OLD SECOND BANCORP INC (OSBC) FY 2023 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

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The following discussion provides additional information regarding our operations for the twelve-month periods ending December 31, 2023, 2022 and 2021, and financial condition at December 31, 2023 and 2022 and should be read in conjunction with our consolidated financial statements and the related notes.  Historical results of operations and the percentage relationships among any amounts included, and any trends that may appear, may not indicate trends in operations or results of operations for any future periods.

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We have made, and will continue to make, various forward-looking statements with respect to financial and business matters.  Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties.  Actual results may differ materially from those contained in these forward-looking statements.  For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” at the beginning of this annual report.

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Business overview

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We provide a wide range of financial services through our 48 banking locations located in Cook, DeKalb, DuPage, Kane, Kendall, LaSalle and Will counties in Illinois.  These banking centers offer access to a full range of traditional retail and commercial banking services including treasury management operations as well as fiduciary and wealth management services.  We focus our business on establishing and maintaining relationships with our clients while maintaining a commitment to providing for the financial services needs of the communities in which we operate through our retail branch network.  We emphasize relationships with individual customers as well as small to medium-sized businesses throughout our market area.  Our market area includes a mix of commercial and industrial, real estate, and consumer related lending opportunities, and provides a stable, loyal core deposit base.  We also offer extensive wealth management services, which include a registered investment advisory platform in addition to trust administration and trust services related to personal and corporate trusts, including employee benefit plan administration services.

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Our primary deposit products are checking, NOW, money market, savings, and certificate of deposit accounts, and our primary lending products are commercial mortgages, leases, construction lending, commercial loans, residential mortgages, and consumer loans.  Many of our loans are secured by various forms of collateral including real estate, business assets, and consumer property although borrower cash flow is the primary source of repayment at the time of loan origination.

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On December 1, 2021, we closed on our acquisition of West Suburban Bancorp, Inc. (“West Suburban”), and its wholly owned subsidiary, West Suburban Bank.  As a result of this transaction, we acquired $1.07 billion of securities available-for sale at fair value, $1.50 billion of loans, net of fair value adjustments, and $2.69 billion of deposits, net of fair value adjustments.  The transaction resulted in us increasing our presence in the west suburban Chicago area, as 34 branches were acquired with a retail and commercial client mix of loans and deposits. Historical periods before December 1, 2021, reflect results of our legacy operations. Subsequent to closing, results reflect all post-acquisition activity of the combined Company.

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Summary Financial Data

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Old Second Bancorp, Inc. and Subsidiaries

Financial Highlights

(Dollars in thousands, except per share data)

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Old Second Bancorp, Inc. and Subsidiaries

Quarterly Financial Information

(Dollars in thousands, except per share data)

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2023 Financial Overview

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In 2023, we recorded net income of $91.7 million, or $2.02 per fully diluted share, compared to $67.4 million, or $1.49 per fully diluted share, in 2022, and $20.0 million, or $0.65 per fully diluted share, in 2021.  Our basic earnings per share for the periods presented were $2.05 in 2023, $1.51 in 2022 and $0.66 in 2021.

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Our 2023 net income increased primarily as a result of the rising interest rate environment throughout much of 2023. Adjusted net income, a non-GAAP financial measure that excludes, litigation expense, net gains on branch sales, and Visa portfolio deconversion/liquidation costs was $92.9 million in 2023. See the discussion entitled “Non-GAAP Financial Measures” on page 44 and the table below, which provides a reconciliation of this non-GAAP measure and related items, to the most comparable GAAP equivalents.

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Adjusted net income provides for a comparative analysis of our performance excluding those one time matters, such as litigation expense related to a claim regarding prior years’ overdraft fee compliance, net gains stemming from branch sales completed to eliminate duplicative geographic locations due to the West Suburban acquisition, and the Visa credit card and land trust portfolio sales were executed to exit products that were not within our strategic plan.

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Net interest and dividend income increased $45.8 million, or 22.2% for 2023 compared to 2022, due primarily to loan growth and the impact of market interest rate increases on loans and securities. Average loans, including loans held-for-sale, increased $362.5 million, or 9.96%, in 2023 compared to 2022. Organic loan growth in 2023 drove increases in our leases, commercial real estate-investor, and multi-family loan portfolios.  Total interest and dividend income growth in 2023, compared to 2022, resulted in a 157 basis point increase in average rates earned on interest earning assets.  Average interest bearing deposits decreased $423.3 million, or 12.9%, for 2023 compared to 2022, while average deposit rates increased 44 basis points over the same period.  The increase in deposit rates was primarily due to an increase in the average time deposit rates and increased rates for NOW and money markets.  Average noninterest bearing deposits decreased by $190.5 million, or 9.1%, from 2022 to 2023.

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We continued to reposition our balance sheet in 2023 to provide appropriate funding for loan growth, ensure adequate liquidity, reduce asset quality risk, and to decrease the rising interest rate risk on our cost of funds.  In 2023, our available-for-sale securities portfolio decreased $346.5 million, compared to year-end 2022, due primarily to $205.7 million of strategic sales and $186.0 million of paydowns, maturities, and calls.  These decreases in 2023 were partially offset by security purchases of $13.4 million. The unrealized mark to market adjustment on securities was an $84.2 million unrealized loss as of December 31, 2023, compared to a $123.5 million unrealized loss at December 31, 2022, due primarily to market interest rate increases.  Average interest bearing liabilities increased $121.8 million, to $3.34 billion in 2023 from $3.46 billion in 2022.  Total average borrowings increased $301.5 million to $492.0 million compared to $190.5 million in 2022. The increase in average borrowings was primarily due to a $343.5 million increase in other short-term borrowings due to additional FHLB advances throughout 2023 that helped to fund loan growth. During 2023, we paid off our notes payable and our senior notes, resulting in a decrease in average borrowings of $11.9 million and $22.5 million, respectively.

