QCR HOLDINGS INC (QCRH) FY 2022 MD&A

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

This section generally discusses 2022 and 2021 items and annual comparison between our fiscal 2022 performance compared to our fiscal 2021 performance.  A detailed review of our fiscal 2021 performance compared to our fiscal 2020 performance can be found in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2021, under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”  This discussion should be read in conjunction with our Consolidated Financial Statements and the accompanying notes thereto included or incorporated by reference elsewhere in this document.

Additionally, a comprehensive list of the acronyms and abbreviations used throughout this discussion is included in Note 1 to the Consolidated Financial Statements.

GENERAL

The Company was formed in February 1993 for the purpose of organizing QCBT. Over the past twenty-nine years, the Company has grown to include four banking subsidiaries and a number of nonbanking subsidiaries. As of December 31, 2022, the Company had $7.9 billion in consolidated assets, including $6.1 billion in total loans/leases, and $6.0 billion in deposits. The financial results of acquired/merged entities for the periods since their acquisition/merger are included in this report. Further information related to acquired/merged entities has been presented in the Annual Reports previously filed with the SEC corresponding to the year of each acquisition/merger. On April 1, 2022, the Company completed its acquisition of GFED and on April 2, 2022 merged Guaranty Bank, the banking subsidiary of GFED, into the Company’s Springfield-based charter, Springfield First Community Bank.  The combined bank changed its name to Guaranty Bank.

CRITICAL ACCOUNTING POLICIES AND CRITICAL ACCOUNTING ESTIMATES

The Company’s financial statements are prepared in accordance with GAAP. The financial information contained within these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred.  The preparation of financial statements, in conformity with GAAP, requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance, determination of the fair value of loans acquired in business combinations, impairment of goodwill and the fair value of financial instruments. A more detailed discussion of these critical accounting policies and estimates can be found in Note 1 to the Consolidated Financial Statements.

Based on its consideration of accounting policies and estimates that involve the most complex and subjective decisions and assessments, management has identified the following as critical accounting policies and estimates:

GOODWILL

The Company records all assets and liabilities purchased in an acquisition, including intangibles, at fair value. Goodwill is not amortized but is subject, at a minimum, to annual tests for impairment. In certain situations, interim impairment tests may be required if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.

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The initial recognition of goodwill and subsequent impairment analysis requires us to make subjective judgments concerning estimates of how the acquired assets will perform in the future using valuation methods, which may include using the current market price of stock or discounted cash flow analyses. Additionally, estimated cash flows may extend beyond five years and, by their nature, are difficult to determine over an extended timeframe. Events and factors that may significantly affect the estimates include, among others, competitive forces, customer behaviors, changes in revenue growth trends, cost structures, technology, changes in discount rates and market conditions. In determining the reasonableness of cash flow estimates, the Company reviews historical performance of the underlying assets or similar assets in an effort to assess and validate assumptions utilized in its estimates.

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In assessing the fair value of reporting units, we may consider the stage of the current business cycle and potential changes in market conditions. We may also utilize other information to validate the reasonableness of our valuations, including

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public market comparables and multiples of recent mergers and acquisitions of similar businesses. Valuation multiples may be based on tangible capital ratios of comparable companies and business segments. These multiples may be adjusted to consider competitive differences, including size, operating leverage and other factors. The carrying amount of a reporting unit is determined based on the capital required to support the reporting unit’s activities, including its tangible and intangible assets. The determination of a reporting unit’s capital allocation requires judgment and considers many factors, including the regulatory capital regulations and capital characteristics of comparably situated companies in relevant industry sectors. In certain circumstances, the Company will engage a third-party to independently validate our assessment of the fair value of our reporting units.

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The Company assesses the impairment of goodwill whenever events or changes in circumstances indicate the carrying value may not be recoverable. Factors considered important, which could trigger an impairment review, include the following:

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As of November 30, 2022, the Company’s management performed an annual assessment at the reporting unit level and determined no goodwill impairment existed.

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ALLOWANCE FOR CREDIT LOSSES ON LOANS AND LEASES AND OFF-BALANCE SHEET EXPOSURES

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On January 1, 2021, the Company adopted ASU 2016-13, “Financial Instruments – Credit Losses (Topic 326),” which replaces the incurred loss methodology with a current expected credit loss methodology, known as CECL.  Additionally, CECL required an allowance for OBS exposures and HTM securities to be calculated using a current expected credit loss methodology.

The Company’s allowance methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance that management believes is appropriate at each reporting date. The Company’s methodologies for estimating the ACL consider available relevant information about the collectability of cash flows, including information about past events, current conditions, and reasonable and supportable forecasts.  The methodologies apply historical loss information adjusted for asset-specific characteristics, economic conditions at the measurement date, and forecasts about future economic conditions that are expected to exist through the contractual lives of the financial assets and that are reasonable and supportable to the identified pools of financial assets with similar risk characteristics for which the historical loss experience was observed.  If a loan is determined to no longer share similar risk characteristics with other assets in the segmented pool, it is evaluated on an individual basis.

