QCR HOLDINGS INC (QCRH) FY 2023 MD&A

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

This section generally discusses 2023 and 2022 items and annual comparison between our fiscal 2023 performance compared to our fiscal 2022 performance.  A detailed review of our fiscal 2022 performance compared to our fiscal 2021 performance can be found in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2022, under the caption “Management’s Discussion and Analysis of Financial Condition and Results

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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 thirty years, the Company has grown to include four banking subsidiaries and a number of nonbanking subsidiaries. As of December 31, 2023, the Company had $8.5 billion in consolidated assets, including $6.5 billion in total loans/leases, and $6.5 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.

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, the fair value of financial instruments, and the fair value of securities. 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 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

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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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The Company’s management performed an annual assessment at the reporting unit level and determined no goodwill impairment existed as of November 30, 2023.

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

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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, 2023 was adequate to absorb losses inherent in the loan/lease portfolio, the HTM 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

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loans and 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, SOFR 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 available for sale and held to maturity debt securities is determined monthly based upon values provided by third parties. Available for sale securities are carried at fair value with unrealized gains and losses 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 and with the remaining noncredit related component for available for sale securities being recognized in other comprehensive income. The fair value of trading securities is determined quarterly based upon estimates provided by a third party valuation specialist. Trading securities are carried at fair value with unrealized gains and losses recorded in earnings.

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EXECUTIVE OVERVIEW

The Company reported net income of $113.6 million for the year ended December 31, 2023, and diluted EPS of $6.73. For the same period in 2022 the Company reported net income of $99.1 million and diluted EPS of $5.87.

The year ended December 31, 2023 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, 2023 and 2022.

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The Company reported adjusted net income (non-GAAP) of $115.1 million, with adjusted diluted EPS of $6.82. 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, as set forth in the “GAAP to Non-GAAP Reconciliation” section.

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 estopablished 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 fee income growth and noninterest expense growth calculations provided exclude non-core noninterest income and noninterest expense.

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

*** 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 2023 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” and “efficiency ratio”. 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.

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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 decreased 4% for the year ended December 31, 2023, compared to the prior year. Net interest income, on a tax equivalent basis (non-GAAP), increased 1% to $249.2 million for the year ended December 31, 2023, as compared to the prior year. Net interest income changed primarily due to the Company’s increase in cost of funds with a shift of the composition of deposits from noninterest and lower beta deposits to higher beta deposits, which more than offset the continued expansion of loan and investment yields.

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 additional 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 equipment financing/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 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, capital markets revenue, including swap fee income and gains on loan securitizations, 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.

RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2023 and 2022

INTEREST INCOME

For 2023, interest income increased $120.8 million, or 41%, compared to 2022. This was due to continued loan growth and repricing of the Company’s floating rate loan portfolio with rapidly rising interest rates as well as a full year of GFED income reflected in the Company’s 2023 results, compared to nine months of such income reflected in the Company’s 2022 results.

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.

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INTEREST EXPENSE

Comparing 2023 to 2022, interest expense increased $131.0 million, or 213%, year-over-year. The increase is primarily due to a significant increase in cost of funds given the sharp rising rate environment and the shift of the composition of deposits from noninterest bearing and lower beta deposits to higher beta deposits as well as a full year of GFED expense reflected in the Company’s 2023 results, compared to nine months of such expense reflected in the Company’s 2022 results. The Company’s cost of funds was 3.31% for the year ending December 31, 2023, which was up from 1.28% for the year ending December 31, 2022.

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, 2023 and 2022.

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The Company’s total provision for credit losses was $16.5 million for 2023, an increase of $8.2 million from 2022. The increase in provision for credit losses on loans and leases was driven by the loan growth and higher criticized loan balances.  For the year ended December 31, 2023, the provision for credit losses related to OBS was $4.0 million, compared to a negative $1.3 million provision for the year ended December 31, 2022.  The increase was due to an increase in the balance of unfunded commitments as there was a surge in commitments in the LIHTC lending business during the year.  The provision related to HTM securities for the year ended December 31, 2023 was $23 thousand as compared to a negative $18 thousand provision for the year ended December 31, 2022.  There was a $989 thousand provision related to AFS securities for the year ended December 31, 2023 as compared to no provision for the prior year.  The increase was entirely due to an impairment of one subordinated debt investment in a failed bank in the first quarter of 2023.  This was a legacy investment acquired as part of the 2022 GFED acquisition and an allowance was established for the entire balance of the investment.

