Oak Valley Bancorp (OVLY) FY 2023 MD&A

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

The following discussion of financial condition as of December 31, 2023 and 2022 and results of operations for each of the years in the two-year period ended December 31, 2022 should be read in conjunction with our consolidated financial statements and related notes thereto, included in this report. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances. This discussion contains forward-looking statements that reflect our plans, estimates and beliefs and involve numerous risks and uncertainties. Actual results may differ materially from those contained in any forward-looking statements. You should carefully read “Special Note Regarding Forward-Looking Statements” included in this report.

Introduction

Our continued focus on responsible community banking fundamentals and our strong customer relationships have enabled us to increase our market presence through growth in our loan portfolio, which is primarily funded by steady core deposit growth.

As of December 31, 2023, we had approximately $1.84 billion in total assets, $1.02 billion in total gross loans, and $1.65 billion in total deposits.

We believe the following were key indicators of our performance during 2023:

These items, as well as other factors, contributed to the increase in net income for 2023 to $30.8 million from $22.9 million in 2022, which translates into $3.75 per diluted share in 2023 as compared to $2.79 per diluted share in 2022.

Over the past several years, our network of branches and loan production offices have expanded geographically. We currently maintain eighteen full-service offices. We intend to continue our growth strategy in future years through the opening of additional branches and loan production offices as our needs and resources permit.

2024 Outlook

As we begin our strategic business plan for 2024, we remained focused on relationship-based expansion throughout our market area. We plan to continue to focus on growth of our loan and deposit portfolios to ease pressure on our net interest margin, while attempting to control expenses and credit losses.

Unfavorable trends in inflation prompted the Federal Reserve Open Market Committee, or FOMC, to increase the target federal funds rate in 2022 and 2023, which resulted yield increases on our earning assets. We expect this positive impact will continue to some degree in 2024 due to continued repricing of existing loans. However, the negative impact of the FOMC rate hikes was increased rates on deposit accounts, which we expect will continue into 2024. Deposit interest rates are determined based on customer demand, market surveys of offerings from competitive institutions, and overall liquidity position.

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The Fed Funds rate is forecasted to decrease towards the end of 2024, which could potentially compress net interest income and net interest margin further, given that our balance sheet is slightly asset sensitive to interest rate changes primarily due to the variable rate loans and interest-earning cash balances.

For 2024, management remains focused on the above challenges and opportunities and other factors affecting the business similar to the factors driving the 2023 results as discussed in this section.

Critical Accounting Estimates

Critical accounting estimates are those estimates made in accordance with generally accepted accounting principles that involve a significant level of estimation and uncertainty and have had or are reasonably likely to have a material impact on our financial condition and results of operations. We consider accounting estimates to be critical to our financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain, (ii) management could have applied different assumptions during the reported period, and (iii) changes in the accounting estimate are reasonably likely to occur in the future and could have a material impact on our financial statements. Management has determined the following accounting estimates and related policies to be critical:

Goodwill Impairment

The Company applies a qualitative analysis of conditions in order to determine if it is more likely than not that the carrying value is impaired. In the event that the qualitative analysis suggests that the carrying value of goodwill may be impaired, the Company uses several quantitative valuation methodologies in evaluating goodwill for impairment that includes assumptions and estimates made concerning the future earnings potential of the organization, and a market-based approach that looks at values for organizations of comparable size, structure and business model.

Estimates of fair value are based on a complex model using, among other things, estimated cash flows and industry pricing multiples. The Company tests its goodwill for impairment annually as of December 31 (the Measurement Date), and quarterly if a triggering event causes concern of a possible goodwill impairment charge. At each Measurement Date, the Company, in accordance with ASC 350-20-35-3, evaluates, based on the weight of evidence, the significance of all qualitative factors to determine whether it is more likely than not that the fair value of each of the reporting units is less than its carrying amount.

The assessment of qualitative factors at the most recent Measurement Date (December 31, 2023), indicated that it was not more likely than not that impairment existed; as a result, no further testing was performed.

Allowance for credit losses

Credit risk is inherent in the business of lending and making commercial loans. Accounting for our allowance for credit losses involves significant judgment and assumptions by management and is based on historical data as well as reasonable and supportable forecasts of future events. At least on a quarterly basis, our management reviews the methodology and adequacy of allowance for credit losses and reports its assessment to the Board of Directors for its review and approval.

The allowance for credit losses is an estimate dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loans, qualitative factors, the valuation of problem loans and the general economic conditions in our market area. See Note 1 and Note 4 to the consolidated financial statements, and the “Provision for Credit Losses” and “Allowance for Credit Losses” sections of this discussion and analysis for more information on the establishment of the Allowance for Credit Losses and the implementation of the Current Expected Credit Loss (“CECL”) model.

Income Taxes

Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of our assets and liabilities. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled using the liability method. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

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We file income tax returns in the U.S. federal jurisdiction, and the State of California. We are no longer subject to examination by taxing authorities for years before 2020 for U.S. federal or for years before 2019 for California.