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Management also continued to emphasize credit quality and maintained our capital ratios with continued strong liquidity.  In 2023, we experienced loan growth of $173.3 million, or 4.5%, over 2022.  The growth was driven primarily by originations of loans from the sponsor finance team, as well as growth in leasing, commercial real estate-investor, and multi-family loans.  Asset quality levels have decreased slightly over the last few years relative to total assets, with nonperforming assets of $73.9 million, or 1.29%, of total assets for 2023, compared to $34.5 million, or 0.59% of total assets for 2022, and $47.0 million, or 0.76% of total assets, for 2021, with the total dollar increase in 2023, compared to 2022, primarily due to the increase in nonaccrual loans of $36.0 million.  However, recent economic circumstances have created pressure on portions of the portfolio such as office and assisted living facility loans. We continue to take steps to control operating expenses and increase noninterest income.

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As we focused on reducing noninterest expenses, exclusive of acquisition-related activity, we were also able to maintain our profitable wealth management business, and continue profitability, though to a lesser extent, with the mortgage banking business as originations and sales were negatively impacted by elevated interest rates.

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For information comparing our financial condition and results of operations for the year ended December 31, 2022, to year ended December 31, 2021, see “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on March 9, 2023.

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Critical accounting estimates

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Our consolidated financial statements are prepared based on the application of accounting policies in accordance with GAAP and follow general practices within the banking industry.  These policies require the reliance on estimates, assumptions and judgements, which may prove inaccurate or are subject to variations.  Changes in underlying factors, estimates, assumptions or judgements could have a material impact on our future financial condition and results of operations.

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Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported.  We have identified the determination of the allowance for credit losses and fair value measurements to be the accounting areas that require the most subjective or complex judgments and, as such, could be most subject to revision as new or additional information becomes available or circumstances change, including overall changes in the economic climate and/or market interest rates.  Therefore, we consider these policies, discussed below, to be critical accounting estimates and discuss them directly with the Audit Committee of our board of directors.

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Significant accounting policies are presented in Note 1 of the financial statements included in this annual report.  These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined.  Recent accounting pronouncements and standards that have impacted or could potentially affect us are also discussed in Note 1 of the consolidated financial statements.

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Allowance for credit losses for loans

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The allowance for credit losses (“ACL”) for loans represents management’s estimate of all expected credit losses over the expected contractual life of our loan portfolio.  Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain.  Subsequent evaluations of the then-existing loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for credit losses in those future periods.

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The ACL involves critical accounting estimates because:

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Because our estimates of the ACL involve judgments and are influenced by factors outside of our control, there is uncertainty inherent in these estimates. Changes in such estimates could significantly impact our ACL and provision for credit losses. See Note 1 – Basis of Presentation and Changes in Significant Accounting Policies in the accompanying notes to the consolidated financial statements included elsewhere in this annual report for a discussion of our ACL.

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As a result of management’s modeling, we recorded an ACL on loans of $44.3 million as of December 31, 2023; in addition, we recorded an ACL on unfunded commitments of $2.7 million as of December 31, 2023, included within other liabilities.  We recorded provision for credit losses of $16.5 million in 2023, comprised of $18.1 million of provision for credit loss expense on loans, and a $1.6 million release of provision on unfunded commitments.  In 2022, we recorded a provision for credit losses of $6.6 million, comprised of a $6.8 million provision for credit loss expense on loans, and a $200,000 release of provision for credit losses on unfunded commitments. In 2021, we recorded a provision for credit losses of $4.3 million, comprised of a $9.4 million release of provision for credit losses expense on loans, a $12.2 million Day Two non-PCD credit mark on West Suburban acquired loans, and a $1.5 million provision for credit losses on unfunded commitments.  In addition, a discussion of the factors driving changes in the amount of the ACL is included in the “Allowances for Credit Losses” section below.

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Fair Value Measurements

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The use of fair values is required in determining the carrying values of certain assets and liabilities, as well as for specific disclosures. Fair value is an estimate of the exchange price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction (i.e., not a forced transaction, such as a liquidation or distressed sale) between market participants at the measurement date and is based on the assumptions market participants would use when pricing an asset or liability.

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In determining the fair value of financial instruments, market prices of the same or similar instruments are used whenever such prices are available.  If observable market prices are unavailable or impracticable to obtain, we are required to make judgments about assumptions market participants would use in estimating the fair value of the financial instrument.  Fair value is estimated using modeling techniques and incorporates assumptions about interest rates, duration, prepayment speeds, risks inherent in a particular valuation technique and the risk of nonperformance. These assumptions are inherently subjective as they require material estimates, all of which may be susceptible to significant change.  See Note 17 “Fair Value Measurements” and Note 18 “Fair Values of Financial Instruments,” to the consolidated financial statements which include information about the extent to which fair value is used to measure assets and liabilities, and the valuation methodologies and key inputs used for further information regarding the valuation processes.

