liabilities and shareholders’ equity during 2022, 2021, and 2020. The subsequent table also depicts the dollar amount of change in interest income and interest expense of interest-earning assets and interest-bearing liabilities, respectively, segregated between change due to volume and change due to rate. Tax-exempt securities interest income and yield for 2022, 2021, and 2020 have been computed on a tax equivalent basis using a marginal tax rate of 21.0%. Securities interest income was increased by $0.2 million in 2022, 2021, and 2020 for this non-GAAP, but industry standard, adjustment. These adjustments equated to increases in our net interest margin of less than one basis point during all three years.

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Interest income is primarily generated from the loan portfolio, and to a significantly lesser degree, from securities and other interest-earning assets. Interest income increased $38.3 million during 2022 from that earned in 2021, totaling $182 million in 2022 compared to $144 million in 2021. The increase in interest income is attributable to a higher yield on average earning assets and the positive impact of an increased level of average earning assets. During 2022 and 2021, earning assets had an average yield (tax equivalent-adjusted basis) of 3.82% and 3.19%, respectively. The higher yield on average earning assets mainly resulted from an increased yield on loans and a change in earning asset mix. The increased yield on loans primarily reflected higher interest rates on variable-rate commercial loans stemming from the previously mentioned FOMC rate hikes. On average, lower-yielding interest-earning deposits represented 9.3% of earning assets during 2022, down from 14.9% during 2021, while higher-yielding loans represented 77.8% of earning assets during 2022, up from 73.7% during 2021. Interest-earning deposits decreased $881 million during 2022 as excess overnight funds were used to fund loan growth, brokered deposit and FHLBI advance maturities, and securities purchases. In addition, a customer’s withdrawal of a majority of funds that were deposited in late 2021 following the sale of a business, as well as other fund withdrawals by customers to make customary tax and bonus payments, contributed to the lower level of interest-earning deposits. Improved yields on other interest-earning assets and securities, reflecting the increased interest rate environment, also contributed to the higher yield on average earning assets.

Interest income generated from the loan portfolio increased $31.8 million in 2022 compared to the level earned in 2021. Growth in the loan portfolio during 2022 resulted in a $16.4 million increase in interest income, while an upturn in loan yield from 4.06% in 2021 to 4.50% in 2022 resulted in a $15.4 million increase in interest income. The improved yield on loans mainly resulted from a higher yield on commercial loans, which increased from 4.09% during 2021 to 4.72% during 2022 primarily due to the aforementioned FOMC rate increases. The increase in loan yield during 2022 was achieved despite a significant reduction in PPP net loan fee accretion, which totaled $1.0 million and $10.8 million in 2022 and 2021, respectively.

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Interest income generated from the securities portfolio increased $2.8 million in 2022 compared to the level earned in 2021. Growth in the average balance of the securities portfolio during 2022 resulted in an increase in interest income of $1.5 million, while an increase in the yield on securities from 1.51% during 2021 to 1.72% during 2022 resulted in a $1.3 million increase in interest income. Interest income on interest-earning deposits increased $3.7 million in 2022 from the level earned in 2021; a higher yield on these balances resulted in an increase in interest income of $4.1 million, while a reduction in the average balance of these balances resulted in a decrease in interest income of $0.4 million.

Interest expense is generated from interest-bearing deposits and borrowed funds. Interest expense increased $4.2 million during 2022 from that expensed in 2021, totaling $23.6 million in 2022 compared to $19.4 million in 2021. Growth in the average balance of interest-bearing liabilities during 2022 resulted in an increase in interest expense of $2.4 million, while an increase in the cost of these liabilities resulted in a $1.8 million increase in interest expense. During 2022, interest-bearing liabilities averaged $2.89 billion, representing an increase of $178 million, or 6.6%, from the $2.71 billion average during 2021; average interest-bearing deposits and borrowings were up $90.0 million and $88.0 million, respectively. During 2022 and 2021, interest-bearing liabilities had a weighted average rate of 0.82% and 0.72%, respectively. The higher average cost of interest-bearing liabilities mainly resulted from increased costs of non-time deposit accounts and borrowings, which more than offset a decreased cost of time deposits.