Fair Value Measurements

We use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. We base our fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Securities available for sale, derivatives, and loans held for sale, if any, are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record certain assets at fair value on a non-recurring basis, such as certain impaired loans held for investment and securities held to maturity that are other-than-temporarily impaired. These non-recurring fair value adjustments typically involve write-downs of individual assets due to application of lower-of-cost or market accounting.

We have established and documented a process for determining fair value. We maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements. Whenever there is no readily available market data, management uses its best estimate and assumptions in determining fair value, but these estimates involve inherent uncertainties and the application of management's judgment. As a result, if other assumptions had been used, our recorded earnings or disclosures could have been materially different from those reflected in these financial statements. For detailed information on our use of fair value measurements and our related valuation methodologies, see Note 14 to the Consolidated Financial Statements in Item 8 of this report.

Recently Issued Accounting Standards

See Note 1 to the Consolidated Financial Statements in Item 8 of this report.

Results of Operations

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities. The second is noninterest income, which primarily consists of deposit service charges and fees, the increase in cash surrender value of life insurance, investment advisory service fee income and mortgage commissions. The majority of the Company's noninterest expenses are operating costs that relate to providing a full range of banking services to our customers.

Overview

We recorded net income for the year ended December 31, 2023 of $30,848,000 or $3.75 per diluted share compared to $22,902,000 or $2.79 per diluted share for the year ended December 31, 2022. The increase in net income for the year ended December 31, 2023 was primarily due to an increase of $15,726,000 in net interest income, mainly from the positive impact of FOMC interest rate hikes and the growth of our loan portfolio. Non-interest income increased by $1,060,000 in 2023, mainly as a result of fair value changes on equity securities and increased service charges on deposit accounts. The provision for credit losses increased compared to last year, mainly due to loan growth. Non-interest expense increased by $3,849,000 associated with staffing and general operating overhead increases to support the growth of our loan and deposit portfolios.

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Highlights of the financial results are presented in the following table:

Net Interest Income and Net Interest Margin

Our primary source of revenue is net interest income, which is the difference between interest and fees derived from earning assets and interest paid on liabilities obtained to fund those assets. Our net interest income is affected by changes in the level and mix of interest-earning assets and interest- bearing liabilities, referred to as volume changes. Our net interest income is also affected by changes in the yields earned on assets and rates paid on liabilities, referred to as rate changes. Interest rates charged on our loans are affected principally by the demand for such loans, the supply of money available for lending purposes and competitive factors. Those factors are, in turn, affected by general economic conditions and other factors beyond our control, such as federal economic policies, the general supply of money in the economy, legislative tax policies, governmental budgetary matters, and the actions of the Federal Reserve Board.

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For a detailed analysis of interest income and interest expense, see the “Average Balance Sheets” and the “Rate/Volume Analysis” below.

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Net interest income, on a fully tax equivalent basis (“FTE”), increased $16,034,000 or 25.7% to $78,342,000 for the year ended December 31, 2023, compared to $62,308,000 in 2022. Net interest spread and net interest margin were 4.14% and 4.33%, respectively, for the year ended December 31, 2023, compared to 3.27% and 3.32%, respectively, for the year ended December 31, 2022. This upward trend is mainly due to the FOMC rate hikes that begin in March 2022, resulting in an increase in earning asset yields, as described below.

Our earning asset yield increased 122 basis points in 2023 compared to 2022. The FOMC increased the federal funds target rate from a range of 0% to 0.25% at the beginning of 2022, to 4.25% to 4.50% by the end of the year. The FOMC approved additional rate hikes in 2023 to a range of 5.25% to 5.50%. All earning asset yields benefited from these increases, especially our interest-bearing cash accounts that receive the full impact of those increases. These cash balances averaged $302 million in 2023, representing over 16% of total average assets. The yield on loans recognized an increase of 33 basis points for 2023 as compared to 2022, due to the upward repricing of variable rate loans and higher rate indexes on new loans. Growth in average gross loans of $61 million, also contributed to net interest margin expansion.

The cost of funds on interest-bearing liabilities increased to 0.46% in 2023 compared to 0.10% in 2022 as a result of the FOMC rate hikes, competitive pressure and customer demand for higher rates. The decrease in deposit balances in 2023 also contributed to the rise in deposit rates, as management utilized promotional rates in order to match competition as a means to retain deposit relationships.

The net interest margin expansion the Company recognized in 2023, is due to the factors discussed above but could reverse and result in interest margin compression if rate indexes on assets were to fall, and/or: 1) deposit interest rates continue to increase due to customer demand, or competitive pressure from peer banks, 2) competition in the lending market restrict significant increases in new loan rates, and 3) deposit growth out-paces loan growth as recognized in recent years, resulting in higher interest-bearing cash balances, which would offer lower yields than loans and investments depending if the FOMC were to cut the Federal Funds rate.

Changes in volume resulted in an increase in net interest income (on a FTE basis) of $2,186,000 for the year of 2023 compared to the year 2022, and changes in interest rates and the mix resulted in an increase in net interest income (on a FTE basis) of $13,848,000 for the year 2023 versus the year 2022. Management closely monitors both total net interest income and the net interest margin.

