MERCANTILE BANK CORP (MBWM) FY 2023 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 national and local economies, and unstable political and economic environments; and risk factors described in our annual report on Form 10-K for the year ended December 31, 2023. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement.

Discussions of 2021 items and year-to-year comparisons between 2022 and 2021 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, 2022.

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 expected in the loan portfolio. Our evaluation of the adequacy of the allowance is an estimate based on historical credit 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. While historical credit loss experience provides the basis for the estimation of expected credit losses, our qualitative model adjusts for risk factors that are not inherently considered in the quantitative modeling process, but are nonetheless relevant in assessing the expected credit losses within the loan portfolio. These adjustments may increase or decrease the estimate of expected credit losses based upon the assessed level of risk for each qualitative factor. The various risks that may be considered in making qualitative adjustments include, among other things, the impact of (i) changes in lending policies and procedures, (ii) changes in the nature and volume of the loan portfolio and in the terms of loans, (iii) changes in the experience, ability and depth of lending management and staff, (iv) changes in the volume and severity of past due loans, nonaccrual loans and adversely classified loans, (v) changes in the quality of the credit review function, (vi) changes in the value of underlying collateral dependent loans, (vii) existence and effect of any concentrations of credit and any changes in such, and (viii) effect of other factors such as competition and legal and regulatory requirements.

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.

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 lives of the mortgage loan pools, 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 subsidiaries, Mercantile Bank (“our bank”) and Mercantile Community Partners LLC ("MCP"), 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. 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 during 2021 and 2022 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 both years.

The Paycheck Protection Program (“PPP”) reflected a substantial expansion of the Small Business Administration’s 100% guaranteed 7(a) loan program. The PPP provided 100% guaranteed loans to cover specific operating costs. PPP loans were eligible to be forgiven based upon certain criteria. Any remaining balance after forgiveness is maintained at the 100% guarantee for the duration of the loan. The interest rate on the loan is fixed at 1.00%, with the financial institution receiving a loan origination fee from the Small Business Administration. The loan origination fees, net of the direct origination costs, are accreted into interest income on loans using the level yield methodology. The program ended on August 8, 2020. We originated approximately 2,200 loans aggregating $554 million. As of December 31, 2023, we recorded forgiveness transactions on all but four loans aggregating $0.1 million. The Consolidated Appropriations Act, 2021 authorized an additional $284 billion in Second Draw PPP loans (“Second Draw”). This program ended on May 31, 2021. Under the Second Draw, we originated approximately 1,200 loans aggregating $209 million. As of December 31, 2023, we recorded forgiveness transactions on all but five loans aggregating $0.2 million.

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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 three times during 2023. Highlights for 2023 included establishing Mercantile Community Partners LLC to facilitate low-income housing tax credits, hiring a fulltime Director of Learning to better develop our employees, engaging a new provider to improve our ESG data gathering and reporting, incorporating a member of our Bank’s Young Professional resource group as a member of the ESG Committee, and rolling out a new Green Mortgage Lending Program to support homeowners looking to make environmentally sustainable home improvements. Our bank also developed a Clawback Policy; an Insider Trading Policy; Corporate Governance Guidelines; an Anti-Bribery and Anti-Corruption Policy; and an Anti-Money Laundering, Bank Secrecy Act, Customer Identification and Due Diligence Programs Letter. These and our other policies (including our Vendor and Supplier Code of Conduct, 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 and can be found on our website.

FINANCIAL OVERVIEW

We recorded net income of $82.2 million, or $5.13 per basic and diluted share, for 2023, compared with net income of $61.1 million, or $3.85 per basic and diluted share, for 2022. Higher net interest income, stemming from an improved net interest margin and ongoing strong loan growth, combined with continued strength in asset quality metrics more than offset higher overhead costs.