The cost of interest-bearing non-time deposit accounts increased from 0.20% during 2021 to 0.34% during 2022, primarily reflecting higher interest rates paid on money market accounts; the higher interest rates mainly reflected the increased interest rate environment. The cost of borrowed funds increased from 1.71% during 2021 to 1.96% during 2022, primarily reflecting a higher cost of subordinated debentures and the issuance of subordinated notes. The cost of subordinated debentures was 5.89% during 2022, up from 3.80% during 2021, reflecting the increased interest rate environment. Subordinated notes totaling $90 million were issued in December of 2021 and January of 2022, with $85.0 million of the proceeds being injected into Mercantile Bank as an increase to equity capital to support expected loan growth. The cost of time deposits declined from 1.24% during 2021 to 1.02% during 2022 primarily due to lower rates paid on local time deposits.

A higher average rate paid on interest-bearing non-time deposits during 2022 resulted in a $2.5 million increase in interest expense, while $178 million of growth in the average balance of these deposits equated to a $0.4 million increase in interest expense. An $87.6 million decrease in the average balance of time deposits equated to a $1.0 million reduction in interest expense during 2022, while a lower average rate paid on time deposits also resulted in a $1.0 million decrease in interest expense. Interest expense related to short-term borrowings, which are comprised entirely of sweep accounts, increased slightly during 2022 due to a higher rate paid on, along with growth in the average balance of, these funds. A $38.4 million decline in the average balance of FHLBI advances during 2022 resulted in a $0.8 million reduction in interest expense, while a lower average rate paid on these borrowings resulted in a $0.3 million reduction in interest expense. An $84.8 million increase in the average balance of other borrowings, mainly reflecting the previously mentioned issuance of subordinated notes, during 2022 equated to a $3.7 million increase in interest expense, while an increased average rate paid on these borrowings resulted in a $0.5 million increase in interest expense.

Provision for Credit Losses

A provision for credit losses of $6.6 million was recorded during 2022, compared to a negative provision expense of $4.3 million during 2021. The provision expense recorded during 2022 primarily reflected the net increase in required reserve levels resulting from changes to several environmental factors that were implemented mainly in response to heightened inherent risk within the commercial loan and residential mortgage loan portfolios, loan growth, and increased specific reserves for certain distressed loan relationships. A higher reserve for residential mortgage loans stemming from slower principal prepayment rates and the associated extended average life of the portfolio also impacted provision expense during 2022. The negative provision expense recorded during 2021 primarily reflected diminished allocations attributable to improvement in both current and forecasted economic conditions and a net loan recovery, which more than offset required reserve allocations necessitated by loan growth.

During 2022, loan charge-offs totaled $0.3 million, while recoveries of prior period loan charge-offs equaled $1.0 million, providing for net loan recoveries of $0.7 million, or 0.02% of average total loans. During 2021, loan charge-offs totaled $1.0 million, while recoveries of prior period loan charge-offs equaled $2.7 million, providing for net loan recoveries of $1.7 million, or 0.05% of average total loans. The allowance for credit losses, as a percentage of total loans, was 1.1% and 1.0% as of December 31, 2022 and December 31, 2021, respectively.

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Noninterest Income

Noninterest income during 2022 was $32.1 million, compared to $56.2 million during 2021. Noninterest income during 2022 included a $0.5 million bank owned life insurance death benefit claim, while noninterest income during 2021 included a $1.1 million gain on the sale of a branch facility, a $0.6 million recovery of loan collection costs, and $0.5 million in gains on the sales of former branch facilities. Excluding these transactions, noninterest income decreased $22.6 million in 2022 compared to 2021.

The lower level of noninterest income during 2022 primarily stemmed from decreased mortgage banking income, which more than offset growth in several key fee income sources, including service charges on accounts, credit and debit card income, and payroll servicing fees. Reduced interest rate swap income, reflecting lower transaction volume, contributed to the decreased level of noninterest income during 2022. Higher interest rates, lower refinancing activity, a reduced sold percentage, and a decreased gain on sale rate negatively impacted mortgage banking income during 2022. Sustained strength in purchase mortgage originations during 2022 partially mitigated the impact of these factors. The residential mortgage loan sold percentage declined from approximately 68% during 2021 to approximately 35% during 2022. The decreased sold percentage in large part reflects customers’ preferences for adjustable-rate loans in the current interest rate environment and construction loans representing an increased percentage of overall loan production. In aggregate, service charges on accounts, credit and debit card income, and payroll servicing fees were up approximately 13% during 2022 compared to 2021.