Market rates are in part based on the FOMC target Federal funds interest rate (the interest rate banks charge each other for short-term borrowings).  The change in the Federal funds sold rates is the result of target rate changes implemented by the FOMC.   In 2020, the FOMC decreased the Federal funds rate by 0.50% and 1.00% on two occasions in March resulting in a range of 0.00% to 0.25% as of December 31, 2020 and 2021. In 2022, the FOMC raised the federal funds rate seven times by an aggregate of 4.00%. In 2023, the FOMC raised the Federal funds rate four times by 0.25% resulting in a range of 5.25% to 5.50%. If FOMC were to cut rates in 2024 or thereafter, we expect this would have a negative impact on our net interest income, due to repricing of interest-bearing cash balances, existing loans and investment securities.

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Rate/Volume Analysis

The following table below sets forth certain information regarding changes in interest income and interest expense of the Company for the periods indicated. For each category of earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in average volume multiplied by old rate); and (ii) changes in rates (change in rate multiplied by old average volume). Changes in rate/volume (change in rate multiplied by the change in volume) have been allocated to the changes due to volume and rate in proportion to the absolute value of the changes due to volume and rate prior to the allocation.

Provision for credit losses

Credit risk is inherent in the business of making loans. The Company establishes an allowance for credit losses through charges to earnings, which are shown in the consolidated statements of income as the provision for credit losses. Specifically identifiable and quantifiable losses are promptly charged off against the allowance. The Company maintains the allowance for credit losses at a level that it considers to be adequate to provide for credit losses inherent in its loan portfolio. Management determines the level of the allowance by performing a quarterly analysis that considers concentrations of credit, past loss experience, current economic conditions, the amount and composition of the loan portfolio (including nonperforming and potential problem loans), estimated fair value of underlying collateral, and other information relevant to assessing the risk of loss inherent in the loan portfolio such as loan growth, net charge-offs, changes in the composition of the loan portfolio, and delinquencies. As a result of management’s analysis, a range of the potential amount of the allowance for credit losses is determined.

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The Company recorded provision for credit loss of $970,000 and a reversal totaling $1,350,000 during the years ended December 31, 2023 and 2022, respectively. The 2023 provision was mainly due to loan growth and was based on macro-economic conditions among other factors as determined by our internal credit risk model. Included in 2022, was the reversal of approximately $1,100,000 for the qualitative adjustment corresponding to the COVID-19 pandemic, which was initially recorded during the second quarter of 2020 and totaled $1,620,000 at that time. The Company did not have any nonperforming loans as of December 31, 2023 and 2022. The allowance for credit losses was $10,896,000 and $9,468,000 as of December 31, 2023 and 2022, or 1.07% and 1.03%, respectively, of total loans. The increase as a percentage of total loans is due to the previously mentioned loan growth and macro-economic conditions. The strong credit quality has resulted in net loan recoveries of $112,000 and $80,000 in 2023 and 2022, respectively.

The Company will continue to monitor the adequacy of the allowance for credit losses and make additions to the allowance in accordance with the analysis referred to above. Because of uncertainties inherent in estimating the appropriate level of the allowance for credit losses, actual results may differ from management’s estimate of credit losses and the related allowance.

Noninterest Income

The following table sets forth a summary of noninterest income for the periods indicated:

Noninterest income was $6,631,000 for the year ended December 31, 2023, compared to $5,571,000 for the year 2022. Service charge income increased to $1,813,000 in 2023 compared to $1,596,000 for 2022, due to an increase in overdraft fees and the number of checking accounts. Debit card transaction fee income increased to $1,773,000 in 2023 as compared to $1,734,000 in 2022, as a result of the increase in the aggregate number of transaction deposit accounts and corresponding service fee income. Earnings on the cash surrender value of life insurance recognized an increase of $39,000 in 2023 compared to 2022, due to higher yields earned on certain life insurance policies. Mortgage commissions have decreased by $53,000 for the year 2023, as compared to 2022, as a result of the decreased demand for home purchases and refinancing. In 2023, other income increased by $662,000, which includes a $511,000 positive change in the fair value of equity securities, and an increase of $156,000 from gains on called and sold securities, as compared to 2022. The Company continues to evaluate its deposit product offerings with the intention of continuing to expand its offerings to the consumer and business depositors.

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Noninterest Expense

The following table sets forth a summary of noninterest expenses for the periods indicated:

Noninterest expense was $41,157,000 for the year ended December 31, 2023, an increase of $3,849,000 or 10.3% compared to $37,308,000 for the year ended 2022. Salaries and employee benefits increased by $3,064,000 in 2023, due to expansion of our staff to support loan and deposit growth, including the staff at our new Roseville branch that opened in December 2022.

Occupancy expense realized an increase of $390,000 in 2023 compared to the prior year, primarily from rent, utilities and facility maintenance increases on certain branch locations, including the overhead expenses related to our new Roseville branch that opened in December 2022.