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 1.33% of gross loans/leases held for investment at December 31, 2023, compared to 1.43% of gross loans/leases held for investment at December 31, 2022.  Management evaluates the allowance needed on the loans acquired in previous acquisitions factoring in the remaining discount, which was $3.9 million and $6.1 million at December 31, 2023 and 2022, respectively.

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

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NONINTEREST INCOME

The following tables set forth the various categories of noninterest income for the years ended December 31, 2023 and 2022.

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Certain increases in these categories were due to the GFED acquisition, as there was a full year of GFED income reflected in the Company’s 2023 results, compared to nine months of such income reflected in the Company’s 2022 results.  The GFED acquisition is further described in Note 2 to the Consolidated Financial Statements.

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 increased by $700.7 million in 2023 with 340 new relationships totaling $762.9 million in new assets under management.  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 increased 10% in 2023 as compared to 2022 due to growth in assets under management. 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. During 2023, the Company expanded its wealth management customer base into the Springfield, Missouri market.

Investment advisory and management fees remained stable in 2023 as compared to 2022. 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 remained stable in 2023 as compared to 2022. This was the result of core deposit growth offset by a decrease in NSF and service charge fee income. The Company continues to be successful in expanding its core deposit base.

Gains on sales of residential real estate loans, net, decreased 33% in 2023 as compared to 2022. The decrease was primarily due to decreased residential real estate purchases and the refinancing of residential real estate loans with the sharp increase in mortgage rates.

The Company has grown its capital markets revenue 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

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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 help the commercial borrowers to obtain a fixed interest rate while the Company receives a variable interest rate as well as an upfront nonrefundable fee dependent upon the pricing.

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Capital markets revenue totaled $92.1 million in 2023 as compared to $41.3 million in 2022. The increase was due to higher revenue from swap fees due to improvements in the supply chain and resetting of the debt and equity needs for the current interest rate environment. In the traditional commercial portfolio, the pricing is more competitive and the duration is shorter as compared to the LIHTC permanent loans.  Therefore, 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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Also included in capital markets revenue are gains on loan securitizations. The Company had two LIHTC securitizations that closed in the fourth quarter of 2023 which resulted in a net gain of $644 thousand.  The Company expects LIHTC securitizations to continue on as a tool to manage liquidity and to provide capacity for continued LIHTC loan production.

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Securities losses, net of gains totaled $451 thousand in 2023.  There were no securities gains or losses in 2022.  The Company sold $30 million of securities during the first quarter of 2023.  The securities sold were part of a strategy to partially deleverage the balance sheet and reduce higher cost borrowings and the related negative arbitrage.  The losses were successfully earned back within the calendar year.

Earnings on BOLI increased 104% in 2023. The increase is primarily due to income of $1.1 million on death benefit proceeds of a former executive that were received in 2023.  There were no purchases of BOLI in 2023.  There were $10.0 million of purchases of BOLI in 2022. Yields on BOLI (based on a simple average and excluding the impact of the federal income tax exemption) were 2.82% for 2023 and 1.92% for 2022. 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 14% in 2023. 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 deposit products with a higher interest rate that incentivizes debit card activity.

Correspondent banking fees increased 72% in 2023 primarily due to a shift of correspondent banking balances from non-interest bearing accounts to interest bearing accounts, in light of increasing rates.  Fees from correspondent banks generally increase when non-interest bearing account balances decrease due to lower associated earnings credits.  Correspondent banking continues to be a core strategy for the Company, as this line of business provides a high level of deposits that can be used to fund loan growth as well as a steady source of fee income.  The Company now serves 182 banks in Iowa, Illinois, Missouri and Wisconsin.