Noninterest Expense

Noninterest expense totaled $108 million during 2022, compared to $111 million during 2021. Overhead costs during 2022 included $1.5 million in charitable contributions to The Mercantile Bank Foundation (the “Foundation”) and a $0.3 million net loss on the sale of a former branch facility, while overhead costs during the prior year included $4.0 million in expenses and contributions associated with the formation and initial funding of the Foundation and $0.6 million in net losses on sales and write-downs of former branch facilities. Excluding these transactions, noninterest expense decreased nominally during 2022 compared to 2021.

Compensation-related costs, in large part reflecting higher residential mortgage loan deferred salary costs, reduced residential mortgage lender commissions and associated incentives, and lower stock-based compensation costs, declined in 2022 compared to 2021. The increased residential mortgage loan deferred salary costs reflected the outcome of an updated loan origination cost study and resulting higher allocated cost per loan, while the decreased residential mortgage lender commissions and associated incentives resulted from reduced loan production, in large part reflecting lower refinancing activity. Regular salary costs, primarily reflecting annual merit pay increases and market adjustments, and a bonus accrual were up in 2022. Data processing costs, mainly depicting higher transaction volume and software support costs, and other employee costs, consisting mainly of meals, training, travel, and mileage, also increased in 2022. The higher level of other employee costs primarily reflected the easing of Covid-19 pandemic-related restrictions.

Federal Income Tax Expense

During 2022, we recorded income before federal income tax of $75.8 million and a federal income tax expense of $14.7 million, compared to income before federal income tax of $73.7 million and a federal income tax expense of $14.7 million during 2021. The less than $0.1 million increase in federal income tax expense in 2022 compared to 2021 resulted from the slightly higher level of income before federal income tax. Our effective tax rate was 19.4% during 2022, compared to 19.9% during 2021. The aforementioned bank owned life insurance death benefit claim, substantially all of which was nontaxable, positively impacted the effective tax rate in 2022.

Future changes in tax laws could have a material effect on our business, cash flows, financial condition, results of operations, tax liability, and effective tax rate. On August 16, 2022, the Inflation Reduction Act of 2022 (the “IR Act”) was signed into federal law. The IR Act provides for a new U.S. federal 1% excise tax on certain repurchases of stock by publicly traded U.S. domestic corporations and certain U.S. domestic subsidiaries of publicly traded foreign corporations occurring on or after January 1, 2023. The excise tax is imposed on the repurchasing corporation itself, not its shareholders from which shares are repurchased. The amount of the excise tax is generally 1% of the fair market value of the shares repurchased at the time of the repurchase. However, for purposes of calculating the excise tax, repurchasing corporations are permitted to net the fair market value of certain new stock issuances against the fair market value of stock repurchases during the same taxable year. In addition, certain exceptions apply to the excise tax, such as repurchases under $1 million.

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Any redemption or other repurchase that occurs after December 31, 2022, in connection with a business combination, extension vote, or otherwise, may be subject to the excise tax. Whether and to what extent we would be subject to the excise tax in connection with a business combination, extension vote, or otherwise would depend on a number of factors, including: (i) the fair market value of the redemptions and repurchases in connection with the business combination, extension, or otherwise; (ii) the structure of a business combination; (iii) the nature and amount of any equity issuances in connection with a business combination (or otherwise issued not in connection with a business combination but issued within the same taxable year of a business combination); and (iv) the content of regulations and other guidance from the U.S. Department of the Treasury.

The IR Act also included a new 15% Corporate Alternative Minimum Tax (“CAMT”) that acts as a new book minimum tax of at least 15% of consolidated GAAP pre-tax income for corporations with average book income in excess of $1 billion. Any increase in our effective tax rate will depend on a number of factors, including any offsets for general business credits or changes in book income following business combinations. The CAMT is effective for tax years beginning on or after January 1, 2023. Lastly, the IR Act also creates a number of potentially beneficial tax credits to incentivize investments in certain technologies and industries.

We are in the process of evaluating the potential impacts of the IR Act. While we do not believe the IR Act will have a material negative impact on our business or our financial performance, the effects of the measures are unknown at this time. Our analysis is ongoing and incomplete, and it is possible that the IR Act could ultimately have a material adverse effect on our tax liability. We continue to monitor the IR Act and related regulatory developments to evaluate their potential impact on our business, tax rate, and financial results.