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Commercial loans increased $283 million, or approximately 9%, during 2023. Owner-occupied commercial real estate (“CRE”) loans grew $78.5 million, commercial and industrial loans increased $69.5 million, multi-family and residential rental property loans were up $66.1 million, nonowner-occupied CRE loans grew $56.5 million, and vacant land, land development, and residential construction loans increased $12.9 million. As a percentage of total commercial loans, commercial and industrial loans and owner-occupied CRE loans combined equaled 57.7% at December 31, 2023, compared to 58.2% at year-end 2022. The new commercial loan pipeline remains strong, and at December 31, 2023, we had $343 million in unfunded loan commitments on commercial construction and development loans that are in the construction phase.

Residential mortgage loans increased $120 million, or approximately 17%, during 2023. The higher residential mortgage loan interest rates during 2023 and 2022 resulted 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. Approximately 53% and 35% of our residential mortgage loan production was comprised of longer-term fixed rate loans during 2023 and 2022, respectively, compared to about 68% during 2021. The shift in production mix resulted in residential mortgage loans comprising a larger percentage of total loans, increasing from about 13% at year-end 2021 to approximately 20% at December 31, 2023. The shift in product mix also 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 0.08% of total loans as of December 31, 2023. Accruing loans past due 30 to 89 days remain very low, as did foreclosed property activity throughout 2023.  Loan charge-offs totaled $0.9 million during 2023, while recoveries of prior period loan charge-offs totaled $0.8 million, providing for net loan charge-offs of $0.1 million, or less than 0.01% of average total loans, for the year.

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.  The average balance of these funds equaled $107 million, or 2.2% of average earning assets, during 2023, compared to $445 million, or 9.3% of average earning assets, during 2022. Typically, we maintain interest-earning deposits at approximately $75 million, or about 2% of average earning assets. The elevated level during 2022 primarily reflected increased local deposits stemming from Covid-19-related federal government stimulus programs and reduced business and consumer investing and spending during 2021 and into 2022.  The level of interest-earning deposits was on a declining trend throughout 2022 as excess monies were used to fund loan growth and securities purchases, as well as out-of-area deposit and Federal Home Loan Bank of Indianapolis (“FHLBI”) advance maturities. We also experienced a decline in local deposits throughout 2022.

Total deposits increased $188 million during 2023, and totaled $3.90 billion at December 31, 2023. Local deposits increased $19.7 million, and out-of-area deposits grew $168 million, during 2023. FHLBI advances increased $160 million during 2023.  The combined $328 million increase in wholesale funds during 2023 was primarily used to fund loan growth.

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Net interest income increased $35.3 million during 2023 compared to 2022.  Interest income was up $89.5 million, in large part resulting from the combined impact of a higher yield on earning assets reflecting a higher interest rate environment and ongoing loan growth. Interest expense was up $54.2 million, in large part reflecting the higher interest rate environment, transfers of deposit balances from no- or low-cost deposit products to higher-costing deposit products and a higher level of wholesale funds.

We recorded a credit loss provision expense of $7.7 million during 2023, compared to $6.6 million during 2022. The provision expense recorded during 2023 was necessitated by the net increase in required reserve levels stemming from loan growth, slower residential mortgage loan prepayment speeds and a modification to the environmental factor grid, which were partially mitigated by the elimination of a specific reserve on a troubled commercial lending relationship that paid-off in full in early 2023 and a change in the segmentation of the home equity lines of credit and credit card portfolios.

Noninterest income was virtually the same during 2023 when compared to 2022. We continued to record growth in treasury management-related fee income categories, such as credit and debit card income and payroll processing, along with increases in interest rate swap income, which mitigated a reduction in service charges on accounts due to increased earnings credit rates on noninterest-bearing checking accounts and lower mortgage banking income reflecting the higher interest rate environment.

Noninterest expense increased $7.3 million during 2023 compared to 2022. Aggregate salary and benefit costs grew $3.7 million, with additional increases recorded for FDIC insurance premiums, swap collateral holding costs and allocations to the reserve for unfunded loan commitments.

FINANCIAL CONDITION

Our total assets increased $481 million during 2023, and totaled $5.35 billion as of December 31, 2023.  Total loans increased $387 million, securities available for sale were up $14.2 million, and interest-earning deposits grew $25.2 million.  Total deposits increased $188 million, FHLBI advances were up $160 million, and shareholders’ equity grew $80.7 million.