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The Company also estimates expected credit losses over the contractual term of the loan for the unfunded portion of the loan commitment that is not unconditionally cancellable by the Company.  Management uses an estimated average utilization rate to determine the exposure of default.  The allowance for OBS exposures is calculated using probability of default and loss given default using the same segmentation and qualitative factors used for loans and leases.

Although management believes the level of the ACL as of December 31, 2022 was adequate to absorb losses inherent in the loan/lease portfolio and OBS exposures, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

FAIR VALUE OF LOANS ACQUIRED IN BUSINESS COMBINATIONS

Loans acquired in business combinations are initially recorded at fair value as adjusted for credit risk and an allowance for credit losses at the date of acquisition. For loans with no significant evidence of credit deterioration since origination, the difference between the fair value and the unpaid principal balance of the loan at the acquisition date is amortized into interest income using the effective interest method over the remaining period to contractual maturity.

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Loans acquired with evidence of deterioration in credit quality since origination, or PCD loans, are accounted for in accordance with ASC Topic 326-20 “Financial instruments - credit losses.” Determining the fair value of the loans involves estimating the amount and timing of principal and interest cash flows initially expected to be collected on the loans and

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discounting those cash flows at an appropriate market rate of interest. An allowance for credit losses is recognized by estimating the expected credit losses of the purchased asset and recording an adjustment to the acquisition date fair value to establish the initial amortized cost basis of the asset. Differences between the established fair value, or amortized cost basis, and the unpaid principal balance of the asset is considered to be a non-credit discount/premium and is accreted/amortized into interest income using the interest method in accordance with ASC 310-10. Subsequent changes to the allowance for credit losses are recorded through provision for credit loss expense using the same methodology as other loans held for investment.

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FAIR VALUE OF FINANCIAL INSTRUMENTS

The fair value of a financial instrument is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts business. A framework has been established for measuring the fair value of financial instruments that considers the attributes specific to particular assets or liabilities and includes a three-level hierarchy for determining fair value based on the transparency of inputs to each valuation as of the measurement date. The Company estimates the fair value of financial instruments using a variety of valuation methods. When financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value and are classified as Level 1. When financial instruments, such as investment securities and derivatives, are not actively traded the Company determines fair value based on various sources and may apply matrix pricing with observable prices for similar instruments where a price for the identical instrument is not observable. The fair values of these financial instruments, which are classified as Level 2, are determined by pricing models that consider observable market data such as interest rate volatilities, LIBOR yield curve, credit spreads, prices from external market data providers and/or nonbinding broker-dealer quotations. When observable inputs do not exist, the Company estimates fair value based on available market data, and these values are classified as Level 3.

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FAIR VALUE OF SECURITIES

The fair value of securities is determined monthly and the securities are stated at fair value. For available for sale securities, unrealized gains and losses are reported as a component of stockholders’ equity, net of the related tax effect. For both available for sale and held to maturity debt securities, any portion of a decline in value associated with credit loss is recognized in income with the remaining noncredit related component being recognized in other comprehensive income.

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EXECUTIVE OVERVIEW

The Company reported net income of $99.1 million for the year ended December 31, 2022, and diluted EPS of $5.87. For the same period in 2021 the Company reported net income of $98.9 million and diluted EPS of $6.20.

The year ended December 31, 2022 was highlighted by several significant items:

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Following is a table that represents the various net income measurements for the years ended December 31, 2022 and 2021.

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The Company reported adjusted net income (non-GAAP) of $114.9 million, with adjusted diluted EPS of $6.80. See section titled “GAAP to Non-GAAP Reconciliations” for additional information. Adjusted net income for the year excludes a number of non-recurring items, after-tax, most significantly:

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The increase in weighted average common shares outstanding when comparing the year ended December 31, 2022 to December 31, 2021 was primarily due to the common stock issuance in connection with the acquisition of GFED as discussed in Note 2 to the Consolidated Financial Statements.

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Following is a table that represents the major income and expense categories.

The following are some noteworthy developments in the Company’s financial results:

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STRATEGIC FINANCIAL METRICS

The Company has established strategic financial metrics by which it manages its business and measures its performance. The metrics are periodically updated to reflect business developments. While the Company is determined to work prudently to achieve these metrics, there is no assurance that they will be met. Moreover, the Company’s ability to achieve these metrics may be affected by the factors discussed under “Forward Looking Statements” as well as the factors detailed in the “Risk Factors” section included under Item 1A. of Part I of this Annual Report on Form 10-K. The Company’s strategic financial metrics are as follows:

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The following table shows the evaluation of the Company’s strategic financial metrics:

* The calculations provided exclude non-core noninterest income and noninterest expense.

** Loan and lease growth excludes the initial loan balances from the GFED acquisition and PPP loans.

*** Fee income growth and noninterest expense growth are both impacted by the GFED acquisition.

It should be noted that these initiatives are long-term targets.