Data processing costs increased in 2023 over 2022 by $386,000, primarily due to servicing costs on the growing number of loan and deposit accounts, as well as upgrades to our online banking platform.

Federal Deposit Insurance Corporation (“FDIC”) and California Department of Financial Protection and Innovation (“DFPI”) regulatory assessments increased by $93,000 in 2023 over 2022, mainly due to the FDIC increasing the base rate to 0.05%, on an annual basis, for all member banks in order to build up the Deposit Insurance Fund. The FDIC adopted a final rule in June 2022, applicable to all insured depository institutions, to increase initial base deposit insurance assessment rate schedules uniformly by 2 basis points, beginning in the first quarterly assessment period of 2023. The final rule became effective as of January 1, 2023, with an invoice payment date of June 30, 2023. The FDIC said that the increase in assessment rate schedules is intended to increase the likelihood that the reserve ratio of the Deposit Insurance fund reaches the statutory minimum of 1.35 percent by the statutory deadline of September 30, 2028. The final assessment rate for financial institutions is determined by making adjustments to the base rate for various credit quality factors and other risk metrics of the institution as defined by the FDIC. The Company’s risk profile and the related assessment rate remains at a relatively low level due to our strong credit quality, earnings and risk-based capital ratios. Management recognizes that assessments could increase further depending on deposit growth throughout the remainder of 2024, as the FDIC assessment rates are applied to average quarterly total liabilities as the primary basis, and based on FDIC’s discretion to increase the base assessment rate as needed to replenish the Deposit Insurance Fund. Moreover, the FDIC retains the authority and discretion to increase base assessment rates for banking entities in the future, as circumstances warrant.

Other operating expenses decreased by $84,000 in 2023 as compared to 2022, due to the reversal of $484,000 in undisbursed loan commitment loss provisions as dictated by the calculation within our CECL internal loan-risk model, which was partially offset by various general operating expense increases required to support our growing business portfolios and compliance mandates. Some of these included audit expenses, software license fees and ATM processing expenses.

Management anticipates that noninterest expense should continue to increase as we continue to grow, and management believes the Company’s administration as currently set up is scalable to handle future deposit growth.  However, management remains committed to cost-control and efficiency, and we expect to keep these increases to a minimum relative to growth.

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Provision for Income Taxes

We reported a provision for income taxes of $9,458,000 and $6,787,000 for the years 2023 and 2022, respectively. The effective income tax rate on income from continuing operations was 23.5% for the year ended December 31, 2023, compared to 22.9% for the year 2022. These provisions reflect accruals for taxes at the applicable rates for federal income tax and California franchise tax based upon reported pre-tax income and adjusted for the effects of all permanent differences between income for tax and financial reporting purposes (such as earnings on qualified municipal securities, BOLI and certain tax-exempt loans). The disparity between the effective tax rates for 2023 as compared to 2022 is primarily due to tax credits from low-income housing projects as well as tax-free income on municipal securities and loans that comprised a larger proportion of pre-tax income in 2022 as compared to 2023.

Financial Condition

The Company’s total assets were $1,842,422,000 at December 31, 2023 compared to $1,968,346,000 at December 31, 2022, a decrease of $125,924,000 or 6.4%. Net loans increased by $99,242,000, investments decreased $9,218,000, bank premises and equipment increased $565,000, interest receivable and other assets decreased $4,651,000 while cash and cash equivalents decreased $213,065,000 for the year ended December 31, 2023 as compared to December 31, 2022.

Loans gross of the allowance for credit losses and deferred fees were $1,016,579,000 as of December 31, 2023, compared to $915,758,000 as of December 31, 2022, an increase of $100,821,000 or 11.0%. The increase was due to an increase of $101,126,000 or 12.8% in commercial real estate loans, a decrease of $1,904,000 or 5.7% in consumer loans, an increase of $4,745,000 or 22.4% in agriculture loans, and a decrease of $3,146,000 or 4.6% in commercial and industrial loans. The composition remained relatively unchanged as a percentage of total loans, with commercial real estate comprising 88% and 85% of the loan portfolio at December 31, 2023 and 2022, respectively.

Deposits decreased $163,763,000 or 9.0% to $1,650,534,000 as of December 31, 2023 compared to $1,814,297,000 at December 31, 2022. Demand, Money Market, and Savings decreased by $102,491,000, $42,411,000 and $34,198,000, respectively, while Time Deposits increased by $15,337,000, as of December 31, 2023 as compared to December 31, 2022.

There were no short-term borrowing or long-term debt outstanding balances at December 31, 2023 and 2022. The Company uses short-term borrowings, primarily short-term FHLB advances, to fund short-term liquidity needs, if needed, and manage net interest margin.

Equity increased $39,466,000 or 31.2% to $166,092,000 as of December 31, 2023, compared to $126,626,000 at December 31, 2022. Equity increased due to earnings and the positive impact interest rates had on our unrealized loss on available-for-sale investment securities.