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Non-GAAP Financial Measures

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This annual report contains references to financial measures that are not defined in GAAP. Such non-GAAP financial measures include the presentation of adjusted net income, net interest income and net interest income to interest earning assets on a tax equivalent (“TE”) basis and our tangible common equity to tangible assets ratio.  Management believes that the presentation of these non-GAAP financial measures (a) provides important supplemental information that contributes to a proper understanding of our operating performance, (b) enables a more complete understanding of factors and trends affecting our business, and (c) allows investors to evaluate our performance in a manner similar to management, the financial services industry, bank stock analysts, and bank regulators. Management uses non-GAAP measures as follows: in the preparation of our operating budgets, monthly financial performance reporting, and in our presentation to investors of our performance.  However, we acknowledge that these non-GAAP financial measures have a number of limitations. Limitations associated with non-GAAP financial measures include the risk that persons might disagree as to the appropriateness of items comprising these measures and that different companies might calculate these measures differently.  These disclosures should not be considered an alternative to our GAAP results.  A reconciliation of non-GAAP financial measures to the most directly comparable GAAP financial measures is presented below or alongside the first instance where each non-GAAP financial measure is used.

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Results of operations

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Net interest income

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Net interest income, which is our primary source of earnings, is the difference between interest income and fees earned on interest-earning assets, such as loans and investment securities, as well as accretion income on purchased loans, and interest incurred on interest-bearing liabilities, such as deposits and borrowings.  Net interest income depends upon the relative mix of interest-earning assets and interest-bearing liabilities, the ratio of interest-earning assets to total assets and of interest-bearing liabilities to total funding sources, and movements in market interest rates.  Our net interest income can be significantly influenced by a variety of factors, including overall loan demand, economic conditions, credit risk, the amount of nonearning assets including nonperforming loans, the amounts of and rates at which assets and liabilities reprice, variances in prepayment of loans and securities, early withdrawal of deposits, exercise of call options on borrowings or securities, a general rise or decline in interest rates, changes in the slope of the yield-curve, and balance sheet growth or contraction.  Our asset and liability committee (“ALCO”) seeks to manage interest rate risk under a variety of rate environments by structuring our balance sheet and off-balance sheet positions.  This process is discussed in more detail in the section entitled “Interest Rate Risk” in “Quantitative and Qualitative Disclosures about Market Risk.”

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Our net interest income increased $45.8 million, or 22.2%, to $251.9 million for 2023, from $206.2 million for 2022.  The increase in 2023 was primarily driven by loan growth and the rising interest rate environment through much of 2023.  Our net interest margin, which is net interest income divided by total interest-earning assets, was 4.64% for the year ended 2023, compared to 3.63% for the year ended 2022, an increase of 101 basis points.  Our net interest margin on a taxable equivalent (TE) basis was 4.67% for the year ended 2023, compared to 3.65% for the year ended 2022, an increase of 102 basis points.  Average interest earning assets decreased $255.1 million during 2023 as volume slowed and rates reflected significant growth, impacting net interest income.  The increase in interest expense in 2023 compared to 2022 was due primarily to an expense increase in all interest bearing deposit categories due to rising rates, as well as higher average balances (FHLB advances) in our short-term funding throughout 2023.

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Our net interest income increased $109.4 million, or 113.2%, to $206.2 million for 2022, from $96.7 million for 2021.  The increase in 2022 was primarily driven by our December 1, 2021 acquisition of West Suburban, and the resultant full year of net interest income from loans and securities.  Our net interest margin, which is net interest income divided by total interest-earning assets, was 3.63% for the year ended 2022, compared to 2.95% for the year ended 2021, an increase of 68 basis points.  Our net interest margin on a taxable equivalent (TE) basis, was 3.65% for the year ended 2022, compared to 3.00% for the year ended 2021, an increase of 65 basis points.  Average interest earning assets increased $2.41 billion during 2022 as both volume and rates reflected growth, impacting net interest income.  The increase in interest expense in 2022 compared to 2021 was due primarily to subordinated debenture expense increases based on a full year of interest in 2022, NOW and money market accounts, as well as a rise in our short-term funding needs, as we utilized short-term borrowings (FHLB advances) during the second half of 2022.

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Our average earning assets decreased $255.1 million, or 4.5%, to $5.43 billion in 2023, from $5.68 billion in 2022.  The decrease was primarily attributable to a decrease in our securities portfolio and our interest earning deposits, partially offset by organic leases, commercial real estate and multifamily loan growth. Our average earning assets increased $2.41 billion, or 73.7%, to $5.68 billion in 2022, from $3.27 billion in 2021.  The increase was primarily attributable to an increase in our securities and loan portfolios, primarily due to the West Suburban acquisition, in addition to organic commercial, lease financing, and commercial real estate loan growth.

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Our average interest bearing liabilities decreased $121.8 million, or 3.5%, to $3.34 billion for 2023, from $3.46 billion in 2022, due primarily to a decrease in all deposit categories, which was partially offset by a noteworthy increase in other short-term borrowings.  Interest bearing deposits decreased by $423.3 million, or 12.9%, to $2.85 billion in 2023, compared to $3.27 billion in 2022, due primarily to the decrease in all deposit categories.  Our average borrowings increased $301.5 million to $492.0 million in 2023 from $190.5 million in 2022. This was mainly due to an increase of $343.5 million in average other short-term borrowings due to obtaining FHLB advances throughout the entirety of 2023. Partially offsetting the increase in our average other short-term borrowings was a decrease of $7.6 million in average securities sold under repurchase agreements, a $22.5 million decrease in average senior notes as the remaining principal balance was paid off in its entirety in June 2023, and a $11.9 million decrease in average notes payable as the term loan was paid off in its entirety in February 2023.