STRATEGIC DEVELOPMENTS

The Company took the following actions in 2022 to support our corporate strategy and further the strategic financial metrics shown above:

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GAAP TO NON-GAAP RECONCILIATIONS

The following table presents certain non-GAAP financial measures related to the “TCE/TA ratio”, “adjusted net income”, “adjusted EPS”, “adjusted ROAA”, “NIM (TEY)”, “adjusted NIM”, “efficiency ratio” and “loan growth excluding acquired and PPP loans”. In compliance with applicable rules of the SEC, all non-GAAP measures are reconciled to the most directly comparable GAAP measure, as follows:

The TCE/TA non-GAAP ratio has been a focus for our investors and management believes that this ratio may assist investors in analyzing the Company’s capital position without regard to the effects of intangible assets.

The following tables also include several “adjusted” non-GAAP measurements of financial performance.  The Company’s management believes that these measures are important to investors as they exclude non-core or non-recurring income and expense items; therefore, they provide a better comparison for analysis and may provide a better indicator of future performance.

NIM (TEY) is a financial measure that the Company’s management utilizes to take into account the tax benefit associated with certain loans and securities. It is standard industry practice to measure net interest margin using tax-equivalent measures.  In addition, the Company calculates NIM without the impact of acquisition accounting net accretion (adjusted NIM), as accretion amounts can fluctuate a great deal, making comparisons difficult.

The efficiency ratio is a ratio that management utilizes to compare the Company to peers. It is standard in the banking industry and widely utilized by investors.

Loan growth, excluding acquired and PPP loans, is a ratio that management utilizes to compare the Company to its peers.  The Company’s management believes this financial measure is important to investors as total loans and leases for the years ended December 31, 2022 and 2021 were materially higher due to the addition of acquired and PPP loans.  By excluding the acquired and PPP loans, the investor is provided a better comparison to prior years for analysis.

Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited. Although these non-GAAP financial measures are frequently used by investors to evaluate a company, they have limitations as analytical tools and should not be considered in isolation, or as a substitute for analyses of results as reported under GAAP.

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*    Non-core or non-recurring items (after-tax) are calculated using an estimated effective tax rate of 21% with the exception of acquisition costs which has an estimated effective tax rate of 13.62%.

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NET INTEREST INCOME AND MARGIN (TAX EQUIVALENT BASIS)

Net interest income, on a GAAP basis, increased 30% for the year ended December 31, 2022, compared to the prior year. Net interest income, on a tax equivalent basis (non-GAAP), increased 31% to $247.5 million for the year ended December

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31, 2022, as compared to the prior year. Net interest income improved primarily due to the Company’s asset-sensitive balance sheet in the rising interest rate environment.

A comparison of yields, spread and margin on a GAAP and tax equivalent basis is as follows:

Acquisition accounting net accretion can fluctuate, mostly depending on the payoff or renewal activity of the acquired loans. In evaluating net interest income and NIM, it's important to understand the impact of acquisition accounting net accretion when comparing periods. The above table reports NIM with and without the acquisition accounting net accretion to allow for more appropriate comparisons.  A comparison of acquisition accounting net accretion included in NIM is as follows:

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The Company's management closely monitors and manages NIM. From a profitability standpoint, an important challenge for the Company's subsidiary banks and leasing company is focusing on quality growth in conjunction with the improvement of their NIMs. Management continually addresses this issue with pricing and other balance sheet management strategies which included better loan pricing, reducing reliance on very rate-sensitive funding, closely managing deposit rate increases and finding additional ways to manage cost of funds through derivatives.

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The Company’s average balances, interest income/expense, and rates earned/paid on major balance sheet categories are presented in the following table:

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The Company’s components of change in net interest income are presented in the following table:

The Company’s operating results are also impacted by various sources of noninterest income, including trust fees, investment advisory and management fees, deposit service fees, swap fee income, gains from the sales of residential real estate loans and government guaranteed loans, earnings on BOLI and other income. Offsetting these items, the Company incurs noninterest expenses, which include salaries and employee benefits, occupancy and equipment expense, professional and data processing fees, FDIC and other insurance expense, loan/lease expense and other administrative expenses.

The Company’s operating results are also affected by economic and competitive conditions, particularly changes in interest rates, income tax rates, government policies and actions of regulatory authorities.

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RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2022 and 2021

INTEREST INCOME

For 2022, interest income increased $92.4 million, or 46%, compared to 2021.  For 2022, interest income (tax equivalent) increased $98.5 million, or 47%, compared to 2021.  This was due to an increase in the yield of average securities and average loans/leases as well as an increased volume of average loans/leases.

The Company intends to continue to grow quality loans and leases as well as its private placement tax-exempt securities portfolio to maximize yield while minimizing credit and interest rate risk.

INTEREST EXPENSE

Comparing 2022 to 2021, interest expense increased $39.5 million, or 180%, year-over-year. The increase is primarily due to an increase in cost of funds given the rising rate environment. The Company’s cost of funds was 1.28% for the year ending December 31, 2022, which was up from 0.59% for the year ending December 31, 2021.

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PROVISION FOR CREDIT LOSSES

The ACL is established through provision for credit losses expense to provide an estimated ACL.  The following table shows the components for the provision for credit losses for the years ended December 31, 2022 and 2021.