CAPITAL RESOURCES

Shareholders’ equity declined $15.2 million during 2022, totaling $441 million as of December 31, 2022. Positively impacting shareholders’ equity was net income of $61.1 million, while negatively affecting shareholders’ equity were cash dividends on our common stock totaling $19.6 million. Activity relating to the issuance and sale of common stock through various stock-based compensation programs and our dividend reinvestment plan positively impacted shareholders’ equity by a total of $4.7 million. Negatively impacting shareholders’ equity during 2022 was a $61.6 million increase in the after-tax net unrealized loss on available for sale securities.

We and our bank are subject to regulatory capital requirements administered by state and federal banking agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. As of December 31, 2022, our bank’s total risk-based capital ratio was 13.7%, compared to 13.6% at December 31, 2021. Our bank’s total regulatory capital increased $66.9 million during 2022, primarily reflecting the net impact of net income totaling $70.2 million, a $15.0 million equity capital injection from us in association with the $15.0 million issuance of subordinated notes in January 2022, and cash dividends paid to us aggregating $26.0 million. Our bank’s total risk-based capital ratio was also impacted by a $482 million increase in total risk-weighted assets, in large part reflecting growth in commercial loans and residential mortgage loans. As of December 31, 2022, our bank’s total regulatory capital equaled $619 million, or approximately $166 million in excess of the amount necessary to attain the 10.0% minimum total risk-based capital ratio, which is among the requirements to be categorized as “well capitalized.”

We maintain a stock repurchase program, which is discussed in Part II, Item 5 “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” in this Annual Report.

LIQUIDITY

Liquidity is measured by our ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment of loans and securities. These funds are used to fund loans, meet deposit withdrawals, maintain reserve requirements and operate our company. Liquidity is essential to our business. An inability to maintain sufficient funds through deposits, borrowings, the sale of assets, and other sources could have a material adverse effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Liquidity is primarily achieved through local and out-of-area deposits and liquid assets such as securities available for sale, matured and called securities, federal funds sold, and interest-earning deposit balances. Asset and liability management is the process of managing the balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity.

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To assist in providing needed funds, we have regularly obtained monies from wholesale funding sources. Wholesale funds, comprised of deposits from customers outside of our market areas and advances from the FHLBI, totaled $308 million, or 7.3% of combined deposits and borrowed funds as of December 31, 2022, compared to $398 million, or 8.5% of combined deposits and borrowed funds, as of December 31, 2021. We had no out-of-area deposits as of December 31, 2022, compared to $23.9 million as of December 31, 2021.

Sweep accounts decreased $3.1 million during 2022, totaling $194 million as of December 31, 2022. The aggregate balance of this funding type can be subject to relatively large daily fluctuations given the nature of the customers utilizing this product and the sizable balances that many of the customers maintain. The average balance of sweep accounts equaled $200 million during 2022, with a high balance of $236 million and a low balance of $173 million. Our sweep account program entails transferring collected funds from certain business noninterest-bearing checking accounts to overnight interest-bearing repurchase agreements. Such repurchase agreements are not deposit accounts and are not afforded federal deposit insurance. All of our repurchase agreements are accounted for as secured borrowings.

Information regarding our repurchase agreements as of December 31, 2022 and during 2022 is as follows:

FHLBI advances declined $65.7 million during 2022, totaling $308 million as of December 31, 2022. Advance maturities aggregating $94.0 million were not replaced as the funds were no longer needed, while advances totaling $28.3 million were obtained to match-fund fixed rate longer term commercial lending relationships. FHLBI advances are primarily used to assist in funding loan demand, as well as playing an integral role in our interest rate risk management program. FHLBI advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on certain commercial real estate property loans, and substantially all other assets of our bank under a blanket lien arrangement. Based on collateral, our aggregate borrowing capacity at year-end 2022 totaled $1.03 billion, with availability of $713 million.

We also have the ability to borrow up to $70.0 million on a daily basis through correspondent banks using established unsecured federal funds purchased lines of credit, with an average balance of less than $0.1 million during 2022. In contrast, our interest-earning deposit account at the Federal Reserve Bank of Chicago averaged $439 million during 2022. We have a line of credit through the Discount Window of the Federal Reserve Bank of Chicago. Based on pledged municipal bonds, we could have borrowed up to $27.2 million at December 31, 2022. We have not utilized this line of credit in over ten years, and we do not plan to access this line of credit in future periods.