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Our average interest bearing liabilities increased $1.41 billion, or 68.4%, to $3.46 billion for 2022, from $2.06 billion in 2021, due primarily to an increase in all deposit categories.  Interest bearing deposits increased by $1.41 billion, or 75.9%, to $3.27 billion in 2022, compared to $1.86 billion in 2021, due primarily to the West Suburban acquisition. Deposit growth was also driven by increases in commercial deposit accounts stemming from new commercial loans.  Our average other borrowings decreased $6.1 million to $190.5 million in 2022 from $196.6 million in 2021. This was mainly due to a decrease of $25.7 million in average securities sold under repurchase agreements and a decrease of $8.5 million in average notes payable as we continued to paydown the US Bank term note, which was ultimately paid off in February 2023. Partially offsetting the decrease in our average other borrowings was an increase of $12.5 million in average other short-term borrowings due to obtaining FHLB advances during the second half of 2022.

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The following table sets forth certain information relating to our average consolidated balance sheets and reflects the yield on average interest earning assets and cost of average interest bearing liabilities for the years indicated obtained by dividing the related interest by the average balance of assets or liabilities.  Average balances are derived from daily balances.

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1 Tax equivalent basis is calculated using a marginal tax rate of 21% in 2023, 2022 and 2021.  See the discussion entitled “Non-GAAP Financial Measures” on page 44 and the table on page 47 that provides a reconciliation of each non-GAAP measure to the most comparable GAAP equivalent.

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2  Interest income from loans is shown on a tax equivalent basis, which is a non-GAAP financial measure, discussed below, and includes net costs of $2.7 million for 2023, and fee income of $3.0 million for 2022 and $5.8 million for 2021.  Nonaccrual loans are included in the above stated average balances.

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For purposes of discussion, net interest income and net interest income to interest earning assets have been adjusted to a non-GAAP (TE) basis to more appropriately compare returns on tax-exempt loans and securities to other earning assets.  The table below provides a reconciliation of each non-GAAP (TE) measure to the GAAP equivalent:

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The following table allocates the changes in net interest income to changes in either average balances or average rates for interest earning assets and interest bearing liabilities.  Interest income is measured on a tax-equivalent basis using a 21% marginal rate for all periods presented.  Interest income not yet received on nonaccrual loans is reversed upon transfer to nonaccrual status; future receipt of interest income is a reduction to principal while in nonaccrual status.

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Analysis of Year-to-Year Changes in Net Interest Income1

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1  The changes in net interest income are created by changes in both interest rates and volumes.  In the table above, volume variances are computed using the change in volume multiplied by previous year’s rate. Rate variances are computed using the change in rate multiplied by the previous year’s volume.  The change in interest due to both rate and volume has been allocated between factors in proportion to the relationship of absolute dollar amounts of the change in each.

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Provision for credit losses

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The provision for credit losses is the expense necessary to maintain the ACL at levels appropriate to absorb our estimate of credit losses expected over the life of our loan portfolio and unfunded lending commitments.

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We recorded a $16.5 million provision for credit losses in 2023, an increase of $10.0 million, from 2022. The increase in provision expense over the prior year was primarily due to loan growth of $173.3 million in 2023, and current-year net charge offs, partially offset by improved economic factors.  The 2022 provision for credit losses of $6.6 million compared to $4.3 million in 2021 was primarily due to loan growth of $448.8 million in 2022, partially offset by improved economic factors.

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For additional discussion of the credit provision and allowance for credit losses, see the section below “Allowance for Credit Losses” in this Item 7. Management’s Discussion and Analysis of Financial Condition.

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Noninterest income

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Our total noninterest income decreased $8.9 million, or 20.7%, to $34.2 million for 2023, compared to $43.1 million for 2022.  The decrease was primarily due to:

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Partially offsetting these decreases was an increase in service charges on deposits of $255,000 and a $1.4 million increase in the cash surrender value of BOLI. We had no BOLI death benefit proceeds in 2023 or 2022.

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Our total noninterest income increased $3.9 million, or 9.8%, to $43.1 million for 2022, compared to $39.3 million for 2021.  This increase was due to growth in wealth management of $479,000, service charges on deposits of $4.2 million, mark to market gains on MSRs of $1.9 million, card related income of $4.3 million, and other income of $2.9 million. Partially offsetting these increases were reductions in secondary mortgage fees of $712,000, or 68.2%, in 2022 compared to 2021, as well as a reduction in the net gain on sales of mortgage loans of $7.3 million, or 78.3%, over the same period, each due to a reduction in secondary market mortgage loan origination volumes in 2022 due to the rising rate environment.  Finally, net securities losses of $944,000 were recorded in 2022, compared to $232,000 of net securities gains in 2021, reflecting strategic security sales in 2022 given the increasing rate environment resulting in downward pressure on the bond market during the year. We had no BOLI death benefit proceeds in 2022 or 2021.

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Noninterest expense

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Our total noninterest expense decreased by $6.0 million, or 4.0%, in 2023 compared to 2022.  The decrease was primarily due to:

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Partially offsetting these decreases to noninterest expense was a $2.0 million, or 2.3%, increase in salaries and employee benefits. Our number of full-time equivalent employees was 834 as of December 31, 2023, compared to 819 as of December 31, 2022. Also partially offsetting the decrease in noninterest expense was a $304,000, or 12.7%, increase in FDIC insurance, a $132,000, or 22.4%, increase in advertising expense for updated branding, a $775,000, or 17.8%, increase in card related expense, a $269,000 increase in other real estate owned expense due to six additions and nine disposals throughout 2023, and a $1.4 million increase in other expense primarily due to a $1.2 million litigation expense recorded in the fourth quarter of 2023 for a pending overdraft fee compliance claim.