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The Company’s total provision for credit losses was $8.3 million for 2022, an increase of $4.8 million from 2021. The increase in provision on loans and leases was driven by the CECL Day 2 credit loss expense on performing loans of $11.0 million (pre-tax) as a result of the GFED acquisition, offset by negative provision recorded at the other three charters.  For the year ended December 31, 2022, the provision related to OBS was a negative $1.3 million which included a $1.4 million provision related to the acquisition of GFED, compared to a negative $2.2 million for the year ended December 31, 2021.  The decrease was due a reduction in the qualitative factors related to economic improvement in the CECL forecast along with improvement in economic factors and credit quality within the qualitative factor matrix.

The ACL for loans and leases is established based on a number of factors, including the Company’s historical loss experience, delinquencies and charge-off trends, economic and other forecasts, the local, state and national economies and the risk associated with the loans/leases and securities in the portfolio as described in more detail in the “Critical Accounting Policies and Critical Accounting Estimates” section.

The Company had an ACL on loans/leases of 1.43% of total gross loans/leases at December 31, 2022, compared to 1.68% of total gross loans/leases at December 31, 2021.  Management evaluates the allowance needed on the acquired loans factoring in the remaining discount, which was $6.1 million and $1.5 million at December 31, 2022 and 2021, respectively.

Additional discussion of the Company’s allowance can be found in the “Financial Condition” section of this report.

NONINTEREST INCOME

The following tables set forth the various categories of noninterest income for the years ended December 31, 2022 and 2021.

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In recent years, the Company has been successful in expanding its wealth management customer base. Trust fees continue to be a significant contributor to noninterest income. Assets under management decreased by $842.4 million in 2022 due

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to market volatility.  Income is generated primarily from fees charged based on assets under administration for corporate and personal trusts and for custodial services. The majority of the trust fees are determined based on the value of the investments within the fully-managed trusts. Trust fees decreased 5% in 2022 as compared to 2021 due to market volatility.  The Company expects trust fees to be negatively impacted during periods of significantly lower market valuations and positively impacted during periods of significantly higher market valuation.

Investment advisory and management fees decreased 5% in 2022 as compared to 2021. Similar to trust fees, fees from these services are largely determined based on the value of the investments managed. As a result, fee income from this line of business fluctuates with market valuations.

Deposit service fees increased 33% in 2022 as compared to 2021. The increase was primarily due to the GFED acquisition. The Company continues to emphasize shifting the mix of deposits from retail time deposits to non-maturity demand deposits across all its markets. With this continuing shift in mix, the Company has increased the number of demand deposit accounts, which tend to be lower in interest cost and higher in-service fees. The Company plans to continue this shift in mix and to further focus on growing deposit service fees.

Gains on sales of residential real estate loans, net, decreased 45% in 2022 as compared to 2021. The decrease was primarily due to decreased residential real estate purchases and the refinancing of residential real estate loans with higher interest rates in 2022.

The Company’s gains on the sale of government-guaranteed portions of loans for 2022 decreased 48% as compared to 2021. Over the past few years, competitors have been offering SBA and USDA loan candidates traditional financing without such a guarantee and the Company is not willing to relax its structure for those lending opportunities.

The Company has grown its interest rate swap program significantly over the past several years.  The Company’s interest rate swap program consists of back-to-back interest rate swaps with two types of commercial borrowers: (1) traditional commercial loans of a certain minimum size and sophistication, and (2) LIHTC permanent loans.  Most of the growth has been in the latter category as the Company has grown relationships with strong LIHTC developers with many years of experience.  The LIHTC industry is strong and growing with an increased need for affordable housing.  The interest rate swaps allow the commercial borrowers to pay a fixed interest rate while the Company receives a variable interest rate as well as an upfront nonrefundable fee dependent upon the pricing. Swap fee income/capital markets revenue totaled $41.3 million in 2022 as compared to $61.0 million in 2021. The decrease was due to delays in client projects caused by ongoing supply chain disruptions, inflationary pressures and higher interest rates. Swap fee income relative to the increase in notional amount of the non-hedging interest rate swap contracts was 8.2% in 2022 and 9.9% in 2021.  The decrease in the ratio was primarily due to the steepening of the yield curve. In the traditional commercial portfolio, the pricing is more competitive and the duration is shorter as compared to the LIHTC permanent loans.  The mix of loans with interest rate swaps continued to be heavily weighted towards LIHTC permanent loans. Future levels of swap fee income are dependent upon the needs of our traditional commercial and LIHTC borrowers, and the size of the related nonrefundable swap fee may fluctuate depending on the interest rate environment.

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There were no securities gains or losses in 2022.  Securities losses, net of gains totaled $88 thousand in 2021.

Earnings on BOLI increased 12% in 2022. There were $10.0 million of purchases of BOLI in 2022 and there were no purchases of BOLI in 2021. Yields on BOLI (based on a simple average and excluding the impact of the federal income tax exemption) were 1.92% for 2022 and 2.94% for 2021. Notably, a portion of the Company’s BOLI is variable rate whereby the returns are determined by the performance of the equity markets. Management intends to continue to review its BOLI investments to be consistent with policy and regulatory limits in conjunction with the rest of its earning assets in an effort to maximize returns while minimizing risk.