Earning Assets

Average earning assets equaled 94.4% of average total assets during 2023, compared to 94.3% during 2022.  The loan portfolio continued to comprise a majority of earning assets, followed by securities and interest-earning deposits.  Average total loans equaled 84.7% of average earning assets during 2023, compared to 77.8% in 2022, while average securities and interest-earning deposits comprised 13.1% and 2.2% of average earning assets during 2023 and 12.9% and 9.3% of average earning assets during 2022, respectively.

Our loan portfolio has historically been primarily comprised of commercial loans. Commercial loans increased $283 million, or approximately 9%, during 2023.  Owner-occupied CRE loans grew $78.5 million, commercial and industrial loans increased $69.5 million, multi-family and residential rental property loans were up $66.1 million, nonowner-occupied CRE loans grew $56.5 million, and vacant land, land development, and residential construction loans increased $12.9 million.  As a percentage of total commercial loans, commercial and industrial loans and owner-occupied CRE loans combined equaled 57.7% at December 31, 2023, compared to 58.2% at year-end 2022. We believe our commercial loan portfolio remains well diversified.

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As of December 31, 2023, availability on commercial construction and development loans that are in the construction phase totaled $343 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 $270 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 2023 at approximately 40%, similar to that of 2022 but lower than our historical average of 47%.

Residential mortgage loans totaled $837 million, or 19.5% of total loans, at December 31, 2023, compared to $718 million, or 18.3% of total loans, as of December 31, 2022. Residential mortgage loans increased $120 million, or approximately 17%, during 2023. We originated $386 million in residential mortgage loans during 2023, compared to $614 million and $952 million in 2022 and 2021, respectively. The decline over the past two years primarily reflected significantly higher residential mortgage loan interest rates, resulting in a substantial reduction of refinancing activity.  Production associated with refinancing activity totaled $59.8 million and $134 million in 2023 and 2022, respectively, compared to $458 million in 2021. The higher residential mortgage loan interest rates during 2023 and 2022 resulted 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. Approximately 53% and 35% of our residential mortgage loan production was comprised of longer-term fixed rate loans during 2023 and 2022, respectively, compared to about 68% during 2021.  The shift in production mix has resulted in residential mortgage loans comprising a larger percentage of total loans, increasing from about 13% at year-end 2021 to 19.5% at December 31, 2023. The shift in product mix also 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 totaled $51.1 million, or 1.1% of total loans, at December 31, 2023. 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 the commercial loan and residential mortgage loan portfolios grow.

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The following table presents total loans outstanding as of December 31, 2023, 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.

Nonperforming loans totaled $3.4 million, or 0.1% of total loans, as of December 31, 2023, compared to $7.7 million, or 0.2% of total loans, as of December 31, 2022. Nonperforming assets, comprised of nonaccrual loans, loans past due 90 days or more and accruing interest and foreclosed properties, totaled $3.6 million (0.1% of total assets) as of December 31, 2023, compared to $7.7 million (0.2% of total assets) as of December 31, 2022. 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 five 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.

Loan charge-offs totaled $0.9 million during 2023, while recoveries of prior period loan charge-offs totaled $0.8 million, providing for net loan charge-offs of $0.1 million, or less than 0.01% of average total loans, for the year. 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.  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 reflects the composition of our allowance for credit loss, nonaccrual loans, and net charge-offs as of and for the year ended December 31, 2023.

The following table reflects the composition of our allowance for credit loss, nonaccrual loans, and net charge-offs as of and for the year ended December 31, 2022.

The following table reflects the composition of our allowance for loan loss, nonaccrual loans, and net charge-offs as of and for the year ended December 31, 2021.

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

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.

The allowance equaled $49.9 million, or 1.16% of total loans, and over 1,400% of nonperforming loans, as of December 31, 2023. As of December 31, 2023, the allowance was comprised of $49.4 million in general reserves relating to performing loans and $0.5 million in specific reserves on other loans, primarily nonperforming loans.  Loans with an aggregate carrying value of $0.4 million as of December 31, 2023 had been subject to previous partial charge-offs aggregating $0.4 million over the past several years.  As of December 31, 2023, there were no specific reserves allocated to loans that had been subject to a previous partial charge-off.