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Our total noninterest expense increased by $47.4 million, or 45.7%, in 2022 compared to 2021.  The increase was comprised of a $22.1 million increase in salaries primarily due to the West Suburban acquisition, a $3.2 million increase in officers’ incentives primarily due to higher incentive accruals in 2022, and a $3.6 million increase in benefits and other expense primarily due to increases stemming from additional employees from our acquisition of West Suburban.  In addition, occupancy, furniture and equipment expense increased $1.4 million due to the acquisition of West Suburban related assets. Computer and data processing expense increased $7.9 million, FDIC insurance increased $1.4 million, net teller & bill paying increased $2.9 million, card related expense increased $1.8 million and other expense increased $3.7 million, all due to merger-related costs incurred and increased activity related to our acquisition of West Suburban.  Partially offsetting these increases to noninterest expense was a $223,000, or 20.3%, reduction in legal fees and a $2.6 million, or 51.5% reduction in consulting & management fees as the majority of legal and consulting fees were captured during the acquisition of West Suburban in December 2021.

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Reconciliation of Adjusted Efficiency Ratio Non-GAAP Financial Measures

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1  See discussion entitled “Non-GAAP Financial Measures” on page 44.

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Income taxes

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Our provision for income taxes includes both federal and state income tax expense (benefit).  An analysis of the provision for income taxes for the three years ended December 31, 2023, is detailed in Note 11 of the consolidated financial statements and our income tax accounting policies are described in Note 1 to the consolidated financial statements.

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Our income tax expense totaled $32.7 million for December 31, 2023 compared to an income tax expense of $24.1 million in 2022 and $7.8 million for 2021.  The increase in income tax expense in 2023, compared to 2022, is commensurate with the growth in our pretax income.  Income tax expense reflected all relevant statutory tax rates and GAAP accounting.  Our effective tax rate was 26.3% for 2023, 26.4% for 2022, and 28.1% for 2021.  Any changes in tax rates will be recorded in the period enacted.

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The determination of whether we will be able to realize our deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, available tax planning strategies, and assessments of both current and future economic and business conditions.  Management considered both positive and negative evidence regarding our ability to ultimately realize the deferred tax assets, which is largely dependent on our ability to derive benefits based on future taxable income.  For all periods presented, management determined that the realization of the deferred tax asset was “more likely than not” as required by GAAP.

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Financial condition

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General

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Our total assets were $5.72 billion at December 31, 2023, a decrease of $165.5 million, or 2.8%, from December 31, 2022.  Our total cash and cash equivalents decreased $15.0 million, driven by a decrease in interest earning deposits with financial institutions, primarily to fund loan growth and pay off rising rate debt.

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Our loans increased by $173.3 million, or 4.5%, to $4.04 billion for the year ended December 31, 2023, compared to 2022.  This increase is primarily due to organic loan growth in 2023, driven by originations of loans from the sponsor finance team, as well as growth in leasing, commercial real estate-investor, and multi-family loans.

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Our total securities decreased by $346.5 million, or 22.5%, for the year ended December 31, 2023, compared to 2022, primarily due to the $205.7 million of strategic sales, and $186.0 million of paydowns, maturities, and calls.  These decreases in 2023 were partially offset by purchases of $13.4 million of securities as well as the $39.3 million reduction of unrealized losses recorded in 2023. We recorded pretax net security losses of $4.1 million in 2023.

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Our total liabilities were $5.15 billion at December 31, 2023, a decrease of $281.7 million, or 5.2%, from December 31, 2022.  Total deposits decreased by $540.0 million, or 10.6%, to $4.57 billion for the year ended December 31, 2023, compared to $5.11 billion for the year ended December 31, 2022, primarily due to customer usage of funds.  Management continued to fund new lending with short term borrowings from the Federal Home Loan Bank of Chicago (the “FHLBC”).  In February of 2023, we paid off the remaining balance of $9.0 million on the original $20.0 million term note issued in 2020. In June 2023, we redeemed all of the $45.0 million senior note, net of deferred issuance costs.

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At December 31, 2023, total stockholders’ equity was $577.3 million, compared to $461.1 million at December 31, 2022. The increase in stockholders’ equity primarily stems from net income of $91.7 million recorded in 2023 as well as the decrease in unrealized losses in the available for sale securities portfolio.

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Investments

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As shown below, we had moderate changes in the overall composition of our securities portfolio in 2023 versus 2022. The overall composition of our securities portfolio was largely consistent in 2022 versus 2021.

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Securities Available-for-Sale Portfolio

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Our investment portfolio serves as both an important source of liquidity and as a source of income.  Accordingly, the size and composition of the portfolio reflects our liquidity needs, loan demand and interest income objectives.  We will adjust the size and composition of the portfolio from time to time.  While a significant portion of the portfolio consists of readily marketable securities to address future liquidity needs, other parts of the portfolio may reflect funds invested pending future loan demand or to maximize interest income without undue interest rate risk.