Debit card fees are the interchange fees paid on certain debit card customer transactions. Debit card fees increased 30% in 2022. The increase was primarily due to the GFED acquisition. These fees can vary based on customer debit card usage, so fluctuations from period to period may occur. As an opportunity to maximize fees, the Company offers a deposit product with a higher interest rate that incentivizes debit card activity.

Correspondent banking fees decreased 13% in 2022 due to higher earnings credits as the Federal Reserve increased rates continually in 2022. The fees are generally included in the earnings credit rates which incent the correspondent bank to maintain higher levels of noninterest bearing deposits to offset the correspondent banking fees.  Management will continue

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to evaluate earnings credit rates and the resulting impact on deposit balances and fees while balancing the ability to grow market share. Correspondent banking continues to be a core strategy for the Company, as this line of business provides a high level of noninterest bearing deposits that can be used to fund loan growth as well as a steady source of fee income.  The Company now serves 185 banks in Iowa, Illinois, Missouri and Wisconsin.

Loan related fee income increased 7% in 2022. The increase was primarily due to the increase in loan volume with the GFED acquisition.

Fair value gain (loss) on derivatives increased 1062% in 2022.  The increase was due to the rapidly rising interest rate environment.  The Company uses cap instruments to manage interest rate risk related to the variability of interest payments due to changes in interest rates.  See Note 7 to the Consolidated Financial Statements for additional information.

Other noninterest income decreased 65% in 2022 primarily due to lower equity investment income and lower gains on disposal of leased assets.

NONINTEREST EXPENSES

The following tables set forth the various categories of noninterest expenses for the years ended December 31, 2022 and 2021.

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Management places strong emphasis on overall cost containment and is committed to improving the Company’s general efficiency. One-time charges relating to acquisitions and post-acquisition compensation, transition and integration cost impacted expense in 2022.

Salaries and employee benefits, which is the largest component of noninterest expense, increased 14% in 2022 as compared to 2021. This increase was primarily related to the GFED acquisition, which resulted in an increase of 165 full-time equivalent employees.

Occupancy and equipment expense increased 38% in 2022 as compared to 2021. This increase was due to higher depreciation expense and computer hardware expense related to the GFED acquisition.

Professional and data processing fees increased 12% in 2022 as compared to 2021. The increase was primarily due to the GFED acquisition.  Generally, professional and data processing fees can fluctuate depending on certain one-time project costs. Management will continue to focus on minimizing such one-time costs and driving recurring costs down through contract negotiation or managed reduction in activity where costs are determined on a usage basis.

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Acquisition costs totaled $3.7 million in 2022 and $624 thousand in 2021.  These costs were comprised of primarily legal, accounting and other professional fees related to the GFED acquisition described in Note 2 to the Consolidated Financial Statements.

Post-acquisition compensation, transition and integration costs totaled $5.5 million in 2022.  There were no post-acquisition compensation, transition and integration costs in 2021. These costs were comprised primarily of personnel costs, IT integration, and conversion costs related to the acquisition of GFED.

There were no disposition costs in 2022. Disposition costs totaled $13 thousand for 2021. The costs were comprised primarily of legal, accounting, disposal of fixed assets and prepaids, personnel costs and IT deconversion costs related to the sale of the Bates Companies.    See Note 2 to the Consolidated Financial Statements for further discussion.

FDIC insurance, other insurance and regulatory fee expense increased 30% in 2022.  The increase in expense was due to the GFED acquisition as well as an increase in the asset size of the Company in 2022 which increased the Company’s insurance rates and expenses.

Loan/lease expense increased 10% in 2022 as compared to 2021. Generally, loan/lease expense has a direct relationship with the level of NPLs; however, it may deviate depending upon the individual NPLs.

Net cost of (income from) and gains/losses on operations of other real estate includes gains/losses on the sale of OREO, write-downs of OREO and all income/expenses associated with OREO. Net income from operations totaled $40 thousand for 2022 as compared to net income of operations of $1.4 million for 2021. The higher amount in 2021 is due primarily to the gain on sale of a large property.

Advertising and marketing expense increased 17% in 2022 as compared to 2021. The increase in expense was primarily due to the return to more normal operations during the second half of 2021 and the full year of 2022 in response to improvements in the general economic environment due to COVID-19 as well as the GFED acquisition.

Communication and data connectivity expense increased 23% in 2022 as compared to 2021. The increase is primarily due to the GFED acquisition.

Supplies expense increased 5% in 2022 as compared to 2021. The increase is primarily due to the GFED acquisition.

Bank service charges, a large portion of which includes indirect costs incurred to provide services to QCBT’s correspondent banking customer portfolio, increased 5% in 2022 as compared to 2021.   As transaction volumes continue to increase and the number of correspondent banking clients increases, the associated expenses is expected to also increase.

Correspondent banking expense increased 5% in 2022 as compared to 2021. These are direct costs incurred to provide services to QCBT’s correspondent banking customer portfolio, including safekeeping and cash management services.

Intangible amortization expense increased 41% in 2022 as compared to 2021. The increase is due to the GFED acquisition. These expenses naturally decrease as intangibles become fully amortized unless there is an addition to intangible assets.