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 $14.2 million during 2023, totaling $617 million as of December 31, 2023.  There were no purchases of U.S. Government agency bonds during 2023; proceeds from matured U.S. Government agency bonds totaled $12.0 million.  There were no purchases of U.S. Government agency guaranteed mortgage-backed securities during 2023; principal paydowns on U.S. Government agency guaranteed mortgage-backed securities totaled $2.8 million.  Purchases of municipal bonds totaled $19.9 million during 2023; proceeds from matured municipal bonds totaled $9.4 million.  At December 31, 2023, the portfolio was primarily comprised of U.S. Government agency bonds (63%), municipal bonds (32%), 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, 2023 totaled $617 million, including a net unrealized loss of $63.9 million.  The net unrealized loss equaled $82.7 million as of December 31, 2022. 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. 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 10% to 12% of total assets.

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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 $21.5 million as of December 31, 2023, compared to $17.7 million as of December 31, 2022.  The $3.8 million increase reflects additional stock purchased in association with an increase in outstanding advances during 2023.  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, 2023 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.  The average balance of these funds equaled $107 million, or 2.2% of average earning assets, during 2023, compared to $445 million, or 9.3% of average earning assets, during 2022.  Typically, we maintain interest-earning deposits at approximately $75 million, or about 2% of average earning assets. The elevated level during 2022 primarily reflected increased local deposits stemming from Covid-19-related federal government stimulus programs and reduced business and consumer investing and spending during 2021 and into 2022. The level of interest-earning deposits was on a declining trend throughout 2022 as excess monies were used to fund loan growth and securities purchases, as well as out-of-area deposit and FHLBI advance maturities. We also experienced a decline in local deposits throughout 2022.

Non-Earning Assets

Cash and due from bank balances averaged 1.2% of total assets during 2023, similar to the average level during 2022, and no significant changes are expected in future periods.  Net premises and equipment equaled $50.9 million at December 31, 2023, representing a decrease of $0.5 million during 2023. In large part, aggregate investments in new and existing offices approximated depreciation expense.  Other real estate owned as of December 31, 2023 equaled $0.2 million, and consisted of property associated with a former branch location.

Other assets equaled $126 million at December 31, 2023, reflecting an increase of $30.0 million during 2023. The increase is primarily associated with an aggregate $22.5 million investment in low-income housing tax credits.

Source of Funds

Total deposits increased $188 million during 2023, and totaled $3.90 billion at December 31, 2023. Local deposits increased $19.7 million, and out-of-area deposits grew $168 million, during 2023. FHLBI advances increased $160 million during 2023.  The combined $328 million increase in wholesale funds during 2023 was primarily used to fund loan growth.

Noninterest-bearing checking accounts declined $357 million during 2023, in large part reflecting transfers to interest-bearing deposit accounts and withdrawals associated with the sales of businesses.  Interest-bearing checking accounts increased $60.8 million, generally resulting from transfers from noninterest-bearing checking accounts.  Savings deposits declined $119 million, primarily reflecting the transfers of funds to higher-paying money market deposit accounts and time deposits.  Money market deposit accounts increased $181 million, in large part reflecting growth in deposits from existing and new municipal depositors, as well as from transfers from no- and low-cost deposit products.  Local time deposits increased $254 million, primarily reflecting transfers of funds from no- and low-cost deposit products.  Out-of-area deposits during 2023 grew by, and totaled, $168 million as of December 31, 2023.

As of both December 31, 2023 and 2022, approximately $1.9 billion of our deposit portfolio was uninsured. The uninsured amounts are estimates based on the methodologies and assumptions used by Mercantile Bank's regulatory reporting requirements.

The balance of certificates of deposit exceeding the FDIC insured limit and their maturity profile as of December 31, 2023 are as follows:

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Securities sold under agreements to repurchase (“sweep accounts”) increased $35.4 million during 2023, totaling $230 million as of December 31, 2023.  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 $204 million during 2023, with a high balance of $269 million and a low balance of $135 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 sweep accounts are accounted for as secured borrowings.