Investment Activities

Investments are a key source of interest income. Management of our investment portfolio is set in accordance with strategies developed and overseen by our Investment Committee. Investment balances, including cash equivalents and interest-bearing deposits in other financial institutions, are subject to change over time based on our asset/liability funding needs and interest rate risk management objectives. Our liquidity levels take into consideration anticipated future cash flows and all available sources of credits and are maintained at levels management believes are appropriate to assure future flexibility in meeting anticipated funding needs.

Cash Equivalents and Interest-bearing Deposits in other Financial Institutions

The Company holds federal funds sold, unpledged available-for-sale securities and salable government guaranteed loans to help meet liquidity requirements and provide temporary holdings until the funds can be otherwise deployed or invested. As of December 31, 2023, and 2022, we had $36,500,000 and $13,830,000, respectively, in federal funds sold.

Investment Securities

Management of our investment securities portfolio focuses on providing an adequate level of liquidity and establishing an interest rate-sensitive position, while earning an adequate level of investment income without taking undue risk. Investment securities that we intend to hold until maturity are classified as held-to-maturity securities, and all other investment securities are classified as either available-for-sale or equity securities. Currently, all of our investment securities are classified as available-for-sale, except for one mutual fund classified as an equity security.

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The fair value of the equity security was $3,132,000 and $2,990,000 at December 31, 2023 and December 31, 2022, respectively. Consistent with ASU 2016-01, equity securities are carried at fair value with the changes in fair value recognized in the consolidated statement of income. Accordingly, the Company recognized an unrealized gain of $41,000 during the year ended December 31, 2023, and an unrealized loss of $475,000 during the year ended December 31, 2022.

Our available-for-sale investment securities holdings decreased by $9,360,000 or 1.8% to $518,078,000 at December 31, 2023, compared to holdings of $527,438,000 at December 31, 2022. The carrying values of available-for-sale investment securities are adjusted for unrealized gains or losses as a valuation allowance and any gain or loss is reported on an after-tax basis as a component of other comprehensive income.

Total investment securities as a percentage of total assets increased to 28.3% as of December 31, 2023 compared to 26.9% at December 31, 2022. As of December 31, 2023, $288,199,000 of the investment securities were pledged to secure public deposits.

As of December 31, 2023, the total unrealized loss on debt securities that were in a loss position for less than 12 continuous months was $465,000 with an aggregate fair value of $52,079,000.  The total unrealized loss on debt securities that were in a loss position for greater than 12 continuous months was $29,679,000 with an aggregate fair value of $336,756,000.

The following table summarizes the maturity and repricing schedule of our debt investment securities, which does not include equity securities, at their amortized cost and their weighted average yields at December 31, 2023:

Debt Investment Maturities and Repricing Schedule

Yields in the above table have been adjusted to a fully tax equivalent basis. The yields are calculated using a weighted average method based on the investment security balances as of December 31, 2023. Securities are reported at the earliest possible call, repricing or maturity date.

Loans

Our residential loan portfolio includes no sub-prime loans, nor is it our normal practice to underwrite loans commonly referred to as "Alt-A mortgages", the characteristics of which are loans lacking full documentation, borrowers having low FICO scores or collateral compositions reflecting high loan-to-value ratios. Substantially all of our residential loans are indexed to U.S. Treasury Constant Maturity Rates and have provisions to reset five years after their origination dates.

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The following table summarizes our commercial real estate loan portfolio by the geographic location in which the property is located as of December 31, 2023 and 2022:

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Construction and land loans are classified as commercial real estate loans and increased $18.6 million in 2023 as compared to 2022.  The table below shows an analysis of construction and land loans by type and location. Non-owner-occupied land loans of $12.5 million as of December 31, 2023 included loans for lands specified for commercial development of $10.7 million and for residential development of $1.8 million, the majority of which are located in Stanislaus County.

Construction and Land Loans Outstanding by Type and Geographic Location

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Loan Maturities

The following table shows the contractual maturity distribution and repricing intervals of the outstanding loans in our portfolio, as of December 31, 2023. In addition, the table shows the distribution of such loans between those with variable or floating interest rates and those with fixed or predetermined interest rates. The large majority of the variable rate loans are tied to independent indices (such as the Wall Street Journal prime rate or a Treasury Constant Maturity Rate). Substantially all loans with an original term of more than five years have provisions for the fixed rates to reset, or convert to a variable rate, after one, three or five years and are therefore classified as a variable rate loan in the table below.

The majority of the properties taken as collateral are located in Northern California. We employ strict guidelines regarding the use of collateral located in less familiar market areas. Positive trends in Northern California real estate values, the low loan-to-value ratios in our commercial real estate portfolio, and the high percentage of owner-occupied properties further solidify our credit quality position.

Nonperforming Assets

Financial institutions generally have a certain level of exposure to credit quality risk and could potentially receive less than a full return of principal and interest if a debtor becomes unable or unwilling to repay. Since loans are the most significant assets of the Company and generate the largest portion of its revenues, the Company's management of credit quality risk is focused primarily on loan quality. Banks have generally suffered their most severe earnings declines due to customers' inability to generate sufficient cash flow to service their debts and/or downturns in national and regional economies which have brought about declines in overall property values. In addition, certain debt securities that the Company may purchase have the potential of declining in value if the obligor's financial capacity to repay deteriorates.