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Our total securities portfolio as of December 31, 2023 reflected a net decrease of $346.5 million, or 22.5%, from December 31, 2022. During 2023, we predominantly executed security sales to rebalance the portfolio to better align with our investment strategy and overall liquidity needs. Of the total $391.8 million recorded in security sales, call, maturities and pay-downs in 2023, $50.0 million were related to US Treasury, $20.7 million were related to U.S. government agency mortgage-backed securities, $159.2 million were related to collateralized mortgage obligations, and $139.7 million were related to asset-backed securities.  Net securities losses of $4.1 million were realized in 2023 related to sales and calls during the year.

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Some of our holdings of U.S. government agency mortgage-backed securities (“MBS”) and collateralized mortgage obligations (“CMOs”) are issuances of government-sponsored enterprises, such as Fannie Mae and Freddie Mac, which are not backed by the full faith and credit of the U.S. government.  Some holdings of MBS and CMOs are issued by Ginnie Mae, which do carry the full faith and credit of the U.S. government. We also hold some MBS and CMOs that were not issued by U.S. government agencies and are typically credit-enhanced via over-collateralization and/or subordination.  Holdings of ABS also includes securities backed by student loans issued under the U.S. Department of Education’s (“DOE”) FFEL program, which generally provides a minimum 97% U.S. DOE guarantee of principal.  These ABS securities also have added credit enhancement through over-collateralization and/or subordination.  The majority of holdings issued by states and political subdivisions are general obligation or revenue bonds that have S&P or Moody’s ratings of AA- or higher.  Other state and political subdivision issuances are unrated and generally consist of smaller investment amounts that involve issuers in our markets.  The credit quality of these issuers is monitored and none have been identified as posing a material risk of loss.  We also hold collateralized loan obligation (“CLOs”) securities that are generally backed by a pool of debt issued by multiple middle-sized and large businesses.  Our CLO S&P or Moody’s ratings distribution consists of 100% rated AAA or AA. CLO credit enhancement is achieved through over-collateralization and/or subordination.

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The following table presents the expected maturities or call dates and weighted average yield (nontax equivalent) of securities by major category as of December 31, 2023.  Weighted average yield is based on amortized costs and not calculated on a tax equivalent basis. Securities not due at a single maturity date are shown only in the total column.

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Securities Portfolio Maturity and Yields

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As of December 31, 2023, net unrealized losses on available-for-sale securities totaled $84.2 million, which, after the impact of the related deferred income taxes, resulted in an overall decrease to equity capital of $60.6 million.  As of December 31, 2022, net unrealized losses on available-for-sale securities totaled $123.5 million, which after the impact of the related deferred income taxes, resulted in an overall decrease to equity capital of $88.9 million.

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Loans

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The following table presents the composition of the loan portfolio at December 31 for the year indicated:

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Loan Portfolio

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1 The “Other” class includes consumer loans and overdrafts.

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Our total loans were $4.04 billion as of December 31, 2023, an increase of $173.3 million from $3.87 billion as of December 31, 2022. This increase was primarily due to loan growth of $120.8 million in our leases and $78.0 million in our multifamily portfolios. In addition, we experienced organic loan growth primarily in our commercial real estate – investor and residential real estate – owner occupied loan portfolios.  We recorded total loan originations, excluding renewals, of $997.2 million in 2023, but we also experienced accelerated paydowns in 2023 due to higher levels of customer liquidity.

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We strive to serve customers in and around our geographic locations and continue to seek opportunities in our primary lending markets; however, our markets remain very competitive for new loan business.

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Management continues to emphasize loan portfolio quality, the increase of nonaccrual and classified loans is isolated to office buildings and assisted living centers, discussed in the “Asset Quality” section below.  We recorded net loan charge-offs of $23.3 million in 2023, $1.6 million in 2022, and $4.4 million in 2021.

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The quality of our loan portfolio is in large part a reflection of the economic health of the communities in which we operate.  Our local communities have been relatively stable in the past five years.  While there are no significant concentrations of loans where the customers’ ability to honor loan terms is dependent upon a single economic sector, the real estate categories represented 68.8% and 70.6% of the portfolio at December 31, 2023 and 2022, respectively.  Our lending exposure is diversified across our commercial, leasing, commercial real estate, residential real estate, construction loan, multifamily and HELOC portfolios, with total loan portfolio growth in each of the three years presented above. We had no concentration of loans exceeding 10% of total loans that were not otherwise disclosed as a category of loans at December 31, 2023.  We remain committed to overseeing and managing our loan portfolio to avoid unnecessarily high credit concentrations in accordance with the general interagency guidance on risk management.  Consistent with those commitments, management monitors our asset diversification and anticipates that the percentage of real estate lending in relation to the overall portfolio will decrease in the future.

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The following table sets forth the remaining contractual maturities for loan categories at December 31, 2023:

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Maturity and Rate Sensitivity of Loans to Changes in Interest Rate

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1 The “Other” class includes consumer loans and overdrafts; column one includes demand notes.

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Asset Quality

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Nonperforming loans consist of nonaccrual loans and loans 90 days or greater past due. Prior to January 1, 2023, nonperforming loans also included performing troubled debt restructured loans accruing interest. Remediation work continues in all segments. Nonperforming loans increased year over year by $35.9 million to $68.8 million at December 31, 2023, and decreased by $11.8 million to $32.9 million at December 31, 2022, compared to December 31, 2021. Nonperforming assets, which includes nonperforming loans plus other real estate owned, totaled $73.9 million as of December 31, 2023, compared to $34.5 million as of December 31, 2022.  Purchased credit deteriorated loans, or PCD loans, are purchased loans that, as of the date of acquisition, we determined had experienced a more-than-insignificant deterioration in credit quality since origination.  Nonperforming credit metrics increased in 2023, largely due to office buildings and senior/assisted living facilities, and management is carefully monitoring loans considered to be in a classified status.  Nonperforming loans as a percent of total loans increased to 1.7% as of December 31, 2023, from 0.9% as of December 31, 2022, and 1.3% December 31, 2021.  The distribution of our nonperforming loans is shown in the following table.