FHLBI advances increased $160 million during 2023, totaling $468 million as of December 31, 2023.  Bullet advances aggregating $240 million were obtained during 2023, consisting of $160 million to fund loan growth and $80.0 million to replace FHLBI bullet advance maturities.  Payments on amortizing FHLBI advances totaled $0.4 million during 2023.  FHLBI bullet advances are generally obtained to provide funds for loan growth and are used to assist in managing interest rate risk, while amortizing FHLBI advances are generally acquired to match-fund specific longer-term fixed rate commercial loans, with the dollar amount and amortization structure of the underlying advances reflective of the associated commercial loans.  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 2023 totaled $903 million, with remaining availability based on collateral of $429 million.

Shareholders’ equity increased $80.7 million during 2023, totaling $522 million as of December 31, 2023.  Positively impacting shareholders’ equity was net income of $82.2 million, while negatively affecting shareholders’ equity were cash dividends on our common stock totaling $21.0 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.  Positively impacting shareholders’ equity during 2023 was a $14.9 million decline in the after-tax net unrealized loss on available for sale securities.

RESULTS OF OPERATIONS

FOR THE YEARS ENDED December 31, 2023 and 2022

Summary

We recorded net income of $82.2 million, or $5.13 per basic and diluted share, for 2023, compared to net income of $61.1 million, or $3.85 per basic and diluted share, for 2022. Diluted earnings per share increased $1.28, or 33.2%, during 2023 compared to 2022.

The increase in net income during 2023 compared to 2022 primarily reflected improved net interest income, which more than offset higher levels of noninterest expense and provisions for credit losses.  The growth in net interest income mainly stemmed from an increased net interest margin and loan growth.  Overhead costs were up in 2023 primarily due to higher salary expense, reflecting annual merit pay increases and market adjustments, along with lower residential mortgage loan deferred salary costs.  The provision expense recorded during 2023 mainly reflected allocations necessitated by net loan growth, slower residential mortgage loan prepayment rates and the related extended average life of the portfolio, and changes in environmental factors depicting heightened inherent risk in the commercial construction loan portfolio.  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 also impacted provision expense during 2022.  Excluding nonrecurring transactions, noninterest income was up marginally during 2023 compared to the prior year as increases in credit and debit card income, interest rate swap income, payroll processing fees, and bank owned life insurance income, as well as the improved performance of an equity fund investment, were in large part offset by decreased mortgage banking income and service charges on accounts.

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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 $272 million and $77.8 million, respectively, during 2023, providing for net interest income of $194 million.  During 2022, interest income and interest expense equaled $182 million and $23.6 million, respectively, providing for net interest income of $158 million.  In comparing 2023 with 2022, interest income increased 49.2%, interest expense was up 230%, and net interest income increased 22.3%. 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 $35.3 million increase in net interest income in 2023 compared to 2022 primarily resulted from an improved net interest margin and loan portfolio expansion.  During 2023, the net interest margin equaled 4.05%, up from 3.33% during 2022 due to a higher yield on average earning assets, which more than offset an increase in the cost of funds.  The yield on average earning assets was 5.68% during 2023, an increase from 3.82% during 2022.  The higher yield on average earning assets primarily resulted from an increased yield on loans.  The yield on loans was 6.25% during 2023, up from 4.50% during 2022 mainly due to higher interest rates on variable-rate commercial loans resulting from the FOMC substantially raising the targeted federal funds rate in an effort to reduce elevated inflation levels.  The FOMC increased the targeted federal funds rate by 525 basis points during the period of March 2022 through July 2023, during which time average variable-rate commercial loans represented approximately 64% of average total commercial loans.  Improved yields on other interest-earning assets and securities, reflecting the increased interest rate environment, and a change in earning asset mix, consisting of an increase in higher-yielding loans as a percentage of total earning assets, also contributed to the enhanced yield on earning assets.  During 2023, earning assets averaged $4.78 billion, up slightly from $4.77 billion during 2022.  Average loans increased $340 million, average other interest-earning assets declined $339 million, and average securities were up $13.5 million.  The cost of funds rose from 0.49% in 2022 to 1.63% in 2023 primarily due to higher costs of deposits and borrowings, stemming from the increased interest rate environment, and a change in funding mix, mainly consisting of a decrease in noninterest-bearing and lower-cost deposits and an increase in time deposits, reflecting deposit migration and new deposit relationships.