Loan related fee income increased 26% in 2023. The increase was primarily due to loan growth.

Fair value gain (loss) on derivatives decreased 164% in 2023.  The decrease was due to the rapidly rising interest rate environment and the derivatives winding down closer to maturity.  The Company uses unhedged cap instruments to manage interest rate risk related to the variability of interest payments due to changes in interest rates.  See Note 8 to the Consolidated Financial Statements for additional information.

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Other noninterest income increased 32% in 2023.  Included in other noninterest income is income on equity investments.  Income on equity investments is largely determined based on the market value of the investments.  As a result, income fluctuates with market valuations.

NONINTEREST EXPENSES

The following tables set forth the various categories of noninterest expenses for the years ended December 31, 2023 and 2022.

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Management places strong emphasis on overall cost containment and is committed to improving the Company’s general efficiency. Certain increases in these categories were due to the GFED acquisition, as there were a full year of GFED expenses reflected in the Company’s 2023 results, compared to nine months of such expenses reflected in the Company’s 2022 results.  The GFED acquisition is further described in Note 2 to the Consolidated Financial Statements.

Salaries and employee benefits, which is the largest component of noninterest expense, increased 18% in 2023 as compared to 2022. This increase was primarily related to higher variable incentive compensation for record capital markets revenue  in 2023, and to the GFED acquisition.

Occupancy and equipment expense increased 14% in 2023 as compared to 2022. This increase was due to higher depreciation expense and computer hardware expense, including with respect to the GFED acquisition.

Professional and data processing fees remained stable as compared to 2022. 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.

There were no acquisition costs in 2023.  Acquisition costs totaled $3.7 million in 2022.  These costs were comprised of primarily legal, accounting and other professional fees related to the GFED acquisition.

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Post-acquisition compensation, transition and integration costs totaled $207 thousand in 2023 and $5.5 million in 2022.  These costs were comprised primarily of personnel costs, IT integration, and conversion costs related to the acquisition of GFED in 2022.

FDIC insurance, other insurance and regulatory fee expense increased 23% in 2023.  The increase in expense was due to an increase in the asset size of the Company and an increase in announced FDIC rates for 2023, which increased the Company’s insurance rates and expenses.

Loan/lease expense increased 57% in 2023 as compared to 2022. Generally, loan/lease expense has a direct relationship with the level of NPLs; however, it may deviate depending upon the individual NPLs.  NPLs have increased 274% since December 31, 2022 driven by three client relationships from unrelated industries.

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 $26 thousand for 2023 as compared to $40 thousand for 2022.

Advertising and marketing expense increased 22% in 2023 as compared to 2022. The increase in expense was primarily due to increased marketing of our deposit products as well as the GFED acquisition, in which 2023 had twelve months of expenses compared to nine months of expenses in 2022.

Communication and data connectivity expense decreased 7% in 2023 as compared to 2022. The decrease is primarily due to improvements to our data center connectivity channels and a reduction in cell phone and air card expenses as the Company continues to improve operational efficiencies.

Supplies expense increased 13% in 2023 as compared to 2022. The increase is primarily due to inflationary factors and 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 14% in 2023 as compared to 2022.   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 15% in 2023 as compared to 2022. 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 3% in 2023 as compared to 2022. The increase is due to the GFED acquisition. These expenses will naturally decrease as intangibles become fully amortized unless there is an addition to intangible assets.

Payment card processing expense increased 35% in 2023 as compared to 2022. The increase is due to the GFED acquisition.

Trust expense increased 80% in 2023 as compared to 2022. The increase was due to new relationships added in 2023 with the addition of  $762.9 million of new assets under management as well as costs for a conversion to a new core operating system and start-up expenses in Springfield market.

Other noninterest expense decreased 2% in 2023 as compared to 2022.  The decrease was due primarily to lower excise tax on lower stock repurchases in 2023.  Also included in other noninterest expense are other items such as meals and entertainment, subscriptions, sales and use tax and expenses related to wealth management.