Nonperforming assets consist of loans on non-accrual status, loans 90 days or more past due and still accruing interest, loans restructured, where the terms of repayment have been renegotiated resulting in a reduction or deferral of interest or principal and OREO.

Loans are generally placed on non-accrual status when they become 90 days past due, unless management believes the loan is adequately collateralized and in the process of collection. The past due loans may or may not be adequately collateralized, but collection efforts are continuously pursued. Loans may be restructured by management when a borrower has experienced some changes in financial status, causing an inability to meet the original repayment terms, and where we believe the borrower will eventually overcome those circumstances and repay the loan in full. OREO consists of properties acquired by foreclosure or similar means and which management intends to offer for sale. The Company did not have any nonperforming loans as of December 31, 2023 and 2022.

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The Company held no OREO properties as of December 31, 2023 and 2022. Accordingly, the Company had zero non-performing assets recorded on the balance sheet as of December 31, 2023 and 2022.

Allowance for credit losses

In anticipation of credit risk inherent in our lending business, we set aside allowances through charges to earnings. Such charges are not only made for the outstanding loan portfolio, but also for off-balance sheet items, such as commitments to extend credits or letters of credit. The charges made for the outstanding loan portfolio are credited to the allowance for credit losses, whereas charges for off-balance sheet items are credited to the reserve for off-balance sheet items, which is presented as a component of other liabilities. The provision for credit losses is discussed in the section entitled “Provision for credit losses” above.

The balance of our allowance for credit losses is management's best estimate of the current expected credit losses inherent in the portfolio. The ultimate adequacy of the allowance is dependent upon a variety of factors beyond our control, including the real estate market, changes in interest rate and economic and political environments.

In 2020, the economy briefly slipped into a recession following the COVID-19 pandemic which inevitability impacted the financial condition of certain borrowers. We responded by making qualitative risk-based discretionary adjustments in connection with the COVID-19 pandemic and corresponding economic stress. In 2022, the financial stress subsided and credit quality improved allowing the Company to reverse $1,350,000 in loan loss provisions, which included the remaining COVID-19 discretionary adjustment of $1,100,000. The allowance for credit losses increased to $10,896,000 as of December 31, 2023, as compared with $9,468,000 at December 31, 2022. The allowance for credit losses as a percentage of total loans increased to 1.07% as of December 31, 2023, as compared to 1.03% as of December 31, 2022, mainly due to loan growth. Based on the current conditions of the loan portfolio, management believes that the $10,896,000 allowance for credit losses at December 31, 2023 is adequate to absorb losses inherent in our loan portfolio. No assurance can be given, however, that adverse economic conditions or other circumstances will not result in increased losses in the portfolio.

Diversification, low loan-to-values, strong credit quality and enhanced credit monitoring contribute to a reduction in the portfolio’s overall risk in recent years and help to offset the various inherent credit risks. We continue to monitor the impact of the economic environment, and adjustments to the provision for credit loss will be made accordingly. During 2023, the Company recognized net loan recoveries of $112,000 as compared to $80,000 in 2022.

Management reviews these conditions with our senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s estimate of the effect of such condition may be reflected as a specific allowance applicable to such credit or portfolio segment. Although management has allocated a portion of the allowance to specific loan categories, the adequacy of the allowance is considered in its entirety.

As required by ASU 2016-13, on January 1, 2023 the Company implemented CECL and increased our ACL, previously the allowance for loan losses, with a $346,000 cumulative adjustment. Under ASU 2016-13, the allowance for credit losses is deducted from the amortized cost basis to present the net amount expected to be collected on the loans. The measurement of expected credit losses is based on relevant information, which includes experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount over the remaining contractual life. The Company’s ACL is calculated monthly, with any difference in the calculated ACL and the recorded ACL trued-up through an entry to the provision for credit losses. Management calculates the quantitative portion of collectively evaluated reserves for all loan categories, using a discounted cash flow (“DCF”) methodology. For purposes of estimating the Company’s ACL, management generally evaluates collectively evaluated loans by federal call code in order to group loans with similar risk characteristics together, however management has grouped loans in selected call codes together in determining portfolio segments, due to similar risk characteristics and reserve methodologies used for certain call code classifications.

The DCF quantitative reserve methodology incorporates the consideration of probability of default (“PD”) and loss given default (“LGD”) estimates to calculate expected lifetime losses. The PD estimates are derived using reasonable and supportable economic forecasts and historical loss rate data from both the bank and a selected peer group. The historical loss rate data is compared to identified benchmark economic indicators to create a regression model that is updated annually. Reasonable and supportable forecasts for the identified economic indicators are then incorporated to arrive at expected default rates for the various loan categories. The reasonable and supportable forecasts are based on the National Unemployment Rate and Real Gross Domestic Product. The expected default rates are then applied to expected monthly loan balances estimated through the consideration of contractual terms and expected prepayments. The Company utilizes a four-quarter forecast period, after which the expected default rates revert to the historical average, over a four-quarter reversion period, on a straight-line basis. The prepayment assumptions are estimated based on historical experience of the bank. The prepayment assumptions are updated quarterly and may be subject to additional updates by Management in the event that changing conditions impact Management’s estimate. LGD utilized in the DCF is derived from the application of models that correlate LGD and PD based on historical peer data.