The following table depicts the average balance, interest earned and paid, and weighted average rate of our assets, liabilities and shareholders’ equity during 2023, 2022, and 2021.  The subsequent table portrays 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 2023, 2022, and 2021 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 2023, 2022, and 2021 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, which is primarily generated from the loan portfolio, increased $89.5 million during 2023 from that earned in 2022, totaling $272 million in 2023 compared to $182 million in 2022.  The increase in interest income is mainly attributable to a higher yield on average earning assets and the positive impact of an increased level of average loans.  During 2023 and 2022, earning assets had an average yield (tax equivalent-adjusted basis) of 5.68% and 3.82%, respectively.  The improved yield on average earning assets primarily resulted from an increased yield on loans, mainly reflecting higher interest rates on variable-rate commercial loans stemming from the previously mentioned FOMC rate hikes.  Enhanced yields on other interest-earning assets and securities, reflecting the increased interest rate environment, and a change in earning asset mix, consisting of an increase in higher-yielding loans as a percentage of total earning assets, also contributed to the improved yield on average earning assets.  Higher-yielding loans represented 84.7% of earning assets during 2023, up from 77.8% during 2022.

Interest income generated from the loan portfolio increased $86.3 million in 2023 compared to the level earned in 2022.  An upturn in loan yield from 4.50% in 2022 to 6.25% in 2023 resulted in a $69.8 million increase in interest income, while growth in the loan portfolio during 2023 resulted in a $16.5 million increase in interest income.  The improved yield on loans mainly resulted from a higher yield on commercial loans, which increased from 4.72% during 2022 to 6.84% during 2023 primarily due to the aforementioned FOMC rate increases.

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Interest income generated from the securities portfolio increased $2.4 million in 2023 compared to the level earned in 2022.  A rise in the yield on securities from 1.72% during 2022 to 2.06% during 2023 resulted in a $1.9 million increase in interest income, while growth in the average balance of the securities portfolio during 2023 resulted in an increase in interest income of $0.5 million.  Interest income on other interest-earning assets increased $0.9 million in 2023 from the level earned in 2022; a higher yield on these balances resulted in an increase in interest income of $6.7 million, while a reduction in the average balance of these balances resulted in a decrease in interest income of $5.8 million.

Interest expense is generated from interest-bearing deposits and borrowed funds.  Interest expense increased $54.2 million during 2023 from that expensed in 2022, totaling $77.8 million in 2023 compared to $23.6 million in 2022.  An increase in the cost of interest-bearing liabilities from 0.82% during 2022 to 2.47% during 2023 resulted in an increase in interest expense of $49.5 million, while growth in the average balance of these liabilities during 2023 resulted in a $4.7 million increase in interest expense.  During 2023, interest-bearing liabilities averaged $3.16 billion, representing an increase of $267 million, or 9.2%, from the $2.89 billion average during 2022; average interest-bearing deposits and borrowings were up $188 million and $78.9 million, respectively.  During 2023 and 2022, interest-bearing liabilities had a weighted average rate of 2.47% and 0.82%, respectively.  The higher average cost of interest-bearing liabilities mainly resulted from increased costs of deposit accounts.  A higher cost of borrowings, along with a change in interest-bearing liability mix, also contributed to the increased average cost of interest-bearing liabilities.

The cost of interest-bearing non-time deposit accounts increased from 0.34% during 2022 to 1.94% during 2023, primarily reflecting higher interest rates paid on money market accounts; the higher interest rates mainly reflected the increased interest rate environment.  The cost of time deposits rose from 1.02% during 2022 to 3.55% during 2023 due to higher rates paid on time deposits, reflecting the increased interest rate environment, and a change in mix, consisting of an increase in higher-cost out-of-area deposits.  During 2023, approximately $191 million in out-of-area time deposits were obtained to increase on-balance sheet liquidity and offset loan growth, seasonal deposit withdrawals, and wholesale fund maturities.  The cost of borrowed funds increased from 1.96% during 2022 to 2.90% during 2023, mainly reflecting higher costs of FHLBI advances, sweep accounts, and subordinated debentures stemming from the increased interest rate environment.