The following table reflects, as of December 31, 2022, significant fixed and determinable contractual obligations to third parties by payment date, excluding accrued interest:

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In addition to normal loan funding and deposit flow, we must maintain liquidity to meet the demands of certain unfunded loan commitments and standby letters of credit. At December 31, 2022, we had a total of $1.88 billion in unfunded loan commitments and $23.5 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $1.56 billion were commitments available as lines of credit to be drawn at any time as customers’ cash needs vary, and $330 million were for loan commitments generally expected to be accepted and become funded within the next 12 to 18 months. We regularly monitor fluctuations in loan balances and commitment levels, and include such data in our liquidity management.

The following table depicts our loan commitments at the end of the past three years:

We monitor our liquidity position and funding strategies on an ongoing basis, but recognize that unexpected events, economic or market conditions, reductions in earnings performance, declining capital levels, or situations beyond our control could cause liquidity challenges. While we believe it is unlikely that a funding crisis of any significant degree is likely to materialize, we have developed a comprehensive contingency funding plan that provides a framework for meeting liquidity disruptions.

MARKET RISK ANALYSIS

Our primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk and inflation risk. All of our transactions are denominated in U.S. dollars with no specific foreign exchange exposure. We have only limited agricultural-related loan assets and therefore have no significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates is assumed to be insignificant. Interest rate risk is the exposure of our financial condition to adverse movements in interest rates.

Inflation risk is the risk that the values of assets or income from investments will be worth less in the future as inflation decreases the value of money. Recently, there has been a pronounced rise in inflation. As a result, the FOMC has significantly increased interest rates and has indicated its intention to continue doing so in an effort to combat inflation. As inflation increases, the value of our investment securities, particularly those with fixed rates and longer maturities, declines. In addition, inflation increases salary and benefit costs, as well as the cost of goods and services we use in our business operations, such as electricity and other utilities, which increases our noninterest expenses. Furthermore, our customers are also affected by inflation and the rising costs of goods and services used in their households and businesses, which could have a negative impact on their ability to repay their loans with us.

We derive our income primarily from the excess of interest collected on interest-earning assets over the interest paid on interest-bearing liabilities. The rates of interest we earn on our assets and owe on our liabilities generally are established contractually for a period of time. Since market interest rates change over time, we are exposed to lower profitability if we cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to our earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to our safety and soundness.

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Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. Our interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems, and internal controls are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, we assess the existing and potential future effects of changes in interest rates on our financial condition, including capital adequacy, earnings, liquidity, and asset quality.

We use two interest rate risk measurement techniques. The first, which is commonly referred to as GAP analysis, measures the difference between the dollar amounts of interest-sensitive assets and liabilities that will be refinanced or repriced during a given time period. A significant repricing gap could result in a negative impact to the net interest margin during periods of changing market interest rates.

The following table depicts our GAP position as of December 31, 2022:

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The second interest rate risk measurement used is commonly referred to as net interest income simulation analysis. We believe that this methodology provides a more accurate measurement of interest rate risk than the GAP analysis, and therefore, it serves as our primary interest rate risk measurement technique. The simulation model assesses the direction and magnitude of variations in net interest income resulting from potential changes in market interest rates.

Key assumptions in the model include prepayment speeds on various loan and investment assets; cash flows and maturities of interest-sensitive assets and liabilities; and changes in market conditions impacting loan and deposit volume and pricing. These assumptions are inherently uncertain and subject to fluctuation and revision in a dynamic environment; therefore, the model cannot precisely estimate net interest income or exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions and our strategies, among other factors.

We conducted multiple simulations as of December 31, 2022, in which it was assumed that changes in market interest rates occurred ranging from up 300 basis points to down 300 basis points in equal quarterly instalments over the next twelve months. The following table reflects the suggested dollar and percentage changes in net interest income over the next twelve months in comparison to the $185 million in net interest income projected using our balance sheet amounts and anticipated replacement rates as of December 31, 2022. The resulting estimates are generally within our policy parameters established to manage and monitor interest rate risk.

In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including: the growth, composition, and absolute levels of loans, deposits, and other earning assets and interest-bearing liabilities; level of nonperforming assets; economic and competitive conditions; potential changes in lending, investing, and deposit gathering strategies; client preferences; and other factors.

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