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Management recognizes that there are additional factors impacting risk of loss in the loan portfolio beyond what is captured in the quantitative portion of collectively evaluated reserves. As current and expected conditions, may vary compared with conditions over historical periods, which are utilized in the calculation of quantitative reserves, management considers whether additional or reduced reserve levels on collectively evaluated loans may be warranted given the consideration of a variety of qualitative factors. Several of the following qualitative factors (“Q-factors”) considered by management reflect regulatory guidance on Q-factors, whereas several others represent factors unique to the Company or unique to the current time period.

The qualitative portion of the Company’s reserves on collectively evaluated loans are calculated using a combination of numeric frameworks, matrices defining reserve rate based on specified metrics, and management judgement, to determine risk categorizations in each of the Q-factors presented above. The amount of qualitative reserves is also contingent upon the relative weighting of Q-factors according to management’s judgement.

Loans identified as losses by management and internal loan review are charged-off. Furthermore, consumer loan accounts are charged-off automatically based on regulatory requirements.

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The table below summarizes, for the periods indicated, loan balances at the end of each period, the daily averages during the period, changes in the allowance for credit losses arising from loans charged off, recoveries on loans previously charged off, additions to the allowance and certain ratios related to the allowance for credit losses:

Allowance for Credit Losses

The table below summarizes the allowance for credit loss balance by type of loan balance at the end of each period (See “Loan Portfolio” above for a description of each type of loan balance):

Allocation of the Allowance for Credit Losses

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Other Earning Assets

For various business purposes, we make investments in earning assets other than the interest-earning securities and loans discussed above. The primary other earning assets held by the Company as of December 31, 2023 and 2022, includes the cash surrender value of the BOLI policies, Federal Home Loan Bank stock and Federal Reserve Bank stock. During 2023, we purchased one new life insurance policy on a director for a total investment of $500,000.

During 2018 and 2022, we committed to invest $5 million and $10.5 million, respectively, in low-income housing tax credit funds (“LIHTC”) to promote our participation in CRA activities, which had unfunded commitments of $9,782,000 and $10,154,000 as of December 31, 2023 and 2022, respectively. For LIHTC investments, we receive the return in the form of tax credits and tax deductions over a period of approximately 15 years.

In 2017, we made a $1 million commitment as a limited partner, to a small business private equity partnership to promote our participation in CRA activities. The value is recorded at fair market value with market gains or losses recorded to other income in the consolidate financial statements. As of December 31, 2023, we have remaining commitments to fund an additional $200,000 on this investment.

The balances of other earning assets as of December 31, 2023 and December 31, 2022 were as follows:

Deposits and Other Sources of Funds

Deposits

Total deposits at December 31, 2023 and 2022 were $1,650,534 and $1,814,297,000, respectively, representing a decrease of $163,763,000 or 9.0% in 2023. The average deposits for the year ended December 31, 2023 decreased $108,026,000 or 5.9% to $1,708,821,000 compared to $1,816,847,000 at December 31, 2022. Deposit data analysis has resulted in an estimate of $768,103,000 in uninsured deposits, representing the balance that is not covered by FDIC insurance limits as of December 31, 2023.

Deposits are the Company’s primary source of funds. Due to strategic emphasis by management, core deposits (based on a definition provided by FDIC’s Uniform Bank Performance Report) decreased by $168,025,000 or 9.4% in 2023 to $1,622,136,000 at December 31, 2023. The percentage of core deposits to total deposits decreased slightly to 98.3% at December 31, 2023 as compared to 98.7% at December 31, 2022. The average rate paid on time deposits in denominations of over $250,000 was 1.35% and 0.27% for the years ended December 31, 2023 and 2022, respectively. The composition and cost of the Company's deposit base are important components in analyzing the Company's net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. See “Net Interest Income and Net Interest Margin” for further discussion.

The Company's liquidity is impacted by the volatility of deposits or other funding instruments or, in other words, by the propensity of that money to leave the institution for rate-related or other reasons. Deposits can be adversely affected if economic conditions in California and the Company's market area in particular, were to weaken. Potentially, the most volatile deposits in a financial institution are jumbo certificates of deposit, meaning time deposits with balances that equal or exceed $250,000, as customers with balances of that magnitude are typically more rate-sensitive than customers with smaller balances.

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The following tables summarize the distribution of average daily deposits and the average daily rates paid for the periods indicated:

Distribution of Average Daily Deposits

The scheduled maturities of our time deposits in denominations of more than $250,000 at December 31, 2023 are as follows:

Maturities of Time Deposits over $250,000

(Dollars in Thousands)

Because our client base is comprised primarily of commercial and industrial accounts, individual account balances are generally higher than those of consumer-oriented banks. Five of our clients carry deposit balances of more than 1% of our total deposits, one of which had a deposit balance of more than 3% of total deposits at December 31, 2023. The Company had no brokered deposits as of December 31, 2023 and 2022.