A higher average rate paid on interest-bearing non-time deposits during 2023 resulted in a $28.8 million increase in interest expense, while growth of $5.4 million in the average balance of these deposits equated to a $0.4 million increase in interest expense.  An increase in the average rate paid on time deposits during 2023 resulted in a $13.6 million increase in interest expense, while growth of $183 million in the average balance of these deposits resulted in a $2.6 million increase in interest expense.  The $2.6 million increase in interest expense on short-term borrowings during 2023 almost exclusively stemmed from higher rates paid on sweep accounts.  A higher average rate paid on FHLBI advances during 2023 resulted in a $2.6 million increase in interest expense, while growth of $71.2 million in the average balance of advances resulted in a $1.6 million increase in interest expense.  During 2023, FHLBI advances totaling $240 million were obtained to augment on-balance sheet liquidity and offset loan expansion, seasonal deposit withdrawals, and wholesale fund maturities.  The $2.0 million increase in interest expense on other borrowings almost completely resulted from an increased average rate paid on these borrowings.

Provision for Credit Losses

Provisions for credit losses of $7.7 million and $6.6 million were recorded during 2023 and 2022, respectively.  The provision expense recorded during 2023 primarily reflected allocations necessitated by net loan growth, slower residential mortgage loan prepayment rates and the associated extended average life of the portfolio, and changes in environmental factors reflecting heightened inherent risk in the commercial construction loan portfolio.  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 higher levels of 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 also impacted provision expense during 2022.  Sustained strength in loan quality metrics, including low levels of loan charge-offs, during 2023 and 2022 significantly mitigated the amount of additional reserves imposed by the previously mentioned factors.  Economic forecasts were relatively stable during 2023 and 2022.

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Noninterest Income

Noninterest income during 2023 was $32.1 million, representing a marginal increase from the amount recorded during 2022. Gains on sales of other real estate owned totaling $0.4 million were included in noninterest income during 2023, while a bank owned life insurance claim of $0.5 million was included in noninterest income during 2022. Excluding these transactions, noninterest income increased $0.2 million in 2023 compared to 2022.  The higher level of noninterest income during 2023 mainly reflected increased credit and debit card income, interest rate swap income, bank owned life insurance income, and payroll processing fees and the improved performance of an equity fund investment, which more than offset decreased mortgage banking income and service charges on accounts. The growth in credit and debit card income and payroll servicing fees during 2023 primarily resulted from the successful marketing of products and services to existing and new customers. The reduction in mortgage banking income mainly stemmed from lower production, the impact of which was partially offset by a higher loan sold percentage, which increased from approximately 35% during 2022 to nearly 53% during 2023. The decline in service charges on accounts year over year reflected a higher earnings credit rate in response to the increasing interest rate environment.

Noninterest Expense

Noninterest expense during 2023 was $115 million, compared to $108 million during 2022.  Overhead costs during 2023 included contributions to The Mercantile Bank Foundation (the “Foundation”), a loss on the sale of a former branch facility, and one-time employee benefit and facility-related costs totaling $1.8 million, while overhead costs during 2022 included contributions to the Foundation and a loss on the sale of a former branch facility totaling $1.8 million.  Excluding these transactions, the increase in noninterest expense during 2023 primarily resulted from higher salary and benefit costs, largely reflecting annual merit pay increases, market adjustments, lower residential mortgage loan deferred salary costs, an increased bonus accrual, and higher health insurance claims, which more than offset reduced residential mortgage lender commissions and incentives mainly stemming from decreased loan production.  The increase in overhead costs during 2023 also resulted from higher allocations to the reserve for unfunded loan commitments and increased levels of Federal Deposit Insurance Corporation (“FDIC”) deposit insurance premiums, interest rate swap collateral holding costs, and occupancy costs.  The increase in FDIC deposit insurance premiums primarily resulted from an increased industry-wide assessment rate, while the higher occupancy costs mainly stemmed from increased rent expense attributable to office openings.