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INCOME TAX EXPENSE

The provision for income taxes was $13.1 million for 2023, or an effective tax rate of 10.3%, compared to $14.5 million for 2022, or an effective tax rate of 12.7%.  Refer to the reconciliation of the expected income tax rate to the effective tax rate that is included in Note 15 to the Consolidated Financial Statements for additional details.

FINANCIAL CONDITION AS OF DECEMBER 31, 2023 AND 2022

OVERVIEW

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

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In 2023, total assets increased $590.1 million, or 7%. The Company’s securities portfolio increased $77.4 million, or 8%, during 2023.  The Company’s net loan/lease portfolio increased $405.1 million, or 7%, during 2023. Deposits grew $529.8 million, or 9%, during 2023. Borrowings decreased $107.6 million, or 13%, during 2023 due primarily to an increase in core deposits which allowed borrowings to mature.

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 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.

Trading securities had a fair value of $22.4 million as of December 31, 2023 and consisted of retained beneficial interests acquired in conjunction with the loan securitizations completed by the Company in 2023.

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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, 2023 and 2022.

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Due to continued increases in intermediate and long-term interest rates during 2023, which directly impact the fair value of the Company’s AFS portfolio, the AFS portfolio declined $41.3 million, or 12.1%, from December 31, 2022 to December 31, 2023.

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:

* Amortized cost above excludes ACL of $203 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.

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

LOANS/LEASES

During 2023, total loans/leases grew 6.6% or 10.9% when excluding the $264.7 million in loan securitizations completed in the fourth quarter. 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.  Additionally, the Company reviews CRE concentrations by industry in relation to risk-based capital on a quarterly basis. Approximately 39% of the CRE portfolio are LIHTC loans of which all are performing and all are pass rated.

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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 also holds 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.

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The following tables set forth the remaining maturities by loan/lease type as of December 31, 2023 and 2022. 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.

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Changes in the ACL for loans/leases for the years ended December 31, 2023, 2022 and 2021 are presented as follows:

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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, 2023, 2022 and 2021:

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The ACL for OBS exposures totaled $9.1 million at the adoption of CECL on January 1, 2021.  The Company recorded $4.0 million of provision for credit losses related to OBS exposures in 2023. Negative provisions in 2021 and 2022 were due to increased line of credit usage resulting in lower OBS exposure. The increase in provision in 2023 was

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driven by an increase in unfunded commitments in the LIHTC lending business during the year. At December 31, 2023, the allowance for OBS exposures was $9.5 million.

The following is a table that reports the criticized and classified loan totals as of December 31, 2023 and 2022.

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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 17% and classified loans increased 2% in 2023 as compared to 2022 due to the downgrade of five large relationships that are still performing. 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, 2023 and 2022.

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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 $992 thousand and $970 thousand as of December 31, 2023 and 2022, respectively. Leases represent 1% of to total loans/leases.

Although management believes that the ACL for loans/leases at December 31, 2023 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

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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, 2023 were $34.2 million, up $25.3 million from December 31, 2022.  The increase from prior year was driven by three client relationships from unrelated industries. The ratio of NPAs to total assets was 0.40% at December 31, 2023, up from 0.11% at December 31, 2022.

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.

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.

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DEPOSITS

Deposits grew $529.8 million, or 8.9%, during 2023, primarily due to an increase in interest-bearing deposits.  The table below presents the composition of the Company’s deposit portfolio.

The Company actively participates in the ICS/CDARS program, which is a trusted resource that provides FDIC insurance coverage for clients of the Company that maintain larger deposit balances.  Deposits in the ICS/CDARS program (which are included in interest bearing demand deposits and time deposits in the preceding table) totaled $2.1 billion, or 31.8% of all deposits, as of December 31, 2023.

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

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The Company had total uninsured deposits of $1.8 billion and $1.9 billion as of December 31, 2023 and 2022 respectively. The table below represents the time deposits in FDIC uninsured accounts by maturity:

There were no other time deposits otherwise uninsured. The Company had no deposits by foreign depositors in domestic offices as of December 31, 2023 and 2022.

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.

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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 10 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.