Payment card processing expense increased 39% in 2022 as compared to 2021. The increase is due to the GFED acquisition.

Trust expense increased 2% in 2022 as compared to 2021. The increase was due to new relationships added in 2022 totaling $481.0 million of new assets under management.

Other noninterest expense decreased 4% in 2022 as compared to 2021.  The decrease was due primarily to losses on disposal of fixed assets no longer in service.  Also included in other noninterest expense are other items such as subscriptions, sales and use tax and expenses related to wealth management.

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INCOME TAX EXPENSE

The provision for income taxes was $14.5 million for 2022, or an effective tax rate of 12.7%, compared to $22.6 million for 2021, or an effective tax rate of 18.6%.  Refer to the reconciliation of the expected income tax rate to the effective tax rate that is included in Note 14 to the Consolidated Financial Statements for additional details.

FINANCIAL CONDITION AS OF DECEMBER 31, 2022 AND 2021

OVERVIEW

Following is a table that represents the major categories of the Company’s balance sheet.

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In 2022, total assets increased $1.9 billion, or 30%. The Company’s securities portfolio increased $117.9 million, or 15%, during 2022.  The Company’s loan/lease portfolio increased $1.5 billion, or 32%, during 2022. Deposits grew $1.1 billion, or 22%, during 2022. Borrowings increased $655.1 million, or 384%, during 2022. The increases were primarily due to the GFED acquisition and strong growth.

INVESTMENT SECURITIES

The composition of the Company’s securities portfolio is managed to meet liquidity needs while prioritizing the impact on interest rate risk and maximizing return, while minimizing credit risk. Over the recent years, the Company has continued to change the mix of the portfolio by decreasing U.S government sponsored agency securities, while increasing residential mortgage-backed and related securities and tax-exempt municipal securities. Of the latter, the large majority are privately placed tax-exempt debt issuances by municipalities located in the Midwest (with some in or near the Company’s existing markets) that require a thorough underwriting process before investment and are generated by our specialty finance group.

Following is a breakdown of the Company’s securities portfolio by type, the percentage of net unrealized gains (losses) to carrying value on the total portfolio, and the portfolio duration as of December 31, 2022 and 2021.

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Due to the sharp increase in intermediate and long-term interest rates during 2022, the valuation of the Company’s AFS portfolio declined significantly.  As a result, the Company’s net unrealized gains as a percentage for amortized cost changed from 7.17% as of December 31, 2021 to a net unrealized loss as a percentage of amortized cost of (11.26)% as of December 31, 2022.

The Company has not invested in non-agency commercial or residential mortgage-backed securities or pooled trust preferred securities.

The following is a breakdown of the weighted-average yield for each range of maturities by category of debt securities that are not held at fair value:

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* Amortized cost above excludes ACL of $180 thousand.

The weighted-average yield is calculated by dividing the total interest for each security per maturity range by the total amortized cost within that maturity range. Yields are not computed on a tax equivalent basis.

There have been no major changes within the tax-exempt portfolio.

See Note 3 to the Consolidated Financial Statements for additional information regarding the Company’s investment securities.

LOANS/LEASES

Total loans/leases grew 31.2% in 2022 over 2021. Total loans/leases, excluding acquired and PPP loans (non-GAAP) grew 14.6% in 2022 over 2021. The mix of loan/lease types within the Company’s loan/lease portfolio is presented in the following tables.

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As CRE loans have historically been the Company’s largest portfolio segment, management places a strong emphasis on monitoring the composition of the Company’s CRE loan portfolio.  For example, management tracks the level of owner-occupied CRE loans relative to non-owner-occupied loans because owner-occupied loans are generally considered to have less risk.  As of December 31, 2022, approximately 16% of the CRE loan portfolio was owner-occupied.

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Historically, the Company structures most residential real estate loans to conform to the underwriting requirements of Freddie Mac and Fannie Mae to allow the subsidiary banks to resell the loans on the secondary market to avoid the interest rate risk associated with longer term fixed rate loans and recognizing noninterest income from the gain on sale. Loans originated for this purpose were classified as held for sale and are included in the residential real estate loans in the table above. Historically, the subsidiary banks structure most loans that will not conform to those underwriting requirements as adjustable-rate mortgages that mature or adjust in one to five years, and then retain these loans in their portfolios. The Company holds a limited amount of 15-year fixed rate residential real estate loans originated in prior years that met certain credit guidelines. In addition, the Company has not originated any subprime, Alt-A, no documentation, or stated income residential real estate loans throughout its history.

The following tables set forth the remaining maturities by loan/lease type as of December 31, 2022 and 2021. Maturities are based on contractual dates.

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See Note 4 to the Consolidated Financial Statements for additional information on the Company’s loan/lease portfolio.