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Risk Elements

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The following table sets forth the amounts of nonperforming assets at December 31 for the years indicated:

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Accrual of interest is discontinued on a loan when principal or interest is 90 days or more past due, unless the loan is well secured and in the process of collection.  When a loan is placed on nonaccrual status, interest previously accrued but not collected in the current period is reversed against current period interest income.  Interest income of approximately $1.9 million, $284,000 and $280,000 was recorded and collected during 2023, 2022 and 2021, respectively, on loans that subsequently went to nonaccrual status by year-end.  Interest income, which would have been recognized during 2023, 2022 and 2021, had these loans been on an accrual basis throughout the year, was approximately $7.3 million, $2.7 million and $1.6 million, respectively.

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Total past due loans, including accruing and nonaccrual loans, totaled $49.4 million at year-end 2023, a $27.2 million increase from year end 2022, resulting in the rate of past due loans to total loans increasing to 1.2% at year-end 2023 compared to 0.6% at year-end 2022, and 0.8% at year-end 2021.  Refer to Note 5, “Loans and Allowance for Credit Losses on Loans”, in our Consolidated Financial Statements, below, for further detail of past due loans by classification for 2023 and 2022.

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Classified Assets

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N/M - Not meaningful

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1 The “Other” class includes consumer loans and overdrafts.

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Classified loans include nonaccrual and all other loans considered substandard.  Classified assets include both classified loans and OREO.  Loans classified as substandard are inadequately protected by either the current net worth and ability to meet payment obligations of the obligor, or by the collateral pledged to secure the loan, if any.  These loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and carry the distinct possibility that we will sustain some loss if deficiencies remain uncorrected.

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Total classified loans increased in 2023 compared to 2022, and increased in 2022 compared to 2021. The growth in 2023 is primarily due to an increase of $16.4 million of Commercial real estate – investor loans, an increase of $13.7 million of commercial real estate – owner occupied, and an increase of $15.8 million of construction, compared to 2022. In 2023, the increases to classified commercial real estate – owner occupied and commercial real estate – investor loans were driven by downgrades to loans collateralized by office buildings and senior/assisted living facilities. The growth in classified assets in 2022 over the prior year is primarily due to an increase of $16.7 million of Commercial real estate – investor loans, and an increase of $25.5 million of Commercial real estate – owner occupied loans, compared to 2021. In 2022, the increase to Commercial real estate – owner occupied was due to increased healthcare industry loans being categorized as substandard and the increase to commercial real estate – investor was due to three unrelated large loans being categorized as substandard.  Total classified assets increased in 2023 compared to both 2022 and 2021. Classified assets, which includes classified loans and OREO, was impacted by a $3.6 million net increase in our OREO portfolio in 2023 from 2022, primarily due to the addition of two large office buildings in late 2023.  Our OREO portfolio decreased $795,000 in 2022 from 2021.  Management monitors a metric of classified assets to the sum of Bank Tier 1 capital and the ACL, which is referred to as the “classified assets ratio.”  Our classified assets ratio increased to 21.66% at December 31, 2023, compared to 18.36% at December 31, 2022, from 13.79% at December 31, 2021.

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Problem Loans

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We utilize an internal asset classification system as a means of reporting problem and potential problem assets.  At the scheduled directors loan committee meetings of the Bank, loan listings are presented, which show significant loan relationships listed as “Special Mention,” “Substandard,” and “Doubtful.”  Loans classified as Substandard include those that have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt.  They are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected.  Assets classified as Doubtful have all the weaknesses inherent as those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.  Assets that do not currently expose us to sufficient risk to warrant classification in one of the aforementioned categories, but possess weaknesses that deserve management’s close attention, are deemed to be Special Mention.  Management defines problem loans as performing loans rated Substandard that do not meet the definition of a nonperforming loan, and those loans that have been placed on nonaccrual, which are classified as Doubtful.  These problem loans carry a higher probability of default and require additional attention by management.  A more detailed description of these loans can be found in Note 5 to the Consolidated Financial Statements, as listed in the credit quality indicators discussion.

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Allowance for Credit Losses

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At December 31, 2023, the ACL on loans totaled $44.3 million, and the ACL on unfunded commitments, included in other liabilities, totaled $2.7 million, compared to the ACL on loans of $49.5 million and ACL on unfunded commitments of $5.1 million at December 31, 2022. The decrease was primarily due to large charge offs taken in the fourth quarter of 2023, which was partially offset by improved economic conditions.

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One measure of the adequacy of the ACL is the ratio of the ACL on loans to total loans. The ACL as a percentage of total loans was 1.1% as of December 31, 2023 and 1.3% as of December 31, 2022. In management’s judgment, an adequate allowance for estimated losses has been established; however, there can be no assurance that losses will not exceed the estimated amounts in the future.

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See Note 1 – Summary of Significant Accounting Policies in the accompanying notes to the consolidated financial statements in this annual report for discussion of our ACL methodology on loans.

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The provision for credit losses, which includes a provision for losses on unfunded commitments, is a charge to earnings to maintain the ACL at a level consistent with management’s assessment of expected losses over the expected life of the loan portfolio as well as considering changes in macroeconomic conditions.