Federal Income Tax Expense

During 2023, we recorded income before federal income tax of $103 million and a federal income tax expense of $20.5 million, compared to income before federal income tax of $75.8 million and a federal income tax expense of $14.7 million during 2022.  The $5.8 million increase in federal income tax expense in 2023 compared to 2022 primarily resulted from the higher level of income before federal income tax.  In addition, our election to apply the proportional amortization method to our tax credit equity investments during 2023 resulted in $0.5 million in tax expense being recorded during the year.  Amortization costs related to tax credit equity investments were included in noninterest expense in prior years.  Our effective tax rate was 19.9% during 2023, compared to 19.4% during 2022.  The tax credit equity investments-related tax election negatively impacted the effective tax rate in 2023, while the aforementioned bank owned life insurance death benefit claim, substantially all of which was nontaxable, positively impacted the effective tax rate in 2022.

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CAPITAL RESOURCES

Shareholders’ equity increased $80.7 million during 2023, totaling $522 million as of December 31, 2023.  Positively impacting shareholders’ equity was net income of $82.2 million, while negatively affecting shareholders’ equity were cash dividends on our common stock totaling $21.0 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.  Positively impacting shareholders’ equity during 2023 was a $14.9 million decline 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, 2023, our bank’s total risk-based capital ratio was 13.4%, compared to 13.7% at December 31, 2022.  Our bank’s total regulatory capital increased $75.7 million during 2023, primarily reflecting the net impact of net income totaling $92.5 million and cash dividends paid to us aggregating $26.0 million.  Our bank’s total risk-based capital ratio was also impacted by a $644 million increase in total risk-weighted assets, in large part reflecting growth within the commercial lending function.  As of December 31, 2023, our bank’s total regulatory capital equaled $694 million, or approximately $177 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, 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 $636 million, or 13.8% of combined deposits and borrowed funds as of December 31, 2023, compared to $308 million, or 7.3% of combined deposits and borrowed funds, as of December 31, 2022. We had $168 million in out-of-area deposits as of December 31, 2023, compared to none as of year-end 2022.

Sweep accounts increased $35.4 million during 2023, totaling $230 million as of December 31, 2023.  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 $204 million during 2023, with a high balance of $269 million and a low balance of $135 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 sweep accounts are accounted for as secured borrowings.

Information regarding our repurchase agreements as of December 31, 2023 and during 2023 is as follows:

FHLBI advances increased $160 million during 2023, totaling $468 million as of December 31, 2023.  Bullet advances aggregating $240 million were obtained during 2023, consisting of $160 million to fund loan growth and $80.0 million to replace FHLBI bullet advance maturities.  Payments on amortizing FHLBI advances totaled $0.4 million during 2023.  FHLBI bullet advances are generally obtained to provide funds for loan growth and are used to assist in managing interest rate risk, while amortizing FHLBI advances are generally acquired to match-fund specific longer-term fixed rate commercial loans, with the dollar amount and amortization structure of the underlying advances reflective of the associated commercial loans.  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 2023 totaled $903 million, with remaining availability based on collateral of $429 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 $2.4 million during 2023.  In contrast, our interest-earning deposit account at the Federal Reserve Bank of Chicago averaged $98.5 million during 2023.  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 $26.9 million at December 31, 2023.  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, 2023, 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, 2023, we had a total of $2.09 billion in unfunded loan commitments and $19.4 million in unfunded standby letters of credit.  Of the total unfunded loan commitments, $1.82 billion were commitments available as lines of credit to be drawn at any time as customers’ cash needs vary, and $270 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.  During the past two years, there was a pronounced rise in inflation. As a result, the FOMC significantly increased interest rates and indicated its intention to continue to do 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 costs 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, 2023:

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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, 2023, 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 $204 million in net interest income projected using our balance sheet amounts and anticipated replacement rates as of December 31, 2023. 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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