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ALLOWANCE FOR CREDIT LOSSES ON LOANS/LEASES AND OFF-BALANCE SHEET EXPOSURES

The adequacy of the ACL was determined by management based on factors that included the overall composition of the loan/lease portfolio, types of loans/leases, historical loss experience, loan/lease delinquencies, potential substandard and doubtful credits, economic conditions, collateral positions, government guarantees and other factors that, in management’s judgment, deserved evaluation. To ensure that an adequate ACL was maintained, provisions were made based on a number of factors, including the increase in loans/leases and a detailed analysis of the loan/lease portfolio. The loan/lease portfolio is reviewed and analyzed quarterly with specific detailed reviews completed on all credits risk-rated less than “fair quality” as described in Note 1 to the Consolidated Financial Statements and carrying aggregate exposure in excess of $250 thousand. The adequacy of the allowance is monitored by the credit administration staff and reported to management and the board of directors.

Changes in the ACL for loans/leases for the years ended December 31, 2022, 2021 and 2020 are presented as follows:

The Company recorded an $11.0 million (pre-tax) provision for credit losses on loans in 2022, for the CECL Day 2 provision as a result of the GFED acquisition.

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Net charge-offs by segment and their percentage of average loans and leases are as follows:

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Changes in the ACL for OBS exposures for the years ended December 31, 2022 and 2021:

The ACL for OBS exposures totaled $9.1 million at the adoption of CECL on January 1, 2021.  The Company recorded negative $1.3 million of provision for credit losses related to OBS exposures. Negative provision is due to increased line of credit usage resulting in lower exposure, offset by Day 2 provision related to the acquisition of GFED of $1.4 million.  At December 31, 2022, the allowance for OBS exposures was $5.6 million.

The following is a table that reports the criticized and classified loan totals as of December 31, 2022 and 2021.

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*    Amounts above exclude the government guaranteed portion, if any. The Company assigns internal risk ratings of Pass (Rating 2) for the government

guaranteed portion.

**   Criticized loans are defined as C&I and CRE loans with internally assigned risk ratings of 6, 7, or 8, regardless of performance.

*** Classified loans are defined as C&I and CRE loans with internally assigned risk ratings of 7 or 8, regardless of performance.

Criticized loans increased 42% and classified loans increased 24% in 2022 as compared to 2021. Increases are due to the acquisition of GFED. The Company continues its strong focus on improving credit quality in an effort to limit NPLs.

The following table summarizes the trend in allowance as a percentage of gross loans/leases and as a percentage of NPLs as of December 31, 2022 and 2021.

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The following table presents the allowance by type and the percentage of loan/lease type to total loans/leases.

* Included within the C&I – Other segment is an ACL on leases of $970 thousand and $1.5 million as of December 31, 2022 and 2021, respectively. Leases represent 1% of to total loans/leases.

Although management believes that the ACL for loans/leases at December 31, 2022 is at a level adequate to absorb losses on existing loans/leases, there can be no assurance that such losses will not exceed the estimated amounts or that the Company will not be required to make additional provisions in the future. Unpredictable future events could adversely affect cash flows for both commercial and individual borrowers, which could cause the Company to experience increases in problem assets, delinquencies and losses on loans/leases, and may require additional increases in the provision for credit losses. Asset quality is a priority for the Company and its subsidiaries. The ability to grow profitably is in part dependent upon the ability to maintain that quality. The Company continually focuses efforts at its subsidiary banks and its leasing company with the intention to improve the overall quality of the Company’s loan/lease portfolio.

See Note 4 to the Consolidated Financial Statements for additional information on the Company’s ACL.

NONPERFORMING ASSETS

The table below presents the amounts of NPAs and related ratios.

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NPAs at December 31, 2022 were $8.9 million, up $6.1 million from December 31, 2021.  The increase from prior year was primarily the result of the GFED acquisition. The ratio of NPAs to total assets was 0.11% at December 31, 2022, up from 0.05% at December 31, 2021.

The majority of the Company’s NPAs consists of nonaccrual loans/leases. For nonaccrual loans/leases, management thoroughly reviewed these loans/leases and provided specific allowances as appropriate.

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OREO is carried at the lower of carrying amount or fair value less costs to sell.

The policy of the Company is to place a loan/lease on nonaccrual status if: (a) payment in full of interest or principal is not expected; or (b) principal or interest has been in default for a period of 90 days or more unless the obligation is both in the process of collection and well secured.  A loan/lease is well secured if it is secured by collateral with sufficient market value to repay principal and all accrued interest. A debt is in the process of collection if collection of the debt is proceeding in due course either through legal action, including judgment enforcement procedures, or in appropriate circumstances, through collection efforts not involving legal action which are reasonably expected to result in repayment of the debt or in its restoration to current status.

The Company’s lending/leasing practices remain unchanged and asset quality remains a top priority for management.

DEPOSITS

Deposits grew $1.1 billion, or 21.6%, during 2022, primarily due to an increase in both non-interest bearing and interest-bearing deposits with the GFED acquisition.  The table below presents the composition of the Company’s deposit portfolio.

Deposit balances can fluctuate a great deal due to large customer and correspondent bank activity. During recent years, the Company had significant core deposit growth mostly from its correspondent banking clients.