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During 2023, we recorded an $18.1 million of provision for credit losses expense on loans and a $1.6 million release of provision for credit losses on unfunded commitments. During 2022, we recorded a $6.8 million provision for credit losses expense on loans, and a $200,000 release of provision for credit losses on unfunded commitments.

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Summary of Loan Loss Experience

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The following table summarizes, for the years indicated, activity in the ACL, including amounts charged-off, amounts of recoveries, additions to the allowance charged to operating expense, and the ratio of net charge-offs to loans outstanding:

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Analysis of Allowance for Credit Losses

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1 The “Other” class includes consumer loans and overdrafts.

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The following table summarizes, for the years indicated, net charge-offs per loan class and the percentage of total average loans per class:

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1 The “Other” class includes consumer loans and overdrafts.

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The provision for credit losses on loans is based upon management’s estimate of future expected credit losses in the loan and lease portfolio and its evaluation of the adequacy of the ACL.  Our provision for credit losses in 2023 totaled $16.5 million, compared to $6.6 million in 2022, and $4.3 million in 2021.  Net charge-offs recorded in 2023 totaled $23.3 million, compared to net charge-offs of $1.6 million recorded in 2022, and net charge-offs of $4.4 million in 2021. The increase of net charge offs in 2023 was due to six large charge offs taken on our commercial real estate, primarily with office buildings and senior/assisted living facilities, in 2023. Our ACL on loans to average loans was 1.1% as of December 31, 2023, compared to 1.4% at December 31, 2022 and 2.2% at December 31, 2021.

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The following table shows our allocation of the ACL by loan type at December 31 for the years indicated, and, for each category of loans, the percent of total loans represented by that category:

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Allocation of the Allowance for Credit Losses

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1 The “Other” class includes consumer loans and overdrafts for each year presented.

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Allocations of the allowance may be made for specific loans, but the entire allowance is available for losses in the loan portfolio.  In addition, the OCC, as part of their examination process, periodically reviews the ACL.  Regulators can require management to record adjustments to the allowance level based upon their assessment of the information available to them at the time of examination.  The OCC, in conjunction with the other federal banking agencies, has adopted an interagency policy statement on the ACL.  The policy statement provides guidance for financial institutions on both the responsibilities of management for the assessment and establishment of adequate allowances and guidance for banking agency examiners to use in determining the adequacy of general valuation guidelines.  Generally, the policy statement recommends that (1) institutions have effective systems and controls to identify, monitor and address asset quality problems; (2) management has analyzed all significant factors that affect the collectability of the portfolio in a reasonable manner; and (3) management has established acceptable allowance evaluation processes that meet the objectives set forth in the policy statement.  Management believes it has established an adequate estimated allowance for expected credit losses over the estimated life of our loan portfolio.  Management reviews its process quarterly using an extensive and detailed loan review process, makes changes as needed, and reports those results at meetings of our Board of Directors and Audit Committee.

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Although management believes the ACL is sufficient to cover expected losses over the estimated life of our loan portfolio, there can be no assurance that the allowance will prove sufficient to cover actual loan and lease losses or that regulators, in reviewing the loan portfolio, would not request us to materially adjust our ACL at the time of their examination. Continued loan growth in future periods, a decline in our current level of recoveries, or an increase in charge-offs could result in an increase in provision expense. Additionally, with the adoption of CECL, provision expense may be more volatile due to changes in CECL model assumptions of credit quality, macroeconomic factors and conditions, and loan composition, which drive the allowance for credit losses balance.

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During 2023, the release of credit losses on unfunded commitments totaled $1.6 million, and the allowance for unfunded commitments totaled $2.7 million as of December 31, 2023.  Management reviewed the securities portfolio for credit loss exposure, and determined that no allowance for credit losses on securities was required for 2023.  See Note 4 to the Consolidated Financial Statements for more detail on the ACL for securities analysis performed.

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Other Real Estate Owned

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Other real estate owned (“OREO”) increased to $5.1 million as of December 31, 2023, compared to $1.6 million as of December 31, 2022, reflecting a $3.6 million increase. During 2023, we transferred six OREO properties from loans with a total fair value of $5.6 million, and we sold nine properties which had a net book value of $2.8 million. Net gains on the sale of OREO properties during 2023 totaled $256,000, compared to net gains on sale of OREO properties of $163,000 in 2022 and $41,000 in 2021. The OREO valuation reserve decreased to $118,000 in 2023 compared to $856,000 in 2022.

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Other real estate assets transferred from loans are recorded at the fair value of the property when transferred, less estimated costs to sell, establishing a new cost basis. The OREO valuation reserve for the year ended 2023 was $118,000, which was 2.3% of gross OREO at year-end 2023.  This compares to $856,000, or 35.4%, of gross OREO, net of participations and purchase accounting adjustments, at year-end 2022.

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Deposits

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Our total deposits contracted by $540.0 million, or 10.6%, to a total of $4.57 billion at year-end 2023, compared to year-end 2022, primarily due to a $216.8 million decrease in non-interest bearing demand deposits, a $190.9 million decrease in money market accounts, and a $174.3 million decrease in savings accounts, partially offset by an $86.0 million increase in certificates of deposit. Total deposits decreased by $355.5 million, or 6.5%, to a total of $5.11 billion at year-end 2022 compared to year-end 2021. We had no brokered certificates of deposit as of December 31, 2023 or December 31, 2022.

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Average Balances and Interest Rates

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