FHLB Borrowings

Although deposits are the primary source of funds for our lending and investment activities and for general business purposes, we may obtain advances from the FHLB as an alternative to retail deposit funds. We had no outstanding balances as of December 31, 2023 and 2022. The average balance of FHLB advances outstanding in 2023 and 2022 was $0. See “Liquidity Management” below for the details on the FHLB borrowings program.

Deferred Compensation Obligations

We maintain a nonqualified, unfunded deferred compensation plan for certain key management personnel.  Under this plan, participating employees may defer compensation, which will entitle them to receive certain payments upon retirement, death, or disability.  The plan provides for payments commencing upon retirement and reduced benefits upon early retirement, disability, or termination of employment. As of December 31, 2023 and 2022, our aggregate payment obligations under this plan totaled $11.4 million and $11.3 million, respectively

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Liquidity and Asset/Liability Management

Management seeks to ascertain optimum and stable utilization of available assets and liabilities as a vehicle to attain our overall business plans and objectives. In this regard, management focuses on measurement and control of liquidity risk, interest rate risk and market risk, capital adequacy, operation risk and credit risk.

Liquidity

Liquidity to meet borrowers’ credit and depositors’ withdrawal demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from depositors. Additional sources of liquidity may include institutional deposits, advances from the FHLB and other short-term borrowings, such as federal funds purchased.

Since our deposit growth strategy emphasizes core deposit growth, we have avoided relying on brokered deposits as a consistent source of funds. The Company had no brokered deposits as of December 31, 2023 and 2022.

As a secondary source of liquidity, we rely on advances from the FHLB to supplement our supply of lendable funds and to meet deposit withdrawal requirements. Advances from the FHLB are typically secured by a portion of our loan portfolio and stock issued by the FHLB. The FHLB determines limitations on the amounts of advances by assigning a percentage to each eligible loan category that will count towards the borrowing capacity. As of December 31, 2023 and 2022, the Company had no FHLB advances outstanding and had sufficient collateral to borrow an additional $333.1 million and $322.4 million, respectively. In addition, the Company had lines of credit with its correspondent banks to purchase overnight federal funds totaling $70 million at December 31, 2023 and 2022. No advances were made on these lines of credit as of December 31, 2023 and 2022.

The Company’s liquidity depends primarily on dividends paid to it as the sole shareholder of the Bank. The Bank’s ability to pay dividends to the Company may depend on whether the Bank will be in a position to pay dividends based on regulatory requirements and the performance of the Bank.

Maintenance of adequate liquidity requires that sufficient resources be available at all time to meet our cash flow requirements. Liquidity in a banking institution is required primarily to provide for deposit withdrawals and the credit needs of its customers and to take advantage of investment opportunities as they arise. Liquidity management involves our ability to convert assets into cash or cash equivalents without incurring significant loss, and to raise cash or maintain funds without incurring excessive additional cost. For this purpose, we maintain a portion of our funds in cash and cash equivalents, loans and securities available for sale. Our liquid assets at December 31, 2023 and 2022 totaled approximately $489.0 million and $754.9 million, respectively. Our liquidity level measured as the percentage of liquid assets to total assets was 26.5% and 38.4% as of December 31, 2023, and 2022, respectively.

We believe that our current unrestricted cash and cash equivalents, cash flows from operations and borrowing capacity under our credit facility will be sufficient to meet our working capital, capital expenditures, and any other capital needs for at least the next 12 months. We are currently not aware of any trends or demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in our liquidity increasing or decreasing in any material way that will impact our capital needs during or beyond the next 12 months.

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The following tables summarizes short- and long-term material cash requirements as of December 31, 2023, which we believe that we will be able to fund these obligations through cash generated from our operations and available alternative sources of funds (dollars in thousands):

Capital Resources and Capital Adequacy Requirements

In the past two years, our primary source of capital has been internally generated operating income through retained earnings. At December 31, 2023, total shareholders’ equity increased to $166.1 million, representing an increase of $39.5 million from December 31, 2022. The increase was due to net income of $30.8 million recorded to retained earnings and other comprehensive gains of $11.6 million, net of income taxes, due to the positive effect that treasury yields had on the unrealized market value adjustment of our available-for-sale investment portfolio during 2023. Also, retained earnings was reduced by the common stock dividend payments totaling $2.6 million during 2023. As of December 31, 2023, we had no material commitments for capital expenditures.

We are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can trigger regulatory actions that could have a material adverse effect on our financial statements and operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that rely on the quantitative measures of our assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. (See “Description of Business-Regulation and Supervision-Capital Adequacy Requirements” in this report for exact definitions and regulatory capital requirements.)

As of December 31, 2023, we were qualified as a “well capitalized institution” under the regulatory framework for prompt corrective action. For more information on our capital resources and capital adequacy requirements, see Note 19 to the Consolidated Financial Statements in Item 8 of this report.

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