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The Company’s correspondent bank deposit portfolio and funds managed consists of the following:

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Generally, the Company can modify the structure and interest rates paid for those correspondent bank deposits on the balance sheet which are the noninterest bearing deposits and the money market deposits.  This has led to more of the correspondent bank portfolio’s excess liquidity to shift to the EBAs at the FRB, which is managed by the Company, but is off the Company’s balance sheet.  On average, over the past two years, the correspondent banks’ EBA ranges from $800 million to $1.5 billion which is approximately $500 million more than pre-pandemic levels.  In the second half of 2022, the Company’s correspondent bank deposit portfolio shifted to more normalized levels of liquidity and the related deposits on and off the Company’s balance sheet.

The Company had total uninsured deposits of $1.6 billion and $1.9 billion as of December 31, 2022 and 2021 respectively. The table below represents the time deposits in FDIC uninsured accounts by maturity:

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There were no other time deposits otherwise uninsured. The Company had no deposits by foreign depositors in domestic offices as of December 31, 2022 and 2021.

Management will continue to focus on growing its core deposit portfolio, including its correspondent banking business at QCBT, as well as shifting the mix from brokered and other higher cost deposits to lower cost core deposits. With the significant success achieved by QCBT in growing its correspondent banking business, QCBT has developed procedures to proactively monitor this industry concentration of deposits and loans. Other deposit-related industry concentrations and large accounts are monitored by the internal asset liability management committee. See discussion regarding policy limits on bank stock loans in the Lending/Leasing section under Item 1 – Business in Part I of this Annual Report on Form 10-K.

SHORT-TERM BORROWINGS

The subsidiary banks purchase federal funds for short-term funding needs from the FRB or from their correspondent banks. The table below presents the composition of the Company’s short-term borrowings.

The Company’s federal funds purchased fluctuates based on the short-term funding needs of the Company’s subsidiary banks. See Note 9 to the Consolidated Financial Statements for additional information on the Company’s short-term borrowings.

FHLB ADVANCES AND OTHER BORROWINGS

As a result of their membership in the FHLB of Des Moines, the subsidiary banks have the ability to borrow funds for short-term or long-term purposes under a variety of programs. The subsidiary banks can utilize FHLB advances for loan matching as a hedge against the possibility of changing interest rates or when these advances provide a less costly or more readily available source of funds than customer deposits.

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It is management’s intention to reduce its reliance on wholesale funding, including FHLB advances and brokered deposits.  Replacement of this funding with core deposits helps to reduce interest expense as wholesale funding tends to be higher cost.  However, the Company may choose to utilize advances and/or brokered deposits to supplement funding needs, as this is a way for the Company to effectively and efficiently manage interest rate risk.

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The Company renewed its revolving credit note in the second quarter of 2022.  At renewal, the available line amount was increased from $25.0 million to $50.0 million. Interest on the revolving line of credit was calculated at the greater of: (a) the effective Prime Rate less 0.50% and (b) 3.00% per annum.  The collateral on the revolving line of credit is 100% of the outstanding stock of the Company’s bank subsidiaries.  There was no outstanding balance on the revolving line of credit at December 31, 2022.

See Notes 10 and 11 to the Consolidated Financial Statements for additional information regarding FHLB advances and other borrowings.

SUBORDINATED NOTES

The Company had subordinated notes totaling $232.7 million and $113.9 million as of December 31, 2022 and 2021, respectively. The Company completed private placements of $100.0 million in aggregate principal amount of fixed-to-

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floating subordinated notes in the third quarter of 2022.  The Company acquired $19.6 million of subordinated notes during 2022 with the GFED acquisition.  The Company prepaid $5.0 million in subordinated debt in 2021 with no gain/loss.

See Note 12 to the Consolidated Financial Statements for additional information regarding the subordinated notes.

JUNIOR SUBORDINATED DEBENTURES

The Company had junior subordinated debentures totaling $48.6 million and $38.2 million as of December 31, 2022 and 2021, respectively.  The Company acquired $10.3 million of junior subordinated debentures during 2022 with the GFED acquisition.

STOCKHOLDERS’ EQUITY

The table below presents the composition of the Company’s stockholders’ equity.

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*   TCE/TA ratio is defined as total common stockholders’ equity excluding goodwill and other intangibles divided by total assets.  This ratio is a non-GAAP measure. Refer to the GAAP to Non-GAAP Reconciliations section of this report for more information.

As of December 31, 2022 and 2021, no preferred stock was outstanding.

Due to the sharp increase in intermediate and long-term interest rates, the valuation of the Company’s AFS securities portfolio and certain hedged financial instruments declined significantly.  The valuation change, net of taxes, which flows through the Company’s AOCI was a net decline of $66.5 million in 2022.

On February 13, 2020, the board of directors of the Company approved a share repurchase program under which the Company was authorized to repurchase, from time to time as the Company deemed appropriate, up to 800,000 shares of its outstanding common stock, or approximately 5% of the outstanding shares as of December 31, 2019.  On May 19, 2022, the board of directors of the Company approved a share repurchase program under which the Company is authorized to repurchase, from time to time as the Company deems appropriate, up to an additional 1,500,000 shares of its outstanding common stock, or approximately 10% of the outstanding shares as of December 31, 2021.  As of December 31, 2022, the Company had repurchased 570,000 shares under the program and all shares purchased have been retired.

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The following table presents the rollforward of stockholders’ equity for the years ended December 31, 2022 and 2021, respectively.